Lecture 2 Ok

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Exchange Rate DeterminationExchange Rate Determination

South-Western/Thomson Learning © 2003

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MeasuringExchange Rate Movements

• An exchange rate measures the value of one currency in units of another currency.

• When a currency declines in value, it is said to depreciate. When it increases in value, it is said to appreciate.

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MeasuringExchange 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.

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1.40

1.45

1.50

1.55

1.60

1.65

1.70

1.75

1.80

1992 1996 2000

Approximate Spot Rate of £

$

5600

5800

6000

6200

6400

6600

6800

7000

1992 1996 2000

Approximate £ that could be Purchased

with $10,000

£

-20

-15

-10

-5

0

5

10

15

20

1992 1996 2000

Approximate Annual %

%

Fluctuation of the British PoundOver Time

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Value of £

Quantity of £

D: Demand for £

$1.55

$1.50

$1.60

S: Supply of £

equilibrium exchange rate

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.

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$/£

Quantity of £

S0

D0

r0

U.S. inflation U.S. demand for

British goods, and hence £.

D1

r1

S1

Factors that InfluenceExchange Rates

Relative Inflation Rates

British desire for U.S. goods, and hence the supply of £.

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$/£

Quantity of £

r0

S0

D0

S1

D1

r1

U.S. interest rates U.S. demand for

British bank deposits, and hence £.


Relative Interest Rates

British desire for U.S. bank deposits, and hence the supply of £.

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• It is thus useful to consider real interest rates, which adjust the nominal interest rates for inflation.

• A relatively high interest rate may actually reflect expectations of relatively high inflation, which discourages foreign investment.

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• This relationship is sometimes called the Fisher effect.

• real nominalinterest interest – inflation rate rate rate

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$/£

Quantity of £

S0

D0

r0

U.S. income level U.S. demand for

British goods, and hence £.

D1

r1


Relative Income Levels

No expected change for the supply of £.

,S1

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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.


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Expectations

• Foreign exchange markets react to any news that may have a future effect.

• Institutional investors often take currency positions based on anticipated interest rate movements in various countries.

• Because of speculative transactions, foreign exchange rates can be very volatile.


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Expectations


Fed chairman suggests Fed is Strengthenedunlikely to cut U.S. interest rates

A possible decline in German Strengthenedinterest rates

Central banks expected to Weakenedintervene to boost the euro

Signal Impact on $

Poor U.S. economic indicators Weakened

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Interaction of Factors

• Trade-related factors and financial factors sometimes interact. Exchange rate movements may be simultaneously affected by these factors.

• For example, an increase in the level of income sometimes causes expectations of higher interest rates.


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Interaction of Factors


• The sensitivity of the exchange rate to these factors is dependent on the volume of international transactions between the two countries.

• Over a particular period, different factors may place opposing pressures on the value of a foreign currency.

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Trade-Related Factors 1. Inflation Differential 2. Income Differential 3. Gov’t Trade Restrictions

Financial Factors1. Interest Rate Differential2. Capital Flow Restrictions

How Factors Can Affect Exchange Rates

U.S. demand for foreign goods, i.e. demand for

foreign currency

Foreign demand for U.S. goods, i.e. supply of foreign

currency

U.S. demand for foreign securities, i.e. demand for

foreign currency

Foreign demand for U.S. securities, i.e. supply of

foreign currency

Exchange rate between

foreign currency and

the dollar

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How Factors Have Influenced Exchange Rates

• Because the dollar’s value changes by different magnitudes relative to each foreign currency, analysts often measure the dollar’s strength with an index.

• The weight assigned to each currency is determined by its relative importance in international trade and/or finance.


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With Respect to the Dollar

Value of Foreign Currency Index Over Time

0

50

100

150

200

250

1972 1976 1980 1984 1988 1992 1996 2000

s

tre

ng

the

ns

$ w

eak

en

s

Note: The index reflects equal weights of £, ¥, French franc, German mark, and Swiss franc.

$ due to relatively high U.S. inflation &

growth

high U.S. interest rates, a

somewhat depressed U.S. economy, & low

inflation

large balance of trade deficit

relatively high U.S. interest rates, & lower balance of trade deficit

Persian Gulf War

U.S. interest rates

Higher U.S.

interest rates

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Exchange at $0.52/NZ$

4. Holds $20,912,320

2. Holds NZ$40 million


Speculating on Anticipated Exchange Rates

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.

1. Borrows $20 million

Borrows at 7.20% for 30 days

Lends at 6.48% for 30 days

3. Receives NZ$40,216,000

Returns $20,120,000Profit of $792,320

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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.


4. Holds NZ$41,900,000

2. Holds $20 million


1. Borrows NZ$40 million


Lends at 6.72% for 30 days

3. Receives $20,112,000

Returns NZ$40,232,000Profit of NZ$1,668,000

or $800,640

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Kerjakan

• Jika kurs rupiah-dolar awal tahun adalah Rp.2,000/$ dan pada akhir tahun adalah Rp.4,000/$ berapa apresiasi/depresiasi rupiah terhadap dolar, dan apresiasi/depresiasi dolar terhadap rupiah?

• Jika kurs Rp/$ adalah Rp.2,500/$ adalah Rp.2,500/$ pada t=0, dan menjadi Rp.2,400/$ pada t = 1. Berapa apresiasi/depresiasi $ terhadap rupiah?

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Kerjakan

• Blue Demon Bank expects that French Franc (FF) will depresiate againts the dolar from its spot rate of $0.15 to $0.14 in 10 days. The following interbank lending and borrowing rate exist:

Lending Rate Borrowing Rate

US Dolar 8% 8.3%

French Franc 8.5% 8.7%

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Chicago Bank expects the exchange rate of the New Zealand dollar to depreciate from its present level of $0.15 to $0.14 in 30 days.

Exchange at $0.14/FF$

4. Holds FF$75,166,666.7

2. Holds $10.5 million

Exchange at $0.15/FF

1. Borrows FF$70 million


Lends at 8% for 10 days

3. Receives $10,523,333.3

Returns FF75,166,666.7-FF70,169,166.7 = FF

4,997,500 or $ 699,650

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• Assume that Blue demon bank has a borrowing capacity of either $10.5 million or FF70 million in the interbank market, depending on which currency it wants to borrow.

1. How could Blue demon bank attempt to capitalize on its expectations without using deposit funds? Estimate the profits that could be generated from this strategy.

2. Assume all the preceding information, with this exception: blue demon bank expect the FF to appreciate from its present spot rate of $0.15 to $0.17 in 10 days. How could it attempt capitalize on its expectations without using deposited funds? Estimate the profits that could be generated from this strategy?

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Thank You

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Lecture 2 Ok