Study Session 6 Global Economics

CFACENTER.COM 1
Study Session 06
Global Economic Analysis


A. Gaining from International Trade

a. state the conditions under which a nation can gain from international trade, and
describe the benefits of international trade.

II each country has comparative advantage in producing a speciIic good, international
trade will lead to mutual gain because it allows the residents oI each country to:
specialize more Iully in the production oI those things that they do best (i.e. at
a lower opportunity cost).
import goods when Ioreigners are willing to supply them at a lower cost than
domestic producers.

Absolute and comparative advantage:

Absolute advantage is the ability oI a nation to produce a good with fewer
resources than another nation. Absolute advantage exists iI a nation can
produce more oI a good with the same amount oI resources. Previous
experience and/or natural endowments determine absolute advantage.

Comparative advantage is the ability to produce a good at a lower
opportunitv cost than others can produce it. Relative costs determine
comparative advantage.

A nation can have comparative advantage in producing a good even iI it has no
absolute advantage in producing any good. As long as the relative costs oI producing
the two goods diIIer in two countries, comparative advantage exists and gains Irom
specialization and trade will be possible. When this is the case, each country will Iind
it cheaper to trade Ior goods that can be produced only at a high opportunity cost.

Example: ReIer to the graph below. The graph demonstrates Saudi Arabia's and the
United States's production possibility curves Ior widgets and wadgets. Given these
production possibility curves, you would suggest that:
A. Saudi Arabia specialize in widgets and the United States in wadgets.
Study Session 6 Global Economics
CFACENTER.COM 2
B. no trade should take place.
C. Saudi Arabia specialize in wadgets and the United States in widgets.
D. Both countries should produce an equal amount oI each.


Correct Answer: A. The opportunity cost Ior Saudi Arabia oI wadgets in terms oI
widgets is higher than the opportunity cost Ior the United States. Saudi Arabia has
comparative advantage in producing widgets and the US has comparative advantage
in producing wadgets. Saudi Arabia should specialize in widgets and the United States
should specialize in wadgets.

Because trade permits nations to expand their joint output, it also allows each nation
to expand its consumption possibilities. Trade between nations will lead to an
expansion in total output and mutual gain Ior each trading partner when each country
specializes in the production oI goods it can produce at a relatively low cost and uses
the proceeds to buy goods that it could produce only at a relatively low cost and uses
the proceeds to buy goods that it could produce only at a high cost. It is comparative
advantage that matters. As long as there is some variation in the relative opportunity
cost oI goods across countries, each country will always have a comparative
advantage in the production oI some goods.

Note that the nation that has a steeper production possibilities line has comparative
advantage in the good on the vertical axis, and the other nation has comparative
advantage in the good on the hori:ontal axis. For the trade to be mutually acceptable,
the terms oI the trade must lie between the slopes oI the two nations'
production-possibilities lines.

Additional gains Irom international trade:

Gains Irom economies oI scale and expansion in the size oI the market:
international trade allows both domestic producers and consumers to gain Irom
reductions in per-unit costs that oIten accompany large-scale production,
marketing and distribution.

Gains Irom more competitive markets: international trade promotes competition
Study Session 6 Global Economics
CFACENTER.COM 3
in domestic markets and allows consumers to purchase a wide variety oI goods at
economical prices.

Gains Irom the adoption oI better institutions and policies: international trade
provides governments with the strong incentive to adopt better institutions and
policies. II they do not, both labor and capital will move to countries with more
Iavorable environment.

Imports and exports are closely linked:
Exports provide the Ioreign exchange that allows a nation to import.
II a nation did not export goods, it would not have the Ioreign currency required
to import.
II a nation did not import goods, Ioreigners would not have the purchasing power
to buy that nation's exports.





b. discuss the effects of international trade on domestic supply and demand.

International trade and specialization result in lower prices (and higher domestic
consumption) Ior imported products and higher prices (and lower domestic
consumption) Ior exported products. More important, trade permits the residents oI
each nation to concentrate on the things they do best (produce at a low cost), while
trading Ior those they do least well.



At a very low world price such as P1 the U.S. will import yo-yos. At a world
price oI P3 the U.S. would be an exporter oI yo-yos. At P2 it would neither export
nor import yo-yos.
Study Session 6 Global Economics
CFACENTER.COM 4
At a world price oI P3 U.S. suppliers will be willing and able to oIIer P3i yo-yos
Ior sale. Domestic buyers want to purchase P3h yo-yos at that price. The
remainder, hi, will be exported.
U.S. consumers gain P2jgP1 and U.S. producers lose P2jIP1. These areas
represent gains in consumer surplus and losses in producer surplus relative to the
no-trade situation.

We can see that producers beneIit Irom exports:
As the result oI exports, US producers gain since they supply more at a higher
price, while US consumers lose since they purchase less at a higher price.
When we Iocus only on one export product, consumers are harmed by Iree trade.
However, this ignores the secondary eIIects:
Free trade allows Ioreigners to export goods to the US Ior which they have a
comparative advantage.
Consequently, US consumers will beneIit Irom the low-cost Ioreign products.

Consumers beneIit Irom imports:
As the result oI imports, US consumers gain since they can consume more at a
lower price, while US producers lose since they produce less at a lower price.
In Iact, international competition will direct the resources oI a nation toward its
areas oI comparative advantage.
When domestic producers have a comparative advantage in producing a good,
they can compete eIIectively in the world market and gain Irom the exports.
In turn, the exports will generate the purchasing power necessary to buy
goods that Ioreigners can supply at lower cost.

ThereIore, international trade and specialization result in an expansion in both
aggregate output and consumption compared to what could be achieved in the absence
oI trade:
Lower prices and higher domestic consumption Ior imported goods.
Higher prices and higher domestic output Ior exported goods.





c. describe commonly used trade-restricting devices, including tariffs, quotas,
voluntary export restraints, and exchange-rate controls.

Almost all countries have erected trade barriers.

A tariff is a tax levied on goods imported into a country. It beneIits domestic
producers and the government at the expense oI consumers.
Study Session 6 Global Economics
CFACENTER.COM 5


Let's illustrate the impact oI a tariII on automobiles. Without a tariII, the world
market price (P
w
) would prevail in the domestic market. US consumers purchase
Q
1
units, while US producers supply Q
d1
units. When the US imposes a tariII (t)
on imports oI automobiles, US consumers now pay (P
w
t) to purchase
automobiles Irom Ioreigners. Due to the higher price, US consumers will reduce
demand Irom Q
1
to Q
2
, while US producers will increase supply Irom Q
d1
to Q
d2
.
Imports Irom Ioreigners will reduce to Q
2
to Q
d2
.

