7.3 Foreign exchange systems

CGMA BA1

7. Foreign currencies

Our CGMA course is currently in development and is a work-in-progress.

Foreign exchange systems

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How to convert currencies

In an exam, an exchange rate might be shown in different (but equivalent) ways, for example:

$US $1 = AUS $1.25$

$US $0.8 = AUS $1.25$

These exchange rates describe the same relationship between the two currencies. They’re just written in different formats.

Format type 1

$US $1 = AUS $1.25$

Converting from the stronger currency to the weaker currency: multiply the amount by the exchange rate.
Converting from the weaker currency to the stronger currency: divide the amount by the exchange rate.

Format type 2

$US $0.8 = AUS $1$

Converting from the stronger currency to the weaker currency: divide the amount by the exchange rate.
Converting from the weaker currency to the stronger currency: multiply the amount by the exchange rate.

Let’s work through a couple of questions.

Example 1

KTA bought a machine on credit for $$100, 000$ overseas and agreed to pay in six months’ time. The agreed exchange rate on the transaction date was:

$US $1 = ZAR $18.55$

How much did KTA pay in South African rand (ZAR)?

Solution

(spoiler)

Using the exchange rate $US $1 = ZAR $18.55$ , we convert from US dollars to rand by multiplying:

$$100, 000 \times 18.55 = ZAR $1, 855, 000$

Example 2

KTA is due to receive a payment from a customer in the USA. The payment due is $$30, 000$ . On the date of the agreement, the exchange rate was:

$US $0.054 = ZAR 1$

By the time the payment was received, the exchange rate had moved to:

$US $0.06 = ZAR 1$

Calculate the gain or loss from this transaction for KTA.

Solution

(spoiler)

First, calculate how much KTA expected to receive on the transaction date (convert $$30, 000$ to ZAR using $US $0.054 = ZAR 1$ ):

$\frac{30 , 000}{0.054} = ZAR 555, 555.55$

Now convert using the exchange rate on the payment date:

$\frac{30 , 000}{0.06} = Z A R 500, 000$

KTA expected to receive $ZAR 555, 555.55$ but actually received $ZAR 500, 000$ .

$Loss = 555, 555.55 - 500, 000 = Z A R 55, 555.55$

This is the final answer.

When converting currencies, stick to one format at a time and apply the matching rule (multiply or divide). That helps you avoid mixing methods.

Always remember that the needs of a buyer and a seller are not the same: when the seller benefits, the buyer incurs a loss.

Understanding exchange rate systems

Floating exchange rates

Definitions

Floating exchange rate: Determined by demand and supply in the foreign exchange market. The currency’s value adjusts automatically as market conditions change.

Here’s the basic cycle:

If demand for a currency rises (for example, because foreign consumers buy more of the country’s exports), the currency becomes stronger.
A stronger currency tends to make imports cheaper and exports more expensive, which can increase imports.
To pay for more imports, residents supply more of their currency in exchange for foreign currency, which puts downward pressure on the currency and makes it weaker.
When the currency is weaker, exports become cheaper and imports become more expensive, which can increase demand for the currency again.

This repeating adjustment is what people mean when they say a floating exchange rate “auto-corrects.”

Dirty floating

Definitions

Dirty floating: When a government deliberately influences (appreciates or depreciates) its currency to affect international trade.

This is achieved by:

Selling reserves in an attempt to strengthen the currency (because doing so increases demand for the local currency).
Buying reserves (because doing so increases the supply of the local currency, which can weaken it).
Increasing or decreasing interest rates to influence the currency’s value.
- Increasing interest rates tends to increase the value of the currency in the short term.
- Decreasing interest rates tends to decrease the value of the currency in the short term.

Fixed exchange rate systems

Definitions

Fixed exchange rate system: Achieved by setting (pegging) the exchange rate to a certain currency, or to a basket of currencies, depending on what the government can maintain.

More information on exchange rates

The condition of the domestic economy affects currency strength. For example, high inflation decreases the value of a currency because it becomes less attractive; low inflation tends to have the opposite effect.

As explained above, increases or decreases in interest rates can have short-term effects. Over the long term, increasing interest rates can be a negative signal about the economy. So, while higher interest rates might support the exchange rate in the short term, they can be damaging in the long term. The opposite can happen when interest rates are decreased. (Keep in mind here we are focusing on the long-term impacts on exchange rates, not the short-term impacts covered above.)

Day trading/speculation can affect the exchange rate in the short term:

If traders are buying a currency, they increase its value.
If traders are selling it, they decrease its value due to oversupply.

Activities in the money market can affect the exchange rate as well. If money market conditions are attractive in the short term, more investors may invest on a short-term basis. That attracts hot money (money that moves quickly from one market to another to take advantage of favorable conditions). The opposite can happen if conditions are unfavorable: investors move their money market instruments to other countries, selling the local currency for a foreign currency and weakening the local currency.

