474 07 exchange rate determination

8/13/2019 474 07 Exchange Rate Determination

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Exchange Rate Determination (Note 07; Ch 7)

I. Market Efficiency

II. Funamenta! "na!y#i#

III. Funamenta! Factor#

I$. Funamenta! Moe!#


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I. Market Efficiency

A market is efficient if prices reflect available information (i.e., requirespeople to process information and form reasonable expectations).

Degrees of Informational Efficiency

a. eak!form efficiency" prices reflect #istorical information only.

b. $emi strong!form efficiency" prices reflect #istorical and publiclyavailable information.

c. $trong!form efficiency" prices reflect #istorical, public and privateinformation.

%enerally, empirical evidence finds t#at t#e market is &eak to semi!strongform efficient.

#at does it mean by ' forecasting if ' markets are efficient

$uppose market is semi!strong" exc#ange rate #as already reflected allrelevant information, and &ill only c#ange en ne& information isrevealed. $ince information is unpredictable, t#e exc#ange rate &ill berandom over time.

II. Funamenta! "na!y#i#

$tudy t#e basic economic factors ic# are important to exc#ange ratedetermination

*. +#e components from t#e international parity conditions (i.e., for&ard

rates, relative inflation rates, and relative interest rates)

. Examine t#e underlying factors be#ind t#e fundamentals (i.e., relativemoney supplies, -/ positions, central bank be#avior)

+#ere are t#ree general approac#es for exc#ange rate determination"


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*) International parity conditions" see t#e c#apter0notes for internationalparity conditions.

) Asset approac#" emp#asis on investment and capital flo& of t#e currency

+#e extent t#at investors are &illing to #old foreign claims depends onrelative interest rates and a country1s financial outlook (economic prospects,

profitability)2 liquidity (can you sell assets quickly at fair market value)political stability2 t#e credibility of corporate governance

3) -alance of /ayments (-/) approac# " emp#asis on t#e interactionbet&een -/ flo&s and exc#ange rate c#ange

$urplus on financial and current account typically creates an increase in

reserve #oldings (gold, and per#aps '4s)2 deficit on account is typically t#ereverse

'ocus on supply 5 demand of currency

6eminder" /roblems *!*7 of 4# 8

3


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8) %D/ gro&t# (%D/ < 4 = I = % = (%&M), ere 4


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I$. Funamenta! Moe!#

Econometric models quantify t#e relations#ip bet&een exc#ange rates andeconomic fundamentals.

4onsider t#e follo&ing multivariate regression model"

$t< b= b*(>B

t; >t) = b(CB

t; Ct) = b3(rBt; rt) = b7(

Bt; t)

= b9(4ABt; 4At) = et

#ere"

Bdenotes foreign country

$t< '40

>t< >oney supply

Ct< %D/

rt< interest rate

t< inflation rate

4At< 4urrent account balance

Determine regression coefficients to explain c#anges in t#e spot exc#angerate

:


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Exam!e (*orro8ing FC&enominate e*t)+$iam 4ement, t#e -angkok!based cement manufacturer #ad been pursuing a very aggressive gro&t#strategy in t#e mid!*FFs, taking on massive quantities of foreign currencydenominated debt (primarily K.$. dollars). $iam 4ement took out a *million loan in Lune *FF8 at t#e interest rate of @.H and t#e spot rate inLune *FF8 &as -9.0. $iam 4ement #ad to repay t#e loan plus interest

payment in one year en t#e spot exc#ange rate #ad stabiliMed at -7.0.(a) #at &ould t#e total payment be in +#ai ba#t if t#e future spot rate &as-9.0 in Lune *FF@(b) Due to t#e devaluation of +#ai ba#t, at &as t#e foreign exc#ange loss(in +#ai ba#t) incurred on t#e dollar!denominated loan of * million(c) #at &as t#e H appreciation of against +#ai ba#t(d) #at &as t#e effective cost of funds (in +#ai ba#t)(Note" t#e effective cost of funds < (+#ai ba#t needed to pay in one year)0

(t#e current loan in +#ai ba#t terms)!*)

,o!ution#+(a) *,,B(*=.@)B-9.0 < 9370/000/000

(b) *,,B(*=.@)B-7.0 < -793,:, (793,:,!8,,) < 926/100/000

(c) (7!9)09 < 1 2 4

Note" *@3,:,08,, < :@H < (7!9)09 < t#e H appreciation of against +#ai ba#t.

