Exchange Rates

EXCHANGE RATE DETERMINATION

EXCHANGE RATE DETERMINATIONEXCHANGE RATE DETERMINATIONECONOMIC IMPACTS ON EXHANGE RATE CHANGES

$ PER £

£

SUPPLY OF £

DO

D1

1.50

1.60

AN INCREASE IN REAL INCOME IN THE U.S. HAS THE EFFECT OF INCREASING U.S. SPENDING ON IMPORTS --- IN THIS CASE IMPORTS FROM THE U.K. --- HENCE AN INCREASE IN DEMAND FOR £ FROM DO TO D1 ---THIS LEADS TO A DEPRECIATION OF THE $’S EXCHANGE VALUE

THE RATE GOES UP—THAT IS MORE $’S ARE REQUIRED IN EXCHANGE FOR £

SHOULD REAL INCOME IN THE U.S. FALL, THE EFFECTS WILL BE TO REDUCE THE DEMAND FOR £’S AND TO APPRECIATE THE $’S EXCHANGE VALUE --- IN GENERAL, A NATION EXPERIENCEING FASTER ECONOMIC GROWTH THAN ITS TRADING PARTNERS TENDS TO FIND ITS CURRENCY’S EXCHANGE VALUE DEPRECIATING AND VICE VERSA

INCOME GROWTH DIFFERENTIALS

INTEREST RATE DIFFERENTIALS

¥

DO

D1

0.0075

0.0080

$/¥SUPPLY, SO,, OF ¥

S1

U.S. INTEREST RATES FALL RELATIVE TO JAPANESE INTEREST RATES---- JAPANESE CITIZENS MAKE FEWER INVESTMENTS IN THE U.S. ---- SUPPLY OF ¥ DECLINES ---BUT U.S. CITIZENS MAKE MORE INVESTMENTS IN JAPAN IN ORDER TO TAKE ADVANTAGE OF RELATIVELY HIGHER INTEREST RATES----HENCE THE DEMAND FOR ¥ INCREASES----THE RESULT IS A DEPRECIATION IN THE $’S EXCHANGE RATE AGAINST THE ¥

WHEN INTEREST RATES FALL IN THE U.S. , THE JAPANESE FIND IT LESS ATTRACTIVE TO INVEST IN THE U.S. , SO FEWER ¥ WILL BE OFFERED TO BUY $’S FOR PURCHASE OF U.S. SECURITIES --- HENCE THE SUPPLY OF ¥ SHIFTS BACK --- THEN DEMAND FOR ¥ INCREASES IN ORDER TO HAVE ¥ TO BUY JAPANESE SECURITIES --- WITH THE COMBINED SHIFT BEING A MOVE FROM POINT a TO POINT b

a

b

NOTICE THAT IF YOU ARE OWED $ AS CONVERTED FROM ￥ THAT YOU WILL GET MORE $’S AT THE 0.0080 $/ ￥ RATE THAN YOU WILL AT THE 0.0075 $/ ￥ RATE

€

DO

D1

0.84

0.93

$/€SUPPLY, SO,, OF €

S1

a

b

INFLATION RATE DIFFERENTIALS

INFLATION RISES IN THE U.S. RELATIVE TO THE NETHERLANDS----IMPORTS BECOME RELATIVELY LESS EXPENSIVE IN THE U.S. RELATIVE TO DOMESTIC GOODS--- U.S. CONSUMERS TEND TO INCREASE SPENDING ON IMPORTED GOODS FROM THE NETHERLANDS LEADING TO AN INCREASE IN DEMAND FOR THE EURO ---BUT AT THE SAME TIME DUTCH CONSUMERS FIND U.S. GOODS BECOMING MORE EXPENSIVE---HENCE THEY REDUCE THEIR DEMAND FOR EXPORTS FROM THE U.S. AND THE SUPPLY OF EURO TO THE MARKET TO BUY UP $ TO GET U.S. GOODS SHIFTS BACK ----- THE RESULT IS A DEPRECIATION IN THE $’S EXCHANGE VALUE AGAINST THE €

THE INCREASE IN THE DEMAND FOR EUROS AND THE DECREASE IN THE SUPPLY OF EUROS RESULTS IN A DEPRECIATION OF THE $ TO THE EURO AS A MOVEMENT FROM THE ORIGINAL EQUILIBRIUM AT a TO POINT b

