Lecture 4
Exchange Rate Determination
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Lecture Objectives
• Explain how exchange rate movements are measured.
• Explain how the equilibrium exchange rate is determined.
• Examine factors that determine the equilibrium exchange rate.
• Explain the movement in cross exchange rates.
• Explain how financial institutions attempt to capitalize on anticipated
exchange rate movements.
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Measuring Exchange Rate Movements (1 of 2)
Depreciation = A decline in a currency’s value relative to the other currency
Appreciation = An increase in a currency’s value relative to the other currency
St − St−1
%Δ Foreign Currency Value =
St−1
where:
%Δ Foreign Currency Value = percentage change in foreign currency value when the exchange
rate is direct quotation, i.e. home currency is price currency and foreign currency is base
currency
St = spot exchange rate at time t (current)
St-1 = spot exchange rate at time t – 1 (past)
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Measuring Exchange Rate Movements (2 of 2)
Example: On Jan.1 value of one unit of Canadian dollar (C$) was $0.70(*), and
one month later, on Feb.1, value of one unit of Canadian dollar was $0.71. The
percentage change in Canadian dollar over 1 month period is calculated as:
St − St−1 0.71 − 0.70
%Δ Foreign Currency (C$) Value = = ≈ +1.43%
St 0.70
The Canadian dollar appreciates by 1.43% relative to the U.S. dollar
(*) Per this quotation, the Canadian dollar is the foreign currency (base
currency), while the U.S. dollar is home currency (price currency)
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The Determinants of Foreign Exchange Rates
Financial Markets Banking Systems
Is there a well-developed and liquid
Exchange rate determinants: Is there a sound and secure banking
money and capital market in that Major schools of thought on the system in place to support currency
currency? trading
determination of the spot FX rate
Parity Condition Balance of Payment Monetary Approach and Asset
Approach: Approach: Approach:
1- Law of one price 1. Current Account Balance 1- Monetary Approach: Supply and
2- Absolute & Relative 2- Portfolio Investment Demand for national monetary stocks (only)
Purchasing Power Parity 3- Foreign Direct Investment 2- Asset Market Approach: Supply and
(PPP) (FDI) Demand for financial assets of a wide
3- Interest Rate Parity variety, including bonds.
4- Exchange Rate Regimes
(IRP) *Lecture “Exchange Rate Determination” –
5- Official Monetary Reserves Madura Chapter 4
5
Exchange Rate Equilibrium (1 of 2)
The exchange rate represents the price of a currency, or the rate at which one
currency can be exchanged for another.
Demand for a currency increases when the value of the currency decreases,
leading to a downward sloping demand schedule. (See Exhibit 4.2)
Supply of a currency for sale increases when the value of the currency
increases, leading to an upward sloping supply schedule. (See Exhibit 4.3)
Equilibrium equates the quantity of pounds demanded with the supply of
pounds for sale. (See Exhibit 4.4)
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Exhibit 4.2 Demand Schedule for British Pounds
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Exhibit 4.3 Supply Schedule of British Pounds for Sale
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Exhibit 4.4 Equilibrium Exchange Rate Determination
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Exchange Rate Equilibrium (2 of 2)
Change in the Equilibrium Exchange Rate
• Increase in demand schedule: Banks will increase the exchange to the
level at which the amount demanded is equal to the amount supplied in the
foreign exchange market.
• Decrease in demand schedule: Banks will reduce the exchange to the level
at which the amount demanded is equal to the amount supplied in the foreign
exchange market.
• Increase in supply schedule: Banks will reduce the exchange to the level
at which the amount demanded is equal to the amount supplied in the foreign
exchange market.
• Decrease in supply schedule: Banks will increase the exchange to the
level at which the amount demanded is equal to the amount supplied in the
foreign exchange market.
