Lecture Economics for investment decision makers: Chapter 9 - CFA In stitute

Chapter 9 - Currency exchange rates. This chapter define an exchange rate, and distinguish between nominal and real exchange rates and spot and forward exchange rates; describe functions of and participants in the foreign exchange market; describe functions of and participants in the foreign exchange market;...

1 Introduction

The foreign exchange (FX) market is the market for trading currencies against

each other

- The FX market is the world’s largest market

- The FX market facilitates world trade

- The FX participants buy and sell currencies needed for trade, but also

transact to hedge and speculate on currency exchange rates

• An exchange rate is the price of a country’s currency in terms of another

country’s currency

2 The Foreign Exchange Market

• Currencies are referred to by their

ISO code (e.g., USD, CHF, EUR).

• Exchange rate: The number of units

of one currency (the price currency)

that one unit of another (the base

currency) will buy

• Convention for exchange rate:

A/B = Number of units of A that one

unit of B will buy.

dollars to buy a rupee In other words,

- The rupee is depreciating relative to the US dollar or

Real exchange rates

Spot and forward rates

• A spot exchange rate is an exchange rate for an immediate delivery (that is,

exchange) of currencies

• A forward exchange rate is an exchange rate for the exchange of currencies

at some specified, future point in time

The FX market

Participants and purposes

• Companies and individuals transact

for the purpose of the international

trade of goods and services

• Capital market participants transact

for the purpose of moving funds into

or out of foreign assets

• Hedgers, who have an exposure to

exchange rate risk, enter into

positions to reduce this risk

• Speculators participate to profit from

future movements in foreign

exchange

Types of FX products

• Currencies for immediate delivery

(spot market).

• Forward contracts, which are

agreements for a future exchange

at a specified exchange rate

• FX swaps, which are a

combination of a spot contract and

a forward contract, used to roll forward a position in a forward contract

• FX options, which are options to

enter into an FX contract some time

in the future at a specified exchange rate

• Large dealing banks

• Other financial institutions

Exhibit 9-3FX Turnover by Instrument

3 Currency Exchange

Rate Calculations

• A direct currency quote uses

the domestic currency as the

price currency and the foreign

currency as the base currency

• An indirect currency quote uses

the domestic currency as the

base currency and the foreign

currency as the price currency

In practice

• There are a number of conventions, which simply refer to a particular exchange rate [see Exhibit 9-6 for a more comprehensive list]

• Dealers will quote a bid (at which the dealer will buy) and an offer price (at

which the dealer will sell) [Note: bid < offer]

FX Rate Quote Convention Convention Name

Actual Ratio (Price currency/Base

currency)

Appreciating or depreciating

Currency cross-rates

Forward rate quotations

• Forward exchange rates are

quoted in terms of points (pips:

points in percentage)

If forward rate > spot rate,

the base currency is trading at a

forward premium.

If forward rate < spot rate,

the base currency is trading at a

forward discount.

• Points are 1:10,000 (move the

decimal place four places)

• Forward quotes can be specified

as the number of pips from the

spot rate or as a percentage of the

spot rate

Forward discounts and premiums

Calculating forward rates

4 Exchange rate regimes

• An exchange rate regime is the policy framework for foreign exchange.

• The ideal currency regime (which does not exist) would consist of the following circumstances:

1. Exchange rate is credible and fixed

2. All currencies are fully convertible

3. All countries undertake independent monetary policy for domestic

objectives

Exchange rate regimes

Regime Type Description

Exchange rate regimes

Regime Type Description

Active and passive

crawling pegs Peg Adjust the exchange rate against a single currency, with adjustments for inflation (passive)

or announced in advance (active)

Fixed parity with

crawling bands Peg Similar to target zone, but bands can be widened.Managed float Float Allow exchange rate to float, but intervene to

manage it toward targets

Independently

floating rates Float Exchange rate is market determined (supply and demand)

5 Exchange rates, International Trade, and Capital

Flows

• The net effect of imports and exports affects a country’s capital flows:

Trade deficit → Capital account surplus

Trade surplus → Capital account deficit

• Using the national accounts relationship, we see the relationship between trade and expenditures/savings and taxes/government spending:X – M = (S – I) + (T – G)

↑Exports less imports Savings less ↑

investment

↑Taxes less government

spending

↑Trade surplus or deficit Fiscal surplus or deficit↑

Exchange rates and trade

There are two theories on the exchange rate/trade relationship:

