Welcome back.
As we move on to currency exchange in this first lesson we begin with a definition and conventions of
foreign exchange rates.
Next we shall learn the distinction between direct and indirect quotes.
The distinction between nominal and real exchange rates and how to make a cross rate calculation.
Let's get rolling and exchange rate is simply the price of one currency in terms of another.
The CFA curriculum uses this convention where the currency on top is known as the price currency and
the one below is the base currency so the exchange rate is the price of one unit of the base currency.
In terms of the price currency so if the exchange rate of U.S. dollar per British pound is one point
three it means that the price of one great British pound is one U.S. dollar and 30 cents do note that
there are alternative conventions for foreign exchange quotes so don't be surprised to see the same
quote expressed in the opposite way just be clear that the CFA Institute's convention is more intuitive
whether Slash is read as per so we say that the exchange rate is one point three dollars per pound
another point to note is that a direct quote is from the point of view of an investor in the price currency
country and an indirect quote is from the point of view of an investor in the base currency country.
So this U.S. dollar per great British pound quota of one point three would be a direct exchange rate
quote Where a USD based investor and an indirect quote for a GBP based investor for instance if an American
wants to buy a British made clock that retails at one hundred pounds he would use the direct quote of
one point three multiplied by 100 hundred pounds to calculate the clock's price in U.S. dollars conversely
a quote of zero point seven six nine two pounds per dollar would be a direct exchange rate quote for
a GBP based investor and an indirect quote for a USD based investor.
So a British person who wishes to buy a 100 dollar pair of sunglasses in the US will also use his direct
quote While the calculation when calculating the percentage change in one currency relative to another
you should be aware that the calculated change is only in terms of the base currency and should not
be reciprocated to the price currency.
For example if the US dollar per great British pound rate falls from one point three to one point one
the percentage change in the dollar price of one GBP is simply minus fifteen point four per cent because
one GBP now buys fifteen point four per cent less dollars.
It is correct to say that the GBP has depreciated fifteen point four per cent relative to USD however
it is not correct to say that the dollar has appreciated by fifteen point four per cent to calculate
the percentage change in USD relative to GBP.
We need to set USD as the base currency so our beginning quote is zero point 7 6 9 2 GBP USD and our
ending quote becomes zero point 9 0 9 1 GBP per USD using these exchange rates.
We can calculate the change in the GBP price of a dollar as eighteen point two per cent in this case.
It's correct to say that the dollar has appreciated eighteen point two per cent with respect to the
great British pound so to reiterate.
Be sure that the percentage change you calculate is valid for the base currency only
another key distinction for exchange rates is between the nominal exchange rate and the real exchange
rate nominal exchange rate is what we've been talking about so far which is the quoted exchange rate
at a point in time.
The real exchange rate however takes into account the relative price changes between the two countries
from a base period.
You may wonder why with the relative price changes be important let's say you're a US based businessman
who regularly imports Cox from the UK that sell us 100 pounds to sell in the US assuming that the nominal
exchange rate is unchanged for the period but the price levels in the UK have gone up by 15 percent
but only by 3 percent in the US.
You would be very worried if the GBP price of the clocks go up by 15 percent while U.S. inflation is
only 3 per cent for the period.
It probably means that your crocs wouldn't sell that well if American income only went up by 3 percent.
So as you can see even though the nominal interest rate is unchanged the real cost of import has increased
while the US importer let's see how the real exchange rate differs.
To calculate the real exchange rate we multiply it by the factor of the CPI of the base currency against
the CPI of the price currency do note that the base is on top.
In this case even though the nominal exchange rate remains unchanged at one point 3.
The real exchange rate has increased to one point 4 5 1 5 a higher real exchange rate means that the
relative cost to import from the UK is higher.
It also means the relative purchasing power of Americans versus British has declined let us pause for
an exercise the IUD per CNY rate was zero point two to 1 5 a year ago.
Currently the rate is zero point 2 3 5 6.
What is the change in a UTI against CNI.
For the past year pulls the video now and work out your answer and we're back.
I hope you remember when we calculate change in an exchange rate it's always in terms of a base currency.
So we have to invert the rates to set a D as the base so the CNY for a 2D rate was 4.5 1 4 7 and the
current rate is four point two 445 calculate the change and we have minus 6 percent.
Therefore the Australian dollar has depreciated by 6 percent against the Chinese yuan continuing with
this example.
If the inflation rate for Australia was one point eight percent in the past year and five point four
percent in China what is the change in real rate in CNI per a 2D rate for the year pulls the video now
and work out your answer and we're back here.
We're not given the real rate nor the CPI but given the change in prices and we know the change in nominal
exchange rate we can calculate the change in real exchange rate plug the figures in and we get minus
nine point two percent.
So in real terms the Australian dollar has depreciated by nine point two per cent against the Chinese
yuan
and to conclude this lesson let us learn how to make cross rate calculations in the foreign exchange
market.
Currencies are traded in currency pairs.
Most currencies will have an active market against major currencies like the US dollar.
So these market quotes are the most relevant for a pair of relatively less traded currencies like the
Malaysian ringgit and the New Zealand dollar.
There may not be an active trade in the pair so the exchange rate may not be that currency if we want
to have a more current exchange rate between the two we can calculate the cross rate between them getting
the cross rate is simple.
For example if we want to get the cross rate for Malaysian ringgit per New Zealand dollar we multiply
NYR per USD with USD per NZ D.
This is just like simple algebra.
The USD cancels out and we get the cross rate for NYR per NZ D so if m y are per USD is four point two
and USD per NZ D is zero point six five.
Then the cross rate for m y ARPA NZ D is two point seventy three and let's end with an exercise the
nominal exchange rate between Mexican peso and the US dollar is twenty one point two five and the nominal
exchange rate between the Thai baht and the US dollar is twenty nine point seventy seven.
What's the cross rate for Thai baht per Mexican peso pose the video now and work out your answer.
And we're back.
You should find this quite easy.
The cross rate is Thai baht per USD multiplied by USD per Amex n do remember that you have to invert
airMAX n per USD punch the numbers in and we get a cross rate of one point for 0 0 9 and that concludes
this lesson on foreign exchange rates.
There is another distinction between quoted exchange rates that you need to know that's between the
spot rate and the forward rate.
We shall address this in the next lesson.
See you again.