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Factors That Influence Exchange Rates (1 of 5)
The equilibrium exchange rate will change over time as supply and demand
schedules change.
e = f (ΔINF , ΔINT, ΔINC, ΔGC , ΔEXP)
where:
e = percentage change in the spot rate
ΔINF = change in the differential between home country’s (U.S) inflation and the foreign
country's inflation
ΔINT = change in the differential between the home country’s (U.S) interest rate and the foreign
country's interest rate
ΔINC = change in the differential between the home country’s (U.S) income level and the
foreign country's income level
ΔGC = change in government controls
ΔEXP = change in expectations of future exchange rates
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Factors That Influence Exchange Rates (2 of 5)
Relative Inflation Rates (ΔINF): Increase in U.S. inflation leads to increase in
U.S. demand for foreign goods, an increase in U.S. demand for foreign
currency, and an increase in the exchange rate for the foreign currency. (See
Exhibit 4.5)
Relative Interest Rates (ΔINT): Increase in U.S. rates leads to increase in
demand for U.S. deposits and a decrease in demand for foreign deposits,
leading to an increase in demand for dollars and an increased exchange rate
for the dollar. (See Exhibit 4.6)
However, high U.S. rates may reflect expectations of relatively high expected
inflation (Fisher Effect) Put downward pressure on US$ Discourage
investors from investing in U.S. deposits consider the Real Interest Rate
Real Interest Rate = Nominal Interest Rate – Expected Inflation Rate
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Exhibit 4.5 Impact of Rising U.S. Inflation on the
Equilibrium Value of the British Pound
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Exhibit 4.6 Impact of Rising U.S. Interest Rates on
the Equilibrium Value of the British Pound
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Factors That Influence Exchange Rates (3 of 5)
Relative Income Levels (ΔINC): Increase in U.S. income leads to an increase
in U.S. demand for foreign goods, an increased demand for foreign currency
relative to the dollar, and an increase in the exchange rate for the foreign
currency. (See Exhibit 4.7)
Government Controls (ΔGC) via:
• Imposing foreign exchange barriers
• Imposing foreign trade barriers
• Intervening in foreign exchange markets
• Affecting macro variables such as inflation, interest rates, and income levels
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Exhibit 4.7 Impact of Rising U.S. Income Levels on
Equilibrium Value of the British Pound
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Factors That Influence Exchange Rates (4 of 5)
Expectations (ΔEXP):
• Impact of favorable expectations: If investors expect interest rates in one
country to rise, they may invest in that country, leading to a rise in the
demand for foreign currency and an increase in the exchange rate for foreign
currency.
• Impact of unfavorable expectations: Speculators can place downward
pressure on a currency when they expect it to depreciate.
• Impact of signals on currency speculation: Speculators may overreact to
signals, causing currency to be temporarily overvalued or undervalued.
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Factors That Influence Exchange Rates (5 of 5)
Interaction of Factors: Some factors place upward pressure while other
factors place downward pressure. (See Exhibit 4.8)
Influence of Factors across Multiple Currency Markets: common for
European currencies to move in the same direction against the dollar.
Influence of Liquidity on Exchange Rate adjustment: If a currency’s spot
market is liquid then its exchange rate will not be highly sensitive to a single
large purchase or sale.
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Exhibit 4.8 Summary of How Factors Affect
Exchange Rates
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Movements in Cross Exchange Rates (1 of 2)
if currencies A and B move in same direction, there is no change
in the cross-exchange rate.
when currency A appreciates against the U.S. dollar by a greater
(smaller) degree than currency B, then currency A appreciates
(depreciates) against B.
when currency A appreciates (depreciates) against the U.S. dollar,
while currency B is unchanged against the dollar, currency A
appreciates (depreciates) against currency B by the same degree
as it appreciates (depreciates) against the dollar.
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Movements in Cross Exchange Rates (2 of 2)
Explaining Movements in Cross Exchange Rate.
• Changes are affected in the same way as types of forces
explained earlier for those that affect demand and supply
conditions between two currencies.
