When someone says that they're "buying American dollars" (USD), what type of asset are they probably buying? They're probably buying:
If a person buys USD, they're usually just lending (depositing) USD in a bank, which is a form of short term debt.
If a big company or bank 'invests in USD', that will also mean that they're lending an amount denominated in USD. But usually these big institutions lend to each other in the money market which is the short-term wholesale debt market.
An Indonesian lady wishes to convert 1 million Indonesian rupiah (IDR) to Australian dollars (AUD). Exchange rates are 13,125 IDR per USD and 0.79 USD per AUD. How many AUD is the IDR 1 million worth?
The IDR 1 million should be divided by the 13,125 IDR per USD exchange rate since then the IDR's will cancel out and only the USD will be left.
Then the USD should be converted to AUD by dividing by the 0.79 USD per AUD exchange rate to cancel out the USD's and leave just the AUD.
###\text{IDR }1m \div \dfrac{\text{13,125 IDR}}{\text{1 USD}} \div \dfrac{\text{0.79 USD}}{\text{1 AUD}}### ###=\text{IDR }1,000,000 \times \dfrac{\text{1 USD}}{\text{13,125 IDR}} \div \dfrac{\text{0.79 USD}}{\text{1 AUD}}### ###=\text{USD } 76.19047619 \div \dfrac{\text{0.79 USD}}{\text{1 AUD}}### ###=\text{USD } 76.19047619 \times \dfrac{\text{1 AUD}}{\text{0.79 USD}}### ###= \text{AUD }96.44364075###Here is another interesting method. Thanks to Fauzan for pointing this out.
###0.79\text{ USD} = 1\text{ AUD}### ###1\text{ USD} = \dfrac{1}{0.79} \text{ AUD}###Substitute ##13,125\text{ IDR} = 1\text{ USD}##
###13,125\text{ IDR} = \dfrac{1}{0.79} \text{ AUD}### ###1\text{ IDR} = \dfrac{\left( \dfrac{1}{0.79} \right)}{13,125} \text{ AUD}### ###1\text{ IDR} = \dfrac{1}{0.79 \times 13,125} \text{ AUD}### ###1\text{ IDR} = 0.00009644364075\text{ AUD}### ###1m\text{ IDR} = 0.00009644364075m\text{ AUD}### ###1m\text{ IDR} = 96.44364075\text{ AUD}###Question 601 foreign exchange rate, American and European terms
Foreign currency quotes with the USD in the numerator (top of the fraction) are called American terms quotes. The so-called "Queen's currencies" use this convention, the Greater British Pound (GBP), Australian Dollar (AUD) and the New Zealand Dollar (NZD).
Ironically, the euro (EUR) is also usually quoted in American terms (USD per 1 EUR) rather than European terms.
Question 602 foreign exchange rate, American and European terms
Foreign currency quotes with the USD in the denominator (bottom of the fraction) are called European terms quotes. Most currencies use this European terms quotation style. Even though this style is named 'European' it doesn't have anything to do with European currencies.
Question 313 foreign exchange rate, American and European terms
American terms currency quotes have the USD in the numerator (top) of the fraction, so they're of the form: ##0.80\frac{USD}{AUD}## which means 0.80 USD per 1 AUD or 0.8 USD = 1 AUD.
Since the AUD is in the denominator, when the AUD appreciates against the USD, the quote number will increase.
As the AUD appreciates or strengthens against the USD, one AUD buys more USD so the numerator ##(\text{0.80 USD})## must increase while the denominator ##(\text{1 AUD})## stays at one.
In these questions, focus on the denominator currency, also called the base currency, because if the base currency:
- Appreciates, the currency quote number will increase.
- Depreciates, the currency quote number will decrease.
In the example used above, ##0.80\frac{USD}{AUD}##, the AUD is the base currency and the USD is the term currency.
Note that if the AUD appreciates against the USD, the USD depreciates against the AUD.
Question 315 foreign exchange rate, American and European terms
If the current AUD exchange rate is USD 0.9686 = AUD 1, what is the European terms quote of the AUD against the USD?
A European terms quote has the USD on the denominator (the bottom) of the fraction, so it's of the form: ##1.0324\frac{AUD}{USD}## which means 1.0324 AUD per 1 USD which is also the same as ##\text{AUD } 1.0324 = \text{USD } 1##.
Note that ##1.0324 = 1/0.9686##
Confusingly, a 'European terms' currency quote has nothing to do with the euro (EUR) currency.
Question 317 foreign exchange rate, American and European terms
European terms currency quotes have the USD in the denominator (bottom) of the fraction, so they're of the form: ##1.25 \frac{AUD}{USD}## which means 1.25 AUD per 1 USD or 1.25 AUD = 1 USD.
