Currency Exchange Rates: Understanding Equilibrium Value

CFA Level 2 | Economics | Learning Module 1

Foreign Exchange Market Concepts

  • Exchange rates represent the price of a base currency in terms of a price currency. Notation is not standardized.
  • The spot exchange rate is for immediate settlement (typically T+2, except CAD/USD at T+1).
  • Market participants are quoted a bid price (price at which the dealer buys the base currency) and an offer (ask) price (price at which the dealer sells the base currency).
  • The bid-offer spread (offer price – bid price) is the dealer’s compensation.
  • Factors affecting the bid-offer spread include the currency pair (major pairs have tighter spreads), time of day (overlap of major trading centers leads to tighter spreads), market volatility (higher volatility widens spreads), transaction size (larger transactions may get tighter spreads), and the dealer-client relationship.
  • Triangular arbitrage involves exploiting inconsistencies in quoted exchange rates among three currencies to make a riskless profit. Arbitrage opportunities arise if a dealer’s posted bid is higher than the interbank offer or the posted offer is lower than the interbank bid.
  • Implied cross rates can be calculated from two exchange rates involving a common currency (e.g., GBP/EUR from GBP/USD and USD/EUR). Arbitrage ensures that the dealer’s cross-rate bids and offers are consistent with implied rates.

Forward Markets

  • Outright forward contracts are agreements to exchange currencies at a future date at a rate agreed upon today (settlement date longer than T+2).
  • A forward premium exists if the forward rate is higher than the spot rate for the base currency; a forward discount exists if the forward rate is lower.
  • Covered interest rate parity (CIP) is a no-arbitrage condition where a hedged foreign investment yields the same return as a domestic investment.
  • Forward rates in professional markets are often quoted as forward points, which are the difference between the forward and spot rates, scaled (e.g., divided by 10,000 or 100 for JPY). These points are added to the spot bid or offer to get the all-in forward bid or offer.
  • The mark-to-market (MTM) value of a forward contract represents the profit or loss if the position were closed out at current market prices. It is calculated by creating an offsetting forward position, determining the all-in forward rate for that position, calculating the settlement cash flow, and then discounting that cash flow to the present using the appropriate discount rate.
  • Factors affecting forward bid-offer spreads are the same as for spot spreads, plus the term of the forward contract (longer terms generally have wider spreads).

International Parity Conditions

  • International parity conditions describe the theoretical long-run relationships between exchange rates, interest rates, and inflation rates.
  • Covered Interest Rate Parity is enforced by arbitrage.
  • Uncovered Interest Rate Parity states that the expected change in the spot exchange rate equals the interest rate differential between two countries. It assumes risk-neutral investors and may not hold in the short to medium term.
  • Forward Rate Parity suggests that the forward exchange rate is an unbiased predictor of the future spot exchange rate. This holds if both Covered Interest Rate Parity and Uncovered Interest Rate Parity hold.
  • Purchasing Power Parity (PPP) relates exchange rates to relative price levels and inflation.
  • Law of One Price: Identical goods should trade at the same price across countries when priced in a common currency.
  • Absolute PPP: The nominal exchange rate is determined by the ratio of national price levels: Sf/d = Pf / Pd. Rarely holds in reality due to transaction costs and non-tradable goods.
  • Relative PPP states that the expected percentage change in the spot exchange rate is approximately equal to the difference between the expected foreign and domestic inflation rates. PPP tends to hold better over the long run.
  • Ex Ante PPP: Expected changes in the spot rate are driven by expected inflation differentials: E(%ΔSf/d) = E(πf) – E(πd).
  • The International Fisher Effect posits that nominal interest rate differentials reflect expected inflation differentials. It implies that real interest rates are equal across countries (real interest rate parity) if Uncovered Interest Rate Parity and PPP hold.

For more information about our CFA Level 2 exam prep courses, check out our CFA Level 2 All-In-One Prep Course or the CFA Level 2 Economics e-learning course.