Introduction to Currency Exchange Rates
Currency exchange rates represent the price of one currency in terms of another currency. They are fundamental to international trade, investment, and economic policy. Understanding exchange rates is crucial for CFA candidates as they affect portfolio returns, corporate cash flows, and economic analysis.
Key Concepts
Base Currency
The currency being quoted in the numerator of an exchange rate. For example, in USD/EUR = 1.20, USD is the base currency.
Quote Currency
The currency in the denominator. In USD/EUR = 1.20, EUR is the quote currency, meaning 1 USD = 1.20 EUR.
Direct Quote
Expresses the domestic currency per unit of foreign currency (e.g., USD 1.30 per EUR for a US investor).
Indirect Quote
Expresses foreign currency per unit of domestic currency (e.g., EUR 0.77 per USD for a US investor).
Spot Exchange Rates
Spot exchange rates are the current market rates for immediate delivery (typically within 2 business days). They represent the most liquid and actively traded exchange rates.
Characteristics of Spot Rates
- Immediate Settlement: Delivery occurs within 1-2 business days
- Market Determined: Prices set by supply and demand in the foreign exchange market
- High Liquidity: Major currency pairs have very tight bid-ask spreads
- 24/7 Trading: FX markets operate around the clock during weekdays
| Currency Pair | Spot Rate | Bid | Ask | Spread (pips) |
|---|---|---|---|---|
| EUR/USD | 1.0850 | 1.0849 | 1.0851 | 2 |
| USD/JPY | 110.25 | 110.23 | 110.27 | 4 |
| GBP/USD | 1.3625 | 1.3623 | 1.3627 | 4 |
| USD/CHF | 0.9180 | 0.9178 | 0.9182 | 4 |
Forward Exchange Rates
Forward exchange rates are agreed-upon rates for currency exchange at a future date. They are used for hedging currency risk and speculation.
Forward Rate Determination
Forward rates are determined by the interest rate differential between two currencies and the current spot rate.
Where:
rd = domestic interest rate
rf = foreign interest rate
t = time to maturity in days
Example: Calculating a 90-day Forward Rate
Given:
- Current EUR/USD spot rate: 1.0850
- US 3-month interest rate: 2.5%
- Eurozone 3-month interest rate: 1.0%
- Time to maturity: 90 days
Calculation:
Forward Rate = 1.0850 × [(1 + 0.025 × 90/360) / (1 + 0.010 × 90/360)]
Forward Rate = 1.0850 × [(1.00625) / (1.0025)]
Forward Rate = 1.0850 × 1.00374 = 1.0891
Result: The 90-day forward rate is 1.0891 EUR/USD
Forward Premium/Discount
Forward Premium
When the forward rate is higher than the spot rate. The currency is said to trade at a premium forward.
Forward Discount
When the forward rate is lower than the spot rate. The currency trades at a discount forward.
Factors Influencing Exchange Rates
Exchange rates are influenced by various economic, political, and market factors. Understanding these factors is essential for currency analysis and forecasting.
Economic Factors
Interest Rate Differentials
Higher interest rates attract foreign capital, increasing demand for the currency and strengthening its value.
Inflation Rates
Lower inflation rates increase purchasing power and currency attractiveness relative to trading partners.
Economic Growth
Strong GDP growth attracts investment and increases demand for the domestic currency.
Current Account Balance
Trade surpluses create demand for the domestic currency, while deficits create selling pressure.
Political and Risk Factors
- Political Stability: Stable governments and policies attract investment
- Geopolitical Events: Wars, sanctions, and conflicts create volatility
- Central Bank Policy: Monetary policy decisions significantly impact exchange rates
- Market Sentiment: Risk-on vs. risk-off sentiment affects currency flows
| Factor | Currency Strengthening | Currency Weakening |
|---|---|---|
| Interest Rates | Rising rates | Falling rates |
| Inflation | Low, stable inflation | High inflation |
| Economic Growth | Strong GDP growth | Recession/slow growth |
| Current Account | Trade surplus | Trade deficit |
| Political Stability | Stable government | Political uncertainty |
Exchange Rate Calculations
Mastering exchange rate calculations is essential for the CFA exam and practical application in international finance.
Cross Rates
Cross rates are exchange rates between two currencies that are derived from their exchange rates with a third currency (usually USD).
Example: Calculating EUR/GBP Cross Rate
Given:
- EUR/USD = 1.0850
- GBP/USD = 1.3625
Calculation:
EUR/GBP = EUR/USD ÷ GBP/USD = 1.0850 ÷ 1.3625 = 0.7963
Result: 1 EUR = 0.7963 GBP
Currency Returns
When investing in foreign assets, total return includes both the asset return and currency return.
Example: Foreign Investment Return Calculation
Scenario: US investor buys European stocks
- Stock return in EUR: +15%
- EUR/USD appreciation: +8%
Calculation:
Total Return = 0.15 + 0.08 + (0.15 × 0.08) = 0.15 + 0.08 + 0.012 = 0.242
Result: Total return in USD = +24.2%
Triangular Arbitrage
Triangular arbitrage opportunities arise when cross rates are inconsistent with direct quotes.
| Step | Action | Currency | Amount |
|---|---|---|---|
| 1 | Start with | USD | $1,000,000 |
| 2 | Buy EUR at 1.0850 | EUR | €921,659 |
| 3 | Buy GBP at 0.7963 | GBP | £733,750 |
| 4 | Sell GBP at 1.3625 | USD | $1,000,234 |
Chapter Summary
Understanding currency exchange rates is fundamental to international finance and investment analysis.
Key Takeaways
Exchange Rate Basics
- Base vs. quote currency
- Direct vs. indirect quotes
- Bid-ask spreads
Spot vs. Forward
- Immediate vs. future delivery
- Interest rate parity
- Premium/discount calculations
Influencing Factors
- Interest rate differentials
- Economic fundamentals
- Political stability
Practical Applications
- Cross rate calculations
- Foreign investment returns
- Arbitrage opportunities