Since the USD is in the denominator, if the USD appreciates against the AUD, the currency quote number will increase.
As the USD appreciates or strengthens against the AUD, one USD buys more AUD so the numerator ##(\text{1.25 AUD})## must increase while the denominator ##(\text{1 USD})## stays at one.
In these questions, focus on the denominator currency, also called the base currency, because if the base currency:
- Appreciates, the currency quote number will increase.
- Depreciates, the currency quote number will decrease.
In the example used above, ##1.25\frac{AUD}{USD}##, the USD is the base currency and the AUD is the term currency.
Question 319 foreign exchange rate, monetary policy, American and European terms
Investors expect the Reserve Bank of Australia (RBA) to keep the policy rate steady at their next meeting.
Then unexpectedly, the RBA announce that they will increase the policy rate by 25 basis points due to fears that the economy is growing too fast and that inflation will be above their target rate of 2 to 3 per cent.
What do you expect to happen to Australia's exchange rate in the short term? The Australian dollar is likely to:
The Australian dollar (AUD) may instantly appreciate on this news, since investors are more likely to buy the AUD and sell foreign currencies because they can get a higher return on their funds in Australia than what they first thought.
When the AUD appreciates against the USD, the European terms quote (AUD per 1 USD) will fall. This is because the USD is in the denominator and the USD is depreciating against the AUD.
Question 321 foreign exchange rate, monetary policy, American and European terms
The market expects the Reserve Bank of Australia (RBA) to increase the policy rate by 25 basis points at their next meeting.
Then unexpectedly, the RBA announce that they will increase the policy rate by 50 basis points due to high future GDP and inflation forecasts.
What do you expect to happen to Australia's exchange rate in the short term? The Australian dollar will:
The surprise action of raising the interest rate means that AUD (debt assets) are a relatively better investment than investors thought. So the Australian dollar (AUD) may instantly appreciate on this news, since investors are more likely to buy the AUD and sell foreign currencies because they can get a higher return on their funds in Australia than what they first expected.
When the AUD appreciates against the USD, the American terms quote (USD per 1 AUD) will rise. This is because the AUD is in the denominator and the AUD is appreciating against the USD.
Question 626 cross currency interest rate parity, foreign exchange rate, forward foreign exchange rate
The Australian cash rate is expected to be 2% pa over the next one year, while the Japanese cash rate is expected to be 0% pa, both given as nominal effective annual rates. The current exchange rate is 100 JPY per AUD.
What is the implied 1 year forward foreign exchange rate?
Using the cross-currency interest rate parity (CCIRP) equation we can find the forward foreign exchange rate:
###F_{T, \text{JPY per AUD}} = S_{0, \text{JPY per AUD}}.\left( \dfrac{1+r_\text{JPY}}{1+r_\text{AUD}} \right)^T### ###\begin{aligned} F_{1, \text{JPY per AUD}} &= 100 \times \left( \dfrac{1+0}{1+0.02} \right)^1 \\ &= 98.03921569 \\ \end{aligned}###This means that the expected exchange rate in one year is 98.04 JPY per AUD, which is a depreciation of the AUD against the JPY.
This makes sense since the cross currency interest rate parity theorem states that the interest rate gain from borrowing in Japan and lending in Australia are lost on the exchange rate when the AUD are converted back to JPY.
For example, if 100JPY is borrowed in Japan at 0% pa interest, then converted to AUD straight away at the current 100JPY per AUD exchange rate, this would make 1AUD now (t=0). This 1AUD can then be invested in Australia at 2% pa interest, and an FX forward contract can be entered into to convert the 1.02AUD into JPY at the one year forward exchange rate of 98.04JPY per 1 AUD. Then in one year the 1.02AUD would be converted to 100JPY ##(=1.02\text{ AUD} \times 98.04\text{ JPY} / \text{ AUD})##, which is just enough to pay back the bank in Japan that you borrowed from in the first place. This is a covered AUD-JPY carry trade.
Notice that borrowing 100JPY in Japan and keeping it there for one year will give you the same 100JPY amount as the complicated carry trade above. Of course this is expected, because if you could make more money with the carry trade strategy, everyone would do it and force the spot or forward FX rates up or down until CCIRP holds and there is no more arbitrage opportunity. For this reason, forward foreign exchange rates are dictated by the CCIRP theory.
