Currency Exchange Simplified

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Slide 1: CFA® LEVEL I_Reading 21 – Currency Exchange Rates

Slide2: Foreign Exchange Market


Let’s now discuss the basics of currency exchange rates. The normal exchange rate that we deal with on day to day to basis is the nominal exchange rate. The nominal exchange rate is actual market value of the currency. The market rate is the nominal exchange rate. The nominal exchange rate is the number of units of one currency i.e. price currency in terms of one unit of another currency (base currency). For example –USD/EUR – 1.2856 i.e. one Euro can buy 1.2856 USD. Here USD is the price currency and Euro is the base currency. Conventions of denoting exchange rate may change from one place to another. Also, the choice of which currency is the price and which is the base currency is really just a matter of perspective. The price currency is normally the domestic currency and the base currency is the foreign currency. When we say exchange rate in this lesson it means for how much of the domestic currency that one unit of foreign currency can be sold for. A decrease in the exchange rate means the price currency has appreciated against the base currency. Imported goods can be bought for less units of the local currency. However, exporters would now be less competitive because there would less units of domestic currency for same units of foreign currency.

The real exchange rate, on the other hand, manifests the relative purchasing power of two currencies. It is mostly studied by economists and analysts. It depends upon the nominal exchange rate and price level in the domestic and foreign country. The higher the real exchange rate the lower is the purchasing power of the domestic currency against foreign country. If a country has higher inflation combined with a decreasing nominal exchange rate or appreciating currency the real purchasing power of its currency would increase multifold.

The PPP or purchasing power parity model manifests that nominal exchange rates must adjust such that purchasing powers of currencies remain the same or relative purchasing power across countries should be same. This would mean nominal exchange rates must follow the real exchange rate or when we have purchasing power parity real exchange rate would be equal to nominal exchange rates. For example PPP says that if USD/EUR nominal exchange rate is 1.2856 then 1 Euro should purchase same amount of goods in Europe as the 1.2856 USD in U.S. PPP is never realized in practical world and may only exist in theory under certain assumptions.

It must be noted that currency exchange rates depend on many different variables and modeling them is very difficult let alone explain their behavior only on one aspect. There we cannot expect that PPP alone could explain currency exchange rates.

Slide 3: FX Market

The currency exchange market is where currencies can be exchanged. For example, banks and online forex exchanges are part of forex markets. Now, the first question that comes to mind is why we need  currency exchanges. Foreign exchange is required for activities like capital investment in foreign assets like MNC investing in a foreign country to establish a factory, portfolio investment in foreign assets, individual household transactions for example tourists, government transactions for example purchase and sale of bonds and also for trading of goods in foreign market.

Corporations tend to engage in forward contracts in order fix their exchange rates and thus reduce  exchange rate risks. This is called hedging. Speculative trading is just pure trading of currencies in order to earn profits from their fluctuations. Traders use highly complex algorithms to predict movements of currencies and make frequent trades.

Spot purchase or sale of currency is at spot rates or nominal exchange rates at the time of trade. A spot contract in online trades normally takes T+2 days to deliver i.e. trading plus two working days.

On the other hand, forward contracts are contracts made to sell or purchase a currency at a future date at a fixed currency exchange rate. For example an agreement to exchange 100 million USD with Euro after 90 Days at USD/Eur 1.2845 or in other words agreement to sell 100 million USD after 90 days at exchange rate of USD/Eur 1.2845.

Slide 4: FX Swaps

Let’s now understand FX Swaps, which are the combination of spot and forward contracts. Swap means swapping of older forward contract with a newer forward contract. A FX swap is a creation of a new similar forward contract at every expiration date of the forward contract. The cost of a FX Swap is the difference between current spot price and forward contract fixed exchange rate.

The slide demonstrates the process of a FX swap with the help of an example. The steps involved are to create a forward contract as per the requirement then at expiration date buy the currency from the open market that you committed to sell in the contract. In our example this currency is USD. Deliver the currency and close the contract. Now the purchase price may be higher or lower than the fixed contract exchange rate. Hence you may earn or you may have to pay depending upon the spot price. In our case USD has appreciated against Euro and hence the company has to pay more Euro than it would get by selling USD as per the fixed contract. This is the cost of the swap. Had the USD depreciated, the company would have earned the difference. Now after closing of the contract just create a new forward contract. Hence the net effect is just the payment or receipt of the difference and the swapping of the contract with a new contract.

Slide 5: Market Participants

Let’s now understand some more important points about exchange rates. A direct exchange rate is when the domestic currency is the price currency and the base currency is the foreign currency where indirect exchange is just the opposite. For an American citizen the direct exchange rate is how much USD is required to buy 1 Euro. The indirect exchange rate is how much Euro he can buy with 1 USD. For a person based in Europe, the direct and indirect exchange rates would be just opposite to that of person based in U.S.

