Determining Exchange Rates

South-Western/Thomson Learning 2006

 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 hen some currencies appreciate hile others depreciate against a particular currency, that currency is said to !e "mixed in

Exchange Rate Movement: Measurement

Exchange Rate Movement: Measurement

$he percentage change %& ) in the value of a foreign currency is computed as
St St 1

St 1 A positive % represents appreciation of here 't denotes the spot rate at time t. the foreign currency, while a negative % represents depreciation.

Annual (hanges in the )alue of the Euro

Date &

Exchange Rate

Annual

*+*+,--- .*.--*+/0 *+*+,--* ..12+/0 3.*& *+*+,--, ..41+/0 5.6& *+*+,--6 .*.-5+/7*4.-& *+*+,--2 .*.,3+/7,-.-&

Exchange Rate E8uili!rium

An exchange rate represents the price of a currency, hich is determined !y the demand for that currency relative to the supply for that currency.

Exchange Rate E8uili!rium

Value of $1. 0 $1.55 $1.50

S& (upply of !"uili#riu$ e%change rate D& 'e$and for Quantity of

Exchange Rate E8uili!rium

$he li8uidity of a currency affects the sensitivity of the exchange rate to specific transactions. With many illing !uyers and sellers, even large transactions can !e easily accommodated. (onversely, illi8uid currencies tend to exhi!it more volatile exchange rate movements.

9actors that :nfluence Exchange Rates

e = f ( INF , INT , INC , GC , EXP )
e

INF;change in the relative inflation rate INT; change in the relative interest rate INC; change in the relative income level GC; change in government controls EXP;change in expectations of future
exchange rates

;percentage change in the spot rate

Relative :nflation Rates

$) r1 r0 (1 (0 '1 '0 Quantity of

9actors that :nfluence Exchange Rates

U.S. inflation U.S. demand for British goods, and hence . British desire for U.S. goods, and hence the decrease in supply of .

Relative :nterest Rates

$) r0 r1 (0 (1 '0 '1 Quantity of

9actors that :nfluence Exchange Rates

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 .

9actors that :nfluence Exchange Rates

Relative :nterest Rates A relatively high interest rate $ay actually
reflect e%pectations of relatively high inflation, which $ay discourage foreign invest$ent.

*t is thus useful to consider the real

interest rate, which ad+usts the no$inal interest rate for inflation.

9actors that :nfluence Exchange Rates

Relative :nterest Rates real no$inal
interest rate

interest . inflation rate rate

,his relationship is so$eti$es called the

-isher effect.

Relative :ncome <evels

$) r1 r0 (0 ,(1 '1 '0 Quantity of

9actors that :nfluence Exchange Rates

U.S. income level U.S. demand for British goods, and hence . No expected change for the supply of .

9actors that :nfluence Exchange Rates

=overnment (ontrols =overnments may influence the e8uili!rium exchange rate !y:
imposing foreign exchange !arriers, imposing foreign trade !arriers, intervening in the foreign exchange mar>et, and affecting macro varia!les such as inflation, interest rates, and income levels.

9actors that :nfluence Exchange Rates

Expectations 9oreign exchange mar>ets react to any ne s that may have a future effect.
?e s of a potential surge in @.'. inflation may cause currency traders to sell dollars.

Many institutional investors ta>e currency positions !ased on anticipated interest rate

9actors that :nfluence Exchange Rates

Expectations !cono$ic signals that affect e%change
rates can change "uic/ly, such that speculators $ay overreact initially and then find that they have to $a/e a correction.

(peculation on the currencies of e$erging

$ar/ets can have a su#stantial i$pact on their e%change rates.

9actor :nteraction $he various factors sometimes interact and simultaneously affect exchange rate movements. 9or example, an increase in income levels sometimes causes expectations of higher interest rates, thus placing opposing pressures on foreign currency values.

9actors that :nfluence Exchange Rates

Ao

9actors (an Affect Exchange Rates

7.(. de$and for foreign goods, i.e. de$and for foreign currency -oreign de$and for 7.(. goods, i.e. supply of foreign currency 7.(. de$and for foreign securities, i.e. de$and for foreign currency -oreign de$and for 7.(. securities, i.e. supply of foreign currency !%change rate #etween foreign currency and the dollar

,rade01elated -actors 1. *nflation 'ifferential 2. *nco$e 'ifferential 3. 4ov5t ,rade 1estrictions -inancial -actors 1. *nterest 1ate 'ifferential 2. 6apital -low 1estrictions

9actors that :nfluence Exchange Rates

9actor :nteraction ,he sensitivity of an e%change rate to the
factors is dependent on the volu$e of international transactions #etween the two countries. !arge volume of international trade relative inflation rates may be more influential !arge volume of capital flo"s interest rate fluctuations may be more influential

9actors that :nfluence Exchange Rates

9actor :nteraction
An understanding of e%change rate

e"uili#riu$ does not guarantee accurate forecasts of future e%change rates #ecause that will depend in part on how the factors that affect e%change rates will change in the future.

Anticipated Exchange Rates 'peculation

Many commercial !an>s attempt to capitaliBe on their forecasts of anticipated exchange rate movements in the foreign exchange mar>et. $he potential returns from foreign currency speculation are high for !an>s that have large !orro ing capacity.

Anticipated Exchange Rates 'peculation

6hicago =an/ e%pects the e%change rate of the 8ew 9ealand dollar to appreciate fro$ its present level of $0.50 to $0.52 in 30 days. =orrows at >.20% for 30 days 1eturns $20,120,000 Arofit of $><2,320

1. =orrows $20 $illion !%change at $0.50)89$ 2. ;olds 89$:0 $illion

:. ;olds $20,<12,320 !%change at $0.52)89$ 3. 1eceives 89$:0,21 ,000

?ends at .:@% for 30 days

Anticipated Exchange Rates 'peculation

6hicago =an/ e%pects the e%change rate of the 8ew 9ealand dollar to depreciate fro$ its present level of $0.50 to $0.:@ in 30 days. =orrows at .< % for 30 days

1. =orrows 89$:0 $illion !%change at $0.50)89$ 2. ;olds $20 $illion

1eturns 89$:0,232,000 Arofit of 89$1, @,000 !%change at or $@00, :0 $0.:@)89$ ?ends at .>2% for 30 days 3. 1eceives $20,112,000

:. ;olds 89$:1,<00,000

Anticipated Exchange Rates 'peculation

Exchange rates are very volatile, and

a poor forecast can result in a large loss. One ellC>no n !an> failure, 9ran>lin ?ational Dan> in *1E2, as primarily attri!uted to massive speculative losses from foreign currency positions. Dan> ?egaraFs <oss in *11-s due to currency speculationGG