The tariII beneIits domestic producers and the government. It protects domestic
producers Irom Ioreign competition. Consequently, domestic producers can
supply at a higher price. Domestic producers gain the area S in the Iorm oI
additional revenue. The government gains the area T in the Iorm oI tax revenues
collected on imports.

The tariII harms domestic consumers as they have to pay higher price Ior Iewer
goods. They lose the area S U T V. Note that areas U and V are a
deadweight loss (loss oI eIIiciency) Ior the economy since they do not beneIit
either producers or the government.

In eIIect, it acts as a subsidy to domestic producers. Potential gains Irom
specialization and trade go unrealized.

An import quota is a speciIic limit or maximum quantity (or value) oI a good
permitted to be imported into a country during a given period. It is designed to
restrict Ioreign goods and protect domestic industries.

Study Session 6 Global Economics
CFACENTER.COM 6


Assume that a quota limits imports oI automobiles to (Q
2
- Q
d2
), a quantity below
the Iree trade level oI imports (Q
1
- Q
d1
). Since the quota reduces Ioreign supply,
domestic price will be pushed up to P
2
. Due to the higher price, US consumers
will reduce demand Irom Q
1
to Q
2
, while the US producers will increase supply
Irom Q
d1
to Q
d2
. Like a tariII, an import quota beneIits domestic producers but
harms domestic consumers. However, diIIerent Irom a tariII, an import quota
beneIits Ioreign producers at the expense oI the government: with a quota, Ioreign
producers who are granted permission to sell in the domestic market can charge
premium prices Ior the limited supply oI Ioreign goods. The area T represents the
gains oI those Ioreign producers. Under a tariII, the government would gain the
area T in the Iorm oI tariII revenues. This politically granted privilege creates a
strong incentive Ior Ioreign producers to engage in rent-seeking activities. In
addition, with a quota Ioreign producers are prohibited Irom selling additional
units regardless oI how much lower their costs are relative to those oI domestic
producers. ThereIore, quotas are more harmIul than tariIIs in many ways.

A voluntary export restraint (VER) is an agreement by Ioreign Iirms to limit
their own exports. Foreign Iirms sometimes will agree to limit their exports to a
country to avoid the imposition oI other types oI trade barriers. The economic
impact oI a VER is similar to that oI a quota.

Licensing requirements and product quality standards are other types oI
barriers used by government to restrict trade. They make it diIIicult and more
costly Ior Iirms to import products into the country. They hurt domestic consumers
but beneIit domestic producers.

Exchange rate controls are oIten adopted by less-developed countries to Iix the
exchange-rate value oI their currency above the market rate and impose
restrictions on exchange-rate transactions. The artiIicially high exchange rate will
cause the country's exports to decline, because the country's export goods will be
relatively expensive to Ioreigners. In turn, the low level oI exports will make it
Study Session 6 Global Economics
CFACENTER.COM 7
diIIicult Ior domestic residents to acquire the Ioreign currency required to buy
imports. Such exchange-rate controls both reduce the volume oI trade and lead to
black-market currency exchanges, and thus limiting the ability oI its citizens to
trade with Ioreigners.

Example 1: ReIer to the graph below. What tariII would the government have to
impose on tomatoes imported Irom Mexico to have the same eIIect as a quota oI Q1?


A tariII that shiIts supply to where it intersects demand at P3 and Q1 would be the
equivalent oI a quota oI Q1. This would happen with a tariII oI P3-P1.

Example 2: ReIer to the graph below. II this graph represents the supply oI and
demand Ior an imported product, a tariII oI t will result in revenue Ior the government
shown by area:



A tariII oI t shiIts the supply curve up Irom S0 to S1. Quantity sold is now OE. TariII
revenue is t times quantity OE shown by the rectangle BDGH.

Example 3: ReIer to the graph below. With a quota on lumber imported Irom Canada
oI 600 tons, the revenue the government would collect Irom the import oI lumber
would be:
Study Session 6 Global Economics
CFACENTER.COM 8



Answer: 0. Government does not collect revenue with a quota.





d. explain the impact of trade barriers on the domestic economy and identify who
benefits and loses from the imposition of a tariff.

II the government imposes a tariII or a quota on Ioreign-made cars, what impact will
this have on the market Ior American-made cars? Who beneIits and who hurts in the
U.S. Irom the tariII or quota imposed on Ioreign-made cars?

An increase in the price oI Ioreign cars (a substitute Ior American cars) will increase
the demand Ior American-made cars. The result is a higher price Ior American-made
cars and a greater amount oI these cars produced and sold in the U.S. as is illustrated
in the Iollowing Iigure.

Study Session 6 Global Economics
CFACENTER.COM 9


Those who beneIit include domestic producers because they are selling more cars at
higher prices. Domestic auto workers will also likely beneIit. The greater quantity oI
cars produced will increase the demand Ior autoworkers, pushing up their wages (or
beneIits) and increasing their employment opportunities (or at least their job security).
However, American consumers are hurt because they will have to pay higher prices
Ior domestically produced cars.

Generally (no matter what the good or service is), the economic costs oI higher prices
to consumers oI any government-imposed trade restriction Iar outweighs the beneIits
to the protected Iew. The cost oI preserving American jobs through government trade
barriers can be very expensive.

Another Example: ReIer to the graph below. Demand and supply are initially D and
S1 respectively. Which oI the Iollowing best describes the eIIect oI a $.50 per pound
tariII on Danish hams imported into the United States?

Study Session 6 Global Economics
CFACENTER.COM 10


Answer: A tariII shiIts the supply curve to the leIt by the amount oI the tax.
Equilibrium price is determined where quantity demanded equals quantity supplied, at
$2.25 a pound and 80 thousand pounds.





e. explain why nations adopt trade restrictions.

Protective tariffs are as much applications of force as are blockading squadrons,
and their objectives is the same "to prevent trade." - Henry George

There are three major arguments Ior protecting certain domestic industries:

National-defense argument: certain industries (i.e. weapons, aircraIt, etc) are
vital to national deIense and thereIore should be protected Irom Ioreign
competitors so that a domestic supply oI necessary materials would be available in
case oI an international conIlict. This argument is oIten abused by special interest
groups to justiIy protection Ior their industry at the expense oI the economy in
general. For example, many industries that contribute only marginally to national
deIense oIten use this argument as an excuse to justiIy protection. In Iact, large,
strong economies are capable oI producing large volumes oI goods necessary to
sustain a large war eIIort.

