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BBK3273 | International Finance Prepared by Dr Khairul Anuar
L2: Exchange Rate Determination
www.lecturenotes638.wordpress.com
Contents
1. Measuring Exchange Rate Movements
2. How Exchange Rate Movements Measured
3. Exchange Rate Equilibrium
4. Factors That Influence Exchange Rates
5. Anticipation of Exchange Rate Movements
6. 6. Summary
2
1. Measuring Exchange Rate Movements
• Exchange rate movements affect an MNCs value because they can affect
the amount of cash inflows received from exporting or from a subsidiary and
the amount needed to pay for imports.
• A decline in a currency’s value is referred to as depreciation
• Increase in a currency’s value is referred to as appreciation
• When a foreign currency's spot rates at two specific points in time are
compared, the spot rate at the more recent date is denoted as S ad the spot
rate at the earlier date is denoted as St-1.
• The percentage change in the value of the foreign currency is computed as
follows:
• A positive percent change indicates that the currency has appreciated. A
negative percent change indicates that it has depreciated.
1
1 aluecurrency vforeign in Percent
t
t
S
SS
3
2. How Exchange Rate Movements Measured
• The exchange rate for the Canadian dollar and the euro are shown in the second and fourth
column of the figure below for the months from 1st January to 1st July.
• Notice that the direction of the movement may persist for consecutive months in some cases or
may not persist in other cases.
• The magnitude of the movement tends to vary every month, although the range of percentage
movements over these months may be a reasonable indicator of the range of percentage
movements in future months.
• A comparison of the movements in these two currencies suggest that they appear to move
independently of each other.
Figure 1: How Exchange Rate Movements and Volatility Are Measured
4
3. Exchange Rate Equilibrium
• The exchange rate represents the price of a currency, or the rate at which one currency can be exchanged for another.
• Demand for a currency increases when the value of the currency decreases, leading to a downward sloping demand schedule. (See Figure 2)
• Supply of a currency increases when the value of the currency increases, leading to an upward sloping supply schedule. (See Figure 3)
• Equilibrium equates the quantity of pounds demanded with the supply of pounds for sale. (Figure 4)
• In liquid spot markets, exchange rates are not highly sensitive to large currency transactions.
5
Figure 2: Demand Schedule
for British Pounds
3. Exchange Rate Equilibrium
• Figure 2 shows a hypothetical number of pounds that would be demanded
under various possibilities of the exchange rate.
• At any one point time, there is only one exchange rate.
• The demand schedule is downward sloping because US corporations is likely to
purchase more British pound when the pound is worthless, as it will take a
fewer dollars to obtain the desired amount of pounds.
6
Figure 3: Supply Schedule of
British Pounds for Sale
3. Exchange Rate Equilibrium
• Figure 3 shows the quantity of pounds for sale (supplied to the foreign exchange market in exchange for dollars) corresponding to each possible exchange rate at a given point in
time. • Notice from the supply schedule that there is a positive relationship between the value of
the British pound ad the quantity of British pounds for sale (supplied). • When the pound is valued high, British consumers and firms are more likely to purchase US
goods. Hence, they supply a greater number of pounds to the market, to be exchanged for dollars. Conversely, when the pounds for sale is smaller, reflecting less British desire to obtain US goods.
7
Figure 4: Equilibrium Exchange
Rate Determination
3. Exchange Rate Equilibrium
• Figure 4 shows the combined demand and supply schedules for British pounds.
• At an exchange rate of $1.50, the quantity of pounds demanded would exceed the supply
of pounds for sale.
• At an exchange rate of $1.60, the quantity of pounds demanded would be less than the
supply of pounds for sale.
• Figure 4 shows that the equilibrium exchange rate of $1.55 because this rate equates the
quantity of pounds demanded with the supply for sale.
8
4. Factors That Influence Exchange Rates
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The equilibrium exchange rate will change over time as supply and demand schedules change.
The following summarizes the factors which can influence a currency’s spot rate:
9
4. Factors That Influence Exchange Rates
1. Relative Inflation: Changes in relative inflation rates can affect international trade activity, which influences the demand for and supply of currencies and therefore influences exchange rates.
See Figure 5 shows an increase in U.S. inflation leads to increase in U.S. demand for foreign goods, an increase in U.S. demand for foreign currency, and an increase in the exchange rate for the foreign currency. If British inflation increased (rather than U.S. inflation), thye
opposite forces would occur.
2. Relative Interest Rates: Changes in relative interest rates affect investment
in foreign securities, which influences the demand for and supply of currencies and therefore influences exchange rates. Figure 6 shows an increase in U.S. rates leads to increase in demand
for U.S. deposits and a decrease in demand for foreign deposits, leading to a increase in demand for dollars and an increased exchange rate for the dollar. In some cases, an exchange rate between two countries’
currencies can be affected by changes in a third country’s interest rate.
