4
Chapter
Exchange Rate Determination
Measuring
Exchange Rate Movements
• Exchange rate movement affect MNC value
because they can affect the amount of cash
inflows and outflows.
• An exchange rate measures the value of one
currency in units of another currency.
• Exchange rate can change with economic
condition.
• When a currency declines in value, it is said to
depreciate. When it increases in value, it is said
to appreciate.
Measuring
Exchange Rate Movements
• The percentage change (% in the value
of a foreign currency is computed as
St – St-1
St-1
where St denotes the spot rate at time t.
• A positive % represents appreciation of
the foreign currency, while a negative %
represents depreciation.
• On some days, most foreign currencies
may appreciate; again most foreign
currencies may depreciate against $.
• On the days when some currencies
appreciate while others depreciate against
the dollar, the dollar is said to be “mixed
in trading.”
Example
• P 100 (Exhibit 4.1)
Exchange Rate Equilibrium
• An exchange rate represents the price of a
currency, which is determined by the
demand for that currency relative to the
supply for that currency.
• For example, Equilibrium exchange rate of
British pound in $ is determined through
interaction of US demand for pounds and
British supply of pounds for sale.
Exchange Rate Equilibrium
Value of £ S: Supply of £
$1.60
equilibrium
$1.55 exchange rate
$1.50
D: Demand for £
Quantity of £
Impact of Liquidity
• The liquidity of currency affects the
sensitivity of the exchange rates to
specific transactions.
• If Currencies Spot Market is liquid, its
exchange rate will not be highly
sensitive to single large sale or
purchase of currency and vice –versa.
Factors that Influence
Exchange Rates
e = f (F , INT, INC, GC, EXP)
e= % change in spot rate
F = change in differential between inflation in 2
countries.
change in differential between interest in 2
countries.
INC= change in differential between 2 countries income
level.
GC = change in Govt control.
EXP = change in expectations in future exchange rate.
Factors that Influence
Exchange Rates
• Relative Inflation Rates
• Changes in relative inflation rate can affect
international trade activity, which influences
the demand for and supply of currencies, and
therefore influences exchange rates.
Factors that Influence
Exchange Rates
Relative Inflation Rates
$/£
U.S. inflation
S1 U.S. demand for
S0
r1 British goods, and
r0 hence £.
D1 British desire for U.S.
D0
goods, and hence the
Quantity of £ supply of £.
• If Sudden and substantial increase in UK
inflation while US inflation is low. What will
happen
1. How is demand schedule for Pounds
affected?
2. How is supply schedule of Pounds for sale
affected?
3. What will be equilibrium value for pounds?
1. The demand schedule for pounds will
shift inward.
2. Supply schedule will shift outward
3. Equilibrium value of pound will decrease.
(depends upon magnitude of shift)
Factors that Influence
Exchange Rates
• Relative Interest Rates
• Changes in relative interest rate affect
investment in foreign securities, which affect
demand and supply of currencies and
therefore, influence exchange rates.
Factors that Influence
Exchange Rates
Relative Interest Rates
$/£
U.S. interest rates
S0 U.S. demand for
S1
r0 British bank deposits,
r1 and hence £.
D0 British desire for U.S.
D1
bank deposits, and
Quantity of £ hence the supply of £.
• In some cases, an exchange rate between
two countries currencies, can be affected
by changes in third countries interest rate.
Example
• When Canadian Interest Rate increases, it
can become more attractive to UK
investors than US rate. This encourage UK
investors to purchase fewer $ dollar
dominated securities.
• Thus, supply of pounds to be exchanged
for $ will be smaller which places upward
pressure on the value of pound against $.
Factors that Influence
Exchange Rates
Relative Interest Rates
• A relatively high interest rate may actually
reflect expectations of relatively high
inflation, which discourages foreign
investment.
• High inflation can place downward
pressure on the local currency, foreign
investors may be discouraged from
investing in securities denominated in
that currencies.
• It is thus useful to consider real interest
rates, which adjust the nominal interest
rates for inflation.
• The RII is compared among currencies to
assess exchange rate movements
because it combines nominal interest rate
and inflation, both affect exchange rate.
• Cet par, high correlation between real
interest rate differential and $ value.
Factors that Influence
Exchange Rates
Relative Interest Rates
• real nominal
interest interest – inflation rate
rate rate
• This relationship is sometimes called the
Fisher effect.
Factors that Influence
Exchange Rates
Relative Income Levels
$/£
U.S. income level
U.S. demand for
S0 ,S1
British goods, and
r1
r0 hence £.
D1 No expected change for
D0
the supply of £.
Quantity of £
Factors that Influence
Exchange Rates
Government Controls
• Governments may influence the equilibrium
exchange rate by:
¤ imposing foreign exchange barriers,
¤ imposing foreign trade barriers,
¤ intervening in the foreign exchange market,
and
¤ affecting macro variables such as inflation,
interest rates, and income levels.
Factors that Influence
Exchange Rates
• Recall the example in which US interest
rate rose relative to UK interest rates.
• The expected reaction was an increase in
the UK supply of pounds for sale to obtain
more US dollars.
• If UK govt placed heavy tax on interest
income earned from foreign investment,
this could discourage the exchange of
pounds for $.
Factors that Influence
Exchange Rates
Expectations
• Foreign exchange markets react to any news
that may have a future effect.