Infant-industry argument: new domestic industries should be protected by older,
established Ioreign competitors. As the new industry matures the protection can be
removed. This argument attempts to give temporarv protection to inIant industries.
However, the protection, once granted, is generally diIIicult to remove even
Study Session 6 Global Economics
CFACENTER.COM 11
though the "inIant" industry has become economically powerIul.

Anti-dumping argument: dumping is the sale oI a good by a Ioreign supplier in
another country at a price below that charged by the supplier in its home market. It
may be prompted by Ioreign government export subsidies, and it is illegal in the
US.
Dumping can, in a Iew instances, be used as a weapon to gain monopoly
power.
However, dumping is usually not a Ieasible strategy Ior monopoly because
domestic producers will re-enter the market iI the price rises in the Iuture.
Dumping sometimes Iorces domestic producers to improve quality and cut
costs.
The law oI comparative advantage indicates that a country (as a whole)
can gain Irom the purchase oI Ioreign-produced goods when they are
cheaper than domestic goods. Unless the Ioreign supplier is likely to
monopolize the domestic market, there is little reason to believe that
dumping harms the economy receiving the goods.

Many people believe that trade restrictions will increase employment and protect jobs.
However, they Iail to understand the implications oI the law oI comparative advantage
and the linkage between imports and exports. For example, trade restrictions will
result in a decline in exports, thus destroying jobs in export industries that would have
been created iI without those restrictions. Why? The sales Irom Ioreigners to us (our
import) provide them with the purchase power required to buy Irom us (our exports).
Trade restrictions reduce the Ioreigners' purchase power, thereby depressing our own
export industries. As a result, any jobs saved in protected industries will be oIIset by
jobs lost in export industries. In Iact, trade restrictions direct resources away Irom
areas where domestic producers have a comparative advantage.

Trade restrictions provide highly visible, concentrated beneIits to a small group oI
people (producers, resource suppliers and their employees in the protected industries).
These special interest groups are well organized, and the jobs saved and high wages
protected in these industries are highly visible. Special interest groups oIten provide
contributions to politicians who are willing to support trade restrictions. However,
trade restrictions impose on the general public widely dispersed costs that are oIten
diIIicult to identiIy: consumers have to pay higher prices Ior the products oI industries
protected by trade restrictions, but they are an unorganized group and oIten unaware
oI the harm oI trade restrictions. In addition, potential workers and investors in export
industries harmed by those restrictions are also uninIormed. ThereIore, special interest
groups have greater political impact than those harmed by the restrictions.

f. discuss the validity of the arguments for trade restrictions.

ReIer to LOS e please.
Study Session 6 Global Economics
CFACENTER.COM 12
B. Foreign Exchange

a. define direct and indirect methods of foreign exchange quotations.

Foreign exchange market permits people to exchange purchasing power
denominated in diIIerent currencies.
Market: Most currency transactions are channeled through the worldwide
interbank market, a wholesale market in which major banks trade with one
another. It accounts Ior 95 oI Ioreign exchange transactions.
In the spot market, currencies are traded Ior immediate delivery (which is
actually two business days aIter the transaction has been conducted). Spot
transactions account Ior about 60 oI the market.
In the forward market, contracts are made to buy or sell currencies Ior
Iuture delivery. Forward transactions account Ior 10 oI the market.
Swap transactions involve a package oI a spot and a Iorward contract,
and accounts Ior the remaining 30 oI the market.

Location: It is not a physical place but an electronically linked network oI banks,
Ioreign exchange brokers and dealers. It is not conIined to any one country but is
dispersed throughout the leading Iinancial centers oI the world.

Participants: large commercial banks, Ioreign exchange brokers in the interbank
market, commercial customers (primarily multinational corporations) and central
banks.

Size: it is by Iar the largest Iinancial market in the world. The largest currency
trading markets are London, New York and Tokyo.

In this market most currencies are quoted against the UD dollar. However, in Asia
many currencies are quoted against the yen, and in Europe many currencies are
quoted against the euro.

The Ioreign exchange rate is determined by the intersection oI the supply and demand
curve Ior domestic currency in the market. When the domestic currency appreciates,
the Ioreign currency depreciates, and vice versa.

Most countries use a system oI direct quotation when dealing with nonbank
customers. A direct exchange rate quote gives the home currency price oI a certain
quantity oI the Ioreign currency quoted (DF/FC). For example, the price oI Ioreign
currency is expressed in French Irancs in France and Deutsche marks in Germany.
Direct quotation is used in most countries.

Indirect quotation is used by banks in Great Britain and in the US Ior domestic
Study Session 6 Global Economics
CFACENTER.COM 13
purposes and Ior the Canadian dollar (FC/DC). It is just the opposite oI direct quote:
they are reciprocals oI each other. For example, a bank in Great Britain will quote the
value oI pound sterling in terms oI the Ioreign currency (i.e. 1 pound $1.4410).

Example: Ior a US resident, $0.0085/Yen is the direct quote Ior Japanese yen, and Yen
119.46/$ is the indirect quote Ior Japanese yen.

In a direct quote, the domestic (foreign) currency moves in the opposite (same)
direction oI the exchange rate.
In an indirect quote, the domestic (foreign) currency moves in the same
(opposite) direction oI the exchange rate.

American terms: number oI US dollars per unit oI Ioreign currency. In the US it
would be a direct quote, and outside the US it would be an indirect quote.

European terms: number oI Ioreign currency units per US dollar. In the US it would
be an indirect quote, and outside the US it would be a direct quote. All currencies
other than the British pound and euro are quoted in European terms.

These terms are used when interbank trades involve dollars.





b. define and calculate the spread on a foreign currency quotation.

Banks do not normally charge a commission on their currency transactions, but they
proIit Irom the spread between the buying and selling rates on both spot and Iorward
transactions. Quotes are always in pairs: the Iirst rate is the buy, or bid, price (Ior a
bank); the second is the sell, or ask, oIIer (Ior a bank). The ask rate is usually higher
than that bid rate, so the bank can make a proIit. The average oI the bid and ask price
is known as the midpoint price: Midpoint price (Ask Bid) / 2.

When American terms are converted to European terms or direct quotation are
converted to indirect quotations, bid and ask quotes are reversed. That is:
The direct ask price is the reciprocal oI the indirect bid price.
The direct bid price is the reciprocal oI the indirect ask price.
No matter how the quote is made, banks will always buy low and sell high.

