Foreign v domestic currency - pls help

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LauraN

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Hi,
I’ve gotten totally confused with schwesers application of foreign v domestic currencies, in the prep books they said if it was euro per dollar, dollar was the domestic - but they use the opposite convention in answers to the practice exams, and I’m totally lost. Any guidance much appreciated
Thanks
L
 
You really need to understand the context of the question as well, and what they’re asking. The TYPICAL convention is to use direct quotes when quoting a currency, which is when the domestic currency is in the numerator and the foreign currency is the denominator (expressed as FC:DC).
Why is this done? Because a quote in this fashion gives you the “price” of the foreign asset, ie currency, in terms of the domestic currency. ”How many dollars does it cost me to buy one euro” - this is what a US investor would want to know.
The convention is to make interest rate quotes as a direct quote- which in your example means that the EURO is the domestic quote. For example, saying “1.2 Euro per dollar” gives you the price of the dollar… which is what a European would be interested in. This is expressed as USD:EURO. It could also be said in the industry that the dollar is the quoted currency when expressed in this fashion.
 
It’s like a price label in a store that says GBP 0.88/Box, you can buy one box for GBP 0.88, or if you have one box you can sell it for GBP 0.88.
If they had said: Bid = GBP 0.88/Box, Ask = GBP 0.89/Box, then
1. You can buy one box of fruit for GBP 0.89, or
2. You can sell them one box of fruit for GBP 0.88/Box
So using the “bad” direct/indirect terminology, GBP 0.88/Box is the direct quote or direct price for buying 1 box. So when you go to the store, the direct quote is what they are showing as the price for one bo, i.e., it’s the direct quote for buying/selling one box.
If next day you go to the store and tell them you want to buy one GBP, they are going to think you are crazy until they realize you’re a CFA geek and you really mean you want to sell them one box and walk awy with some GBP! In that case, the price of one GBP is not obvious “directly”, hence it is indirectly obtained from GBP 0.88/Box, or 1.14 Box/GBP, so you have to give them 1.14 boxes to walk away with one GBP
 
don’t use quote like the way Schweser does X/Y, don’t!
you should be familiar with this one X:Y= E, because it’s what you will see and use in CFA exam
it means that 1 unit of currency of country X equals E units of currency of country Y.
If X is foreign country, Y is the domestic country => that’s direct quote.
I think this way is easier to remember, even in the case you have to derive a cross exchange rate with bid, ask.
 
Thanks, so if Forward Price = Spot Price (1 + domestic rate) / (1 + foreign rate) how do I decide which is domestic and which is foreign?
 
LauraN wrote:
Thanks, so if Forward Price = Spot Price (1 + domestic rate) / (1 + foreign rate) how do I decide which is domestic and which is foreign?
Click to expand...
I believe the best way to look at it is to see if the S is given as FC:DC or DC:FC.
If, DC:FC than use 1+Rfc / 1+Rdc, if given under direct convention FC:DC, then use 1+Rdc / 1+Rfc
 
Spot rate in direct quote is always DC / FC or FC:DC.
Just remember to apply the same currency to the numerator and denominator for both interest rate (interest rate parity) and inflation (purchasing power parity).
 
In that scenario, you will be given the quoting convention, ie they will say $:euro or euros per dollar (but they may not tell you which is foreign or which is domestic, because the key is it doesnt matter).
The concept is that the forward premium/discount should equal the interest rate differential, ie the currency with the higher interest rate should depreciate.
So, if they give you a quote of $:EUR, then you want to keep the EUR rate in the numerator and the $ rate in the denominator.
BUT, even if they quote a currency in $:EUR (in which the dollar is quoted and this is an indirect quote) and then say the $ is the domestic currency, it won’t matter. You would still put the $ rate in the denominator.
 
this is very confusing because when you use the colon it is different directionally when using the slash.
USD/EUR = $1.20 the country that has the sign (i.e. “$” in this case) is domestic (foreign int rate - euro int rate - in denominator). You can always double check work by seeing if the higher inflation nation depreciated. So in this case if US has higher inflation, it should cost more to buy 1 euro - say $1.30/EUR.
In colon notation, this is EUR:USD which is what is annoying. If you see a colon, flip it to make it a direct quote which I think is more intuitive.
 
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