€

DO

D1

0.525

0.65

£/€SUPPLY, SO,, OF €

S1

a

b

MARKET EXPECTATIONS AND EXCHANGE RATE DETERMINATION

GIVEN FUTURE EXPECTATIONS OF A DEPRECIATION IN THE £’S EXCHANGE VALUE AGAINST THE €, U.K. IMPORTERS OF FRENCH GOODS HAVE THE INCENTIVE TO PURCHASE ADDITIONAL EURO’S BEFORE THEY BECOME MORE EXPENSIVE--- HENCE THE DEMAND FOR EUROS INCREASES--- BUT FRENCH IMPORTERS OF U.K. GOODS WILL BE LESS WILLING TO SELL THE €’S FOR £’S THAT ARE EXPECTED TO SOON BECOME LESS EXPENSIVE---- SO THE SUPPLY OF EURO’S DECREASES--- THE RESULT IS A DEPRECIATION IN THE £’S ECHANGE RATE AGAINST THE €

SOMETIMES INVESTORS CHANGE THEIR EXPECTATIONS ABOUT FUTURE EXCHANGE RATES EVEN WITHOUT NEW INFORMATION ABOUT MARKET FUNDAMENTALS---THESE CHANGES AFFECT THE EXCHANGE RATE

SPECULATIVE BUBBLES AFFECT EXCHANGE RATES IN THIS WAY --- SUPPOSE A SIGNIFICANT NUMBER OF INVESTORS THINK THE MEXICAN PESO IS RIPE FOR A TAKEOFF– THEY WILL BUY THE PESO WHICH LEADS TO A RISE IN ITS VALUE --- SO THE EXPECTATIONS BECOME SELF FULFILLING

MARKET FUNDAMENTALS AND THE $’S EXCHANGE VALUEMARKET FUNDAMENTALS AND THE $’S EXCHANGE VALUE

MARKET FUNDAMENTALS AND THE $’S EXCHANGE VALUE

CHANGE FACTOR CHANGE EFFECT

FOREIGN DEMAND FOR U.S. PRODUCT

DECREASE

INCREASE

DEPRECIATION OF $

APPRECIATION OF $

FOREIGN DEMAND FOR U.S. ASSETS

DECREASE

INCREASE

DEPRECIATION OF $

APPRECIATION OF $

U.S DEMAND FOR IMPORTS

DECREASE

INCREASE

APPRECIATION OF $

DEPRECIATION OF $

U.S DEMAND FOR FOREIGN ASSETS

DECREASE

INCREASE

APPRECIATION OF $

DEPRECIATION OF $

U.S. PRICE LEVEL DECREASE

INCREASE

APPRECIATION OF $

DEPRECIATION OF $

U.S. INTEREST RATES DECREASE

INCREASE

DEPRECIATION OF $

APPRECIATION OF $

U.S. REAL INCOME DECREASE

INCREASE

APPRECIATION OF $

DEPRECIATION OF $

U.S. PRODUCTIVITY DECREASE

INCREASE

DEPRECIATION OF $

APPRECIATION OF $

U.S. TRADE RESTRICTIONS

DECREASE

INCREASE

APPRECIATION OF $

DEPRECIATION OF $

RELATIVE TO FOREIGN CURRENCY

MARKET FUNDAMENTALS AND THE $’S EXCHANGE VALUERELATIVE TO THE SWISS FRANC (SF)

MARKET FUNDAMENTALS AND THE $’S EXCHANGE VALUERELATIVE TO THE SWISS FRANC (SF)

MARKET FUNDAMENTALS AND THE $’S EXCHANGE VALUE

CHANGE FACTOR CHANGE EFFECT

FOREIGN DEMAND FOR U.S. PRODUCT

DECREASE

INCREASE

DEPRECIATION OF $

APPRECIATION OF $

FOREIGN DEMAND FOR U.S. ASSETS

DECREASE

INCREASE

DEPRECIATION OF $

APPRECIATION OF $

U.S DEMAND FOR IMPORTS

DECREASE

INCREASE

APPRECIATION OF $

DEPRECIATION OF $

U.S DEMAND FOR FOREIGN ASSETS

DECREASE

INCREASE

APPRECIATION OF $

DEPRECIATION OF $

U.S. PRICE LEVEL DECREASE

INCREASE

APPRECIATION OF $

DEPRECIATION OF $

U.S. INTEREST RATES DECREASE

INCREASE

DEPRECIATION OF $

APPRECIATION OF $

U.S. REAL INCOME DECREASE

INCREASE

APPRECIATION OF $

DEPRECIATION OF $

U.S. PRODUCTIVITY DECREASE

INCREASE

DEPRECIATION OF $

APPRECIATION OF $

U.S. TRADE RESTRICTIONS

DECREASE

INCREASE

APPRECIATION OF $

DEPRECIATION OF $

WHY?Franc supply decreaseFranc supply increase

Franc supply decrease demand increaseFranc supply increase demand decrease

Franc demand decrease Franc demand increase

Franc demand decrease supply increaseFranc demand increase supply decrease

Franc demand decrease supply increaseFranc demand increase supply decrease

Franc supply decrease demand increaseFranc supply increase demand decrease

Franc demand decreasesFranc demand increases

Franc demand increases supply decrease?Franc demand decrease supply increase?