For example, the Japanese yen is quoted at $0.0081-83 (a direct quote) Irom the US
perspective. That is, banks are willing to buy yen at $0.0081/yen (direct bid price) and
sell them at $0.0083/yen (direct ask price). The indirect bid price is: 1/0.0083
Yen120.48/$, and the indirect ask price is: 1/0.0081 Yen123.45/$.
Study Session 6 Global Economics
CFACENTER.COM 14
The bid-ask spread is the spread between bid and ask rates Ior a currency: Bid-ask
spread ask price - bid price. It is usually stated as a percentage oI the ask price:
Percent spread (Ask price - Bid Price) x 100 / Ask Price

For example, with pound quoted at $1.4419 - 28, the percentage spread is: (1.4428 -
1.4419) x 100 / 1.4428 0.062.

Note that the percentage spread is the same irrespective oI whether the exchange rate
is expressed in direct or indirect quotations.





c. explain how spreads on foreign currency quotations can differ as a result of
market conditions, bank/dealer positions, and trading volume.

The bid-ask spread is based on breadth and depth oI the market Ior that currency as
well as on the currency's volatility.

Market conditions: Higher exchange rate volatility increases banks' risk oI
holding currency positions. ThereIore, the greater the volatility, the larger the
size oI the spread.

Trading volume: Large transactions (large volume) can get narrower spreads
than small transactions. This is due to the higher average costs banks incur on
small transactions.

Dealer/bank positions: Some dealers may believe they can trade a little more
Iavorably than the market rates indicate -- that is, to widen the spread when
trading with their customers.





d. convert direct (indirect) foreign exchange quotations into indirect (direct) foreign
exchange quotations.

See los a please.




Study Session 6 Global Economics
CFACENTER.COM 15
e. calculate currency cross rates, given two spot exchange quotations involving
three currencies.

A cross rate is the exchange rate between two countries computed Irom each
country's exchange rate against a third country. For example, since most currencies
are quoted against the dollar, sometimes we need to work out the cross rates Ior
currencies other than the dollar. For example, iI the Deusche mark is selling Ior $0.60
and the buying rate Ior the French Iranc is $0.15, then the DM/FF cross rate is DM 1
FF 4.

Cross rates with bid-ask spread:

The rate between Japanese yen and the US$ is Yen119.05 - 121.95/$ and the rate
between French Iran and the US$ is FF5.30-5.76/$. The direct quote between yen and
Iranc in Japan will be:
(Yen119.05/$)/(FF5.76/$) Yen20.67/FF, and (Yen121.95/$)/(FF5.30/$)
Yen23.01/FF

The lower rate is the bid, and the higher rate is the ask. ThereIore, the rate between
yen and Iranc is Y20.67 - 23.01/FF.

In Iact, each cross currency transaction is the combination oI two trades:
The bid price: a bank will buy dollars with yen low (Y119.05/$), and sell
dollars Ior Iranc high (FF5.76/$). Thus, the bid price is Y20.67/FF.
The ask price: a bank will sell dollars Ior yen high (Y121.95/$), and buy
dollars with Iranc low (FF5.30/$). Thus, the ask price is Y23.01/FF.

Note that in calculating the cross rates you should always assume that you have to sell
a currency at the lower (or bid) rate and buy it at the higher (or ask) rate, giving you
the worse possible rate. This method oI quotation is how banks make money in
Ioreign exchange.

Similarly, the direct quote in France is FF0.0435 - 0.0484/Yen.





f. calculate the widest interval within which the mid-point of the bid-ask spread in
the domestic country must remain to allow no arbitrage between the currencies of
the domestic country and a foreign country.

Exchange traders are continuously alert to the possibility oI taking advantage, through
currency arbitrage transactions, oI exchange rate inconsistencies in diIIerent money
Study Session 6 Global Economics
CFACENTER.COM 16
centers. These transactions involve buying a currency in one market at a lower price
and simultaneously selling it in another at a higher price. As a result, the value oI the
bought currency will rise, while the value oI the sold currency will Iall. Such activities
tend to keep exchange rates uniIorm in the various markets.

Bilateral arbitrage aligns the bid-ask spread between two countries. II we use S
I
to
represent the midpoint oI the direct exchange rate quote in the Ioreign country (which
is also the indirect quote in the domestic country): S
I
FC/DC. In the domestic
country, the direct quote is thereIore 1/S
I
( which is DC/FC). Assume that the
transaction cost t
c
in both countries are the same percentage oI the direct quote
mid-point in each country. II a trader starts with one unit oI domestic currency. He
can buy |(1 - t
c
) x S
I
| units oI the Ioreign currency in the Ioreign country. Then he will
use these |(1 - t
c
) x S
I
| units oI Ioreign currency to buy domestic currency in the
domestic country. Let x be the deviation in midpoint oI the direct exchange rate quote
in the domestic country. ThereIore, the units oI domestic currency you can buy is: |(1
- t
c
) x S
I
| x (1 - t
c
) x (1/SI X). Due to the transaction cost, the units oI domestic
currency you end up with should be no more than 1 (otherwise an arbitrage
opportunity would exist):
|(1 - t
c
) x S
I
| x (1 - t
c
) x (1/S
I
X) 1

ThereIore, the largest no-arbitrage deviation in the midpoint oI the direct exchange
rate quote in the domestic country is (k 1 - t
c
):
X - (1/SI) 1/(k2 x SI)

Accordingly, the widest no-arbitrage range oI domestic direct quote midpoint is (1/S
I
)
- X.

Suppose a trader Iaces an indirect exchange rate midpoint oI approximately 1.25FC
units Ior 1 DC unit in his domestic country. The transaction costs are 0.02 oI the
direct quote midpoint in each country.
In the domestic country, the direct bid-ask spread on the Ioreign country is
(0.80025 bid, 0.80041 ask).
In the Ioreign country, the direct bid-ask spread is (1.2498 bid, 1.2503 ask).

Multiplying the Ioreign country direct bid price by the domestic country direct bid
price, we get a value 1.2498 x 0.80025 1.00015 that's greater than 1, an indication
oI an arbitrage opportunity. The transaction cost is 0.02, and the direct exchange
rate midpoint in the Ioreign country is S
I
1.25. Hence, X - (1/1.25) 1/(0.9998
2
x
1.25) 0.00032. So the no-arbitrage range oI midpoint exchange rate quotes in the
domestic country is |0.79968, 0.80032|. Notice that the midpoint oI the domestic
bid-ask spread is 0.80033 (0.80025 0.80041) / 2, a midpoint outside the
no-arbitrage range.


