Download - Topic 4 Ex Rate Determiation.ppt
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7/28/2019 Topic 4 Ex Rate Determiation.ppt
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Topic
Exchange Rate Determination
M. M. Shah Khan
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Learning Objectives
To explain how exchange rate movements
are measured;
To explain how the equilibrium exchange
rate is determined; and
To examine the factors that affect the
equilibrium exchange rate.
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Measuring
Exchange Rate Movements An exchange rate measures the value of
one currency in units of another currency.
When a currency declines in value, it issaid to depreciate. When it increases in
value, it is said to appreciate.
On the days when some currenciesappreciate while others depreciate against
the dollar, the dollar is said to be mixed
in trading.
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Measuring
Exchange Rate Movements The percentage change (% D) in the value
of a foreign currency is computed as
St St-1St-1
where Stdenotes the spot rate at time t.
A positive % D represents appreciation ofthe foreign currency, while a negative % Drepresents depreciation.
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Value of IR
Qty. of IR
D: Demand for IR
PKR 1.55
PKR 1.50
PKR 1.60
S: Supply of IR
EquilibriumER
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.
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PKR/IR
Quantity of IR
S0
D0
r0
PAK inflation
PAK demand for
Indian goods, and hence
Indian Rupee (IR).
D1
r1
S1
Factors that Influence
Exchange RatesRelative Inflation Rates
Indians desire for PAKgoods, and hence the
supply of Indian Rupee
(IR).
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PKR/IR
Quantity of IR
r0
S0
D0
S1
D1
r1
PAK. interest rates
PAK. demand for
Indian bank deposits,
and hence IR.
Factors that Influence
Exchange RatesRelative Interest Rates
Indians desire forPAK. bank deposits, and
hence the supply of IR.
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Relative Interest Rates
Factors that Influence
Exchange Rates
It is thus useful to considerreal interestrates, which adjust the nominal interest
rates for inflation.
A relatively high interest rate may actually
reflect expectations of relatively highinflation, which discourages foreign
investment.
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Relative Interest Rates
Factors that Influence
Exchange Rates
This relationship is sometimes called the
Fisher effect.
real nominal
interest interest inflation raterate rate
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PK/IR
Quantity of IR
S0
D0
r0
PAK income level
PAK demand for
Indian goods, and hence
IR.D
1
r1
Factors that Influence
Exchange RatesRelative Income Levels
No expected change forthe supply of IR.
,S1
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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.
Factors that Influence
Exchange Rates
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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.
Factors that Influence
Exchange Rates
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Expectations
Factors that Influence
Exchange Rates
SBP suggests It is unlikely to cut StrengthenedPak interest rates
A possible decline in Indian Strengthenedinterest rates
Central banks expected to Weakenedintervene to boost the euro
Signal Impact on Rs.
Poor PAK economic indicators Weakened
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Interaction of Factors
Trade-related factors and financial factors
sometimes interact. Exchange ratemovements may be simultaneously
affected by these factors.
For example, an increase in the level ofincome sometimes causes expectations of
higher interest rates.
Factors that Influence
Exchange Rates
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Interaction of Factors
Factors that Influence
Exchange Rates
The sensitivity of the exchange rate to
these factors is dependent on the volumeof international transactions between the
two countries.
Over a particular period, different factors
may place opposing pressures on thevalue of a foreign currency.
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Trade-Related
Factors1. Inflation
Differential2. Income
Differential3. Govt TradeRestrictions
Financial
Factors1. Interest Rate
Differential
2. Capital Flow
Restrictions
How Factors Can Affect Exchange Rates
PK. demand for foreigngoods, i.e. demand for
foreign currency
Foreign demand for PK.goods, i.e. supply offoreign currency
PK demand for foreign
securities, i.e. demandfor foreign currency
Foreign demand for PKsecurities, i.e. supply of
foreign currency
Exchangerate
betweenforeign
currency
and thePKR
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How Factors Have Influenced Exchange Rates
Because the PKRs value changes by
different magnitudes relative to eachforeign currency, analysts often measure
the PKRs strength with an index.
The weight assigned to each currency isdetermined by its relative importance in
international trade and/or finance.
Factors that Influence
Exchange Rates
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Exchange at
PK0.52/BT
4. HoldsPK20,912,320
2. Holds BT40 million
Exchange at
PK0.50/BT
Speculating on Anticipated Exchange Rates
Habib Bank expects the exchange rate of the Bangali
Takka to appreciate from its present level of PK0.50 to
PK0.52 in 30 days.
1. BorrowsPK 20 m
Borrows at 7.20%
for 30 days
Lends at 6.48%for 30 days 3. Receives
BT40,216,000
Returns PK 20,120,000
Profit of PK792,320
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Impact of Exchange Rates on an MNCs Value
) ) )
n
tt
m
j
tjtj
k1=
1
,,
1
ERECFE
=Value
E (CFj,t ) = expected cash flows in currencyj to be receivedby the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currencyj canbe converted to dollars at the end of period t
k = weighted average cost of capital of the parent
Inflation Rates, Interest Rates,Income Levels, Government Controls,
Expectations
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Measuring Exchange Rate Movements
Exchange Rate Equilibrium Demand for a Currency
Supply of a Currency for Sale
Equilibrium
Topic Review
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Topic Review
Factors that Influence Exchange Rates
Relative Inflation Rates
Relative Interest Rates Relative Income Levels
Government Controls
Expectations
Interaction of Factors
How Factors Have Influenced Exchange
Rates
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Topic Review
Speculating on Anticipated Exchange
Rates
How Exchange Rates Affect an MNCsValue