• Institutional investors (Banks, Insurance Co)
often take currency positions based on
anticipated interest rate movements in various
countries.
• Because of speculative transactions, foreign
exchange rates can be very volatile.
Factors that Influence
Exchange Rates
• e.g. News of a potential surge in US
inflation may cause currency traders to
sell $ in anticipating a future decline in
Dollar’s value.
• Examples P 107
Factors that Influence
Exchange Rates
• Impact of Signals on Currency Speculation
¤ Day to day speculation on future exchange
rate movements is commonly driven by
signals of future interest rate movements
as well as future economic conditions.
¤ Speculators overreaction makes abrupt
corrections
¤ More influence on the currencies in
emerging markets.
¤ Example: Russian Ruble during 1998
Factors that Influence
Exchange Rates
Expectations
Signal Impact on $
Poor U.S. economic indicators Weakened
Fed chairman suggests Fed is Strengthened
unlikely to cut U.S. interest rates
A possible decline in German Strengthened
interest rates
Central banks expected to Weakened
intervene to boost the euro
Factors that Influence
Exchange Rates
Interaction of Factors
• Trade-related factors and financial factors
sometimes interact.
• Trade related FeX transactions are
generally less responsive while financial
flow transactions are very responsive to
news.
• Exchange rate movements may be
simultaneously affected by these factors.
Factors that Influence
Exchange Rates
• For example, an increase in the level of income
sometimes causes expectations of higher interest
rates.
• Higher income level result in more imports, also
can indirectly attract more financial inflows.
(assuming high interest rate).
• Here favorable financial flows overcome the
unfavorable trade flows.
• So, increase in income level frequently expected
to strengthen local currency.
Factors that Influence
Exchange Rates
• Over a particular period, different factors
may place opposing pressures on the
value of a foreign currency.
• The sensitivity of the exchange rate to
these factors is dependent on the volume
of international transactions between the
two countries.
How Factors Can Affect Exchange Rates
Trade-Related
Factors
U.S. demand for foreign
1. Inflation goods, i.e. demand for
Differential foreign currency
2. Income
Differential Foreign demand for U.S.
3. Gov’t Trade goods, i.e. supply of Exchange
Restrictions foreign currency rate
between
foreign
Financial U.S. demand for foreign currency
Factors securities, i.e. demand and the
1. Interest Rate for foreign currency dollar
Differential Foreign demand for U.S.
2. Capital Flow securities, i.e. supply of
Restrictions foreign currency
Example: Morgan Company
Factor US Venezuela Japan
Change in -1% -2% -4%
Interest
Rate
Change in +2% -3% -6%
Inflation
• Assume US and VZL conduct large
volume international trade ; less capital
flow
• US and JPN conduct less trade but engage
in more financial transaction.
• Result:
¤ Bolivar appreciates.
¤ Yen depreciates
Influence of Factors across
Multiple Currency Markets
• Each exchange rate has its own market,
meaning its own demand and supply
conditions.
• Say, The value of the Swiss franc in dollars
is influenced by the U.S. demand for francs
and the amount of francs supplied to the
market (by Swiss consumers and firms) in
exchange for dollars.
• In some periods, most currencies move in
the same direction against the dollar.
• This is typically because of a particular
underlying factor in the United States that
is having a somewhat similar impact on
the demand and supply conditions across
all currencies in that period.
• See Example : P 110
MOVEMENTS IN CROSS EXCHANGE RATES
• The value of the British pound in Swiss
francs (from a U.S. perspective, this is a
cross exchange rate) is influenced by the
Swiss demand for pounds and the supply
of pounds to be exchanged (by British
consumers and firms) for Swiss francs.
• The movement in a cross exchange rate
over a particular period can be measured
as its percentage change in that period
• Example : Page 110
Explaining Movements in Cross
Exchange Rates
Example : P -111
Anticipation
Of
Exchange
Rate
Movements
Institutional Speculation Based on
Expected Appreciation
• Chicago Bank expects Currency Lending
rate
Borrowing
rate
the exchange rate of
the New Zealand
dollar to appreciate
from its present level USD 6.72% 7.20%
of $0.50 to $0.52 in 30
days.
• It can borrow $20 m in
NZD 6.48% 6.96%
short term basis from
other bank.
Chicago Bank expects the exchange rate of the New
Zealand dollar to appreciate from its present level of
$0.50 to $0.52 in 30 days.
Borrows at 7.20%
for 30 days
1. Borrows 4. Holds
$20 million $20,912,320
Returns $20,120,000
Profit of $792,320
Exchange at Exchange at
$0.50/NZ$ $0.52/NZ$
Lends at 6.48%
2. Holds for 30 days 3. Receives
NZ$40 million NZ$40,216,000
Institutional Speculation Based on Expected
Depreciation
Chicago Bank expects the exchange rate of the New
Zealand dollar to depreciate from its present level of
$0.50 to $0.48 in 30 days.
Borrows at 6.96%
for 30 days
1. Borrows 4. Holds
NZ$40 million NZ$41,900,000
Returns NZ$40,232,000
Profit of NZ$1,668,000
Exchange at or $800,640 Exchange at
$0.50/NZ$ $0.48/NZ$
Lends at 6.72%
2. Holds for 30 days 3. Receives
$20 million $20,112,000