(d) *,,B(*=.@)B-7.0 < -793,:, (+#ai ba#t needed topay in one year)*,,B-9.0 < -9,, (t#e current loan in +#ai ba#t terms)

(793,:,09,,)!* < 2.4

Note" ('4 in t#is example) appreciated by :@H ic# equals to (7!9)09.

(*=.@)B(*=.:@);* < 2.4

@


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Exam!e (:::/ ea!uation/ an co#t of e*t)+ +#e East Asiatic 4ompany(EA4), a Danis# company &it# subsidiaries all over Asia, #as been fundingits -angkok subsidiary primarily &it# K.$.!dollar debt because of t#e costand availability of dollar capital as opposed to +#ai ba#t (-) funds. +#etreasurer of EA4!+#ailand is considering a one!year bank loan for 39,.+#e current spot exc#ange rate is -7.@70, and t#e dollar!based interest is@.@@9H for t#e one!year period. +#e expected inflation rates over one yearare 7.9H in +#ailand and .H in t#e Knited $tates, respectively.(a) -ased on ///, at s#ould t#e exc#ange rate be at t#e end of one year(-0)(b) -ased on ///, at is t#e effective cost of funds in +#ai ba#t terms(c) it#out using /// in part (a) and (b) but analyMing t#e possiblegovernment intervention, EA41s foreign exc#ange advisors believe stronglyt#at t#e +#ai government &is#es to pus# t#e value of t#e ba#t do&n against

t#e dollar by *H over t#e coming year (to promote its exportcompetitiveness in dollar markets), at &ould t#e effective cost of funds bein +#ai ba#t terms based on t#e devaluation of *H

,o!ution#+

(a) +#e expected one!year spot rate< -7.@70B(*=7.9H)0(*=.H) < 96.20


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Note+ ('4 in t#is example) appreciated by **.**H ic# equals to (78.:!

7.@7)07.@7.(*=@.@@9H)B(*=**.**H) ; * < 30.524

*


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Exam!e (euity ine#tment return) + A K.$. international mutual fundinvested in a stock traded on t#e +okyo $tock Exc#ange (+$E) using*,, on 0*0. +#e spot rate &as O*30 on t#at day. +#e fund

purc#ased :,9 s#ares valued at O,0s#are. In one year, t#einternational fund sold all t#e s#ares at a price of O9,0s#are. n0*03, t#e spot rate &as O*90.(a) #at &as t#e investment return in O(b) -y at percentage did O c#ange in value over t#e period of one year(c) #at &as t#e investment return in (d) If t#e stock paid a cas# dividend of O during t#e investment period,at is t#e total investment return (including dividends) in

,o!ution#+(a) +#e international mutual fund receives a O return of 9H oninvestment ((9,!,)0(,) < 34)

(b) O is t#e numerator currency(*3!*9)0*9 < 4

(c) amount received < (:,9B9,)0*9 < *,3,(*,3,!*,,)0*,, < 604

Note+In general, initial investment B $ (O0) < O initial investment+#e ending portfolio value (in O) < O initial investmentB(*= 6s#are)

+#e ending portfolio value (in )< O initial investmentB(*= 6s#are)0$*(O0)< initial investment B $ (O0) B(*= 6

s#are)0$*(O0)

6 < (*=*

*A

S

SS

)B(*= 6s#are) ! *


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Exam!e (euity ine#tment return)+%iri Iyer is a European analyst andstrategist for +ristar 'unds, a Ne& Cork!based mutual fund company. %iri iscurrently evaluating t#e recent performance of s#ares in /acific ietM, a

publicly traded specialty c#emical company in %ermany listed on t#e'rankfurt DA. +#e baseline investment amount used by +ristar is*,. Pe gat#ers t#e follo&ing quotes"

Lan. */urc#ase

Dec. 3*$ale

Distributions

$#are price G*9. G*9. G*.

Exc#angerate

*.::0G *.7:970G !

