bbk3273 | international finance · bbk3273 | international finance prepared by dr khairul anuar l2:...

BBK3273 | International Finance Prepared by Dr Khairul Anuar

L2: Exchange Rate Determination

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Contents

1. Measuring Exchange Rate Movements

2. How Exchange Rate Movements Measured

3. Exchange Rate Equilibrium

4. Factors That Influence Exchange Rates

5. Anticipation of Exchange Rate Movements

6. 6. Summary

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1. Measuring Exchange Rate Movements

• Exchange rate movements affect an MNCs value because they can affect

the amount of cash inflows received from exporting or from a subsidiary and

the amount needed to pay for imports.

• A decline in a currency’s value is referred to as depreciation

• Increase in a currency’s value is referred to as appreciation

• When a foreign currency's spot rates at two specific points in time are

compared, the spot rate at the more recent date is denoted as S ad the spot

rate at the earlier date is denoted as St-1.

• The percentage change in the value of the foreign currency is computed as

follows:

• A positive percent change indicates that the currency has appreciated. A

negative percent change indicates that it has depreciated.

1

1 aluecurrency vforeign in Percent

t

t

S

SS

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2. How Exchange Rate Movements Measured

• The exchange rate for the Canadian dollar and the euro are shown in the second and fourth

column of the figure below for the months from 1st January to 1st July.

• Notice that the direction of the movement may persist for consecutive months in some cases or

may not persist in other cases.

• The magnitude of the movement tends to vary every month, although the range of percentage

movements over these months may be a reasonable indicator of the range of percentage

movements in future months.

• A comparison of the movements in these two currencies suggest that they appear to move

independently of each other.

Figure 1: How Exchange Rate Movements and Volatility Are Measured

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• 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 Figure 2)

• Supply of a currency increases when the value of the currency increases, leading to an upward sloping supply schedule. (See Figure 3)

• Equilibrium equates the quantity of pounds demanded with the supply of pounds for sale. (Figure 4)

• In liquid spot markets, exchange rates are not highly sensitive to large currency transactions.

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Figure 2: Demand Schedule

for British Pounds


• Figure 2 shows a hypothetical number of pounds that would be demanded

under various possibilities of the exchange rate.

• At any one point time, there is only one exchange rate.

• The demand schedule is downward sloping because US corporations is likely to

purchase more British pound when the pound is worthless, as it will take a

fewer dollars to obtain the desired amount of pounds.

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Figure 3: Supply Schedule of

British Pounds for Sale


• Figure 3 shows the quantity of pounds for sale (supplied to the foreign exchange market in exchange for dollars) corresponding to each possible exchange rate at a given point in

time. • Notice from the supply schedule that there is a positive relationship between the value of

the British pound ad the quantity of British pounds for sale (supplied). • When the pound is valued high, British consumers and firms are more likely to purchase US

goods. Hence, they supply a greater number of pounds to the market, to be exchanged for dollars. Conversely, when the pounds for sale is smaller, reflecting less British desire to obtain US goods.

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Figure 4: Equilibrium Exchange

Rate Determination


• Figure 4 shows the combined demand and supply schedules for British pounds.

• At an exchange rate of $1.50, the quantity of pounds demanded would exceed the supply

of pounds for sale.

• At an exchange rate of $1.60, the quantity of pounds demanded would be less than the

supply of pounds for sale.

• Figure 4 shows that the equilibrium exchange rate of $1.55 because this rate equates the

quantity of pounds demanded with the supply for sale.

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The equilibrium exchange rate will change over time as supply and demand schedules change.

The following summarizes the factors which can influence a currency’s spot rate:

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1. Relative Inflation: Changes in relative inflation rates can affect international trade activity, which influences the demand for and supply of currencies and therefore influences exchange rates.

See Figure 5 shows an 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. If British inflation increased (rather than U.S. inflation), thye

opposite forces would occur.

2. Relative Interest Rates: Changes in relative interest rates affect investment

in foreign securities, which influences the demand for and supply of currencies and therefore influences exchange rates. Figure 6 shows an increase in U.S. rates leads to increase in demand

for U.S. deposits and a decrease in demand for foreign deposits, leading to a increase in demand for dollars and an increased exchange rate for the dollar. In some cases, an exchange rate between two countries’

currencies can be affected by changes in a third country’s interest rate.

