Multinational Operations

Question

Hi guys, I was doing a question in the schweser notes and was confused with the exchange rate quotes they are using.

Level 2 Book 2 Page 152 question 6 (Study Session 6 Reading 21).

The question listed a couple of exchange rates for "USD:MXN", the question did not mention whether this is a direct or indirect quote and I assumed it was referring to USD per unit of MXN however after looking at the solution its actually an indirect quote (foreign currency per unit of domestic currency).

My question is, how would I know whether this should be direct or indirect since it's using : (colon) rather than the usual / (slash) as that would make a huge difference to the calculation.

TradeBaron · Answer

@Christine with reference to the above I was hoping you could help me out, I've noticed (to my dismay) that so far the CFA have used the convention Price/Base, however in FX markets it is in fact Base/Price - fully understood - despite spending a couple of hours going nuts about it.

In the in the CFA textbooks the equation for CIRP and such linked equations state the notation is Foreign/Domestic = P/B now I understand that:

"A direct currency quote takes the domestic country as the price currency and the foreign country as base currency"
"An indirect currency quote takes the foreign country as the price currency and domestic country as the base currency"

So basically what I'm reading is that Price/Base = Domestic/Foreign (Direct Quote) and Price/Base = Foreign/Direct (Indirect Quote) the order Price/Base (A/B) do not change direction (unless in forex markets) and everything else to the right of the equation does? So when the CFAI is using CIRP it's using the "indirect method" If this isn't the case then the CFA textbooks appear to be wrong (hopefully not) as I see Domestic/Foreign quoted in CIRP equations elsewhere. In a nutshell is it the case that Price(A)/Base(B) - do not ever move format and Foreign/Domestic do move depending on the direct or indirect exchange rate?

Thanks!!!

christine · Answer

This is a slightly confusing topic. Let's park direct and indirect for a second and look at the notations first.

In FX notation, the convention for a currency pair is BASE:FOREIGN, or BASE/FOREIGN. If I write down GBP:USD, this is the same as GBP/USD. For example, if GBP:USD = GBP/USD = 1.5, this means it's USD 1.5 to GBP 1. The slash ('/') symbol here is not a divisor. So to your specific question, even if it is a slash sign, it should still be MXN per unit USD.

I think of it as DENOMINATOR:NUMERATOR, or DENOMINATOR/NUMERATOR. The latter term is very confusing, I know, but that's the convention for FX.

Now for indirect and direct quotes. You can only say something is a direct or indirect quote if you know what is the domestic currency of the person being quoted to. In this case, if the investor is British, GBP:USD would be a direct quote, but if the investor is American, GBP:USD would be an indirect quote.

Hope that helps - let me know if you need more details.