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LM01 Alternative Investment Features, Methods, and Structures
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IFT Notes for Level I CFA® Program
IFT Notes for Level I CFA® Program

LM08 Currency Exchange Rates

Part 1

 

1. Introduction & The Foreign Exchange Market

This reading covers:

  • How the foreign exchange market is structured, who the major players are, and how they conduct their business.
  • The nitty-gritty of how exchange rates are quoted and calculated.
  • How to calculate cross-exchange rates and forward exchange rates.
  • The different exchange rate regimes throughout the world.
  • The effect of exchange rates on international trade and capital flows.

1.1 The Foreign Exchange Market

Exchange Rate

  • It is the price or cost of one currency expressed in terms of another currency.
  • Stated otherwise, it is the number of units of the price currency needed to buy/sell one unit of the base currency.
  • Consider an exchange rate quote of 1.4500 USD/EUR.
  • The numerator currency (USD) is called as the price currency and the denominator currency (EUR) is called as the base currency.
  • It implies that one EUR is exchangeable with 1.45 USD.
  • So, 1.4500 USD/EUR is interpreted as $1.45 per euro. Here, USD is the currency used to express price per one unit of euro.
  • To determine appreciation or depreciation of a currency, if the quote rate increases in terms of the base currency → base currency has appreciated; and vice versa.
  • If one currency in a currency exchange pair appreciates, the other currency depreciates.

Example

Determine whether the following currencies have appreciated or depreciated.

Currency pair Current exchange rate Exchange rate three years later
USD/EUR 1.4160 1.4051
INR/USD 60.4560 61.3869
CHF/USD 0.8895 0.8863

Solution:

In USD/EUR, the quoted exchange rate decreases → EUR depreciates (relative to USD), USD appreciates.

In INR/EUR, the quoted exchange rate increases → USD appreciates (relative to INR), INR depreciates.

In CHF/USD, the quoted exchange rate decreases → USD depreciates (relative to CHF), CHF appreciates.

Nominal exchange rate is the quoted currency exchange rate at any point in time.

Real exchange rate adjusts the nominal exchange rate for inflation in each country compared to a base period.

  • Real exchange rate price currency/base currency = nominal exchange rate price currency/base currency x (Base currency CPI / Price currency CPI).
  • Real exchange rate shows the relative purchasing power of currencies and has the following correlations:
    • Directly related to nominal exchange rate.
    • Directly related to price level in base currency.
    • Inversely related to price level in price currency.

Example 1 from the curriculum will help understand these concepts better.

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