1. Marshall–Lerner theory

- The effectiveness of currency devaluations or depreciation on trade depends

on the price sensitivities (that is, price elasticities) of the goods and services

- If the goods and services are highly elastic, trade responds to devaluation or depreciation, improving the domestic economy

- If the goods and services are inelastic, trade is less responsive to devaluation

or depreciation

2. The Absorption Approach

- If there is devaluation or depreciation, this change in the exchange rate must increase income relative to expenditures to improve the economy

Conclusions and Summary

• The foreign exchange market is by far the largest financial market in the world

It has important effects, either directly or indirectly, on the pricing and flows in all other financial markets

- There is a wide diversity of global FX market participants that have a wide variety of motives for entering into foreign exchange transactions

• Individual currencies are usually referred to by standardized three-character codes These currency codes can also be used to define exchange rates (the price of one currency in terms of another) There are a variety of exchange rate quoting conventions

- A direct currency quote takes the domestic currency as the price currency and the foreign currency as the base currency

- An indirect quote uses the domestic currency as the base currency

- To convert between direct and indirect quotes, invert the quote

FX markets use standardized conventions for quoting exchange rate for

Conclusions and Summary

• Currencies trade in foreign exchange markets based on nominal exchange rates An increase in the exchange rate, quoted in indirect terms, means that the domestic currency is appreciating versus the foreign currency

• The real exchange rate measures the relative purchasing power of the

currencies An increase in the real exchange rate implies a reduction in the relative purchasing power of the domestic currency

• Given exchange rates for two currency pairs—A/B and A/C—we can compute the cross-rate (B/C) between currencies B and C.

• Spot exchange rates are for immediate settlement (typically, T + 2), whereas

forward exchange rates are for settlement at agreed-on future dates

• Forward rates can be used to manage foreign exchange risk exposures or can

be combined with spot transactions to create FX swaps

Conclusions and Summary

• The spot exchange rate, the forward exchange rate, and the domestic and

foreign interest rates must jointly satisfy an arbitrage relationship that equates the investment return on two alternative but equivalent investments

• Forward rates are typically quoted in terms of forward points The points are added to the spot exchange rate to calculate the forward rate

• The base currency is said to be trading at a forward premium if the forward rate

is higher than the spot rate (that is, forward points are positive) Conversely, the base currency is said to be trading at a forward discount if the forward rate

is less than the spot rate (that is, forward points are negative)

• The currency with the higher interest rate will trade at a forward discount

• Points are proportional to the spot exchange rate and to the interest rate

differential and approximately proportional to the term of the forward contract

• Empirical studies suggest that forward exchange rates may be unbiased

predictors of future spot rates, but the margin of error on such forecasts is too

Conclusions and Summary

• Virtually every exchange rate is managed to some degree by central banks The policy framework that each central bank adopts is called an “exchange rate regime.”

• An ideal currency regime would have three properties:

1. The exchange rate between any two currencies would be credibly fixed;

2. All currencies would be fully convertible; and

3. Each country would be able to undertake fully independent monetary policy

in pursuit of domestic objectives, such as growth and inflation targets

• The IMF identifies the following types of regimes: dollarization, monetary union, currency board, fixed parity, target zone, crawling peg, crawling band,

managed float, and independent float

Conclusions and SUmmary

• Any factor that affects the trade balance must have an equal and opposite impact on the capital account, and vice versa

• The impact of the exchange rate on trade and capital flows can be analyzed from two perspectives

1. The elasticities approach focuses on the effect of changing the relative price of domestic and foreign goods This approach highlights changes in the composition of spending

2. The absorption approach focuses on the impact of exchange rates on aggregate expenditure/saving decisions

Conclusions and Summary

• The elasticities approach leads to the Marshall–Lerner condition, which

describes combinations of export and import demand elasticities such that

depreciation of the domestic currency will move the trade balance toward

surplus and appreciation will lead toward a trade deficit

• The idea underlying the Marshall–Lerner condition is that demand for imports and exports must be sufficiently price sensitive so that an increase in the

relative price of imports increases the difference between export receipts and import expenditures

- If there is excess capacity in the economy, then currency depreciation can increase output/income by switching demand toward domestically produced goods and services

- If the economy is at full employment, then currency depreciation must reduce domestic expenditure to improve the trade balance