Franc supply increaseFrance supply decrease

GOVERNMENT GETS INTO THE ACTOR CENTRAL BANK INTERVENTION ISSUE

CHANGES IN RATES HAVE IMPACT ON THE PRICE OF GOODS AND SERVICES– A WORRY FOR GOVERNMENTS AND THE CENTRAL BANK --- SO THERE CAN BE INTERVENTION IN THE FOREIGN EXCHANGE MARKET

U.S DEMAND FOR BRITISH GOODS AND FINANCIAL ASSETS INDUCES THE DEMAND FOR THE £ IN EXCHANGE FOR $’S --- THE SUPPLY OF £ IN EXCHANGE FOR $’S IS REFLECTIVE OF BRITISH DEMAND FOR U.S. GOODS AND ASSETS

IF THE $/£ = 1.60, AND THEN THE U.S. DEMAND FOR BRITISH GOODS RISES, THIS CAUSES THE DEMAND FOR THE £ TO SHIFT UP FROM D TO D’---- THIS RESULTS IS THAT THE £ APPRECIATES AGAINST THE $---HENCE U.S. IMPORTS FROM THE U.K. BECOME MORE EXPENSIVE --- THE EXCHANGE RATE GOES FROM $1.60 AT POINT A TO $1.70 AT POINT C --- A £100 ITEM IN THE U.K. HAS A $ PRICE OF $170 IN THE U.S. FROM ITS PREVIOUS PRICE OF $160

EXPORTS MUST BE STIMULATED FROM THE U.K. TO THE U.S. ---- BANK OFENGLAND WANTS TO HALT THE £ APPRECIATION --- SO THEY SELL (SUPPLY £’S) ON THE MARKET--- SUPPLY SHIFTS FROM S TO S’--- AND A NEW EQUILIBRIUM FORMS AT POINT B --- $1.60 IS NOW THE RATE AGAIN, BUT NOW A HIGHER QUANTITY OF £’S IS BEING TRADED AT £O’ THAN WAS TRADED AT £O

IN A DEPRECIATING CASE, THE CENTRAL BANK WOULD SELL FOREIGN CURRENCY IN EXCHANGE FOR DOMESTIC CURRENCY TO STOP THE DEPRECIATION

CHANGES IN EXCHANGE RATESCHANGES IN EXCHANGE RATES

CHANGES IN RATES HAVE IMPACT ON THE PRICE OF GOODS AND SERVICES–

LET’S LOOK AT SOME EXCHANGE RATE CHANGE CALCULATIONS

DEPENDING ON THE CURRENT VALUE OF THE EURO RELATIVE TO THE DOLLAR, THE AMOUNT OF APPRECIATIONS OR DEPRECIATION IS COMPUTED AS THE FRACTIONAL INCREASE OR DECREASE IN THE DOLLAR VALUE OF THE EURO --- EXAMPLE

IF THE €/$ EXCHANGE RATE GOES FROM €1 = $0.93 TO €1 = $1.09, THE EURO HAS APPRECIATED BY THE CHANGE IN ITS DOLLAR VALUE WHICH IS

(1.09 – 0.93)/0.93 = 17.20%

AMOUNT OF € APPRECIATION (DEPRECIATION) =

(NEW $ VALUE OF € - OLD $ VALUE OF €) / (OLD $ VALUE OF €)

= (e1 – e0) / e0 FOR e1 = $1.09, e0 = $0.93

ALTERNATIVELY CALCULATE THE CHANGE IN THE € VALUE OF THE $

AMOUNT OF $ DEPRECIATION (APPRECIATION) =(NEW € VALUE OF THE $ - OLD € VALUE OF THE $)/(OLD $ VALUE OF €)

