CFA® Level II · Economics · free lesson

Currency Exchange Rates: Understanding Equilibrium Value

Currency movements can add or remove several percentage points from an international portfolio's return in a single year. This module covers the mechanics of spot and forward quotes, cross rates and forward valuation, then the parity conditions that link interest rates, inflation and exchange rates, how far they can be trusted as forecasts, the carry trade that exploits their failure, and the balance-of-payments, policy and crisis dynamics that drive currencies in practice.

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What you will learn

1. Work with bid-offer quotes, including cross-rate arbitrage, forward points and the mark-to-market value of a currency forward.

Price/base notation: USD/EUR = 1.0850 is USD per euro; the dealer buys the base at the bid and sells it at the offer.
Invert with (B/A)bid = 1/(A/B)offer; cross by multiplying bids with bids and offers with offers.
Triangular arbitrage exists when a dealer's cross quote lies outside the implied bid-offer range.
Forward outright = spot + points (bid to bid, offer to offer), scaled to the quote's decimals.
Forward MTM = (Ft - F0) x notional / (1 + i_price x days/360), with Ft taken from the side that closes the position.

2. Explain covered and uncovered interest parity, purchasing power parity and the international Fisher effect, and how they link to one another.

CIP: F = S x (1 + i_P tau)/(1 + i_B tau); the higher-yield currency trades at a forward discount.
UIP: expected spot change of about i_P - i_B; the high-yield currency is expected to depreciate (often fails short term).
Relative PPP: spot change of about pi_P - pi_B; a long-run, not short-run, guide.
International Fisher effect: nominal rate differentials equal expected inflation differentials when real rates are equal.
CIP + UIP make the forward rate an unbiased predictor of the future spot rate.

3. Judge which forecasting anchor (spot, forward, PPP or uncovered parity) is most useful, and assess long-run fair value of a currency.

Over short horizons the spot rate (random walk) is hard to beat; the forward rate is a biased forecast (forward premium puzzle).
PPP works poorly in the short run but deviations tend to narrow over several years.
PPP fair value = base-period rate x cumulative price-currency inflation / cumulative base-currency inflation.
Real exchange rate q(P/B) = S(P/B) x P_B/P_P; a rising q is a real appreciation of the base currency.
Long-run fair value also reflects productivity (Balassa-Samuelson), current accounts, real rate differentials and risk premiums.

4. Explain the carry trade and calculate its return, and relate it to the failure of uncovered interest parity.

Borrow in a low-yield currency, invest in a high-yield currency, unhedged.
Return = (1 + i_inv)(S1/S0) - (1 + i_fund), with S in funding currency per investment currency.
Approximate return = interest differential + percentage change in the investment currency.
Carry profits reflect the failure of UIP: high-yield currencies have not depreciated by the full differential on average.
Returns are negatively skewed with crash risk, especially when global risk appetite collapses.

5. Analyse how the balance of payments, monetary and fiscal policy, intervention and capital controls affect exchange rates, and recognise early signs of a currency crisis.

Persistent current account deficits weaken a currency over time via flows, portfolio balance and debt-sustainability concerns.
High capital mobility: expansionary monetary policy depreciates, expansionary fiscal appreciates; tight money plus loose fiscal appreciates strongly.
Low capital mobility: expansionary fiscal policy weakens the currency through the trade balance.
Money growth weakens currencies in the long run and can cause short-run overshooting.
Crisis warning signs: falling reserves versus short-term foreign debt, real overvaluation, credit booms, current account deficits, terms-of-trade shocks, banking stress and a fixed exchange rate.

Module at a glance

Quotes are price/base; clients buy the base currency at the offer and sell at the bid; invert with 1/offer for the new bid.
Cross rates multiply like sides; triangular arbitrage exists when a direct quote lies outside the implied range.
Forward MTM = (Ft - F0) x notional, discounted at the price-currency rate, with Ft from the side that closes the position.
CIP: F = S(1 + i_P tau)/(1 + i_B tau); UIP, relative PPP and the international Fisher effect link rates, inflation and expected spot changes.
Spot is the best short-run anchor; PPP and fundamentals guide long-run fair value; the forward rate is a biased forecast.
Carry trades profit from UIP's failure but carry crash risk and negatively skewed returns.
High capital mobility: tight money plus loose fiscal policy appreciates a currency; pegs, overvaluation, credit booms and thin reserves signal crisis risk.

This free module has 5 lessons, 17 practice questions with full explanations.

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