determination of foreign exchange chapter 4

Exchange Rate Determination

4 Chapter

South-Western/Thomson Learning © 2003

B4 - 2

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.

• On the days when some currencies appreciate while others depreciate against the dollar, the dollar is said to be “mixed in trading.”

B4 - 3

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.

B4 - 4

1.401.451.501.551.601.651.701.751.80

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

-505

101520

1992 1996 2000

Approximate Annual %

%

Fluctuation of the British PoundOver Time

B4 - 5

Value of £

Quantity of £

D: Demand for £

$1.55$1.50

$1.60S: 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.

B4 - 6

$/£

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 £.

B4 - 7


Currency Inflation Price Demand Demand for Currency

Supply for Currency

$ Rise Rise Fall Fall Rise

£ Same Same Rise Rise Fall

B4 - 8

$/£

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 £.

B4 - 9


Currency Existing Change Supply Demand

$ 5% 8% Fall Rise£ 7% 7% Rise Fall

Currency Existing Change

$ 7% 7%£ 5% 5%

$ (Can) 4% 9%

B4 - 10

$/£

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

B4 - 11


Relative Economic Growth Rates• Nation with stronger economic growth will attract

investment seeking to acquire domestic assets.

• In turn this will increase demand for domestic currency.

• Will result into a stronger domestic currency, other things being equal.

B4 - 12


Political and Economic Risk• Investors prefer to hold lesser amount of riskier

assets.

• Low risk currencies are more preferred than high risk currencies.

• Risk is associated with political and economic factors.

B4 - 13

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.


B4 - 14

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.


B4 - 15

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.


B4 - 16

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.

B4 - 17

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

B4 - 18

The Asset Market Model of Exchange Rate

• The value today of a given currency, say, the dollar, depends on whether or not and how strongly people still want the amount of dollars and dollar denominated assets they held yesterday.• The exchange rate between two currencies represent the price that just balances the relative supplies of and the demands for assets denominated in those currencies.• Shifts in preferences can lead to massive shifts in currency values.

B4 - 19

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

B4 - 20

Speculating on Anticipated Exchange Rates

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

Borrows at 6.96% for 30 days

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

determination of foreign exchange chapter 4

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