Trying to get my head around calculating real exchange rates (see CFAI Volume 6, page 489, under International Asset Pricing).
Let’s assume the spot exchange rate is (using THB and AUD) ฿30 to $1.
Using the equation on page 489, Sreal = S (PFC/ PDC), where the rates are direct quotes from an Australian perspective and AUD is the domestic currency (so the THB:AUD = $0.0333), then the equation reads:
Sreal = 0.0333 x (0.66667/5) = $0.00444 (or $1 buys ฿225 in real terms). I don’t believe this result is correct, and that I’m missing something, probably related to the way my rates are presented (direct or indirect).
My thinking has always been like this: If a consumption basket in Thailand costs ฿20, and the consumption basket in Australia costs $5, then the real exchange rate between the two countries is ฿4 per $1 (or $0.25 as a direct quote from an Australian perspective).
Which means in order to make the above equation equal ฿4 is to use indirect quotes (from an AUD perspective) instead of direct quotes, so that
Sreal = 30 x (0.66667/5) = 4
What am I missing here? Should indirect quotes be used instead of direct quotes (from an AUD perspective)? (Alternatively, should the foreign currency direct quote be used?)
The text says “direct quote FC:DC”, which means “1 FC buys x DC”. This is a direct quote for a domestic currency (p489)
To break it down, for “Real exchange rate = Spot rate (Foreign ccy price/ domestic ccy price)”, are the spot rates direct or indirect in relation to the domestic ccy?
I didn’t read half of what you wrote above because my head is mush from 6hours straight studying but i always in my head use AUD/USD 1.03 (DC/FC) to answer these questions. Here it takes 1.03 us dollars to buy 1 australian dollar. If you look at it another way (FC:DC) 1 us dollar buys aussie 0.9709c (1/1.03)
I get lost in all the direct/indirect terminlogy i just remember these questions like this. I dont know if i helped but yeah…
Your formula real exchange rate = spot rate x (FC level/DC level) based on indirect quoted DC/FC
FC level increase -> exchange rate DC/FC increase so FC level on numerator
DC level decrease -> exchange rate DC/FC increase so DC level on denumerator
Hope this help!
Agreed ^ - words and exchange rate quotes do not go well together in plain text.
I’ll make an attempt at the cliffs notes version, but without bothering to sort through the whole problem I think you have the quotes mixed up (AUD should be the DC)
A direct quote always has the investors currency in terms of 1 unit of the foreign currency. Expressed in the notation, it will be Foreign Currency : Investor’s Currency. The goal is to tell you how much of your (or the investors currency) buys 1 unit of the foreign currency.
To a Thai investor, the direct quote is AUD:THB which is expressed numerically as THB / 1AUD. The indirect quote to a Thai investor is THB/AUD, or AUD/THB = “1 Thai Bhat buys x amount of AUD”
Hi giakhanh39, thanks that helped.
However, there’s some confusion about what AUD/THB. THB/AUD, AUD:THB, and THB:AUD mean.
40 THB/AUD = 40 AUD:THB = $1 AUD buys 40 Baht (this is a direct Thai quote and indirect Aussie quote)
0.025 AUD/THB = THB:AUD = 1 THB buys $0.025 AUD (this is a direct Aussie and indirect Thai quote)
See page 598 of the first CFA book or page 298 of Schwesher book 1.
you can also think of the slash (AUD/THB) meaning AUD per THB, alternatively AUD:THB means 1 AUD in ‘X’ amount of THB, direct Thai quote. per CFA text they’ll be using the : on the exam. i’ve gotten mixed up a few times since Schweser is still using /
Unfortunately with currencies it doesnt really do much good to memorize the formulas - you can get twisted and mindfkd pretty quickly on the exam if you get flustered and its much better to learn the notation inside and out
Direct and Indirect quotes are pretty self explanatory.
We are given 2 countries. Just arbitarily make one country your home country. Say you live in there. Then the other country becomes foreign country. Once you do that it becomes straightforward to interepret direct and indirect quotes. Direct means how much you’ll pay to buy one foriegn currency (memorize this). Indirect is inverse of that.
let’s say in exam they say, GBP per Euro = .6
I make GBP my home country. Then what kind of quote is this? is it telling me i have to pay .6gbp to buy 1 euro? yes. So its a direct quote.
let’s say in exam they give you EURO/GBP = 1.25
is it telling me that i have to pay 1.25 gbp to buy 1 euro? no. it’s telling me that for 1 gbp i can get 1.25 euro. so its an indirect quote. so you’d inverse it and get 1/1.25 = .8
so you can say GBP per EURO = .8
Once you have sorted your home and foriegn country, life should be easy. I wish someone could explain me this trick for the first time around.