(20) Currency Exchange Rates Flashcards
LOS 20. a: Define exchange rate and distinguish between nominal and real exchange rates and spot and forward exchange rates.
Currency exchange rates are given as the price of one unit of currency in terms of another.
A nominal exchange rate of 1.44 USD/EUR is interpreted as $1.44 per euro.
We refer to the USD as the price currency and the EUR as the base currency.
A decrease (increase) in a direct exchange rate represents an appreciation (depreciation) of the domestic currency relative to the foreign currency.
A spot exchange rate is the rate for immediate delivery. A forward exchange rate is a rate for exchange of currencies at some future date.
A real exchange rate measures changes in relative purchasing power over time.
Real exchange rate(domestic/foreign) = spot exchange rate(domestic/foreign) x (CPIforeign/CPIdomestic)
Exchange rate
What is an ‘Exchange Rate’
An exchange rate is the price of a nation’s currency in terms of another currency. Thus, an exchange rate has two components, the domestic currency and a foreign currency, and can be quoted either directly or indirectly. In a direct quotation, the price of a unit of foreign currency is expressed in terms of the domestic currency. In an indirect quotation, the price of a unit of domestic currency is expressed in terms of the foreign currency. Exchange rates are quoted in values against the US dollar. However, exchange rates can also be quoted against another nations currency, which are known as a cross currency, or cross rate.
BREAKING DOWN ‘Exchange Rate’
An exchange rate has a base currency and a counter currency. In a direct quotation, the foreign currency is the base currency and the domestic currency is the counter currency. In an indirect quotation, the domestic currency is the base currency and the foreign currency is the counter currency. Most exchange rates use the US dollar as the base currency and other currencies as the counter currency. However, there are a few exceptions to this rule, such as the euro and Commonwealth currencies like the British pound, Australian dollar and New Zealand dollar.
Exchange rates for most major currencies are generally expressed to four places after the decimal, except for currency quotations involving the Japanese yen, which are quoted to two places after the decimal.
Furthermore, exchange rates can also be categorized as the spot rate – which is the current rate – or a forward rate, which is the spot rate adjusted for interest rate differentials.
Let’s consider some examples of exchange rates to enhance understanding of these concepts:
- US$1 = C$1.1050. Here the base currency is the US dollar and the counter currency is the Canadian dollar. In Canada, this exchange rate would comprise a direct quotation of the Canadian dollar. This is easy to understand intuitively, since prices of goods and services in Canada are expressed in Canadian dollars; therefore the price of a US dollar in Canadian dollars is an example of a direct quotation for a Canadian resident.
- C$1 = US$ 0.9050 = 90.50 US cents. Here, since the base currency is the Canadian dollar and the counter currency is the US dollar, this would be an indirect quotation of the Canadian dollar in Canada.
- If US$1 = JPY 105, and US$1 = C$1.1050, it follows that C$1.1050 = JPY 105, or C$1 = JPY 95.02. For an investor based in Europe, the Canadian dollar to yen exchange rate constitutes a cross currency rate, since neither currency is the domestic currency.
Base currency
What is a ‘Base Currency’
In the forex market, currency units are quoted as currency pairs. The base currency – also called the transaction currency - is the first currency appearing in a currency pair quotation, followed by the second part of the quotation, called the quote currency or the counter currency. For accounting purposes, a firm may use the base currency as the domestic currency or accounting currency to represent all profits and losses.
BREAKING DOWN ‘Base Currency’
In forex, the base currency represents how much of the quote currency is needed for you to get one unit of the base currency. For example, if you were looking at the CAD/USD currency pair, the Canadian dollar would be the base currency and the U.S. dollar would be the quote currency.
The abbreviations used for currencies are prescribed by the International Organization for Standardization (ISO). These codes are provided in standard ISO 4217. Currency pairs use these codes made of three letters to represent a particular currency. Currencies constituting a currency pair are sometimes separated with a slash character. The slash may be omitted or replaced by a period, a dash or nothing.
The major currency codes include USD for the U.S. dollar, EUR for the euro, JPY for the Japanese yen, GBP for the British pound, AUD for the Australian dollar, CAD for the Canadian dollar and CHF for the Swiss franc.
Nominal effective exchange rate
What is a ‘Nominal Effective Exchange Rate - NEER’
The nominal effective exchange rate (NEER) is an unadjusted weighted average rate at which one country’s currency exchanges for a basket of multiple foreign currencies. In economics, the NEER is an indicator of a country’s international competitiveness in terms of the foreign exchange (forex) market. Forex traders sometimes refer to the NEER as the trade-weighted currency index.
