Currency Exchange Rates

Section: Currency Exchange Rates Estimated study time: 60 minutes Content: Currency exchange rate analysis at CFA Level 2 requires mastery of several parity conditions that link exchange rates to interest rates, inflation, and forward prices. The four key parity relationships are covered acid: Covered Interest Rate Parity (CIP), Uncovered Interest Rate Parity (UIP), Purchasing Power Parity (PPP), and the International Fisher Effect (IFE). These relationships are interlinked — they share assumptions about market efficiency and capital mobility, and violations of these parities create profit opportunities (or persistent puzzles in empirical finance). CFA Level 2 candidates must not only know the formulas but apply them to determine fair value of currencies, expected spot rates, and carry trade profitability. Covered Interest Rate Parity (CIP) is an arbitrage-free relationship between spot exchange rates, forward exchange rates, and interest rate differentials. CIP states: F/S = (1 + r_d) / (1 + r_f), where F is the forward exchange rate (domestic currency per unit of foreign), S is the spot rate, r_d is the domestic interest rate, and r_f is the foreign interest rate. CIP must hold because it can be enforced by arbitrage through the foreign exchange forward market: if the forward rate diverges from CIP, arbitrageurs can lock in riskless profits. A common exam formulation uses the approximation: (F - S)/S = r_d - r_f, meaning the forward premium (or discount) equals the interest rate differential. A currency with higher interest rates trades at a forward discount; a currency with lower interest rates trades at a forward premium. Uncovered Interest Rate Parity (UIP) extends CIP to the unhedged case. UIP asserts that the expected change in the spot rate equals the interest…