10
Figure 5: Impact of Rising U.S. Inflation on
the Equilibrium Value of the British Pound
4. Factors That Influence Exchange Rates
11
Figure 6: Impact of Rising U.S. Interest Rates on the Equilibrium Value of the British Pound
4. Factors That Influence Exchange Rates
12
4. Factors That Influence Exchange Rates
• Real Interest Rates: Although a relatively high interest rate may attract
foreign inflows (to invest in securities offering high yields) the relatively high
interest rate may reflect expectations of relatively high inflation. Because
high inflation can place downward pressure on the local currency, some
foreign investors may be discouraged from investing in securities
denominated in that currency. For this reason, it is helpful to consider the
real interest rate, which adjusts the nominal interest rate for inflation:
The relationship is sometimes referred to as the Fisher effect.
rateInflation rateinterest Nominal rateinterest Real
13
3. Relative Income Levels: A third factor affecting exchange
rates is relative income levels. Because income can affect the
amount of imports demanded, it can affect exchange rates.
Figure 7 shows an increase in U.S. income leads to
increased in U.S. demand for foreign goods and increased
demand for foreign currency relative to the dollar and an
increase in the exchange rate for the foreign currency.
4. Factors That Influence Exchange Rates
14
Figure 7: Impact of Rising U.S. Income Levels on
the Equilibrium Value of the British Pound
4. Factors That Influence Exchange Rates
15
4. Government Control: The fourth factor affecting the exchange rate
is government controls. The government of foreign countries can
influence the equilibrium exchange rate in many ways, including:
i. imposing foreign exchange barriers;
ii. imposing foreign trade barriers
iii. intervening in foreign exchange markets
iv. affecting macro variables such as inflation, interest rates, and
income levels.
4. Factors That Influence Exchange Rates
16
5. Expectations: The fifth factor affecting exchange rates is market
expectation of future exchange rates.
If investors expect interest rates in one country to rise, they may
invest in that country leading to a rise in the demand for foreign
currency and an increase in the exchange rate for foreign
currency.
• 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, but it can also be driven by other
factors.
Speculators may overreact to signals causing currency to be
temporarily overvalued or undervalued.
4. Factors That Influence Exchange Rates
17
• Interaction of Factors:
Transactions within the foreign exchange markets facilitate trade or
financial flows.
Trade-related foreign exchange transactions are generally less responsive
to news.
Financial flow transaction are very responsive to news, however, because
decisions to hold securities denominated in a particular currency are
often dependent on anticipated changes in currency values.
Sometimes trade related factors and financial factors interact and
simultaneously affect exchange rate movements.
Figure 8 separates payment flows between countries into trade-related and finance-related flows and summarizes the factors that affect these
flows.
Over a period, some factors may place upward pressure on the
value of a foreign currency while other factors place downward
pressure on the pound’s value.
4. Factors That Influence Exchange Rates
18
Figure 8: Summary of How Factors Can Affect Exchange Rates
4. Factors That Influence Exchange Rates
19
5. Anticipation of Exchange Rate Movements
• Institutional speculation based on expected appreciation - When
financial institutions believe that a currency is valued lower than it
should be in the foreign exchange market, they may invest in that
currency before it appreciates.
• Institutional speculation based on expected depreciation - If financial
institutions believe that a currency is valued higher than it should be in
the foreign exchange market, they may borrow funds in that currency
and convert it to their local currency now before the currency’s value
declines to its proper level.
• Speculation by individuals – Individuals can speculate in foreign
currencies.
• The “Carry Trade” – Where investors attempt to capitalize on the
differential in interest rates between two countries.
20
6. Summary
• Exchange rate movements are commonly measured by the percentage change
in their values over a specified period, such as a month or a year. MNCs closely
monitor exchange rate movements over the period in which they have cash flows
denominated in the foreign currencies of concern.
• The equilibrium exchange rate between two currencies at any point in time is
based on the demand and supply conditions. Changes in the demand for a
currency or the supply of a currency for sale will affect the equilibrium exchange
rate.
• The key economic factors that can influence exchange rate movements through
their effects on demand and supply conditions are relative inflation rates, interest
rates, and income levels, as well as government controls. As these factors cause a
change in international trade or financial flows, they affect the demand for a
currency or the supply of currency for sale and therefore affect the equilibrium
exchange rate.
21
• Unique international trade and financial flows between every pair of countries
dictate the unique supply and demand conditions for the currencies of the
two countries, which affect the equilibrium cross exchange rate. The
movement in the exchange rate between two non-dollar currencies can be
determined by considering the movement in each currency against the dollar
and applying intuition.
• Financial institutions can attempt to benefit from expected appreciation of a
currency by purchasing that currency. Conversely, they can attempt to
benefit from expected depreciation of a currency by borrowing that
currency, exchanging it for their home currency, and then buying that
currency back just before they repay the loan.
6. Summary
22