BREAKING DOWN ‘Nominal Effective Exchange Rate - NEER’
The NEER may be adjusted to compensate for the inflation rate of the home country relative to the inflation rate of its trading partners. The resulting figure is the real effective exchange rate (REER).
Unlike the relationships in a nominal exchange rate, NEER is not determined for each currency separately. Instead, one individual number, typically an index, expresses how a domestic currency’s value compares against multiple foreign currencies at once.
If a domestic currency increases against a basket of other currencies inside a floating exchange rate regime, NEER is said to appreciate. If the domestic currency falls against the basket, the NEER depreciates.
Real effective exchange rate
What is the ‘Real Effective Exchange Rate - REER’
The real effective exchange rate (REER) is the weighted average of a country’s currency relative to an index or basket of other major currencies, adjusted for the effects of inflation. The weights are determined by comparing the relative trade balance of a country’s currency against each country within the index. This exchange rate is used to determine an individual country’s currency value relative to the other major currencies in the index, such as the U.S. dollar, Japanese yen and the euro.
BREAKING DOWN ‘Real Effective Exchange Rate - REER’
The REER is used to measure the value of a specific currency in relation to an average group of major currencies. The REER takes into account any changes in relative prices and shows what can actually be purchased with a currency. This means that the REER is normally trade-weighted.
The REER is derived by taking a country’s nominal effective exchange rate (NEER) and adjusting it to include price indices and other trends. The REER, then, is essentially a country’s NEER after removing price inflation or labor cost inflation. The REER represents the value that an individual consumer pays for an imported good at the consumer level. This rate includes any tariffs and transaction costs associated with importing the good.
A country’s REER can also be derived by taking the average of the bilateral real exchange rates (RER) between itself and its trading partners and then weight it using the trade allocation of each partner. Regardless of the way in which REER is calculated, it is an average and considered in equilibrium when it is overvalued in relation to one trading partner and undervalued in relation to a second partner.
Spot exchange rate
What is a ‘Spot Exchange Rate’
A spot exchange rate is the price to exchange one currency for another for immediate delivery. The spot rates represent the prices buyers pay in one currency to purchase a second currency. Although the spot exchange rate is for delivery on the earliest value date, the standard settlement date for most spot transactions is two business days after the transaction date.
BREAKING DOWN ‘Spot Exchange Rate’
The spot exchange rate is the price paid to sell one currency for another for delivery on the earliest possible value date.
Forward exchange rate
The forward exchange rate (also referred to as forward rate or forward price) is the exchange rate at which a bank agrees to exchange one currency for another at a future date when it enters into a forward contract with an investor. Multinational corporations, banks, and other financial institutions enter into forward contracts to take advantage of the forward rate for hedging purposes. The forward exchange rate is determined by a parity relationship among the spot exchange rate and differences in interest rates between two countries, which reflects an economic equilibrium in the foreign exchange market under which arbitrage opportunities are eliminated. When in equilibrium, and when interest rates vary across two countries, the parity condition implies that the forward rate includes a premium or discount reflecting the interest rate differential. Forward exchange rates have important theoretical implications for forecasting future spot exchange rates. Financial economists have put forth a hypothesis that the forward rate accurately predicts the future spot rate, for which empirical evidence is mixed.
LOS 20. b: Describe functions of and participants in the foreign exchange market.
The market for foreign exchange is the largest financial market in terms of the value of daily transactions and has a variety of participants, including large multinational banks (the sell side) and corporations, investment fund managers, hedge fund managers, investors, governments, and central banks (the buy side).
Participants in the foreign exchange markets are referred to as hedgers if they enter into transactions that decrease an existing foreign exchange risk and as speculators if they enter into transactions that increase their foreign exchange risk.
Forward currency contract
What is a ‘Currency Forward’
A binding contract in the foreign exchange market that locks in the exchange rate for the purchase or sale of a currency on a future date. A currency forward is essentially a hedging tool that does not involve any upfront payment. The other major benefit of a currency forward is that it can be tailored to a particular amount and delivery period, unlike standardized currency futures. Currency forward settlement can either be on a cash or a delivery basis, provided that the option is mutually acceptable and has been specified beforehand in the contract. Currency forwards are over-the-counter (OTC) instruments, as they do not trade on a centralized exchange. Also known as an “outright forward.”