Study Session 6 Global Economics
CFACENTER.COM 17
g. calculate the profit on a triangular arbitrage opportunity, given the bid-ask
quotations for the currencies of three countries.

Exchange traders are continuously alert to the possibility oI taking advantage, through
currency arbitrage transactions, oI exchange rate inconsistencies in diIIerent money
centers. These transactions involve buying a currency in one market and selling it in
another. Such activities tend to keep exchange rates uniIorm in the various markets.

For example, suppose the pound sterling is bid at $1.9809 in New York and the
Desutsche mark at $0.6251 in FrankIurt. At the time, London banks are oIIering
pounds sterling at DM 3.1650. An astute trader would sell dollars Ior Deutsche marks
in FrankIurt, use the Deutsche marks to acquire pounds sterling in London, and sell
the pounds in New York. SpeciIically, the trader would:
1. begin in New York with $1 million.
2. acquire DM 1,599,744.04 Ior $1,000,000 in FrankIurt.
3. sell these Deutsche marks Ior 505,448.35 pounds in London.
4. sell these pounds in New York Ior $1,001,242.64.
5. get a proIit oI $1,242.64 with no investment and risk!





h. distinguish between the spot and forward markets for foreign exchange.

In the spot market, currencies are traded Ior immediate delivery (which is actually
two business days aIter the transaction has been conducted). In the forward market,
contracts are made to buy or sell currencies Ior Iuture delivery.

In a typical Iorward transaction, a US company buys textiles Irom England with
payment oI 1 million pounds due in 90 days. The importer is thus short pounds --
that is, it owes pounds Ior Iuture delivery. Suppose the present price oI the pound is
$1.71. Over the next 90 days, however, the pound might rise against the dollar, raising
the dollar cost oI the textiles. The importer can guard against this exchange risk by
immediately negotiating a 90-day Iorward contract with a bank at a price, say,
$1.72/pound. In 90 days the bank will give the importer 1 million pounds and the
importer will give the bank 1.72 million dollars. By going long in the Iorward market
the importer is able to convert a short underlying position in pounds to a zero net
exposed position.

Three points are worth noting:
The gain or loss on the Iorward contract is unrelated to the current spot rate oI
$1.71/pound.
The Iorward contract gain or loss exactly oIIsets the change in the dollar cost
Study Session 6 Global Economics
CFACENTER.COM 18
oI the textile order that is associated with movements in the pound's value.
The Iorward contract is not an option contract. Both parties must perIorm the
agreed-on behavior.





i. define and calculate the spread on a forward foreign currency quotation.

The diIIerence between the bid and ask price oI a Ioreign exchange rate quotation is
the bid-ask spread. It represents a proIit to the banks and a cost to customers. For
example, a bank quotes the 1-month euro/dollar exchange rate as 0.80200 - 0.80250.
This means that the bank is willing to commit itselI today to buy dollars Ior 0.80200
euro or to sell them Ior 0.80250 euro in one month. The bid-ask spread oI the 1-month
Iorward rate is 0.80250 - 0.80200 0.00050 euro/dollar.






j. explain how spreads on forward foreign currency quotations can differ as a result
of market conditions, bank/dealer positions, trading volume, and maturity/length of
contract.

As with spot rates, bid-ask spreads oI Iorward rates are inIluenced by market
conditions, bank/dealer positions, and trading volume.
The greater the exchange rate volatility, the larger the size oI the spreads.
Bank/dealer positions aIIect the midpoints oI the spreads.
The lower the trading volume oI a currency, the larger the spreads.

Unlike spot rates, the bid-ask spread on Iorward contracts rises with Iorward contract
maturity: This widening is caused by the greater uncertainty surrounding Iuture
exchange rates. Dealers will quote wider spreads on longer-term Iorward contracts to
compensate themselves Ior the risk oI being unable to reverse their positions
proIitably. ThereIore, the longer the contract maturity, the larger the size oI the spread.





k. define forward discount and forward premium.

Study Session 6 Global Economics
CFACENTER.COM 19
Forward exchange rates are oIten quoted as a premium, or discount, to the spot
exchange rate. A Ioreign currency is at a forward discount iI the Iorward rate
expressed in dollars is below the spot rate, whereas a forward premium exists iI the
Iorward rate is above the spot rate. Clearly, a negative premium is a discount.

For example, iI the one-month Iorward exchange rate is 0.80200 euro/dollar and the
spot rate is 0.80000euro/dollar, the dollar quotes with a premium oI 0.0020 euro per
dollar. In the language oI currency traders, the dollar is "strong" relative to the euro.

Consequently, when a trader announces that a currency quotes at a premium
(discount), the premium (discount) should be added to (subtracted Irom) the spot
exchange rate to obtain the value oI the Iorward exchange rate.

The Iorward premium or discount can be expressed as an annualized percentage using
the Iollowing Iormula:

Annualized Iorward premium/discount |(Forward Rate - Spot Rate)/Spot Rate| x
|12/Number oI Months Forward|

In the above Iormula, both Iorward rate and spot rate are stated in direct quotation
(DC/FC). |(Forward Rate - Spot Rate)/Spot Rate| is known as the forward
differential. The second part can be also expressed as |360/Number oI days Iorward|,
where there are 30 days per month.

In the example above, the annualized Iorward premium on the dollar |(0.802 -
0.800)/0.800| x |12/1| 3.0.

Another example: Spot Japanese yen on April 1997, sold at $0.007960 whereas
180-day Iorward yen were priced at $0.008184. Thus the Iorward premium
annualized |(0.008184 - 0.007960) / 0.007960| x |360 / 180| 0.0563 5.63.





l. calculate a forward discount or premium and express either as an annualized
rate.

See los k please.





Study Session 6 Global Economics
CFACENTER.COM 20
m. explain covered interest rate parity.

According the interest rate parity (IRP) theory, the currency oI the country with a
lower interest rate should be at a Iorward premium in terms oI the currency oI the
country with the higher rate. In an eIIicient market with no transaction costs, the
interest diIIerential should be (approximately) equal to the Iorward diIIerential.
The exact relationship between the Iorward rate and the spot rate between two
currencies is as Iollows:

|(1 r
domestic
)/(1 r
Ioreign
)| Forward Rate / Spot Rate

Both the Iorward rate and the spot rate in the above Iormula are stated in direct
quotation (DC/FC).
Both the domestic interest rate and the Ioreign interest rate in the above
Iormula are periodic interest rate, which should be computed as r annual
interest rate x number oI days till the Iorward contract expires / 360.
It is assumed that there are no transaction costs.

