CFA Level I - Study Session 6

“Foreign Exchange” **** New Text and Changed LOS for 2004The candidate should be able to a define direct and indirect methods of foreign exchange quotations; Direct Method: Domestic on t

2005 CFA® REVIEW PROGRAM

Offered by SASF

Class Notes Level I Date of Class: May 9, 2005

Global Economic Analysis

CFA Institute Study Session(s): 6

Slides used in class available on my website -

www.usfca.edu/economics/veitch/

Security Analysts of San Francisco

The CFA Institute does not endorse, promote, review or warrant the accuracy of the products or services offered by SASF or the verify pass rates claimed by SASF CFA and Chartered Financial Analystare a licensed trademarks owned by CFA Institute.

CFA Level I - Study Session 6

1 A “Gaining from International Trade”

The candidate should be able to:

a state the conditions under which a nation can gain from international trade;

Nations can gain from trade if they produce goods in which they have a comparative

advantage and trade for goods in which they have a comparative disadvantage

• Comparative Advantage is the ability to produce a good at a lower opportunity cost than others can produce it

• As long as the relative costs of production differ across nations, gains from

specialization and trade will be possible

When nations produce and trade based on Comparative Advantage trade between nations leads to an expansion in total world output and mutual gains to each nation

b discuss the effects of international trade on domestic supply and demand;

When product can be transported long distances at low cost (relative to its value) then

domestic price of the product is determined by world demand and supply

Trade & specialization thus results in:

1 Lower prices and higher domestic consumption for imported products

2 Higher prices and higher domestic production for exported goods

c describe commonly used trade-restricting devices including tariffs, quotas, voluntary export

restraints, and exchange-rate controls;

Commonly used trade-restricting policies are:

I Import Tariff – are a tax on goods and services imported into the country.

II Import Quota – puts an upper limit on the amount of a good or service that is

allowed to be imported into the country

III Voluntary Export Restriction (VER) – an agreement by foreign firms to limit the

amount of a good or service they will export into the country

IV Exchange Rate Controls – when the government either sets the exchange rate at a

rate above the market rate or it limits the access to foreign currency by its citizens Effect is to make imports into the country more expensive and reduce trade

d explain the impact of trade barriers on the domestic economy and identify who benefits

and loses from the imposition of a tariff;

Trade restrictions promote inefficiency and reduce the potential gains from trade for the domestic economy Thus trade restrictions are harmful to the wealth of the economy

Tariff is a tax levied on imports, has following effects:

i) Domestic Price rises by amount of tariff.

iii) Loss of consumer surplus as less of good consumed at higher price

Effects of an import quota are similar to those of a tariff but involve a larger deadweight loss because it generates NO revenue for the government as a result of the quota

e explain why nations adopt trade restrictions;

• Power of Special Interests : Trade restrictions provide concentrated benefit to small groups while imposing widely-dispersed costs on majority of nation Thus politicians often have the incentive to favor trade restrictions even though they hurt economic efficiency

• Economic Illiteracy: Many fallacies associated with arguments for trade barriers (1) Trade restrictions that limit imports save jobs for Americans

(2) Free trade with low wage countries will reduce the wages of Americans

Both statements are untrue and ignore the effects of trade based on comparative advantage

on the welfare of the nation as a whole and the effects of specialization in what we are comparatively good at on our standard of living

f discuss the validity of the arguments for restrictions.

Trade barriers are generally harmful to level and growth of economic well-being in a country, with the following exceptions:

Partially Valid Economic Arguments

i) National Defense: Certain industries “vital”, must be protected.

• Argument has some validity but often abused as relatively few industries are truly vital to our national defense

ii) Infant Industry: New industries “need protection” until established.

