CHAPTER 4: Exchange Rate Determination

*Financial managers of MNCs that conduct international business must continuously monitor exchange rates because their cash flows are highly dependent on them

I. Managing Exchange Rate Movements As economic conditions change, exchange rates can change

substantially Appreciate – increase in currency strength/value

Depreciate – decrease in currency strength/value

% change in exchange rate =St -St-1St

x100%

Where:St – spot rate at more recent period

St-1 – spot rate at earlier period

(+) change indicates appreciation(-) change indicates depreciation

Volatility – “drasticness” of changeMovement – change in exchange rate

Movements tend to be more volatile for longer time horizons; Movements in daily assessments are less volatile than movements in yearly assessments

Length of time horizons where exchange rate movement measurements are based depend on whether a firm’s transactions will occur in the near (just days from now) or distant future (a year from now).

II. Exchange Rate Equilibrium Measuring exchange rate movements is easy. What is

difficult is to explain why they move the way they do or to forecast how it may change in the future. To explain or forecast exchange rate movements, understanding first exchange rate equilibrium is necessary

The price of a currency depends on the supply and demand of that currency (law of supply and demand)

U.S. DEMAND for pounds

What does the phrase “US demand for pounds” mean? That phrase means that the demand of pounds came from the US.

US demand for pounds increases as price of pounds decreases and vice versa(price, demand)

British SUPPLY of pounds

What does the phrase “British supply of pounds” mean? That phrase means that the supply of pounds in the US came from the UK. It does NOT refer to supply of pounds in the UK

British supply of pounds increases as price of pounds increases (price, supply).

That happens because a more expensive currency (pounds in this case) is stronger or has more buying power. Of course, British investors will take advantage of this by buying dollars and investing so much in the US.

Equilibrium Exchange Rate

At an exchange rate of $1.50, the quantity of pounds demanded would exceed the supply of pounds for sale. And at an exchange rate of $1.60, the quantity of pounds demanded would be less than the supply of pounds for sale. According to the graph, the equilibrium exchange rate is $1.55 because this rate equates the quantity of pounds demanded with the supply of pounds for sale.

Impact of spot market liquidity: illiquid currencies are low in supply. Its exchange rate is highly sensitive to a single sale/purchase.

III. Factors That Influence Exchange Rates Factors that influence currency supply and demand will also

influence exchange rates(1) Relative Inflation Rate

Changes in inflation rates affect international trade activities which influence supply and demand of currencies which, consequently, also influence exchange rates.

US inflation will:1. US demand for British goods, US

demand for pounds2. British demand for US goods, British

supply of pounds in the ForEx market

(2) Relative Interest Rate

Changes in relative interest rates affect investments in

foreign securities which, consequently, also influence exchange rates.

Increase in U.S. interest rates will attract foreign investors:

1. US demand for British securities, US demand for pounds

2. British demand for US securities, British supply of pounds in the market

Real Interest Rate: In reality, a relatively high interest rate expected high inflation rate. For this reason, it is helpful to consider the real interest rate.

Real interest rate = nominal interest rate – inflation rate

Why does a high inflation rate increase interest rates in banks? Remember, too much money in circulation causes prices of commodities to rise (inflate). What the Central Bank / Federal Reserve does to combat inflation is to increase interest rates of commercial banks to attract investors. That way money is kept in banks and to not circulate in the local economy.

(3) Relative Income Levels

Income can affect imports and foreign investments which, consequently, also influence exchange rates.

Increase in US income:1. US demand for British goods, US

demand for pounds2. No effect on British supply of pounds

(4) Government Control The government of foreign countries can influence

equilibrium exchange rates in many ways:1. Imposing foreign exchange barriers2. Imposing foreign trade barriers3. Affecting macrovariables such as inflation

rates, interest rates, and income levels Recall the instance on increase in US interest rates.

British supply for pounds increased right? Yet, if the British government placed a heavy tax on interest income earned from foreign investments, this could discourage the exchange of pounds for dollars

(5) Market expectations for future exchange rates Foreign exchange markets react to changes in inflation

rate / interest rate / other factors even before they occur.

Currency supply and demand (which influence exchange rates) will be affected

Interaction of factors Think about this:

- Assume the simultaneous existence of (1) a sudden increase in U.S. inflation and (2) a sudden increase in U.S. interest rates. If the British economy is relatively unchanged, the increase in

U.S. inflation will place upward pressure on the pound’s value because of its impact on international trade. Yet, the increase in U.S. interest rates places downward pressure on the pound’s value because of its impact on capital flows.

- The sensitivity of an exchange rate to these factors is dependent on the volume of international transactions between the two countries. If the two countries engage in a large volume of international trade but a very small volume of international capital flows, the relative inflation rates will likely be more influential. If the two countries engage in a large volume of capital flows, however, interest rate fluctuations may be more influential.

Summary of how factors can affect exchange rates

Movements in Cross Exchange Rates Example: Cross rate of euro to Mexican peso

Forecasted spot rate in one year (St)€1.00 = $1.33M₱ = $0.10

Spot rate today (St-1)€1.00 = $1.40M₱ = $0.09

Cross rate of € in one year = 1.33/0.10 = M₱13.33Cross rate of € today = 1.40/0.09 = M₱15.55

% change / movement =13.33 -15 ,5515.55

x100%= - 14.3%

Anticipation of Exchange Rate Movements(1) Institutional Speculation Based on Expected Appreciation

Example A

(2) Institutional Speculation Based on Expected Depreciation

Example B

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