Question 246 foreign exchange rate, forward foreign exchange rate, cross currency interest rate parity
Suppose the Australian cash rate is expected to be 8.15% pa and the US federal funds rate is expected to be 3.00% pa over the next 2 years, both given as nominal effective annual rates. The current exchange rate is at parity, so 1 USD = 1 AUD.
What is the implied 2 year forward foreign exchange rate?
Using the cross-currency interest rate parity (IRP) equation we can find the forward foreign exchange rate:
###F_{T, \text{AUD per USD}} = S_{0, \text{AUD per USD}}.\left( \dfrac{1+r_\text{AUD}}{1+r_\text{USD}} \right)^T### ###\begin{aligned} F_{2, \text{AUD per USD}} &= 1 \times \left( \dfrac{1+0.0815}{1+0.03} \right)^2 \\ &= 1.1025 \\ \end{aligned}###This is a European terms quote since the USD is in the denominator (the bottom of the fraction). So the European terms quote of the AUD is 1.1025 AUD per USD, which is the same as 1.1025 AUD = 1 USD.
Alternatively, if you began the interest rate parity equation using the American terms currency quotes, the answer can be converted into a European terms quote at the end.
###F_{T, \text{USD per AUD}} = S_{0, \text{USD per AUD}}.\left( \dfrac{1+r_\text{USD}}{1+r_\text{AUD}} \right)^T### ###\begin{aligned} F_{2, \text{USD per }\mathbf{\text{AUD}}} &= 1 \times \left( \dfrac{1+0.03}{1+0.0815} \right)^2 \\ &= 0.907029478 \\ \end{aligned}###This is an American terms quote since the USD is in the numerator (the top of the fraction). To get the European terms quote, invert the fraction.
###\begin{aligned} F_{2, \mathbf{\text{AUD}}\text{ per USD}} &= \dfrac{1}{F_{2, \text{USD per }\mathbf{\text{AUD}}}} \\ &= \dfrac{1}{0.907029478} \\ &= 1.1025 \\ \end{aligned}###As above, the European terms quote of the AUD is 1.1025 AUD = 1 USD.
Commentary
Notice that the AUD interest rate is higher than the USD interest rate, so the cross currency interest rate parity theorem requires that the AUD forward exchange rate be lower than the spot exchange rate. This is because any excess interest rate gains by borrowing cheap in the US and lending at a high rate in Australia will be offset by a loss caused by the depreciation of the AUD against the USD over time. So when the AUD loan proceeds are repatriated back to USD in the future, the gain will be equal to simply keeping the USD in a US bank at the low US interest rate. This will be true so long as all things remain equal, meaning there are no surprise interest rate changes, for example.
The Chinese government attempts to fix its exchange rate against the US dollar and at the same time use monetary policy to fix its interest rate at a set level.
To be able to fix its exchange rate and interest rate in this way, what does the Chinese government actually do?
- Adopts capital controls to prevent financial arbitrage by private firms and individuals.
- Adopts the same interest rate (monetary policy) as the United States.
- Fixes inflation so that the domestic real interest rate is equal to the United States' real interest rate.
Which of the above statements is or are true?
The Chinese government adopts capital controls to prevent financial arbitrage. If it didn't, then arbitrageurs could borrow in the US at low interest rates (0.125% in 2015), convert the USD to RMB in a spot transaction, invest (deposit) the RMB in a Chinese bank account in China at a high interest rate, and after some time, turn the RMB into USD at the fixed exchange rate. Assuming that the Chinese government maintain their fixed RMB/USD exchange rate and interest rate, the above arbitrage would be highly lucrative.
However, arbitrageurs who rush to make this trade would be buying RMB and selling USD, causing an appreciation in the RMB against the USD, which is the very thing that the Chinese government want to avoid. They wish to keep their exchange rate artificially low to give their exporters an advantage.
Hence the Chinese government adopt capital controls to stop arbitrageurs from easily buying RMB. This allows the Chinese government control the interest rate and exchange rate at the same time.
Exchange rates cannot all appreciate together. At least one must depreciate. This is because they are measured against each other, they're a relative measure.
For example,
- If all countries' currencies appreciated except for the AUD, then the AUD must have depreciated.
- If all countries' currencies appreciated except for the USD, then the USD must have depreciated.
- If the USD depreciates then all other countries' currencies will appreciate against the USD. Indeed this is what happened during the global financial crisis (GFC) that started in 2007 when the US Federal Reserve (the US central bank) cut interest rates to zero, which led to a significant depreciation of the USD.
Question 606 foreign exchange rate, American and European terms
Which of the following FX quotes (current in October 2015) is given in American terms?