BREAKING DOWN ‘Currency Forward’
Unlike other hedging mechanisms such as currency futures and options contracts – which require an upfront payment for margin requirements and premium payments, respectively – currency forwards typically do not require an upfront payment when used by large corporations and banks. However, a currency forward has little flexibility and represents a binding obligation, which means that the contract buyer or seller cannot walk away if the “locked in” rate eventually proves to be adverse. Therefore, to compensate for the risk of non-delivery or non-settlement, financial institutions that deal in currency forwards may require a deposit from retail investors or smaller firms with whom they do not have a business relationship.
The mechanism for determining a currency forward rate is straightforward, and depends on interest rate differentials for the currency pair (assuming both currencies are freely traded on the forex market). For example, assume a current spot rate for the Canadian dollar of US$1 = C$1.0500, a one-year interest rate for Canadian dollars of 3%, and one-year interest rate for US dollars of 1.5%.
After one year, based on interest rate parity, US$1 plus interest at 1.5% would be equivalent to C$1.0500 plus interest at 3%.
Or, US$1 (1 + 0.015) = C$1.0500 x (1 + 0.03).
So US$1.015 = C$1.0815, or US$1 = C$1.0655.
The one-year forward rate in this instance is thus US$ = C$1.0655. Note that because the Canadian dollar has a higher interest rate than the US dollar, it trades at a forward discount to the greenback. As well, the actual spot rate of the Canadian dollar one year from now has no correlation on the one-year forward rate at present. The currency forward rate is merely based on interest rate differentials, and does not incorporate investors’ expectations of where the actual exchange rate may be in the future.
How does a currency forward work as a hedging mechanism? Assume a Canadian export company is selling US$1 million worth of goods to a U.S. company and expects to receive the export proceeds a year from now. The exporter is concerned that the Canadian dollar may have strengthened from its current rate (of 1.0500) a year from now, which means that it would receive fewer Canadian dollars per US dollar. The Canadian exporter therefore enters into a forward contract to sell $1 million a year from now at the forward rate of US$1 = C$1.0655.
If a year from now, the spot rate is US$1 = C$1.0300 – which means that the C$ has appreciated as the exporter had anticipated – by locking in the forward rate, the exporter has benefited to the tune of C$35,500 (by selling the US$1 million at C$1.0655, rather than at the spot rate of C$1.0300). On the other hand, if the spot rate a year from now is C$1.0800 (i.e. the C$ weakened contrary to the exporter’s expectations), the exporter has a notional loss of C$14,500.
Hedging
What is a ‘Hedge’
A hedge is an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract.
BREAKING DOWN ‘Hedge’
Hedging is analogous to taking out an insurance policy. If you own a home in a flood-prone area, you will want to protect that asset from the risk of flooding – to hedge it, in other words – by taking out flood insurance. There is a risk-reward tradeoff inherent in hedging; while it reduces potential risk, it also chips away at potential gains. Put simply, hedging isn’t free. In the case of the flood insurance policy, the monthly payments add up, and if the flood never comes, the policy holder receives no payout. Still, most people would choose to take that predictable, circumscribed loss rather than suddenly lose the roof over their head.
A perfect hedge is one that eliminates all risk in a position or portfolio. In other words, the hedge is 100% inversely correlated to the vulnerable asset. This is more an ideal than a reality on the ground, and even the hypothetical perfect hedge is not without cost. Basis risk refers to the risk that an asset and a hedge will not move in opposite directions as expected; “basis” refers to the discrepancy.
Speculation
What is ‘Speculation’
Speculation is the act of trading in an asset or conducting a financial transaction that has a significant risk of losing most or all of the initial outlay with the expectation of a substantial gain. With speculation, the risk of loss is more than offset by the possibility of a huge gain, otherwise there would be very little motivation to speculate. It may sometimes be difficult to distinguish between speculation and investment, and whether an activity qualifies as speculative or investing can depend on a number of factors, including the nature of the asset, the expected duration of the holding period, and the amount of leverage.
BREAKING DOWN ‘Speculation’
Real estate is an area where the line between investment and speculation blurs. Buying property with the intention of renting it out would qualify as investing, but buying multiple condominiums with minimal down payments for the purpose of reselling them quickly at a profit would undoubtedly be regarded as speculation. Speculators can provide market liquidity and narrow the bid-ask spread, enabling producers to hedge price risk efficiently Speculative short-selling may also keep rampant bullishness in check and prevent the formation of asset price bubbles.
Mutual funds and hedge funds often engage in speculation in the foreign exchange, bond and stock markets.
