exchange rate deter mini ti on

8/2/2019 Exchange Rate Deter Mini Ti On

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Exchange Rate Determination


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Exchange Rates

An exchange rate measures the value of onecurrency in units of another currency.

When a currency declines in value, it is said todepreciate. When it increases in value, it is said to

appreciate. The percentage change (% D) in the value of a foreign

currency is computed asS

t S

t-1

St-1where Stdenotes the spot rate at time t.

A positive % D represents appreciation of the foreigncurrency, while a negative % D represents depreciation.


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Value of

Quantity of

D: Demand for

$1.55

$1.50

$1.60

S: Supply of

equilibrium exchangerate

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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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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Relative Inflation Rates

$/

Quantity of

S0

D0

r0

U.S. inflation U.S. demand for British

goods, and hence .

D1

r1

S1

British desire for U.S.goods, and hence the

supply of .


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Relative Interest Rates

$/

Quantity of

r0

S0

D0

S1

D1

r1

U.S. interest rates U.S. demand for British

bank deposits, and hence.

British desire for U.S.bank deposits, and hence

the supply of .


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Relative Income Levels

$/

Quantity of

r0

S0

D0

S1

D1

r1

U.S. income levels U.S. demand for British

goods, and hence .

British supply of poundsfor sale is not expected to

change


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Real Interest Rates,

which adjust the nominal interest rates for

inflation.

A relatively high interest rate may actually reflectexpectations of relatively high inflation, which

discourages foreign investment.

Fisher effect.

real nominalinterest interest inflation rate

rate rate


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Government Controls

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.


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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.


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Fed chairman suggests Fed is Strengthenedunlikely to cut U.S. interest rates

A possible decline in German Strengthenedinterest rates

Central banks expected to Weakened

intervene to boost the euro

Signal Impact on $

Poor U.S. economic indicators Weakened


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Interaction of Factors

Trade-related factors and financial factors sometimesinteract. Exchange rate movements may besimultaneously affected by these factors.

For example, an increase in the level of incomesometimes causes expectations of higher interest rates.

Over a particular period, different factors may placeopposing pressures on the value of a foreign currency.

The sensitivity of the exchange rate to these factors isdependent on the volume of international transactions

between the two countries.


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Trade-RelatedFactors

1. Inflation

Differential2. IncomeDifferential

3. Govt TradeRestrictions

FinancialFactors

1. Interest Rate

Differential2. Capital FlowRestrictions

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 ratebetween foreign

currency and thedollar


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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 currencyjto be received by the

U.S. parent at the end of period t

E (ERj,t) = expected exchange rate at which currencyjcan be

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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Forecasting Exchange Rates

Efficient Markets Approach

Fundamental Approach

Technical Approach


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Exchange at

$0.52/NZ$

4. Holds $20,912,320

2. Holds NZ$40million

Exchange at

$0.50/NZ$

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 $20million

Borrows at 7.20% for 30 days

Lends at 6.48% for 30days

3. ReceivesNZ$40,216,000

Returns $20,120,000Profit of $792,320


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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.

Exchange at

$0.48/NZ$

4. HoldsNZ$41,900,000

2. Holds $20million

Exchange at

$0.50/NZ$

1. Borrows NZ$40million

Borrows at 6.96% for 30 days

Lends at 6.72% for 30days

3. Receives $20,112,000

Returns NZ$40,232,000Profit of NZ$1,668,000or $800,640


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Efficient Markets Approach

Financial Markets are efficientif prices reflectall available and relevant information.

If this is so, exchange rates will only change

when new information arrives, thus:St= E[St+1]

and

Ft= E[St+1| It]

Predicting exchange rates using the efficientmarkets approach is affordable and is hard tobeat.


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Fundamental Approach

Involves econometrics to develop models thatuse a variety of explanatory variables. Thisinvolves three steps:

step 1: Estimate the structural model. step 2: Estimate future parameter values.

step 3: Use the model to develop forecasts.

The downside is that fundamental models donot work any better than the forward ratemodel or the random walk model.


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Technical Approach

Technical analysis looks for patterns in the

past behavior of exchange rates.

Based upon the premise that history repeats

itself.

exchange rate deter mini ti on

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