American terms foreign exchange quotes have the USD in the numerator, such as how the British Pound (GBP) is normally quoted 1.55 USD per GBP. European terms FX quotes have the USD in the denominator, which is how most currencies are quoted.
Question 318 foreign exchange rate, American and European terms
The AUD is usually given as an American terms quote against the USD in Australia, for example is 0.9686 USD per AUD, so USD 0.9686 = AUD 1.
An American wishes to convert USD 1 million to Australian dollars (AUD). The exchange rate is 0.8 USD per AUD. How much is the USD 1 million worth in AUD?
The USD 1 million should be divided by the 0.8 AUD per USD exchange rate since then the USD's will cancel out and only AUD will be left.
###\text{USD }1m \div \dfrac{\text{0.8 USD}}{\text{1 AUD}}### ###= \text{USD }1m \times \dfrac{\text{1 AUD}}{\text{0.8 USD}}### ###= \text{AUD }1.25m###Another interesting method (Thanks to Fauzan):
###0.8\text{ USD} = 1\text{ AUD}### ###1\text{ USD} = \dfrac{1}{0.8} \text{ AUD}### ###1\text{ USD} = 1.25 \text{ AUD}### ###1m\text{ USD} = 1.25m \text{ AUD}###A Chinese man wishes to convert AUD 1 million into Chinese Renminbi (RMB, also called the Yuan (CNY)). The exchange rate is 6.35 RMB per USD, and 0.72 USD per AUD. How much is the AUD 1 million worth in RMB?
The AUD 1 million should be multiplied by the 0.72 USD per AUD exchange rate since then the AUD's will cancel out and only USD will be left.
This result should be multiplied by the 6.35 RMB per USD since then the USD's will cancel out and only the RMB will be left.
Another interesting method:
###0.72\text{ USD} = 1\text{ AUD}### ###1\text{ AUD} = 0.72 \times 1 \text{ USD}###Substitute ##6.35\text{ RMB} = 1\text{ USD}##
###1\text{ AUD} = 0.72 \times 6.35\text{ RMB}### ###1\text{ AUD} = 4.572\text{ RMB}### ###1m\text{ AUD} = 4.572m\text{ RMB}###Question 603 foreign exchange rate, American and European terms
Foreign currency quotes with the USD in the denominator (bottom of the fraction) are called European terms quotes. Most currencies use this European terms quotation style. Even though this style is named 'European' it doesn't have anything to do with European currencies.
Question 314 foreign exchange rate, American and European terms
American terms currency quotes have the USD in the numerator (top) of the fraction, so they're of the form: ##0.80\frac{USD}{AUD}## which means 0.80 USD per 1 AUD or 0.8 USD = 1 AUD.
Since the AUD is in the denominator, focus on what happens to the AUD when the USD appreciates. When the USD appreciates against the AUD, the AUD depreciates against the USD, and the quote number will decrease.
As the AUD depreciates or weakens against the USD, one AUD buys less USD so the numerator ##(\text{0.80 USD})## must decrease while the denominator ##(\text{1 AUD})## stays at one.
In these questions, focus on the denominator currency, also called the base currency, because if the base currency:
- Appreciates, the currency quote number will increase.
- Depreciates, the currency quote number will decrease.
In the example used above, ##0.80\frac{USD}{AUD}##, the AUD is the base currency and the USD is the term currency.
Question 316 foreign exchange rate, American and European terms
European terms currency quotes have the USD in the denominator (bottom) of the fraction, so they're of the form: ##1.25 \frac{AUD}{USD}## which means 1.25 AUD per 1 USD or 1.25 AUD = 1 USD.
Since the USD is in the denominator, focus on what happens to the USD if the AUD appreciates. If the AUD appreciates against the USD, the USD depreciates against the AUD, and the currency quote number will decrease.
This is because as the USD depreciates or weakens against the AUD, one USD buys less AUD and the numerator ##(\text{1.25 AUD})## must decrease while the denominator ##(\text{1 USD})## stays at one.
In these questions, focus on the denominator currency, also called the base currency, because if the base currency:
- Appreciates, the currency quote number will increase.
- Depreciates, the currency quote number will decrease.
In the example used above, ##1.25\frac{AUD}{USD}##, the USD is the base currency and the AUD is the term currency.
Question 320 foreign exchange rate, monetary policy, American and European terms
Investors expect the Reserve Bank of Australia (RBA) to decrease the overnight cash rate at their next meeting.
Then unexpectedly, the RBA announce that they will keep the policy rate unchanged.