Sell side
What does ‘Sell Side’ mean
Sell side refers to the part of the financial industry that is involved in the creation, promotion and sale of stocks, bonds, foreign exchange and other financial instruments. Sell-side individuals and firms work to create and service products that are made available to the buy side of the financial industry. The sell side of Wall Street includes investment bankers who serve as intermediaries between issuers of securities and the investing public, and the market makers who provide liquidity in the market.
BREAKING DOWN ‘Sell Side’
The sell side and buy side of Wall Street are dependent upon each other - one could not operate without the other. The sell side tries to get the highest price possible for each financial instrument while providing insight and analysis. Any individual or firm that purchases stock with the objective of selling it later at a profit is from the buy side. The buy side players include money managers at hedge funds, institutional firms, mutual fundsand pension funds. Despite the fact the individual investors are technically on the buy side, the term is usually reserved for professional money managers.
The market makers are the driving force on the sell side of the financial market.
Buy side
What does ‘Buy Side’ mean
Buy side is the side of Wall Street made up of investing institutions such as mutual funds, pension funds and insurance firms that tend to buy large portions of securities for money-management purposes. The buy side is the opposite of the sell side, which provides the public with recommendations for upgrades, downgrades, target prices and other opinions on the public market. Together, the buy side and sell side make up both sides of Wall Street.
BREAKING DOWN ‘Buy Side’
Specifically, buy-side firms are companies that purchase securities and other assets for their own needs or the needs of their clients. In addition to the institutions listed above, other buy-side firms include private equity funds, hedge funds, trusts and other proprietary traders.
For example, a buy-side analyst typically works in a nonbrokerage firm, such as a mutual fund or pension fund, and provides research and recommendations exclusively for the benefit of the company’s own money managers as opposed to individual investors. Unlike sell-side recommendations, which are meant for the public, buy-side recommendations are not available to anyone outside the firm. In fact, if the buy-side analyst discovers a formula, vision or approach that works, it is kept secret.
Corporations
What is a ‘Corporation’
A corporation is a legal entity that is separate and distinct from its owners. Corporations enjoy most of the rights and responsibilities that an individual possesses; that is, a corporation has the right to enter into contracts, loan and borrow money, sue and be sued, hire employees, own assets and pay taxes. It is often referred to as a “legal person.”
BREAKING DOWN ‘Corporation’
Corporations are used throughout the world to operate all kinds of businesses. While its exact legal status varies somewhat from jurisdiction to jurisdiction, the most important aspect of a corporation is limited liability. This means that shareholders have the right to participate in the profits, through dividends and/or the appreciation of stock, but are not held personally liable for the company’s debts.
Almost all well-known businesses are corporations, including Microsoft Corporation, The Coca-Cola Company and Toyota Motor Corporation. Some corporations do business under their names and also under business names, such as Alphabet Inc., which famously does business as Google.
Leverage
What is ‘Leverage’
Leverage is the investment strategy of using borrowed money: specifically, the use of various financial instruments or borrowed capital to increase the potential return of an investment. Leverage can also refer to the amount of debt used to finance assets. When one refers to something (a company, a property or an investment) as “highly leveraged,” it means that item has more debt than equity.
The Difference Between Leverage and Margin
Although interconnected – since both involve borrowing – leverage and margin are not the same. Leverage refers to the act of taking on debt. Margin is a form of debt or borrowed money that is used to invest in other financial instruments. A margin account allows you to borrow money from a broker for a fixed interest rate to purchase securities, options or futures contracts in the anticipation of receiving substantially high returns.
In short, you can use margin to create leverage.
LOS 20. h: Calculate and interpret the forward rate consistent with the spot rate and the interest rate in each currency.
The condition that must be met so that there is no arbitrate opportunity available is:
If the spot exchange rate for the euro is 1.25 USD/EUR, the euro interest rate is 4% per year, and the dollar interest rate is 3% per year, the no-arbitrage one-year forward rate can be calculated as:
1.25 x (1.03 / 1.04) = 1.238 USD/EUR.
The J-Curve
Because import and export contracts for the delivery of goods most often require delivery and payment in the future, import and export quantities may be relatively insensitive to currency depreciation in the short run. This means that a currency depreciation may worsen a trade deficit initially. Importers adjust over a time by reducing quantities. The Marshall-Learner conditions take effect and the currency depreciation begins to improve the trade balance.
This short-term increase in the deficit followed by a decrease when the Marshall-Lerner condition is met is referred to as the J-curve and is illustrated in Figure 1.