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Exhibit 4.9 Example of How Forces Affect the
Cross Exchange Rate (1 of 2)
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Exhibit 4.9 Example of How Forces Affect the
Cross Exchange Rate (2 of 2)
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Capitalizing on Expected Exchange Rate Movements (1 of 2)
Institutional speculation based on expected appreciation: When
financial institutions believe that a currency is valued lower than it should be
(i.e. undervalued) in the foreign exchange market, they may invest in that
currency before it appreciates.
Institutional speculation based on expected depreciation: If financial
institutions believe that a currency is valued higher than it should be (i.e.
overvalued) in the foreign exchange market, they may borrow funds in that
currency and convert it to their local currency now before the currency’s
value declines to its proper level.
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Example on Institutional Speculation
Chicago Financial Co. expects the exchange rate of the New Zealand dollar
(NZ$) to appreciate from its present level of $0.50 to $0.52 in 30 days.
Chicago Financial is able to borrow $20 million on a short-term basis from
other banks. Present short-term interest rates (annualized) in the interbank
market are as given in the table
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Example on Institutional Speculation
Solution: Given this information, Chicago Financial could proceed as follows:
1. Borrow $20 million.
2. Convert the $20 million to NZ$: $20,000,000 / 0.50 = NZ$40 million.
3. Invest the New Zealand dollars at 6.48% annualized. After 30 days,
Chicago Financial will receive:
NZ$40,000,000 × (1 + 6.48%×30/360) = NZ$40,216,000
4. Use the proceeds from the New Zealand dollar investment (on day 30) to
repay the U.S. dollars borrowed. The total U.S. dollar amount necessary to
repay the U.S. dollar loan is:
$20,000,000 × (1 + 7.20%×30/360) = $20,120,000
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Capitalizing on Expected Exchange Rate Movements (2 of 2)
Speculation by individuals: Individuals can speculate in foreign currencies
by taking position in the currency futures market or options market.
The “Carry Trade” — Where investors attempt to capitalize on the
differential in interest rates between two countries (used by both institutional
and individual investors)
o Impact of appreciation in the investment currency: Increased trade
volume can have a major influence on exchange rate movements over a
short period.
o Risk of the Carry Trade: Exchange rates may move opposite to what
the investors expected.
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Example on Carry Trade
Hampton Investment Co. is a U.S. firm that executes a carry trade in which it
borrows euros (interest rates are presently low in the eurozone) and invests in
British pounds (interest rates are presently high in the United Kingdom).
Hampton uses $90,000 of its own funds and borrows an additional 600,000
euros. It will pay 0.5% on its euros borrowed for the next month and will earn
1.0% on funds invested in British pounds.
Assume that the euro’s spot rate is $1.20 and that the British pound’s spot rate
is $1.80 (so the pound is worth 1.5 euros at this time). Hampton uses today’s
spot rate as its best guess of the spot rate one month from now What is
Hampton’s expected profits rom its carry trade?
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Example on Carry Trade
Solution: Solution:
At the Beginning of the Investment Period At the End of the Investment Period
Hampton invests $90,000 of its own funds into Hampton receives: 450,000 × 1.01 = 454,500 pounds
British pounds: $90,000/$1.80 per pound 50,000 Hampton repays loan in euros: 600,000 euros × 1.005
pounds = 603,000 euros
Hampton borrows 600,000 euros and converts Amount of pounds Hampton needs to repay loan in
them into British pounds: 600,000 euros/1.5 euros euros: 603,000 euros/1.5 euros per pound = 402,000
per pound 400,000 pounds pounds
Hampton’s total investment in pounds: 50,000 Amount of pounds Hampton has after repaying loan:
pounds + 400,000 pounds = 450,000 pounds 454,500 pounds – 402,000 pounds = 52,500 pounds
Hampton converts pounds held into U.S. dollars:
52,500 pounds × $1.80 per pound = $94,500
Hampton’s profit: $94,500 – $90,000 = $4,500 ~ 5.0%
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