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Figure 5: Impact of Rising U.S. Inflation on

the Equilibrium Value of the British Pound


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Figure 6: Impact of Rising U.S. Interest Rates on the Equilibrium Value of the British Pound


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• Real Interest Rates: Although a relatively high interest rate may attract

foreign inflows (to invest in securities offering high yields) the relatively high

interest rate may reflect expectations of relatively high inflation. Because

high inflation can place downward pressure on the local currency, some

foreign investors may be discouraged from investing in securities

denominated in that currency. For this reason, it is helpful to consider the

real interest rate, which adjusts the nominal interest rate for inflation:

The relationship is sometimes referred to as the Fisher effect.

rateInflation rateinterest Nominal rateinterest Real

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3. Relative Income Levels: A third factor affecting exchange

rates is relative income levels. Because income can affect the

amount of imports demanded, it can affect exchange rates.

Figure 7 shows an increase in U.S. income leads to

increased in U.S. demand for foreign goods and increased

demand for foreign currency relative to the dollar and an

increase in the exchange rate for the foreign currency.


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Figure 7: Impact of Rising U.S. Income Levels on

the Equilibrium Value of the British Pound


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4. Government Control: The fourth factor affecting the exchange rate

is government controls. The government of foreign countries can

influence the equilibrium exchange rate in many ways, including:

i. imposing foreign exchange barriers;

ii. imposing foreign trade barriers

iii. intervening in foreign exchange markets

iv. affecting macro variables such as inflation, interest rates, and

income levels.


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5. Expectations: The fifth factor affecting exchange rates is market

expectation of future exchange rates.

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 signals on currency speculation – day-to-day speculation

on future exchange rate movements is commonly driven by signals

of future interest rate movements, but it can also be driven by other

factors.

Speculators may overreact to signals causing currency to be

temporarily overvalued or undervalued.


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• Interaction of Factors:

Transactions within the foreign exchange markets facilitate trade or

financial flows.

Trade-related foreign exchange transactions are generally less responsive

to news.

Financial flow transaction are very responsive to news, however, because

decisions to hold securities denominated in a particular currency are

often dependent on anticipated changes in currency values.

Sometimes trade related factors and financial factors interact and

simultaneously affect exchange rate movements.

Figure 8 separates payment flows between countries into trade-related and finance-related flows and summarizes the factors that affect these

flows.

Over a period, some factors may place upward pressure on the

value of a foreign currency while other factors place downward

pressure on the pound’s value.


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Figure 8: Summary of How Factors Can Affect Exchange Rates


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5. Anticipation of Exchange Rate Movements

• Institutional speculation based on expected appreciation - When

financial institutions believe that a currency is valued lower than it

should be 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 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.

• Speculation by individuals – Individuals can speculate in foreign

currencies.

• The “Carry Trade” – Where investors attempt to capitalize on the

differential in interest rates between two countries.

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6. Summary

• Exchange rate movements are commonly measured by the percentage change

in their values over a specified period, such as a month or a year. MNCs closely

monitor exchange rate movements over the period in which they have cash flows

denominated in the foreign currencies of concern.

• The equilibrium exchange rate between two currencies at any point in time is

based on the demand and supply conditions. Changes in the demand for a

currency or the supply of a currency for sale will affect the equilibrium exchange

rate.

• The key economic factors that can influence exchange rate movements through

their effects on demand and supply conditions are relative inflation rates, interest

rates, and income levels, as well as government controls. As these factors cause a

change in international trade or financial flows, they affect the demand for a

currency or the supply of currency for sale and therefore affect the equilibrium

exchange rate.

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• Unique international trade and financial flows between every pair of countries

dictate the unique supply and demand conditions for the currencies of the

two countries, which affect the equilibrium cross exchange rate. The

movement in the exchange rate between two non-dollar currencies can be

determined by considering the movement in each currency against the dollar

and applying intuition.

• Financial institutions can attempt to benefit from expected appreciation of a

currency by purchasing that currency. Conversely, they can attempt to

benefit from expected depreciation of a currency by borrowing that

currency, exchanging it for their home currency, and then buying that

currency back just before they repay the loan.

6. Summary

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