• Argument is valid as stated but generally abused More often used to cushion industries from international competition rather than provide temporary shelter while they become internationally competitive

iii) Anti-Dumping: Domestic producers “need protection” from foreign suppliers

selling products below cost (dumping)

• Often considerable ambiguity about whether true dumping is occurring or not Dumping aimed at eliminated domestic competitors should be met with tariffs Other types of dumping should not be met with tariffs but other policies, such as income supplements to affected industries

2 A “Foreign Exchange” **** New Text and Changed LOS for 2004

The candidate should be able to

a) define direct and indirect methods of foreign exchange quotations;

Direct Method: (Domestic on top)

• # units of home currency per unit of foreign currency ($0.01 US$/Yen)

Indirect Method: (International on top)

• # units of foreign currency per unit of home currency (100 Yen/US$)

One method is simply the inverse of the other

b) calculate the spread on a foreign currency quotation;

Bid or Buy rate: Exchange rate at which agent (the bank) will buy a currency.

Ask or Sell rate: Exchange rate at which agent (the bank) will sell a currency.

[Ask Rate - Bid Rate]

c) explain how spreads on foreign currency quotations can differ as a result of market

conditions, bank/dealer positions, and trading volume;

Anything that increases the dealer’s risk of holding the foreign currency will increase the Bid-Ask spread

• Increased volatility in spot market conditions or lack of spot market liquidity

• Bank/dealer positions are more likely to influence the midpoint exchange rate

quote [ = (bid+ask)/2 ] than the size of the bid-ask spread for a currency.

d) convert direct (indirect) foreign exchange quotations into indirect (direct) foreign exchange

quotations;

• When there is NO Bid-Ask spread

Direct Exchange Rate =

Indirect Exchange Rate

• When there is a Bid-Ask Spread

Direct ASK Exchange Rate =

Indirect BID Exchange Rate

• Rate to sell domestic currency equals the reciprocal of the rate to buy the foreign currency.

Direct BID Exchange Rate =

Indirect ASK Exchange Rate

• Rate to buy domestic currency equals the reciprocal of the rate to sell the foreign currency.

e) calculate currency cross rates, given two spot exchange quotations involving three

currencies;

Please see my slides for what I think is a better way to do this The following is a summary of the book’s approach which I think is confusing

Let FC1 and FC2 be the two foreign currencies for which the cross-rate is desired Let DC be the vehicle currency against which each foreign currency is quoted The vehicle currency is generally the US dollar (USD) I will take FC1 = Japanese Yen (¥) and FC2 = Euros (€) for concreteness below

Cross – Ask 1 1

2 ask ask 2 ask

      or ( ) (ask ) (ask )ask

USD

Cross – Bid 1 1

2 bid bid 2 bid

      or ( ) (bid ) (bid )bid

USD

The nice thing about the above is that to calculate a cross - ask (bid) you use ask (bid) rates The confusing thing is that one is quoted as indirect and the other is quoted as direct As long

as you keep the units straight I guess you’ll be ok

If you don’t like this approach, go to my slides Everything there is quoted in DIRECT terms and the formulas are laid out with only Direct quoted exchange rates

f) distinguish between the spot and forward markets for foreign exchange;

Spot market: Currencies traded for immediate delivery.

Forward Market: Trade contracts to buy or sell a specified amount of currency at a specified

future date at the specified forward exchange rate Forward contracts are customized to

customer needs in contrast to futures contracts which have fixed sizes and maturity dates

g) calculate the spread on a forward foreign currency quotation;

The calculation is identical to the one performed earlier for the spot exchange rate Make sure that the Bid and the Ask rates are for the same forward delivery date in a question The spread does not apply across Bid and Ask on different forward delivery dates

[Ask Rate - Bid Rate]

h) explain how spreads on forward foreign currency quotations can differ as a result of market

conditions, bank/dealer positions, trading volume, and maturity/length of contract;

All the same considerations that determine spreads in the spot FX market affect the spread in the forward FX market In the forward market, however, an additional source of risk is the length of the forward contract – the longer the maturity of the forward contract the higher is the spread on the contract due to increased bank/dealer risk

i) calculate a forward discount or premium and express either as an annualized rate;

Forward foreign exchange contract:

