Currency Exchange

Section: Currency Exchange Rates 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…