BUSI 163 International Financial Management

Lecture 5Chapter 4. Exchange Rate Determination

Instructor: Phil Zhu

Measuring Exchange Rate MovementsBasic Movements in Rates

-when one currency depreciates against another, the other must appreciate.

Let St-1 = the original rate (in direct quote)S = the current rate (in direct quote)% ∆ spot exchange rate = (S – St-1) / St-1

a. %∆ >0, Appreciationb. %∆ <0, Depreciation• “Mixed” exchange rate change may happen in the

exchange of more than two currencies (e.g. US dollar appreciates against euro but depreciates against Japanese yen)

Exchange Rate Equilibrium

• Exchange rate is the “price” of a currency. Thus, it is determined by the “supply” and “demand” rule in economics.

• Demand for a foreign currencya. derived from the local buyers who are

willing and able to purchase foreign goods but who must convert their local currencies.

b. A direct relationship exists between the cost of foreign currency and amount

demanded.

Draw the Demand Curve of a Foreign Currency and Explain…….

USD/GBP

Quantity of British Pounds (GBP)

• Supply of a foreign currency for salea. derived from the foreigners who are

willing and able to supply foreign currency that must be converted to purchase local goods or assets.

b. A direct relationship exists between cost of the foreign currency and the amount supplied.

Draw the Supply Curve of a Foreign Currency and Explain…….

USD/GBP

Quantity of British Pounds (GBP)

Equilibrium

Factors That Influence Exchange Rates

• % ∆ spot rate = f (∆ INF, ∆ INT, ∆ INC, ∆ GC, ∆ EXP)

– Relative Inflation Rates– Relative Interest Rates• Real Interest Rates

– Relative Income Levels– Government Control– Expectation

Inflation: Question?• Assume that the U.S. inflation rate becomes

high relative to Canadian inflation. Other things being equal, how should this affect the

(a) demand for Canadian dollars (b) supply for Canadian dollars for sale (c) equilibrium value of the Canadian dollars?

Draw the graph and explain……..

USD/CAD

Quantity of Canadian dollar (CAD)

D1

S1

$0.92

This relates to “Purchase power parity” (PPP) theory in the next chapter.

Interest Rate: Question?

• Assume the U.S. interest rate falls relative to the British interest rate. Other things being equal, how should this affect the

(a) U.S. demand for British pounds, (b) supply of pounds for sale (c) equilibrium value of the pound?

Draw the graph and explain……..

USD/GBP

Quantity of British Pound (GBP)

D1

S1

$1.50

This relates to “Interest rate parity” (IRP) theory in the next chapter.

Real interest rate

• Fisher effect:Nominal risk-free interest rate = (1+ risk-free

real interest rate) X (1+ inflation rate) – 1

It can be also approximated by:Nominal risk-free interest rate = Real risk-free

interest rate + Inflation rate

Income effect: Question?

• Assume that the U.S. income level rises at a much higher rate than does the Canadian income level. Other things being equal, how should this affect the

(a) demand for Canadian dollars (b) supply for Canadian dollars for sale (c) equilibrium value of the Canadian dollars?

Draw the graph and explain……..

USD/CAD

Quantity of Canadian dollar (CAD)

D1

S1

$0.90

Assume no interest rate change in this case.

Government control

• Imposing foreign exchange barriers• Imposing foreign trade barriers (e.g. tariff,

quota, subsidy)• Intervening (buying and selling currencies) in

the foreign exchange markets• Macro economic policies to affect inflation,

interest rates and income levels.

Government control: Question?

• Assume that the Japanese government relaxes its controls on imports by Japanese companies. Other things being equal, how should this affect the

(a) U.S. demand for Japanese yen, (b) supply of Japanese yen for sale, (c) equilibrium value of the yen?

Draw the graph and explain……..

USD/JPY

Quantity of Japanese Yen (JPY)

D1

S1

$0.0105

Market expectations• Market efficiency in the foreign exchange market• In an efficient foreign exchange market, the

current exchange rate should reflect the aggregated market expectations of all factors that may impact the future exchange rate.

• Investors rely on signals to form their expectation. As signals contain noise information, investors may under-react or overreact in the foreign exchange market.

• Expectations can also quickly spread to other regions and currencies – “contagion effect”.

Interaction of Factors• Impact of income increase– Import increases, depreciation pressure– Interest rate increases, appreciation pressure– But high national income is mostly related to good

economic fundamentals. • What if both interest rate and inflation rate go up

in the country?– Overall impact depends on the relative weights of

international trade and international financial capital flow in the country’s balance of payment

• Good economic fundamentals usually result in strong currency value.

Example: Weight of international trade and capital flows for the exchange rate determinants

Factor United States Venezuela Japan

Change in interest rate -1% -2% -4%Change in inflation +2% -3% -6%

• Assume the U.S. and Venezuela have large amount of international trade, but not much financial capital flows.

• On the contrary, the U.S. and Japan have heavy capital investment, but not as much international trade.

• What do you expect about the exchange rate for Venezuela currency and Japanese currency in the next year?

Summary of How Factors Can Affect Exchange Rates