What do you expect to happen to Australia's exchange rate in the short term? The Australian dollar is likely to:
Even though the interest rate does not change, the surprise action of not lowering the interest rate means that AUD (debt assets) are a relatively better investment than investors thought. So the Australian dollar (AUD) may instantly appreciate on this news, since investors are more likely to buy the AUD and sell foreign currencies because they can get a higher return on their funds in Australia than what they first expected.
When the AUD appreciates against the USD, the European terms quote (AUD per 1 USD) will fall. This is because the USD is in the denominator and the USD is depreciating against the AUD.
Question 322 foreign exchange rate, monetary policy, American and European terms
The market expects the Reserve Bank of Australia (RBA) to decrease the policy rate by 25 basis points at their next meeting.
Then unexpectedly, the RBA announce that they will decrease the policy rate by 50 basis points due to fears of a recession and deflation.
What do you expect to happen to Australia's exchange rate? The Australian dollar will:
The surprise action of lowering the interest rate more than expected means that AUD (debt assets) are a relatively worse investment than investors thought. So the Australian dollar (AUD) may instantly depreciate on this news, since investors are more likely to sell the AUD and buy foreign currencies because they will get a lower return on their funds in Australia than what they first expected.
When the AUD depreciates against the USD, the American terms quote (USD per 1 AUD) will fall. This is because the AUD is in the denominator, so one AUD will buy less USD.
Question 323 foreign exchange rate, monetary policy, American and European terms
The market expects the Reserve Bank of Australia (RBA) to increase the policy rate by 25 basis points at their next meeting.
As expected, the RBA increases the policy rate by 25 basis points.
What do you expect to happen to Australia's exchange rate in the short term? The Australian dollar will:
There is no surprise interest rate movement, so there is no expected exchange rate movement. It is true that the Australian interest rate was raised, but this news should already have been reflected in the AUD exchange rate. The AUD would have appreciated in the past when the market first discovered the news, assuming that the market is efficient. But now there is no reason for the exchange rate to change since what was expected is exactly what occurred.
Sudden exchange rate fluctuations only occur due to surprises that the market did not already expect.
Question 605 cross currency interest rate parity, foreign exchange rate
The theory of cross currency interest rate parity (IRP) states that any profit on interest rates from borrowing in the low interest rate country (US at 0%) and lending in the high interest rate country (Australia at 2%) will be lost on the exchange rate when the AUD are converted back to USD in one year.
Therefore the AUD is expected to depreciate against the USD over the next year by around 2% which is the difference in interest rates, all things remaining equal.
This result should always hold if the one year forward exchange rate that converts AUD back to USD is locked-in (hedged) using a forward foreign exchange agreement because otherwise risk free arbitrage profits could be earned. This is called the theory of covered interest rate parity.
###F_{T, \text{USD per AUD}} = S_{0, \text{USD per AUD}}.\left( \dfrac{1+r_\text{USD }}{1+r_\text{AUD}} \right)^T###When not locking-in the exchange rate that converts the AUD back to USD in one year, then theoretically this strategy should break even (give zero profits) over the long term, all things remaining equal. This is called uncovered interest rate parity. However, in the real world all things do not remain equal so profits and losses will occur. For example:
- If the US Fed suddenly and unexpectedly decided to raise interest rates, then the USD would appreciate against the AUD and a profit would be made when the AUD were converted back to USD in one year;
- If the RBA suddenly and unexpectedly decided to raise interest rates, then the AUD would appreciate against the USD and a loss would be made when the AUD were converted back to USD in one year.
In the 1997 Asian financial crisis many countries' exchange rates depreciated rapidly against the US dollar (USD). The Thai, Indonesian, Malaysian, Korean and Filipino currencies were severely affected. The below graph shows these Asian countries' currencies in USD per one unit of their currency, indexed to 100 in June 1997.
Of the statements below, which is NOT correct? The Asian countries':
Domestic currency interest payments on domestic fixed-interest bonds would have been unchanged when paid in their own currency. All other statements are true.
Economists label statement (d) as 'original sin'. Governments and businesses borrowing in foreign currency such as USD while earning their income in the local currency expose themselves to serious foreign exchange risks.
If the local currency depreciates against the USD, then USD interest payments on USD fixed-interest bond liabilities will become more expensive in the local currency. Unfortunately, many governments and firms in developing countries are forced to borrow in the larger foreign currency bond markets since their local bond markets are non-existent or very small and local banks are unable or unwilling to lend.
Note that in some of these countries, central banks increased interest rates rapidly to encourage investors to buy their currency and stop the large depreciation. This meant that domestic currency interest payments on domestic floating-interest bonds would have been more expensive when paid in their own currency. But domestic currency interest payments on fixed-interest bonds denominated in their own currency would be unchanged.