Example:
Suppose that the US is the domestic country and the annual interest rate in the US is
5. The spot exchange rate between the British pound and the US dollar is
$1.50/pound, and the 180-day Iorward rate is $1.45/pound (direct quotes). The US
periodic interest rate (180) is: 0.05 x 180 / 360 0.025. II interest rate parity holds:

|(1 0.025)/(1 r
UK
)| 1.45/1.5 ~ r
UK
6. ThereIore, the annual UK interest rate
is approximately 12.

Similarly, you can calculate Iorward rate based on domestic and Ioreign interest rates
and spot rate.





n. define and illustrate covered interest arbitrage.

Interest parity ensures that the return on a hedged (or "covered") Ioreign investment
will just equal the domestic interest rate in investments oI identical risk, thereby
eliminating the possibility oI having a money machine. When this condition holds, the
covered interest differential -- the diIIerence between the domestic interest rate and
the hedged Ioreign rate -- is zero.

II the diIIerence is not zero, covered interest arbitrage will generate proIits without
any risk or investment.
Study Session 6 Global Economics
CFACENTER.COM 21

For example, suppose the interest rate on pound sterling is 12 in London, and the
interest rate on a comparable dollar investment in New York is 7. The pound spot
rate is $1.75 and the one-year Iorward rate is $1.68. These rates imply a Iorward
discount on sterling oI 4 |(1.68 - 1.75)/1.75| and a covered yield on sterling
approximately equal to 8 (12 - 4). Suppose the borrowing and lending rates are
identical and the bid-ask spread in the spot and Iorward markets is zero. An
arbitrageur will:
borrow $1,000,000 in New York at 7.
convert the $1,000,000 to 571,428.57 at 1 $1.75.
invest the 571,428.57 in London at 12 Ior one year, and sell 640,000 Iorward at a
rate oI 1 $1.68 Ior delivery in one year.

At the end oI the year, collect 640,000 Irom his investment in London, deliver it to
the bank's Ioreign exchange department in return Ior $1,075,200, and use $1,070,000
to repay the loan in New York. The arbitrageur will earn $5,200 on this set oI
transactions with no investment at all.


Study Session 6 Global Economics
CFACENTER.COM 22
C. Foreign Exchange Parity Relations

a. explain how exchange rates are determined in a flexible or floating exchange
rate system.

Terms:

Foreign exchange market: the market in which the currencies oI diIIerent countries
are bought and sold.

Exchange rate: the domestic price oI one unit oI Ioreign currency. For example, iI it
takes $1.5 to purchase one English pound, the dollar-pound exchange rate is 1.50.

Appreciation: an increase in the value oI a domestic currency relative to Ioreign
currencies. An appreciation increases the purchasing power oI the domestic currency
Ior Ioreign goods.

Depreciation: a reduction in the value oI a domestic currency relative to Ioreign
currencies. A depreciation reduces the purchasing power oI the domestic currency Ior
Ioreign goods.

Flexible exchange rate: Exchange rates that are determined by the market Iorces oI
supply and demand. They are sometimes called floating exchange rates.

The dollar demand for foreign exchange arises Irom the purchase (import) oI goods,
services and assets by Americans Irom Ioreigners. The supply of foreign currency in
exchange for dollars arises Irom the sale (export) oI goods, services and assets by
Americans to Ioreigners. The equilibrium exchange rate will bring these two Iorces
into balance.

An above-equilibrium exchange rate creates excess supply oI Ioreign exchange, and a
below-equilibrium exchange rate creates excess demand Ior Ioreign currency.

This market-clearing exchange rate not only equates demand and supply in the Ioreign
exchange market, but also equates (1) the value oI US purchases oI items supplied by
Ioreigners with (2) the value oI items sold by US residents to Ioreigners.





b. explain the role of each component of the balance-of-payments accounts.

Study Session 6 Global Economics
CFACENTER.COM 23
The balance of payments summarizes the transactions oI the country's citizens,
businesses, and government with Ioreigners. Its account reIlects all payments and
liabilities to Ioreigners (debits) and all payments and obligations received Irom
Ioreigners (credits).

Balance-oI-payments accounts are recorded using the regular bookkeeping method.
Any transaction that creates a financial inflow is recorded as a credit (or plus)
item. Exports are an example oI a credit item.
Any transaction that creates a financial outflow is recorded as a debit (or plus)
item. Imports are an example oI a debit item.

Because the Ioreign exchange market will bring quantity demanded and quantity
supplied into balance, it will also bring the total debits and total credits into balance.

There are three major balance oI payments components:

Current account

All payments (and giIts) related to the purchase or sale oI goods and services and
income Ilows during the designated period are included in this component. They
involve only current exchanges oI goods and services and current income Ilows (and
giIts). They do not involve changes in the ownership oI either real or Iinancial assets.
The current account balance represents the net value oI all these Ilows associated with
current transactions by residents abroad or by nonresidents in the home country. There
are Iour major types oI current account transactions:

the exchange oI merchandise goods: the largest portion oI a nation's
balance-oI-payments account is balance of merchandise trade (or balance of
trade), which is the diIIerence between the value oI merchandise exports and
the value oI merchandise imports Ior a nation. The convention is to treat all
inIlows (exports or sale oI domestic assets) as a credit to the balance oI
payments.
the exchange oI services: i.e. services in transportation, communication,
insurance, and Iinance.
income Irom investments: i.e. interest, dividends, and various investment
income Irom cross-border investments.
unilateral transIers: giIts and other Ilows without quid pro quo compensation.

Capital account

Capital account (Iinancial account) transactions Iocus on changes in the ownership oI
real and Iinancial assets. These transactions are composed oI
direct investment made by companies.
portIolio investments in equity, bonds, and other securities oI any maturity.
Study Session 6 Global Economics
CFACENTER.COM 24
other investments and liabilities (such as deposits or borrowing with Ioreign
banks and vice versa).

When nonresidents make investments in the home country, they provide cash inIlows.
Capital inIlow transactions are recorded as credits. When residents make investment
in Ioreign countries, they transIer capital abroad. Capital outIlow transactions are
recorded as debits.

