In a previous article, we introduced the CFA Institute
Investment Foundation Program (Read
more here). It is a free program
designed for anyone who wants to enter or advance within the investment
management industry, including IT, operations, accounting, administration, and
marketing. Candidates who successfully
pass the online exam earn the CFA Institute Investment Foundations Certificate.
There are total of 20 Chapters in 7 modules, covering all
the essential topics in finance, economics, ethics and regulations. This series of articles will highlight the
core knowledge of each chapter.
Chapter 6 provides an overview of macroeconomics. The
learning outcome of chapter 6 is as follows:
·
Define imports and exports and describe the need
for and trends in imports and exports;
·
Describe comparative advantages among countries;
·
Describe the balance of payments and explain the
relationship between the current account and the capital and financial account;
·
Describe why a country runs a current account
deficit and describe the effect of a current account deficit on the country’s
currency;
·
Describe types of foreign exchange rate systems;
·
Describe factors affecting the value of a
currency;
·
Describe how to assess the relative strength of
currencies;
·
Describe foreign exchange rate quotes;
·
Compare spot and forward markets.
An exchange rate is the rate at which one currency can be
exchanged for another. It can also be considered as the value of one country’s
currency in terms of another currency.
Three main types of exchange rate systems are fixed exchange
rate, floating exchange rate, and managed floating exchange rate systems. A
fixed exchange rate system does not allow for fluctuations of currencies. By
contrast, a floating exchange rate system is driven by supply and demand for
each currency, allowing exchange rates to adjust to correct imbalances, such as
current account deficits. In practice, pure floating exchange rate systems are
rare. Managed floating exchange rate systems, in which a central bank will intervene
to stabilise its country’s currency, are more common although intervention is
uncommon.
Major factors that affect the value of a currency include
the balance of payments, inflation, interest rates, government debt, and the
political and economic environment. A current account deficit, high inflation,
low interest rates, high government debt, political instability, and poor
economic prospects tend to lead to a depreciation in value of the domestic
currency relative to foreign currencies; it will take more of the domestic
currency to buy a unit of foreign currency.
One of the simplest models for determining the relative
strength of currencies is purchasing power parity, which is based on the
principle that a basket of goods in two different countries should cost the
same after taking into account the exchange rate between the two countries’
currencies. Purchasing power parity has limitations because of the difficulty
of identifying a basket of goods for comparison between countries and barriers
to international trade.
Two exchange rates are quoted in the market: the bid rate
and the offer rate. The bid rate is the rate at which the dealer will buy the
foreign currency, and the offer rate is the rate at which the dealer will sell
the foreign currency. The bid–offer spread is how the dealer makes money.
Foreign exchange transactions may take place with immediate
delivery via the spot market or with future delivery via the forward market.
The forward market allows importers and exporters to eliminate
currency risk by fixing today the exchange rate at which they will trade in the
future.
Sample Question:
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