Currency conversion methods

Exchange rates can be presented in different formats (e.g., $US $1 = AUS $1.25$ or $US $0.8 = AUS $1$ )
For $US $1 = AUS $1.25$ :
- Stronger to weaker: multiply by exchange rate
- Weaker to stronger: divide by exchange rate
For $US $0.8 = AUS $1$ :
- Stronger to weaker: divide by exchange rate
- Weaker to stronger: multiply by exchange rate

Currency conversion examples

Always use the correct multiply/divide rule for the given format
Exchange rate changes can result in gains or losses for buyers/sellers
- Seller gains = buyer loss, and vice versa

Floating exchange rates

Determined by demand and supply in the forex market
Currency strengthens with higher demand (exports up), weakens with higher supply (imports up)
System “auto-corrects” through cycles of import/export activity

Dirty floating

Government intervenes to influence currency value
- Sells reserves to strengthen currency
- Buys reserves to weaken currency
- Adjusts interest rates to impact value (increase = strengthen, decrease = weaken, short term)

Fixed exchange rate systems

Currency pegged to another currency or basket of currencies
Government actively maintains the set rate

Other exchange rate influences

High inflation weakens currency; low inflation strengthens it
Interest rate changes:
- Short-term: higher rates strengthen, lower rates weaken
- Long-term: higher rates can signal economic problems, possibly weakening currency
Speculation and money market activity:
- Buying increases value, selling decreases value
- Attractive money market draws “hot money” inflows, strengthening currency; unattractive market leads to outflows, weakening currency

Next | 8.1 The time value of money

Foreign exchange systems

How to convert currencies

In an exam, an exchange rate might be shown in different (but equivalent) ways, for example:

$US $1 = AUS $1.25$

$US $0.8 = AUS $1.25$

These exchange rates describe the same relationship between the two currencies. They’re just written in different formats.

Format type 1

$US $1 = AUS $1.25$

Converting from the stronger currency to the weaker currency: multiply the amount by the exchange rate.
Converting from the weaker currency to the stronger currency: divide the amount by the exchange rate.

Format type 2

$US $0.8 = AUS $1$

Converting from the stronger currency to the weaker currency: divide the amount by the exchange rate.
Converting from the weaker currency to the stronger currency: multiply the amount by the exchange rate.

Let’s work through a couple of questions.

Example 1

KTA bought a machine on credit for $$100, 000$ overseas and agreed to pay in six months’ time. The agreed exchange rate on the transaction date was:

$US $1 = ZAR $18.55$

How much did KTA pay in South African rand (ZAR)?

Solution

(spoiler)

Using the exchange rate $US $1 = ZAR $18.55$ , we convert from US dollars to rand by multiplying:

$$100, 000 \times 18.55 = ZAR $1, 855, 000$

Example 2

KTA is due to receive a payment from a customer in the USA. The payment due is $$30, 000$ . On the date of the agreement, the exchange rate was:

$US $0.054 = ZAR 1$

By the time the payment was received, the exchange rate had moved to:

$US $0.06 = ZAR 1$

Calculate the gain or loss from this transaction for KTA.

Solution

(spoiler)

First, calculate how much KTA expected to receive on the transaction date (convert $$30, 000$ to ZAR using $US $0.054 = ZAR 1$ ):

$\frac{30 , 000}{0.054} = ZAR 555, 555.55$

Now convert using the exchange rate on the payment date:

$\frac{30 , 000}{0.06} = Z A R 500, 000$

KTA expected to receive $ZAR 555, 555.55$ but actually received $ZAR 500, 000$ .

$Loss = 555, 555.55 - 500, 000 = Z A R 55, 555.55$

This is the final answer.

When converting currencies, stick to one format at a time and apply the matching rule (multiply or divide). That helps you avoid mixing methods.

Always remember that the needs of a buyer and a seller are not the same: when the seller benefits, the buyer incurs a loss.

Understanding exchange rate systems

Floating exchange rates

Definitions

Floating exchange rate: Determined by demand and supply in the foreign exchange market. The currency’s value adjusts automatically as market conditions change.

Here’s the basic cycle:

If demand for a currency rises (for example, because foreign consumers buy more of the country’s exports), the currency becomes stronger.
A stronger currency tends to make imports cheaper and exports more expensive, which can increase imports.
To pay for more imports, residents supply more of their currency in exchange for foreign currency, which puts downward pressure on the currency and makes it weaker.
When the currency is weaker, exports become cheaper and imports become more expensive, which can increase demand for the currency again.

This repeating adjustment is what people mean when they say a floating exchange rate “auto-corrects.”

Dirty floating

Definitions

Dirty floating: When a government deliberately influences (appreciates or depreciates) its currency to affect international trade.

This is achieved by:

Selling reserves in an attempt to strengthen the currency (because doing so increases demand for the local currency).
Buying reserves (because doing so increases the supply of the local currency, which can weaken it).
Increasing or decreasing interest rates to influence the currency’s value.
- Increasing interest rates tends to increase the value of the currency in the short term.
- Decreasing interest rates tends to decrease the value of the currency in the short term.

Fixed exchange rate systems

Definitions

Fixed exchange rate system: Achieved by setting (pegging) the exchange rate to a certain currency, or to a basket of currencies, depending on what the government can maintain.

More information on exchange rates

Day trading/speculation can affect the exchange rate in the short term:

If traders are buying a currency, they increase its value.
If traders are selling it, they decrease its value due to oversupply.

CGMA BA1

7. Foreign currencies

Our CGMA course is currently in development and is a work-in-progress.