Estimated study time: 45 minutes
Content:
Foreign exchange (FX) markets are the largest and most liquid financial markets in the world, with daily trading volume exceeding $7 trillion. Exchange rates can be quoted as direct or indirect rates. A direct quote expresses the domestic currency price of one unit of foreign currency (e.g., USD/EUR = 1.10 means 1 euro costs $1.10). An indirect quote expresses the foreign currency price of one unit of domestic currency. Understanding the quotation convention is critical on the CFA exam — many errors arise from inverting rates. The bid price is the rate at which a dealer will buy the base currency; the ask price is the rate at which they will sell. The bid-ask spread compensates dealers for transaction risk and is wider for less liquid currencies.
Cross-rates allow calculation of exchange rates between two currencies using a third reference currency (typically USD). For example, if USD/GBP = 1.30 and USD/EUR = 1.10, then EUR/GBP = 1.30 / 1.10 ≈ 1.182 — meaning one British pound costs about 1.182 euros. Triangular arbitrage exploits inconsistencies among three exchange rates: if the implied cross-rate differs from the quoted cross-rate, traders can profit by converting currencies in sequence until the discrepancy is eliminated. The forward exchange rate is a rate agreed today for a future currency exchange. Covered interest rate parity (CIP) links forward rates to spot rates and interest rate differentials: Forward/Spot = (1 + r_domestic) / (1 + r_foreign). If this relationship does not hold, covered interest arbitrage opportunities exist.
Purchasing power parity (PPP) provides a long-run theory of exchange rate determination. Absolute PPP states that exchange rates should equalize the prices of identical goods across countries. Relative PPP is more practical: the expected percentage change in the exchange rate equals the difference in inflation rates between two countries. For example, if Country A has 6% inflation and Country B has 2%, Country A's currency is expected to depreciate by approximately 4% against Country B's. Relative PPP holds better over long time horizons; in the short run, exchange rates are driven by capital flows, risk sentiment, and monetary policy rather than inflation differentials. The Real Exchange Rate (RER) adjusts the nominal exchange rate for price level differences: RER = Nominal rate × (P_domestic / P_foreign). An appreciating RER means domestic goods are becoming relatively more expensive.
Exchange rate regimes range from fully fixed to fully floating. In a fixed (pegged) regime, the central bank commits to maintaining the exchange rate at a specified level, requiring large foreign exchange reserves and potentially sacrificing domestic monetary policy autonomy (as described by the "impossible trinity" or "trilemma": a country cannot simultaneously maintain free capital flows, a fixed exchange rate, and independent monetary policy). Managed float regimes allow some flexibility but involve central bank intervention. Freely floating exchange rates are determined purely by market forces. Factors driving exchange rate movements in the short to medium term include: interest rate differentials (higher domestic rates attract capital, appreciating the currency), economic growth differentials, inflation expectations, risk appetite, and central bank intervention.
Key Terms:
Quiz Questions:
Q1. The USD/EUR spot rate is 1.08 (i.e., $1.08 per €1). The 1-year U.S. interest rate is 5% and the 1-year Eurozone interest rate is 2%. According to covered interest rate parity, what should the 1-year forward USD/EUR rate be?
A) 1.08 B) 1.112 C) 1.049 D) 1.048
Answer: B — Forward/Spot = (1 + r_USD) / (1 + r_EUR) = 1.05 / 1.02 = 1.02941. Forward rate = 1.08 × 1.02941 ≈ 1.1118 ≈ 1.112. Because U.S. rates are higher, the dollar trades at a forward discount relative to the euro — the forward rate requires more dollars per euro. This is covered interest rate parity: any deviation would allow riskless arbitrage profits.
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Q2. Country X has an annual inflation rate of 8%. Country Y has an annual inflation rate of 3%. According to relative purchasing power parity, what should happen to Country X's currency relative to Country Y's over the next year?
A) Country X's currency should appreciate by 5% B) Country X's currency should depreciate by approximately 5% C) Country X's currency should remain unchanged since PPP only applies to goods D) Country Y's currency should depreciate by 5%
Answer: B — Relative PPP states that the expected exchange rate change equals the inflation differential. With 8% inflation in Country X vs. 3% in Country Y, Country X's currency is expected to depreciate by approximately 5% (8% – 3%). Higher inflation erodes purchasing power, so the currency must weaken to maintain the relative price of traded goods. Option A would imply higher inflation leads to appreciation, which contradicts the theory.
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Q3. A dealer quotes USD/GBP at 1.2700/1.2710. An investor wants to buy British pounds with US dollars. The relevant rate is:
A) 1.2700, because the investor buys at the bid B) 1.2710, because the investor buys pounds at the ask C) The midpoint of 1.2705 D) Either rate, since the spread is minimal
Answer: B — The dealer's ask rate (1.2710) is the price at which the dealer sells pounds (and the investor buys pounds). The bid (1.2700) is the rate at which the dealer buys pounds from the investor. The investor always transacts at the less favorable rate — buying at the ask, selling at the bid — which is how the dealer earns the spread. For $1 million, the investor pays $1,271,000 for £1,000,000.
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Q4. A country currently maintains a fixed exchange rate and has free capital mobility. It also wants to use monetary policy to stimulate domestic growth. According to the impossible trinity, which of the following is correct?
A) The country can achieve all three goals simultaneously with sufficient foreign exchange reserves B) The country must choose between free capital mobility and the fixed exchange rate to conduct independent monetary policy C) The fixed exchange rate automatically adjusts monetary policy appropriately D) Monetary policy is irrelevant in a fixed exchange rate regime
Answer: B — The impossible trinity states that a country can maintain at most two of: (1) free capital mobility, (2) a fixed exchange rate, and (3) independent monetary policy. With free capital mobility and a fixed exchange rate, any attempt to lower domestic interest rates below the anchor country's rates will trigger capital outflows, forcing the central bank to sell reserves to defend the peg — effectively nullifying the rate cut. To regain monetary independence, the country must either restrict capital flows or abandon the peg.
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Q5. If the nominal exchange rate is $1.20/€1 and U.S. prices are 20% higher than Eurozone prices (P_US / P_EU = 1.20), what is the real exchange rate of the USD versus the EUR?
A) 0.80 B) 1.20 C) 1.00 D) 1.44
Answer: C — Real exchange rate = Nominal rate × (P_domestic / P_foreign) = 1.20 × (1 / 1.20) = 1.00. A real exchange rate of 1.00 means that after adjusting for price level differences, the two currencies are at purchasing power parity — neither country's goods are systematically cheaper or more expensive in real terms. A real exchange rate below 1.00 would suggest undervaluation of the domestic currency.
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