= (1/e1 - 1/e0 ) / (1/e0 ) = (e0 - e1)/ e1

SO EMPLOYING THIS LAST RELATIONSHIP, WE CAN FIND THE INCREASE IN THE € EXCHANGE RATE FROM $0.93 TO $1.09 TO BE EQUIVALENT TO A $ DEPRECIATION OF 14.68%, OR [(0.93 – 1.09)/1.09] = -0.1468, OR DOWN BY 14.68%

WHY DON’T THE TWO EXCHANGE RATE CHANGES EQUAL EACH OTHER? THE REASON EURO APPRECIATION IS UNEQUAL TO THE AMOUNT OF DOLLAR DEPRECIATION DEPENDS ON THE FACT THAT THE VALUE OF ONE CURRENCY IS THE INVERSE OF THE VALUE OF THE OTHER CURRENCY. HENCE, THE PERCENTAGE CHANGE IN CURRENCY VALUE DIFFERS BECAUSE THE BASE OF WHICH THE CHANGE IS MEASURED DIFFERS.

THE CROSS RATE

THE CROSS RATE IS THE THIRD EXCHANGE RATE IMPLIED BY ANY TWO EXCHANGE RATES INVOLVING THREE CURRENCIES

SUPPOSE IN LONDON, $/£ = $2.00, WHILE IN NEW YORK $/SF = $0.40

THE CORRESPONDING CROSS RATE IS THE £/SF RATE, WHERE, USING ALGEBRA

£/SF = ($/SF)/($/£) = 0.40/2.00 = 0.2

IF WE OBSERVE A MARKET WHERE ONE OF THE 3 EXCHANGE RATES --- $/£, $/SF, OR £/SF - - - IS OUT OF LINE WITH THE OTHER 2, THERE IS AN ARBITRAGE OPPORTUNITY

SUPPOSE IN ZURICH THE EXCHANGE RATE IS £/SF = 0.2 WHILE IN NEW YORK $/SF = 0.40, BUT IN LONDON $/£ = $1.90

TRADERS WOULD NOTICE THIS DESCREPANCY AND TAKE QUICK ACTION BEFORE THE ARBITRAGE DISAPATES - - - THE TRADER STARTS WITH $’S AND BUY £1 MILLION IN LONDON FOR $1,900,000, SINCE $/£ = $1.90 - - - THE £’S WOULD THEN BUY THE FRANC IN AT £/SF = 0.2, SO THAT £1,000,000 = SF5,000,000 --- THE SF5 MILLION ARE THEN USED IN NEW YORK TO BUY $’S @ $/SF = $0.40 AS SF5,000,000 =$2,000,000

THE INITIAL $1,900,000 COULD BE TURNED INTO $2,000,000 WITH THIS TRIANGULAR ARBITRAGE ACTION, EARNING $100,000 (BUT WITH COSTS OF THE TRANSACTION BEING NETTED OUT OF THE PROCEEDS)

THIS MAY BE ENOUGH FOR THE TRADER TO START THE DAY OF TRADING AND EXHANGING AT THE INTERNATIONAL DIVISION AT THE NEW YORK BANK

SUCH ACTION IS TAKEN QUICKLY SINCE THE ARBITRAGE SITUATION WILL QUICKLY EVAPORATE AS OTHERS SEE THE OPPORTUNITY AND THE CURRENCIES COME IN LINE

THE EXCHANGE RATES RETURN TO INTERNATIONALLY CONSISTENT LEVELS

SO THE TRADER IN THE INTERNATIONAL DIVISION AT CITIGROUP IN NEW YORK IS COMING INTO THE BANK ON THE TRAIN VERY EARLY IN THE MORNING FROM HER HOME IN WESTERN CONNECTICUT AND IS WATCHING THE CURRENCY MOVEMENTS IN EACH MARKET --- SHE QUICKLY PHONES INTO EACH MARKET AND MAKES THE TRIANGULAR TRADE ---- STEPS OF THE TRAIN AND GETS TO THE OFFICE ---

SHE MAY DO 2 OR 3 OF THESE IN ORDER TO COVER FORWARDS AND SPOTS AT THE BANK THAT ENSUE AS THE DAY PROGRESSES

TRIANGULARARBITRAGE

OBSERVE RATES ARE OUT OF LINE: ZURICH £/SF = 0.2; NY $/SF = 0.4; LONDON $/£ =$1.90

BUY £ FOR $1.90£1,000,000 FOR$1,900,000

BUY SF5,000,000WITH £1,000,000 AT RATE £/SF = 0.2OR 1/0.2 = 5(1,000,000)

LONDON ZURICH

CONVERT SF5,000,000 TO$2,000,000 SINCE $/SF = 0.40

NEW YORK

STA

RT