• Calls for delivery, at a fixed future date, of a specified amount of one currency against US$ payment Exchange rate fixed by the forward contract is called the forward rate or the outright rate

Swap Rate:

• Difference between forward rate and current spot rate is the swap rate There is a forward premium if the forward rate quoted in dollars is above the spot rate There

is a forward discount if forward rate is below the current spot rate

Annualized forward premium or discount to current spot rate adjusts % difference between forward and spot rate for length of forward contract:

Forward Premium Calculation

0

.0105 1.3078

360

E s S

The Canadian $ is at a premium to the US$ on the 1-year forward Thus the US$ is expected to strengthen slightly (1.05%) over the period From Financial Times January 27, 2004

j) explain covered interest rate parity;

Interest rate parity theory ensures that return on a hedged foreign exchange rate position over a

certain period of time is just equal to the domestic interest rate on an investment of identical risk over the same period of time If the returns on the two positions are not identical then an arbitrage opportunity exists, and capital will flow to take advantage of the mispricing of the forward rate

k) illustrate covered interest arbitrage.

Strategy 1: Domestic Investment –

• Invest in home gov’t bond yielding nominal interest rate, r DC

o Return in DC is = (1 + r DC )

Strategy 2: Hedged Foreign Investment –

• Convert DC to FC at current indirect exchange rate, S 0; invest in Foreign

government bond yielding r FC for given period; convert proceeds back to DC at

current forward rate, F 1

o Return in HC is = (1 + r FC )S 0 /F 1

Riskless Arbitrage Profits available if (1 + r DC ) ≠ (1 + r FC )S 0 /F 1:

How to take advantage of this mispricing? Look at the returns above

(1) If (1 + r DC ) < (1 + r FC ) S 0 /F 1

• borrow in Domestic currency, lend (hedged foreign investment) in Foreign currency.

(2) If (1 + r DC ) > (1 + r FC ) S 0 /F 1

• borrow in Foreign currency (hedged foreign borrowing), lend Domestic currency.

Be careful! The interest rates must match the forward contract in duration!

2 B “Foreign Exchange Parity Relations”

The candidate should be able to:

a explain how exchange rates are determined in a flexible or floating exchange rate system;

Demand for foreign currency from domestic individuals buying goods, services, or assets from ROW

Supply of foreign currency from foreign individuals buying goods, services, or assets in domestic economy

Equilibrium

Flexible Exchange Rate System: Demand and supply for foreign currency determine

exchange rate (value of foreign currency in terms of domestic currency)

Fixed Exchange Rate System: Gov’t sets exchange rate and then fixes this level by

intervening to buy or sell foreign currency depending on demand/supply at the fixed rate

b explain the role of each component of the balance-of-payments accounts;

Balance of Payments = Current Account + Capital Account i) Current Account

• Balance on Services = Export of Services – Imports of Services

• Unilateral Transfers = Net Gifts from – to foreigners

ii) Capital Account

• Net changes in ownership of assets to – from foreigners

iii) Official Reserve Account

• Official Reserve Assets held in form of foreign currencies, gold, and Special

Drawing Rights (SDR’s) held at IMF

c explain how current-account deficits or surpluses and financial account deficits or surpluses

affect an economy.

Current Account balance reflects primarily trade in goods & services Current account deficit means nation is buying more goods & services from the Rest of the World than the Rest of the World is buying from it.

• Current Account Deficit must be financed,

• For a Current Account Deficit to be sustained in over some period of time it must be

accompanied by an offsetting Financial Account Surplus, i.e capital flowing into the

country from the Rest of the World – think the United States

• For a Current Account Surplus to be sustained in over some period of time it must be

accompanied by an offsetting Financial Account Deficit, i.e capital flowing out of the

country to the Rest of the World – think Japan

• Be careful about causality Current Account Deficits may cause capital inflows (Financial Account Surpluses) OR capital inflows may cause current account deficits The latter is

likely true for the U.S in recent years.

