Determination of Exchange Rates, Exchange Rate Dynamics and

Intervention

Exchange Rate Terminologies Exchange Rate – the price of one nation’s currency in terms of another currency, the numerator being the reference currency.

a. Spot Rate – the price at which currencies are traded for immediate delivery, or in two days in the

interbank market.

b. Forward Rate – the price at which foreign exchange is quoted for delivery at a specified future date.

Currency Devaluation/Depreciation – the decrease in the stated value of a pegged currency, one whose value is set by the government.

Currency Revaluation/Appreciation – the increase in the par value of a pegged currency.

Floating Currency – one whose value is set by the market forces.

Determination of Exchange Rates

The Foreign Exchange (Forex) Market

Forex Market – network of markets and institutions that handle foreign currency. The commodity being bought and sold is the foreign currency.

a. Spot Market – deals with currency transactions for immediate delivery, or in two days. (over the counter)

b. Forward Market – deals with currency transactions for delivery at a specified future date.

Determination of Exchange Rates

The Foreign Exchange (Forex) Market

What would the possible reasons why people would want to buy foreign currency? (Demand for foreign currency)

a. Travel/Tourism (domestic residents who want to travel

abroad)

b. Trade (purchase of goods and services by domestic residents from another country)

c. Investment (financial and/or real investments by domestic residents in another country)

d. Speculation and hedging (expectations by domestic residents on the foreign currency.

Determination of Exchange Rates

The Foreign Exchange (Forex) Market

What would the possible reasons why foreigners would want to buy our domestic currency? (Supply for local currency)

a. Travel/Tourism (foreign residents who want to

travel the domestic country)

b. Trade (purchase of domestic goods and services by foreign residents)

c. Investment (financial and/or real domestic

investments by foreign residents)

d. Speculation and hedging (expectations by foreign residents on the domestic currency)

Determination of Exchange Rates

The Foreign Exchange (Forex) Market

In summary, the following are factors that affect the DEMAND and SUPPY in the forex:

a. Exchange rate

b. Real Rate (domestic)

c. Real Rate (foreign)

d. Inflation Rate (domestic)

e. Inflation Rate (foreign)

f. Expectations (speculations)

• Factors Affecting Supply and Demand

– Relative Inflation Rates (domestic)• Growth in the money supply would cause the price of

domestic goods and services to rise relative to those in other countries

• Domestic residents may get to find foreign goods and services cheaper and may switch consumption from domestic to foreign goods

• Higher domestic inflation should lead to a depreciation of the local currency

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Determination of Exchange Rates

• Factors Affecting Supply and Demand (Shapiro and Sarin, 2009)

– Relative Interest Rates• Higher interest rates may attract foreign capital inflow

(provided a rise in real interest rates)• Higher real interest rates will cause the domestic currency to

appreciate

– Relative Economic Growth• Strong economic growth attracts foreign capital• The production of high quality products lead to higher

demand by both domestic and foreign consumers

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Determination of Exchange Rates

• Factors Affecting Supply and Demand

– Political and Economic Risks

• Politically stable nations generate less risky assets

• Capital seeks safe havens for investments and the currency of such havens would appreciate

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Determination of Exchange Rates

• Participants in the Forex Market– Bank and Non-Bank Forex Dealers– Individuals and Firms conducting International

Commercial and Investment Transactions– Speculators and Arbitrageurs– Central Banks and Treasuries– Forex Brokers

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Determination of Exchange Rates

• The amount of currency appreciation or depreciation is computed as the percentage increase or decrease in value of the domestic currency in terms of another currency

KenYu: If less of a foreign currency is required to buy a domestic currency, that means that the domestic currency has depreciated. If there a + sign, appreciation; - sign, depreciation.Tip: In computing for the appreciation/depreciation, the DC is the base currency!

• Sample Problem 1:– In 2002, the yen went from $0.0074074 to $0.0084746.

By how much did the yen appreciate against the dollar?– By how much has the dollar depreciated against the yen?11

Calculating Exchange Rate Changes

• 2nd Sample Problem:– On April 1, 1998, the government of

Yugoslavia devalued the Yugoslav dinar, setting its new rate at 10.92 dinar to the dollar, from 6 dinar previously.• By how much has the dinar devalued against

the dollar?• By how much has the dollar appreciated

against the dinar?

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Calculating Exchange Rate Changes

• 3rd Sample Problem:– On July 2, 1997, the Thai baht fell 17%

against the US$. By how much has the dollar appreciated against the baht?

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Calculating Exchange Rate Changes