Official reserve account

Governments maintain oIIicial reserve balances in the Iorm oI Ioreign currencies,
gold, and special drawing rights (SDRs) with the International Monetary Fund (IMF).
When a country runs a deIicit on its current and capital-account balances, it can draw
on its oIIicial reserve to balance the aggregate balance-oI-payments accounts. These
oIIicial reserve transactions are usually quite modest relative to the total oI all
international transactions. The oIIicial reserve account records all reserve transactions
by the country's monetary authorities.

The balances oI these three components must sum to zero, but the individual
components oI the accounts need not be in balance.

Balance on current account Balance on Iinancial account Balance on oIIicial
reserve account 0

ThereIore, a deIicit in one area implies an oIIsetting surplus in other areas. Under a
pure Ilexible rate system, there will not be any oIIicial reserve account transactions.
Under these circumstances, a current-account deIicit implies a capital-account surplus
(and vice versa). The sum oI current account and capital account (called overall
balance), should be zero.



c. explain how current account deficits or surpluses and financial account deficits
or surpluses affect an economy.

The current account measures mainly trade in goods and services. The other three
current-account categories are generally small.

Since trade in goods and services dominates current-account transactions, a
current-account deIicit usually means that the country imports more goods and
services than it exports. A current account deIicit should not be conIused with an
overall balance deIicit. A current account deIicit has to be oIIset by a Iinancial account
surplus. Under a pure Ilexible rate system, a current account deIicit implies a
capital-account surplus. Though a country may use oIIicial reserves to oIIset a current
Study Session 6 Global Economics
CFACENTER.COM 25
account deIicit, this can only be a temporary measure because its reserves will quickly
be depleted.

Current account deIicits are not necessarily a bad economic signal.

A nation's trade deIicit or surplus is an aggregation oI the voluntary choices oI
businesses and individuals. In contrast with a budget deIicit oI an individual,
business or government, there is no legal entity that is responsible Ior the trade
deIicit.

II a current-account deIicit is caused by economic growth, it is not a bad
economic signal. When a country grows Iaster than its trading partners, it
tends to need more imports to sustain its output growth. However, its exports
will not grow as Iast as its imports because oI the lower economic growth oI
its trading partners. ThereIore, higher economic growth causes a current
account deIicit. Similarly, a large current account surplus may be a bad signal
because it may indicate that the economic growth oI a country Ialls behind its
trading partners.

Higher economic growth also yields attractive returns on invested capital and
attracts Ioreign investment. This capital inIlow provides natural Iinancing Ior
the current account deIicit. Countries that attract a net inIlow oI Ioreign capital
tend to run current-account deIicits. As long as the inIlow oI capital is
channeled into proIitable investment, it enhances the growth and prosperity oI
a nation. For example, the US current-account deIicit reIlects an attractive
domestic investment environment and a low saving rate.

A nation can continue to run a current-account deIicit Ior a long time: it is not
like business losses or an excess oI household spending relative to income.

However, large current account imbalances can have social implications (i.e. "lost"
jobs). Current account deIicits are used as evidence to provide the harmIul eIIects oI
Iree trade on domestic labor. ThereIore, countries with large current account deIicits
tend to impose tariIIs and other trade barriers on countries with large current account
surpluses.

d. describe the factors that cause a nation's currency to appreciate or depreciate.

In a Ilexible exchange rate system, the value oI a currency is driven by changes in
Iundamental economic Iactors. The major Iactors that move an exchange rate can be
associated with the transaction motives on the Ioreign exchange market, namely,
current account transactions and Iinancial account transactions, resulting in changes in
supply and demand oI its currency.

Study Session 6 Global Economics
CFACENTER.COM 26
DiIIerences in national inIlation rates: A country's imports and exports depend
on the relative prices oI Ioreign-produced and domestically produced goods. A
rise in the prices oI domestically produced goods (domestic inIlation) that is
not matched abroad leads to depreciation oI the domestic currency. The
current oI a country with low inIlation tends to appreciate. For example, iI
inIlation makes American goods more expensive than Japanese goods,
Americans will spend more on Japanese imports, causing the demand Ior Yen
to increase. Due to the higher prices oI American goods, the Japanese will
reduce their demand on American goods, causing the supply oI Yen to Iall. As
a result, the exchange rate will rise and the dollar will depreciate.

Note that:
It is the relative rate oI inIlation that matters. Identical rates oI inIlation
in two countries have no eIIect on the exchange rate.
Changes in inIlation rates mainly aIIect current account transactions.

Changes in real interest rates: Financial Ilows are attracted by high expected
return. For debt securities, investors search Ior high real interest rates. Rising
domestic real interest rates (and/or Ialling rates abroad) lead to an appreciation
oI domestic currency. As in the case oI inIlation, it is the relative interest rate
that matters.

Changes in investment climate: Financial Ilows are attracted by high expected
return, but also by low risk. An improvement in a country's investment climate
(such as a stable political system, a eIIective and Iair legal and tax system, Iree
movements oI capital) will lower investment risk and lead to increased
Iinancial inIlows and a currency appreciation.

DiIIerences in economic perIormance: Unlike the other three Iactors, this
Iactor aIIects both current account and Iinancial account transactions.
Good news on the prospect Ior growth oI a nation should attract more
international equity capital. The nation's currency should appreciate.
However, Iast-growing economy has a Iast-growing demand Ior
imports. This will put a downward pressure on the current account,
which could lead to a depreciation oI the nation's currency. On the
other hand, the impact oI sluggish growth oI income on exchange rate
is similar to the impact oI a decline in income.
As the diIIerences in economic growth have opposite eIIects on the current
account and Iinancial account oI a country, the direction oI the cumulative
eIIect is unclear. Note that current economic growth aIIects the current
account; Iuture economic growth aIIects the Iinancial account.



Study Session 6 Global Economics
CFACENTER.COM 27
e. explain how monetary and fiscal policies affect the exchange rate and balance-of
payments components.

Both monetary and Iiscal policies aIIect the exchange rate since they have an impact
on economic growth, inIlation, and real interest rates. However, monetary and Iiscal
policies diIIer with regard to their impact on the Ioreign exchange market.

An unanticipated shiIt to a more expansionary monetary policy will have the
Iollowing short-term impacts:
Higher income growth, which leads to an increase in imports.
A higher inIlation rate, which makes domestic products more expensive and
thus reduces exports.
Lower real interest rates, which encourage capital outIlow.

These Iactors will increase the demand Ior Ioreign currencies and reduce its supply,
causing the dollar to depreciate. In the mean time, both current account and Iinancial
account will shiIt toward deIicits.