Cross rates are used for calculation of currency exchange rates between currencies by using  other exchange rates. Most of the time, currencies are converted into frequently traded currencies and then converted into the other currency. For example, we can use the Euro-USD exchange rate and the USD-yen exchange rate to calculate the Euro-yen exchange rate. Normally a trader would quote a direct rate by using cross rates. In world markets you would barely find any discrepancy between cross rates and market rates exchange. Market participants are frequently in search of such discrepancies in order to exploit them and hence if any discrepancy does appear it fades away immediately.

The percentage change calculation is just the calculation of exchange rate changes in terms of percentages. This gives the appreciation or depreciation of a currency against another currency. Negative value means the price currency has appreciated. The Euro-USD exchange rate change percentage would be different from USD-Euro exchange rate change  percentage; that is, appreciation of one currency in percentage terms would not equal the depreciation of the other currency in percentage terms.

When traders quote the rate they do it in terms of a bid-offer spread. Traders buy and sell the base currency. For example, in the Euro-USD exchange rate they would buy Euro at the lower rate and sell Euro at higher rate and thus make a profit.

Market participants include both the buy side and the sell side. The sell side creates products like forward contracts, currency exchange, international traveler’s checks, international credit cards, and forex transfers for the buy side. The buy side includes corporate accounts who wish to make international trade or investment, real money accounts like insurance companies or wealth funds, leveraged accounts like speculative trading of traders and individuals, retail accounts like tourist purchasing local currency or no-resident citizen converting his foreign income, governments or central banks purchasing or selling currencies either for monetary policy implementation or for borrowing money from outside the country, and Sovereign Wealth Funds investing government surplus in foreign assets. The sell side includes large multinational banks that can easily provide forex services and small local banks who tie up with large multinational banks to provide their clients such services.

Slide 6: Forward Rate Contract Calculations

Fixed exchange rates of forward contracts are forward contract rates. These rates may be at a premium or discount from spot rates.

Forward contract rates are normally quoted in terms of points or pips. A point is the difference between the forward contract rate and the spot rate. Hence, given the number of points of the forward contract just add it up in the spot rates to calculate the forward rate. In our example suppose we were given that forward rate is 4 points premium. Hence in order to calculate forward contract rate just add 4 points i.e. in our case 4 divided 1000 plus spot rate.  As illustrated in slide forward rate can also be calculated in percentage terms.

The forward rate is at a premium when the forward rate is higher than the spot rate. It means the currency is depreciating at a fixed rate. A forward discount means the forward exchange rate is less than the spot rate.
Now how are forward rates calculated? A forward rate is such that a person would earn the same amount of risk-free return by investing in either foreign country or domestic country or else traders can earn higher risk-free return by exploiting forward contracts. To understand how this rate is calculated let us first understand how we can invest in another countries risk-free asset without any exchange rate risk. The first step is to convert the domestic currency in foreign currency at the spot rate. Then invest the foreign currency at the foreign risk-free rate. Now suppose investment is for one period then make the forward currency contract for that period and for revenue that you are going to receive at fixed risk free rate. Now you have no exchange rate risk. After the period your revenue would be investment plus interest income i.e. investment into one plus interest rate. Now when income has been received convert it into domestic currency. Now in order that domestic risk-free income and foreign risk-free income are the same we equate the two. Domestic income per unit of currency is equal to one plus the risk-free interest rate. Now this equation derives the forward contract rate. This is the currency arbitrage equation and can be rearranged as per our requirement.  The generalized equation for investment for ‘t’ time period is also given in the slide.

Slide 7: Exchange Rate Regimes

Let’s now discuss   exchange rate regimes. Not all countries have freely floating currencies.

Let us first discuss what could be the ideal currency regime. It is a regime with a fixed credible currency exchange rate and all currencies are fully convertible. Apart from that, the country is able to undertake independent monetary policy. Now these statements are self-contradictory. If we have a fully convertible and almost stable exchange rate it would be a sort of single currency around the world and hence any effort to affect prices, income and interest rates by increasing and decreasing money supply would be futile. Hence there could be no ideal currency regimes. Some countries have made arrangements with no legal tender of their own. They use the currency of another nation or use the tender of their monetary union. For example many governments use the U.S. dollar as the currency in their country. It gives them the stability of the US dollar.  Eurozone countries use the Euro. However, no independent monetary policy can be followed as central banks cannot increase or decrease the supply of dollars.

