Understanding Foreign Exchange Rates | CFA Level I Economics
In this lesson, we’ll delve into currency exchange rates, starting with the basics and moving on to more advanced concepts. We’ll discuss:
- Definition and conventions of foreign exchange rates
- Direct and indirect quotes
- Nominal and real exchange rates
- Cross rate calculation
Definition and Conventions of Foreign Exchange Rates
An exchange rate is simply the price of one currency in terms of another. The CFA curriculum uses this convention:
- Price currency: The currency on top
- Base currency: The currency below
The exchange rate is the price of one unit of the base currency in terms of the price currency.
For example, if the exchange rate of USD/GBP is 1.3, it means that the price of 1 GBP is USD $1.30.
Keep in mind that there are alternative conventions for foreign exchange quotes, so don’t be surprised to see the same quote expressed in the opposite way. The CFA Institute’s convention is more intuitive.
Direct and Indirect Quotes
Direct quote: From the point of view of an investor in the price currency country
Indirect quote: From the point of view of an investor in the base currency country
For example, a USD/GBP quote of 1.3 is a direct exchange rate quote for a USD-based investor and an indirect quote for a GBP-based investor.
EXAMPLE
A USD-based investor wants to buy a British-made clock retailing at 100 pounds. How much would it cost in USD?
Answer: Use the direct quote of 1.3 multiplied by 100 pounds to calculate the clock’s price in US dollars: $130.
Nominal and Real Exchange Rates
Nominal exchange rate: The quoted exchange rate at a point in time
Real exchange rate: Takes into account the relative price changes between the two countries from a base period
The real exchange rate is important because it helps us understand how changes in price levels between countries affect the cost of imports and purchasing power. To calculate the real exchange rate, multiply the nominal exchange rate by the ratio of the CPI of the base currency to the CPI of the price currency.
Cross Rate Calculation
When you want to find the exchange rate between two less-traded currencies, you can calculate the cross rate using the following formula:
Target currency per Base currency = (Base currency per Major currency) × (Major currency per Target currency)
EXAMPLE
Find the cross rate for Thai Baht / Mexican Peso if the nominal exchange rate between Mexican Peso and the USD is 21.25, and the nominal exchange rate between Thai Baht and the USD is 29.77.
Answer: To find the cross rate, we need to multiply Thai Baht per USD by the inverse of MXN per USD:
Cross rate THB/MXN = THB/USD × USD/MXN
First, calculate USD/MXN: 1 / 21.25 = 0.04706
Now, calculate the cross rate: 29.77 × 0.04706 = 1.4009
Thus, the cross rate for THB/MXN is 1.4009.
Conclusion
That wraps up our lesson on foreign exchange rates. By now, you should have a solid understanding of the fundamentals, including direct and indirect quotes, nominal and real exchange rates, and cross rate calculations.
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