An unanticipated switch to a more restrictive monetary policy will do the opposite.

Fiscal policy tends to generate conIlicting inIluences on the Ioreign exchange market.
An expansionary Iiscal policy will encourage demand and thus imports, which
will place downward pressure on the exchange-rate value oI a nation's
currency.
However, the increased interest rate will draw Ioreign investment to the nation
and cause the currency to appreciate.
Since Iinancial capital is highly mobile, in the short run the second outcome is
more likely.

An unanticipated shiIt to a more expansionary Iiscal policy will have the Iollowing
impacts:
exchange rate uncertain, but the interest rate eIIect is likely to cause
appreciation.
real interest rates increase.
capital inIlow (the capital account shiIts towards a surplus).
current account shiIts toward a deIicit: large budget deIicits will tend to result
in large current-account deIicits.

An unanticipated shiIt to a more restrictive Iiscal policy will do the opposite.

1-curve effect: The tendency oI a nation's current-account deIicit to widen initially
beIore it shrinks in response to an exchange-rate depreciation. This tendency results
because the short-run demand Ior both imports and exports is oIten inelastic, even
though the long-run demand is almost always elastic.
Study Session 6 Global Economics
CFACENTER.COM 28
f. describe a fixed exchange rate and a pegged exchange rate system.


In a flexible exchange rate regime, the exchange rate is determined by the market
Iorces oI supply and demand, and thereIore Iluctuates Ireely in the market. The central
bank intervenes in the Ioreign exchange market only to smooth temporary imbalances.
The advantages are that the exchange rate reIlects economic Iundamentals at a given
point in time, and governments are Iree to adopt independent monetary and Iiscal
policies. However, exchange rates can be extremely volatile in this regime.

A fixed exchange rate is an exchange rate that is set at a determined amount by
government policy. The distinguishing characteristic oI a Iixed rate, uniIied currency
regime is the presence oI only one central bank with the power to expand and contract
the supply oI money. Those linking their currency at a Iixed rate to the dollar or the
euro are no longer in a position to conduct monetary policy. They essentially accept
the monetary policy oI the nation to which their currency is tied. They also accept the
exchange-rate Iluctuations oI that currency relative to other currencies outside oI the
uniIied zone.

Between 1944 and 1971 most oI the world operated under the Iixed exchange rates
system. The advantage oI a Iixed exchange rate is that it eliminates exchange rate risk,
at least in the short run. Such a regime imposes discipline on government policies.
However, this constrained countries' monetary independence: countries conIronting
balance-oI-payments problems oIten imposed tariIIs, quotas and other trade barriers
in and eIIort to keep their payments and receipts in balance. A Iixed exchange rate
regime lacks long-term credibility. When a country runs into economic turmoil, it is
oIten Iorced to remove the Iixed rate system and devalue its currency. These problems
eventually led to the demise oI the system.

A pegged exchange-rate system is a commitment to use monetary and Iiscal policy
to maintain the exchange-rate value oI the domestic currency at a Iixed rate or within
a narrow band relative to another currency (or bundle oI currencies). It is
characterized as a compromise between a Ilexible and a Iixed exchange rate.
Study Session 6 Global Economics
CFACENTER.COM 29
Countries adopting this system continue to conduct monetary policy, but the monetary
policy must be consistent with the Iixed rate. The advantage oI a pegged exchange
rate is that it reduces exchange rate volatility, at least in the short run. The
disadvantage is that it can induce destabilizing speculation. Maintenance oI the
pegged rate requires the country to give up monetary independence. Under such a
system, a country is oIten under the pressure to deIend its target exchange rate against
speculative activities. II devaluation oI the domestic currency ultimately happens,
speculators will beneIit, and deIending the target exchange rate becomes a costly
process Ior the country. A country cannot maintain the convertibility oI its currency at
the Iixed exchange rate while Iollowing a monetary policy more expansionary than
that oI the country to which the domestic currency is tied: Iinancial crisis in Mexico,
Brazil, and several Asian countries Iorced these countries to abandon their
exchange-rate pegs.





g. define and discuss absolute purchasing power parity and relative purchasing
power parity.

The law of one price states that the same good cannot sell Ior diIIerent prices in
diIIerent locations at the same time. Purchasing power parity (PPP) is an application
oI this principle in the international market place. It states that the spot exchange rate
adjusts perIectly to inIlation diIIerentials between two countries (inflation
differential). ThereIore, PPP links spot exchange rates and inIlation by the no
arbitrage condition. In contrast, interest rate parity (IPP) links spot rates, Iorward rates,
and interest rates by the no arbitrage condition.

There are two versions:

Absolute PPP. The law oI one price states that the real price oI a good must be
the same in all countries. II goods prices rise in one country relative to another, the
country's exchange rate must depreciate to maintain a similar real price Ior the
goods in the two countries. ThereIore, the exchange rate between two currencies
will exactly reIlect the purchase power oI the two currencies. II we take a
weighted average oI the prices oI all goods in the economy, absolute PPP claims
that the exchange rate should be equal to the ratio oI the average price levels oI
the two economies. In practice, countries calculate movements in price indexes.

Relative PPP. It Iocuses on the general, across-the-board inIlation rates in two
countries and claims that the exchange rate movements should exactly oIIset any
inIlation diIIerential between the two countries. II it holds, PPP implies that the
real return on an asset is identical Ior investors Irom any country. It might be
Study Session 6 Global Economics
CFACENTER.COM 30
written as:
S
1
/S
0
(1 + I
FC
)/(1 + I
DC
)

where
S
0
is the spot exchange rate at the start oI the period (the Ioreign price oI one
unit oI the domestic currency).
S
1
is the spot exchange rate at the end oI the period.
I
FC
is the inIlation rate over the period in the Ioreign country.
I
DC
is the inIlation rate over the period in the domestic country.

Suppose the indirect exchange rate is 2.235 Canadian dollars Ior one pound and
inIlation rates are I
Canada
1.3 and I
Britain
2.1 in Britain, then the end-oI-period
spot exchange rate "should" be equal to S1 which is calculated as 2.2175 C$ per
pound. Here the higher British inIlation rate means that the pound depreciates against
the Canadian dollar as seen by a decline in the indirect exchange rate.

The PPP relation is oIten presented as the linear approximation stating that the
exchange rate variation is equal to the inIlation rate diIIerential: s S
1
/S
0
- 1 I
FC
-
I
DC
.