Currency board system regimes have an explicit legislative commitment to exchange the domestic currency for a specified currency like the dollar at a fixed exchange rate. In this case, central banks do have a legal tender but the domestic currency is only issued against a foreign currency. In order to follow the legislative commitment to exchange domestic currency for specified currency, the domestic currency is fully backed by foreign currency. An example is Hong Kong. Again in this case no independent monetary policy can be followed as central banks cannot freely print money. However, short term lending by central banks is possible.

A fixed parity regime is where a government follows a fixed exchange rate for a specific currency like the dollar. However fixed parity is without any legislative commitment and also the domestic currency is not fully backed by foreign currency. The central bank in this case can at any time refuse to exchange at the fixed exchange rate. Hence the government tries to manage the exchange rate in a small band. However once  traders believe that currency cannot be fully convertible at the specified exchange rate and government does not have enough foreign exchange reserves to support the rates it may become a self-fulfilling prophecy.

A target zone is similar to fixed parity except that the band is larger.

A passive crawling peg is a frequent adjustment to exchange rates against the pegged currency to maintain reserves as well as to implement monetary policy. An active Crawl follows pre announced changes in the exchange rate. Fixed parity with crawling bands is a regime which starts with fixed parity and slowly start increasing band of free movements. Once a central bank finds that the economy is big enough to maintain exchange rate price stability it would start increasing the band and eventually move to a freely floating currency. Under mixed float, the market determines the prices i.e. demand and supply of currency and international trades determines the exchange rate. However there are frequent interventions by the government or central bank to maintain stability and to implement internal policy.

Independently floating rates are free floating and such regimes have completely market determined prices without any interventions by governments and central banks.

Slide 8: Exchange Rate and Trade balance

Let us try to understand the impact of exchange rates on trade balance. In the previous slide we have studied that depreciation of domestic currency means exports should increase and imports should decrease and trade balance would improve. However it’s not as simple as that. There are other factors also involved.

We have studied in the previous lesson, as the equations manifest, that a trade deficit can only be financed by foreign borrowings or sale of domestic assets. If we have net imports it means we are consuming more than we are producing and hence income is less than consumption.  A trade deficit means private sector savings are not able to fulfill investment demand and the government deficit. If we look at the first equation, trade balance X-M is funded by savings from private sector, S-I, and net government savings, T-G. Hence if X-M is negative it means either government deficit is too big or investments are too big or savings are too small. Hence in order for the trade balance to be in surplus either savings has to increase i.e. domestic consumption has to go down or income has to increase without any increase such that savings increase. As studied in the previous lesson the balance of payments manifests that the current account must balance the capital account and the financial account i.e. trade flow must be balanced by equal capital flow. Asset prices and exchange rates adjust to balance capital flow with trade flow. In the case of free float if the capital start going out of the country exchange rates would immediately adjust and depreciate such that either taking money out the country is not profitable or traders would feel that there is no more depreciation possible. With the flight of capital from the country asset prices would decrease and hence they would become cheaper i.e. as investors start selling to bonds yields on bonds would raise or interest rates would increase. Therefore capital must again start flowing back.

Slide 9: Impact of Exchange rate on Trade Balance

Let’s understand how much the exchange rate can affect the trade balance. The impact can be explained using two approaches, namely, the elasticity approach and the absorption approach.

We’ll first study the elasticity approach. We  learned in lesson 14 that in elastic region i.e. elasticity greater than 1 increase in prices decreases expenditure and in inelastic region i.e. elasticity less than increase in prices means more expenditure. The graphs from lesson 14 have been produced for ready reference. We also know that expenditure is equal to Price into Quantity. Now from that we can define that percentage change in expenditure is equal to percentage change in price plus percentage change in quantity. From this equation we derive that percentage change in expenditure is equal to one plus elasticity multiplied by percentage change in price. Now depreciation would lead to an increase in trade surplus or decrease in trade deficit if import demand is elastic. As depreciation would increase the price of the good and if demand is inelastic it would rather lead to increase in total import expenditure. Export expenditure would increase even when elasticity is very low because domestic price is same and increase is only in foreign demand at the same price. This can be explained in terms of Marshall-Lerner equation. If Marshall- Lerner equation is satisfied depreciation would lead to increase in trade surplus or decrease in trade deficit.

Absorption is the difference between domestic income ‘Y’ and domestic consumption (C+I+G). Depreciation increases the price of imports and makes domestic firms more competitive. Hence, if the economy is at full employment or at potential GDP, depreciation would not lead to an increase in exports because domestic firms cannot increase their supply. Hence, if there is no excess capacity, as imports become expensive domestic firms would just increase their prices as demand for their goods increase. After some time price of domestic good would match imported goods and net effect on trade balance would be zero. Hence, depreciation only provides a short-term increase in the trade balance and for a long-term increase either investments must decrease or government deficit must decrease or both. The absorption approach says that the trade balance would only increase if savings increase or domestic consumption must decrease.
 

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