Managing International Risks

8/14/2019 Managing International Risks

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Determining Exchange Rates

South-Western/Thomson Learning 2006


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Exchange Rate

Movement: Measurement An exchange ratemeasures the valueof one currency in units of anothercurrency.

When a currency declines in value, itis said to depreciate. When itincreases in value, it is said toappreciate.

On the days hen some currenciesappreciate hile others depreciateagainst a particular currency, that

currency is said to !e "mixed in#


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Exchange Rate

Movement: Measurement $he percentage change %& )in

the value of a foreign currencyiscomputed as

St St 1

St 1

here 'tdenotes the spot rate at time t. A positive % represents appreciation ofthe foreign currency, while a negative %

represents depreciation.


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Annual (hanges

in the )alue of the Euro

Date Exchange Rate Annual

& *+*+--- *.--*+/0

*+*+--* .12+/0 3.*&

*+*+-- .41+/0 5.6&

*+*+--6 *.-5+/7*4.-&

*+*+--2 *.3+/7-.-&


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Exchange Rate E8uili!rium

An exchange rate represents theprice of a currency, hich isdetermined !y the demand for that

currency relative to the supply forthat currency.


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Value of

Quantity of

$1.55

$1.50

$1.0!"uili#riuechange rate

D& 'eand for

S& (upply of



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$he li8uidityof a currency affectsthe sensitivity of the exchange rateto specific transactions.

With many illing !uyers andsellers, even large transactions can!e easily accommodated.

(onversely, illi8uid currencies tendto exhi!it more volatileexchangerate movements.


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9actors that nfluence

Exchange Rates

e ;percentage change in the spot rate

INF;change in the relative inflation rateINT; change in the relative interest rate

INC

; change in the relative income levelGC; change in government controlsEXP;change in expectations of futureexchange rates

( )EXPGCINCINTINFfe = ,,,,


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$)

Quantity of

(0

'0

r0

U.S. inflation U.S. demand for

British goods, and

hence .

'1

r1

(1


Exchange RatesRelative nflation Rates

British desire for U.S.goods, and hence the

decrease in supply of .


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$)

Quantity of

r0

(0

'0

(1

'1

r1

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

British bank deposits,

and hence .


Exchange RatesRelative nterest Rates

British desire for U.S.bank deposits, and

hence the supply of .


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*t is thus useful to consider the realinterest rate, which ad+usts the noinal

interest rate for inflation.

A relatively high interest rate ay actuallyreflect epectations of relatively highinflation, which ay discourage foreign

investent.


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his relationship is soeties called the

-isher effect.

real noinalinterest interest inflation rate rate rate


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$)

Quantity of

(0

'0

r0

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

British goods, and

hence .'

1

r1


Exchange RatesRelative ncome


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Exchange Rates=overnment (ontrols

=overnments may influence the

e8uili!rium exchange rate !y: imposing foreign exchange !arriers,

imposing foreign trade !arriers,

intervening in the foreign exchangemar>et, and

affecting macro varia!les such asinflation, interest rates, and incomelevels.


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Exchange RatesExpectations

9oreign exchange mar>ets react to

any nes that may have a futureeffect.

?es of a potential surge in @.'.

inflation may cause currency tradersto sell dollars.

Many institutional investors ta>ecurrency positions !ased onantici ated interest rate


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Exchange RatesExpectations

!conoic signals that affect echange

rates can change "uic/ly, such thatspeculators ay overreact initially and

then find that they have to a/e a

correction.

(peculation on the currencies of eergingar/ets can have a su#stantial ipact on

their echange rates.


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Exchange Rates9actor nteraction $he various factors sometimes

interact and simultaneously affectexchange rate movements.

9or example, an increase in incomelevels sometimes causesexpectations of higher interest rates,thus placing opposing pressures onforeign currency values.


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radeelated

-actors1. *nflation

'ifferential2. *ncoe

'ifferential3. 4ovt rade

estrictions

-inancial

-actors1. *nterest ate

'ifferential

2. 6apital -low

estrictions

o 9actors (an Affect Exchange Rates

7.(. deand for foreigngoods, i.e. deand for

foreign currency

-oreign deand for 7.(.goods, i.e. supply offoreign currency

7.(. deand for foreign

securities, i.e. deandfor foreign currency

-oreign deand for 7.(.securities, i.e. supply of

foreign currency

!changerate

#etweenforeign

currency

and thedollar


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Exchange Rates9actor nteraction

!arge volume of international trade relative inflation rates may be more influential

!arge volume of capital flo"s interest ratefluctuations may be more influential

he sensitivity of an echange rate to the

factors is dependent on the volue ofinternational transactions #etween the two

countries.


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Exchange Rates9actor nteraction

An understanding of echange rate

e"uili#riu does not guarantee accurateforecasts of future echange rates

#ecause that will depend in part on how

the factors that affect echange rates will

change in the future.


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Anticipated Exchange Rates'peculation

Many commercial !an>s attempt tocapitaliBe on their forecasts ofanticipated exchange rate

movements in the foreign exchangemar>et.

$he potential returns from foreign

currency speculation are high for!an>s that have large !orroingcapacity.


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!change at

$0.52)89$

:. ;olds$20,


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Anticipated Exchange Rates 'peculation

6hicago =an/ epects the echange rate of the 8ew

9ealand dollar to depreciate fro its present level of$0.50 to $0.:@ in 30 days.

!change at

$0.:@)89$

:. ;olds89$:1,


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Anticipated Exchange Rates'peculation

Exchange rates are very volatile, anda poor forecast can result in a largeloss.

One ellC>non !an> failure, 9ran>lin?ational an> in *12, as primarilyattri!uted to massive speculative

losses from foreign currencypositions.

an> ?egaraFs

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