CFA Level I Review: Foreign Exchange (with Videos)

Study session 6 in the Level I CFA Program curriculum concludes the economics material with two readings (20-21) on economics in a global context.  Only 19 LOS but is important to set a base (especially forex) for level II

International Trade and Capital Flows

The reading is almost completely conceptual and just a series of lists, theories and competing models. The most testable material is often the comparison between theories or models, so understand basic advantages/disadvantages of each.

Understand the different impacts of tariffs, quotas and subsidies across the economy. Producer surplus increases while the consumer surplus decreases under these trade policies.

The effect on the government is mixed with an increase from tariffs, decreasing revenue from an export subsidy and dependent results on import quotas.

Prices in the importing country increase under a tariff and quota system while domestic consumption falls under all three trade policies. Domestic production generally increases though at the expense of national welfare.

Currency Exchange Rates

The material on foreign exchange rates can get tough but you have to build a good understanding. It is not only easily testable on the Level I exam but will also be an important part of the curriculum in the other two exams.

Failure to understand the basic concepts here only means that you will need to spend the time to learn them in subsequent years.
Understand the differences between currency futures and forwards. As a exchange product, futures are available only at a fixed contract amount and for settlement on fixed dates.

Collateral (margin) must be posted and is marked-to-market on a daily basis. Liquidity is much higher for futures and there is no counterparty risk. Forwards are OTC agreements between private parties so will be much more flexible in terms of amount, settlement and collateral. They are not as liquid and include counter-party risk.

The real points here and through the other two exams is in your ability to do the rate calculations. First understand the difference between a direct and indirect quote.

The direct quote will have the domestic currency last (i.e. after the slash) and in terms of one unit of the currency. $1.37/Euro is the direct quote for euros in the US dollar. One euro costs $1.37 dollars.

Be able to calculate and determine depreciation/appreciation in a currency as well as the forward rate.

* Forex was a tough one for me and I really couldn’t get the hang of it until I watched a couple of videos. Work through the curriculum and any study guides you have but don’t be afraid to look on YouTube for a visual interpretation as well.

A good explanation of Bid and Ask quotes is available on YouTube at:
http://www.youtube.com/watch?v=PmjUx8ZcsoY

Cross rates and arbitrage are easily testable and will really test whether you understand forex quotes and calculations. A good explanation of triangular arbitrage is available on YouTube at:
http://www.youtube.com/watch?v=FElk-K1vb_I

Beyond the basic function of the currency regimes, the advantages and disadvantages are the most important part here.

A few times drilling yourself on flash cards should be enough to be able to pick these out of a list if questioned on the exam.

The material on capital flows and currency rates is largely theoretical so understand the general concepts. Understand the difference between the elasticities approach and the absorbtion approach.

The basic idea behind the Marshall-Lerner condition is that demand for imports and exports is price sensitive so that increases in relative prices will lead to a changing trade balance that can be managed through devaluations of the domestic currency.

Under the absorption approach, a depreciation will improve the trade balance only for a short period through the wealth effect, and that is only under an economy operating under full employment.

Study session 7 begins your introduction to Financial Reporting and Analysis, probably the most important topic within the entire CFA curriculum. Fortunately, the material on the Level I CFA Program exam is pretty basic and you will probably have seen it before in any basic finance course.

‘til next time, happy studyin’
Joseph Hogue, CFA

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