(a) Po& many s#ares did +ristar buy on Lanuary *st (6ounded to t#e nearestinteger)(b) #at &as t#e percentage total return on t#e security in G terms

(c) #at &as t#e percentage total return on t#e security in terms(d) #at &as t#e end!of!period proceeds (in ) to +ristar based on t#enumber of s#ares +ristar boug#t and exc#ange rate on December 3*

,o!ution#+

(a) (*,0*.::)0*9 < 70 #hare#

(b) (*9!*9=*)0*9 < 324

(c) (*.7:97!*.::)0*.:: < 38.7:8H2+#e percentage total return < (*=.387:8)B(*=.@) ! * < 7.514

(d) +#e end!of!period proceeds (in ) < 89B(*9=*)B*.7:97 < -7/22

4#eck" t#e amount used en buying 89 s#ares

89B*9B*.:: < FF,F38.9 percentage return < (*89,@7@0FF,F38.9) ! * < 89.F:H

*


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(Reie8)+ /acific %roup, a private equity firm #eadquartered out ofPouston, +exas, borro&s Q*,, for one year at t#e interest rate of :H,and during t#e year t#e pound appreciates from *.@@0Q to .30Q.(a) #at is t#e total payable (principal = interest) denominated in in oneyear(b) #at is t#e percentage c#ange in dollar value of Q over t#is period(c) #at is t#e dollar cost of t#is debt

"n#8er#+

(a) Q*,,B(*=.:)B .30Q < -3//200

(b) (.3!*.@@)0*.@@B*H < 7.524

(c) +#e dollar cost of t#is debt < (*=.8F@)B(*=.:) ; * < .14

Alternatively, Q*,,B*.@@0Q < *,@@, (principal in )+#e dollar cost of t#is debt < (,*9*,@0*,@@,)!* < .14

*3


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(Reie8)+ $uppose EA4 in +#ailand took out a : million loan at t#einterest rate of @.H and t#e spot exc#ange rate &as -7*.0 en t#e loan&as initiated. EA4 #ad to repay t#e loan plus interest payment in one year.(a) If t#e spot rate in one year is -77.0, at is t#e foreign exc#ange loss(in +#ai ba#t) incurred on t#e loan of : million due to t#e c#ange inexc#ange rate(b) #at is t#e effective cost of funds in +#ai ba#t terms in part (a)(c) Assume +#ai government &is#es to pus# t#e value of t#e +#ai ba#tdo&n by *H from -7*.0 over t#e coming year to promote its exportcompetitiveness in dollar markets, at is t#e ne& exc#ange rate follo&ingt#e devaluation of *H(d) #at is t#e effective cost of funds in +#ai ba#t terms based on t#edevaluation of *H in part (c)(Note" t#e effective cost of funds < (+#ai ba#t needed to pay in one year)0

(t#e current loan in +#ai ba#t terms)!*)

"n#8er#+

(a) :,,B(*=.@)B-7*0 < -:9,:@,:,,B(*=.@)B-770 < -@9,*,

(@9,*,!:9,:@,) < 95/0/000

(b) H appreciation of against +#ai ba#t < (77!7*)07* < 8.3H(


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(Reie8)+A K.$. international mutual fund invested in a stock traded on t#e+okyo $tock Exc#ange (+$E) using *,, for t#e investment #oriMonof one year. +#e spot rate &as O*90 and stock price &as O*,0s#are att#e beginning of t#e investment #oriMon. In one year, t#e international fundsold all t#e s#ares at a price of O3,*0s#are and t#e spot rate &as [email protected], t#e stock paid a cas# dividend of O*0s#are immediately before t#eend of one! year investment #oriMon.(a) Po& many s#ares did t#e fund buy initially(b) #at &as t#e percentage total return (including dividend) on t#e stock inO(c) -y at percentage did O c#ange in value over t#e period of one year(d) #at &as t#e percentage total return (including dividend) on t#e stock in

"n#8er#+(a) *,,B*90*, < /000 #hare#

(b) +#e total return (H) in O < capital gain (H) = dividend yield (H) < (3,*!*,=*)0*, < 4

(c) O (foreign currency in t#is example) appreciation against < (*9!F@)0F@< 7.4

(d) Investment return (H) in < (*=.**)B(*=.8*7) ! * < 2.564

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474 07 exchange rate determination

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