Currency Exchange Rates Flashcards
1 Euro = 1.30 USD
which is the base and price
euro is price
usd is base
price = base
USD/EUR = 1.3 means what
price/base = “P/B”
1 Euro = 1.3 USD
USD/EUR = 1.3 then USD/EUR = 1.4 means what
- 1 euro now gets 1.4 USD
- the euro appreciated relative to USD
Nominal exchange rate is
AKA the spot rate “S”
- the quoted currency exchange rate at any point in time
The spot rate, aka
aka the nominal exchange rate
“S”
The real exchange rate …
- adjusts the spot rate (nominal rt) for inflation in each country compared to a base period
- shows the relative purchasing power of currencies
characteristics
- directly related to nominal exchange rate
- directly related to price level in base currency
- inversely related to price level of price currency
Real exchange rate formula
and characteristics
Rp/b = Sp/b * (Pb / Pp)
characteristics
- directly related to nominal exchange rate
- directly related to price level in base currency
- inversely related to price level of price currency
Spot transaction
- currencies exchanged for immediate delivery
- most trades are settled “T+2” after the traded is agreed
Consider AUD/HKD. If the spot rate increases by 5%, HKD increases by 5%, and AUD increases by 2%, what is the change in purchasing power?
Rp/b (aka purchasing power) = Sp/b * (Pb / Pp)
so, Raud/hkd = Saud/hkd * (hdk / aud)
R = 1+5% * (1+5% / 1+2%)
= 1.05 * (1.05/1.02)
= 8.08%
CFA shortcut:
5% + 5% - 2% = 8%
In the FX market, which instrument has the highest usage?
- swaps have the highest volume
- followed by the spot market
Direct quote
- domestic currency is the Price currency and the foreign currency is the Base currency
- a lower FX rt implies the value of the domestic currency is higher
ie a smaller amount of domestic currency is needed to exchange for 1 unit of foreign currency
Indirect quote
- domestic currency as the base currency and the foreign currency as the price currency
Direct and indirect quotes are
- are the reciprocal of each other
USD/EUR = 1.4 as a direct quote
EUR/USD = .7142 as an indirect quote (1/1.4 = .7142)
If the USD/EUR goes up from 1.4 to 1.5, which currency appreciated, how much did it appreciate by, and how much did the other depreciate by?
- the EUR is the base currency so 1 EUR = 1.4 USD then 1.5 USD. So, the EUR appreciated
- 1.5 - 1.4 / 1.4 x 100 = 7.142% appreciation
**USD did not depreciate by 7.142%!!
- must first convert USD/EUR to an indirect quote
= 1 / 1.4 = EUR/USD= .7143
and 1 / 1.5 = EUR/USD = .6667
so USD depreciated:
- .6667 - .7143 / .7143 x 100 = -6.67%
A shortcut to find currency depreciation =
= the inverse of the appreciation currency
= (( 1 / 1 + appreciation %) - 1 ) * 100
If the BID/ASK from a dealer was 12.4020 - 12.4060 MXN/USD what is the bid/offer in terms of USD/MXN?
MXN/USD: Bid Ask
12.4020 - 12.4060
USD/MXN: 1/12.4060 - 1/12.4020
USD/MXN = 0.08061 - 0.08063 bid/ask
If the USD/EUR spot is 1.2875 and the 12-month forward is -26.5 points, what is the 12-month forward rate?
Forward rt = 1.2875 + ( -26.5 / 10,000)
= 1.28485
- divide by 10,000 if exchange rate uses four decimal places
- divide by 100 if the exchange rate uses two decimal places
The forward rate equation based on the spot rate and int rates in the two different countries =
Fp/b = Sp/b * (( 1 + ip) / ( 1 + ib))
Fp/b = Sp/b * (( 1 + ( ip * x / 360)) / ( 1 + ( ib * x / 360))
ip is the risk-free rate of the price currency
ib is the risk-free rate of the base currency
The currency with the higher interest rate will always trade at …
- will always trade at a discount in the forward market
Finding fx cross rates:
- given two exchange rates and three currencies, it is possible to determine the third exchange rate
- set the unknow currency = to the rate 1 * rate 2 and use alg to solve.
- might need to use the inverse of one rate in order to eliminate like terms
If a country has a trade deficit, it imports more G/S than it exports. This deficit must be financed by …
- by borrowing from foreigners or by selling assets to foreigners.
- a trade deficit must be exactly matched by an offsetting capital account surplus
- a trade deficit means a country’s investment spending is more than its domestic savings
X-M = S-I + T-G
If demand of a currency increases, then ….
- the fx rate increases
- capital flows are the primary determinant of exchange rt movements in the short-to-intermediate term
Marshall-Lerner condition:
- the combinations of exports and demand elasticities that cause depreciation of the domestic currency will move the trade balance toward surplus
- and domestic currency appreciation will move trade balance toward deficit
- the impact of currency appreciation or depreciation on trade balance depends on the elasticities of demand for imports and exports
Marshall-Lerner condition formula and meaning
= (wX * eX) + (wM * (eM - 1))
- if > 0, then a depreciation in the domestic currency will more the trade balance towards surplus
A Marshall-Lerner of 0.04 means that …
- a 1% decrease in the value of the domestic currency will improve the trade balance by 0.04%
- so a 10% decrease leads to a .4% improvement
The Absorption Approach and formula
- focuses on the impact of exchange rate changes on capital flows
- as a trade deficit must be offset by a surplus in the capital account (KA)
(X - M) = (S - I) + (T - G)
(X - M) = (S - I) - (G - T)
(X - M) = (S + T) - (I + G)
Balance of trade = national income - total expenditure
*total expenditure represents the absorption of G/S in an economy
For a currency exchange rate change to improve trade balance, national income must increase relative to expenditure.
ie domestic savings (S) must increase relative to domestic investment (I)
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