Exchange Rates- Direct vs. Indirect Quotation

CFA Level I
#1

Hi everyone,

I am struggling a bit with the following question from the curriculum:

[question removed by admin]

But doesn’t the answer to this question depend on whether we start at direct or indirect notation??

#2

Here is my issues with this:

The depreciation of the CHF against the GBP can have two effects, depending on whether we start at direct notation or indirect notation ( from the perspective of Switzerland ):

  1. If we start with direct notation. i.e. the price of one unit of GBP expressed in CHF, we would have for instance: 1.42 CHF/GBP, which increases by 12% (because the CHF depreciates) and we get 1.42*1.12=1.59 CHF/GBP

Now from the perspective of the indirect notation, the following happened: The rate used to be: 0.70 GBP/CHF and now it is 0.62 GBP/CHF (1/1.59). This corresponds with a decrease of -10.7%

  1. If we start with indirect notation. i.e. the quantity of GBP we can buy with one CHF, we would have for instance: 0.70 GBP/CHF, which decreases by 12% (because the CHF depreciates) and we get 0.7*0.88=0.61 CHF/GBP

Now from the perspective of the direct notation, the following happened: The rate used to be: 1.42 GBP/CHF and now it is 1.61 GBP/CHF (1/0.61). This corresponds with an increase of 13.63%

#3

This is incorrect. You’re showing that GBP appreciates by 12%, not that CHF depreciates by 12%.

Here’s the correct approach:

CHF has depreciated 12%. Think of the exchange rate as having gone from:

GBP/CHF 1.00

to:

GBP/CHF 0.88

(It doesn’t matter what the actual rates are, as long as the second number is 88% of the first; I made it easy.)

Then, inverting the quotes, the exchange rate has gone from:

CHF/GBP 1.00

to:

CHF/GBP 1/0.88 = CHF/GBP 1.1364

GBP has appreciated 13.64% vis-à-vis CHF.

#4

Ok, now I got it!!

My example with the direct notation was not correct because the direct notation from the perspective of Switzerland, shows the price of one unit of GBP expressed in CHF. So that is the similar to the price of one beer expressed in CHF. Now if that amount goes up,it means that one unit of GBP or beer just got more expensive.

In order to make the price of CHF more expensive, I need to use the price notation from the perspective of the Brits, i.e what is the price of one unit of CHF (or cheese) expressed in GBP, so as you pointed out, GBP/CHF needs to decrease by 12%.

Thanks for clarifying S2000!!! This was driving me nuts.

#5

You’re quite welcome.