Currency exchange rates

Exchange rate: the price at which foreign currency denominated investments are valued in
terms of the domestic currency

Basis convention, standardized three letter codes that the market has agreed upon through
ISO

Convention A/B 1 B will buy how many A

Real exchange rates: are indexes often constructed by economists to assess changes in the
relative purchasing power of one currency compared with another

Purchasing power parity: nominal rates would adjust so that identical goods will have the same
price in different markets. Assumptions: homogenous products. There are not trade barriers
and transaction costs

The higher the real exchange rate that individual faces, the fewer foreign goods, the individual
can purchase and the lower that individuals relative purchasing power compared with another
country

Real exchange rate: Sd/f*(pf CPI /pd)

The higher the price, the lower your relative purchasing power of a currency

Difference in inflation rates between countries affect their relative competitiveness

Market functions

Spot transactions involve the exchange of currencies for immediate delivery t+2 settled two
business days

Forward contracts: deliver foreign exchange at a future date at an exchange rate agreed upon
today. Two characteristics: date and forward rate

Liquidity in forward market declines the longer the maturity and the larger the trade size

Future and forward: main differences:

● Exchanges
● Fixed contract amounts and fixed settlement dates
● Less flexible

FX swap: combination of an offsetting spot transaction and a new forward contract

FX swap consists of a simultaneous spot and forward transactions, these swap can extend an
existing forward position to a new future date and rolling the position forward leads to a cash
flow on settlement date

Market participants

Selling side: large FX trading banks

Buying side

Corporate accounts

Real money accounts: restricted in their use of leverage or financial transactions

Retail accounts: normal people

Governments

Central banks

Sovereign wealth funds

Market size and composition

FX Swap market average daily trade volume

Portfolio flows and speculative dominate the market

Currency exchange rate calculations

Exchange rate quotations

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

Indirect currency domestic currency is the base currency. Base currency is always mentioned
first

Bank will provide a bid (willingness to buy) and offer (willingness to sell) for base currency

Increases appreciation base currency and decrease the opposite inverse are not equal

X foreign currency/ Y base currency

Cross rate calculations

Forward calculations

Pips the points on a forward are simply the difference between forward exchange rate and the
spot exchange rate

Positive forward premium and vice versa the price currency is trading at a forward discount

Given the interest rate differential, the longer the maturity the greater absolute number of
forward points

Divide points by 10.000 and add it back

Forward rate= Spot*(1+iforeing)/(1+Idomestic)

The forward rate will be higher than the sport rate if foreign interest rates are higher than
domestic interest rates

The currency with the higher interest rate will always trade at discount in the forward market

Exchange rate regimes

Ideal currency regime

● The exchange rate between any two currencies would be credibly fixed.
● All currencies would be fully convertible
 ● Each country would be able to undertake fully independent monetary policy in pursuit
of domestic objectives such as growth and inflation targets

It should be clear that independent monetary policy is not possible if exchange rates are
credibly fixed and currencies are fully convertible

It would lead to a massive flow of capital and central banks to use international reserves to
maintain exchange rate

Dollarization: the country uses the currency of another nation as its medium of exchange and
unit of account

Monetary Union: the country participates in a monetary union whose members share the
same legal tender. Both cases the country loses its ability to exert monetary policy

It inherits that country´s currency credibility. Interest rates in US dollars in a dollarized

It imposes fiscal policy discipline by eliminating the possibility that the central bank will be
induced to monetize government debt

Currency board system

It is based on an explicit legislative commitment to exchange domestic currency for a specified

They work if domestic prices and wages are very flexible, non-traded sectors of the domestic
economy are relatively small, and global supply of the reserve assets grow at a slow steady
rate consistent with long run real growth stable prices.

It can earn a little interest and earn a market rate on its assets and it is called seigniorage

Fixed parity:

Main differences there is not legislative commitment to maintaining the specified parity. The
target level of foreign exchange reserves is discretionary. Central banks can be lender of last
resort

The level of reserves required to maintain credibility is a key issue for a simple fixed exchange
rate regime target zone +-2% around parity

Active and passive crawling pegs

Passive: exchange rate was adjusted frequently to keep pace with the inflation rate

Active: exchange rate was announced before for the coming weeks with changes taking place
in small steps

Exchange rates, international trade and capital flows

Using a fundamental identity from macroeconomics, the relationship between the trade
balance and expenditure/saving decisions can be expressed as:20
X – M = (S – I) + (T – G)
where X represents exports, M is imports, S is private savings, I is investment in plant
and equipment, T is taxes net of transfers, and G is government expenditure
We can summarize this relationship more simply by saying that a trade surplus means the
country saves more than enough to fund its investment (I) in plant and equipment. The excess
saving is used to accumulate financial claims on the rest of the world. Conversely, a trade
deficit means the country does not save enough to fund its investment spending (I) and must
reduce its net financial claims on the rest of the world.

Capital flows—potential and actual—are the primary determinant of exchange rate

The basic idea behind the Marshall–Lerner condition is that demand for imports and
exports must be sufficiently price-sensitive so that increasing the relative price of
imports increases the difference between export receipts and import expenditures. The
generalized Marshall–Lerner condition is:
ωXεX + ωM(εM – 1) > 0  
Examination of the generalized Marshall–Lerner condition indicates that more elastic demand
—for either imports or exports—makes it more likely that the trade balance will improve.

In conjunction with the Marshall–Lerner condition, our review of the factors that
determine price elasticities suggests that exchange rate changes will be a more-effective
mechanism for trade balance adjustment if a country imports and exports the following:

▪ Goods for which there are good substitutes

hus, in the absence of excess capacity in the economy, currency depreciation is likely to
provide only a temporary solution for a chronic trade imbalance. Lasting correction of the
imbalance requires more fundamental changes in expenditure/saving behavior

Questions

1. B
2. A IT IS B DOMESTIC PRICE LEVEL
3. B
4. C
5. B
6. A
7. B IT IS MORE THAN 12% (1/(1-12%))-1
8. C
9. A
10. C
11. B
12. A
13. B
14. B IT IS C FOREING
15. B
16. C
17. C
18. B
19. A
20. A
21. B IT IS C