If nation is running a Current Account Deficit but has no offsetting Financial Account Surplus, then its currency will fall in value against the Rest of the World.

- A trade deficit will reduce the country’s international reserves

- This should lead to depreciation in the value of the local currency as the government will be unable to support its currency in the FX market as its international reserves dwindle

- This depreciation makes the country’s goods and services cheaper to the rest of world This will increase the country’s exports

- Net result is an increase in the trade balance until the trade deficit is reversed

d describe the factors that cause a nation’s currency to appreciate or depreciate;

Factors causing Nation’s Currency to Appreciate (Strengthen)

increase more than imports (decrease in Demand for FX)

ii) Inflation rate lower than trading partner’s will cause foreign goods to become expensive (Demand for FX falls, Supply of FX rises) As result foreign currency

weakens, its goods become competitive

iii) Domestic real interest rates higher than trading partners will attract inflows of foreign capital, increasing demand for domestic currency (Demand for FX falls, Supply

of FX rises)

Factors causing Nation’s Currency to Depreciate (Weaken)

e explain how monetary and fiscal policies affect the exchange rate and balance-of-payments

components;

Monetary Policy Expansionary Restrictive

Real Interest rates Decline Rise

Exchange Rate Depreciates Appreciates

Flow of Capital Outflow Inflow

Current Account Move to surplus Move to deficit

Fiscal Policy Expansionary Restrictive

Real Interest rates Rise Decline

Exchange Rate Uncertain but Uncertain but

likely appreciate likely depreciate Flow of Capital Inflow Outflow

Current Account Move to deficit Move to surplus

f describe a fixed exchange rate and a pegged exchange rate system.

Fixed Exchange Rate System:

• When a nation absolutely fixes its exchange rate between its own currency and the currency of another country or region

o Example: Countries such as Hong Kong that have a currency board that exchanges HK$ for US$ at a fixed rate

Pegged Exchange Rate System:

• When a nation sets a desired level and bands around that level for the exchange rate between its currency and the currency of another country or region

regime is that in a pegged system the nation’s exchange rate can vary within the bands without central bank intervention

o Example: Many European countries prior to the euro belonged to the Exchange Rate Mechanism (ERM) Each nation in the ERM set its exchange rate with the Deutschemark (DM) but allowed their exchange with DM to fluctuate within established bands

g) discuss absolute purchasing power parity and relative purchasing power parity;

Absolute Purchasing Power Parity (PPP):

- Basic idea is the “Law of One Price”, i.e the real price of a good should be the same in all countries at any point in time otherwise arbitrage opportunities exist through trade.

- Absolute PPP relates overall price indexes for two countries to the level of the nominal exchange rate.

● P DC = Price level for the domestic country

● P FC = Price level for the foreign country

● S = Spot Exchange rate between DC and FC in FC/DC units

- Let S be the INDIRECT quoted exchange rate Then the Absolute PPP relationship is then

written as FC

DC

P

S= P .

Relative Purchasing Power Parity (PPP):

- Focuses on the general relationship between inflation rates in two countries and the

movements in the exchange rate necessary to offset the effects of differential inflation on goods prices.

- Relative PPP relates overall inflation rates in two countries and changes in the nominal exchange rate.

● I DC = Inflation Rate for the domestic country

● I FC = Inflation rate for the foreign country

● S 0 = Spot Exchange rate at beginning of year between DC and FC in DC/FC units

● S 1 = Spot Exchange rate at end of year between DC and FC in FC/DC units

- Relative PPP relationship is then written as ( )

1 0

1

1

FC

DC

I S

+

- Relative PPP calculation can also be adjusted for more than one year periods.

● I DC = Average Annual Inflation Rate over the period for the domestic country

● I FC = Average Annual Inflation Rate over the period for the foreign country

● S 0 = Spot Exchange rate at beginning of year between DC and FC in DC/FC units

● S t = Spot Exchange rate at end of t years between DC and FC in FC/DC units