The document discusses factors that influence exchange rates and movements in exchange rates. It begins by defining exchange rate movements like depreciation and appreciation. It then discusses exchange rate equilibrium as the point where currency demand and supply are equal. Several factors are described as influencing exchange rates, including relative inflation, interest rates, income levels, government controls, and expectations of future exchange rates. The document also discusses how cross-exchange rates between currencies can move and how financial institutions can capitalize on expected exchange rate movements through speculation.
The document discusses factors that influence exchange rates and movements in exchange rates. It begins by defining exchange rate movements like depreciation and appreciation. It then discusses exchange rate equilibrium as the point where currency demand and supply are equal. Several factors are described as influencing exchange rates, including relative inflation, interest rates, income levels, government controls, and expectations of future exchange rates. The document also discusses how cross-exchange rates between currencies can move and how financial institutions can capitalize on expected exchange rate movements through speculation.
The document discusses factors that influence exchange rates and movements in exchange rates. It begins by defining exchange rate movements like depreciation and appreciation. It then discusses exchange rate equilibrium as the point where currency demand and supply are equal. Several factors are described as influencing exchange rates, including relative inflation, interest rates, income levels, government controls, and expectations of future exchange rates. The document also discusses how cross-exchange rates between currencies can move and how financial institutions can capitalize on expected exchange rate movements through speculation.
The document discusses factors that influence exchange rates and movements in exchange rates. It begins by defining exchange rate movements like depreciation and appreciation. It then discusses exchange rate equilibrium as the point where currency demand and supply are equal. Several factors are described as influencing exchange rates, including relative inflation, interest rates, income levels, government controls, and expectations of future exchange rates. The document also discusses how cross-exchange rates between currencies can move and how financial institutions can capitalize on expected exchange rate movements through speculation.
Chapter 4 Determination of exchange rates I N T E R N AT I O N A L F I N A N C E
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Contents 1. Measuring Exchange Rate Movements
2. Exchange Rate Equilibrium
3. Factors That Influence Exchange Rates
4. Movements in Cross Exchange Rates
5. Capitalizing on Expected Exchange Rate Movements
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2 1. Measuring Exchange Rate Movements ▪ Depreciation: decline in a currency’s value ▪ Appreciation: increase in a currency’s value ▪ Comparing foreign currency spot rates over two points in time, S and St-1 S − St −1 Percent in foreign currency value = St −1 A positive percent change indicates that the currency has appreciated. A negative percent change indicates that it has depreciated.
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1. Measuring Exchange Rate Movements
Example: Assume the spot rate of the British pound is $1.73. The expected spot rate one year from now is assumed to be $1.66. What percentage depreciation does this reflect?
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4 1. Measuring Exchange Rate Movements
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1. Measuring Exchange Rate Movements
Example: Assume you want to determine whether the monthly movements in the Polish zloty against the dollar are more volatile than the monthly movements in some other currencies against the dollar. The zloty was valued at $0.4602 on May 1, $.04709 on June 1, $0.4888 on July 1, $0.4406 on August 1, and $0.4260 on September 1. Compute the standard deviation (a measure of volatility) of the zloty’s monthly exchange rate movements.
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6 1. Measuring Exchange Rate Movements
Value of zloty Monthly % change
1-May $0.4602
1-Jun $0.4709
1-Jul $0.4888
1-Aug $0.4406
1-Sep $0.4260
Standard deviation of monthly changes
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2. Exchange Rate Equilibrium
▪ 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. ▪ Supply of a currency increases when the value of the currency increases, leading to an upward sloping supply schedule. ▪ Equilibrium equates the quantity of pounds demanded with the supply of pounds for sale. ▪ In liquid spot markets, exchange rates are not highly sensitive to large currency transactions.
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8 2. Exchange Rate Equilibrium
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2. Exchange Rate Equilibrium
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10 2. Exchange Rate Equilibrium
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3. Factors That Influence Exchange Rates
e = f(∆INF, ∆INT, ∆INC, ∆GC, ∆EXP) e = percentage change in the spot rate ∆INF = change in the differential between U.S. inflation and the foreign country’s inflation ∆INT = change in the differential between the U.S. interest rate and the foreign country’s interest rate ∆INC = change in the differential between the U.S. income level and the foreign country’s income level ∆GC = change in government controls ∆EXP = change in expectations of future exchange rates
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12 3. Factors That Influence Exchange Rates 1. Relative Inflation:
Increase in U.S. inflation → increase in U.S. demand for foreign goods → an
increase in U.S. demand for foreign currency → an increase in the exchange rate for the foreign currency.
Increase in U.S. rates → an increase in demand for U.S. deposits and a decrease in demand for foreign deposits → an increase in demand for dollars → an increased exchange rate for the dollar.
Fisher Effect:
Real interest rate Nominal interest rate − Inflation rate
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3. Factors That Influence Exchange Rates
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16 3. Factors That Influence Exchange Rates 3. Relative Income Levels:
Increase in U.S. income → increase in U.S. demand for foreign goods → increase in demand for foreign currency relative to the dollar → increase in the exchange rate for the foreign currency.
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3. Factors That Influence Exchange Rates
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18 3. Factors That Influence Exchange Rates 4. Government Controls:
▪ 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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3. Factors That Influence Exchange Rates
5. 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 signals on currency speculation. Speculators may overreact to
signals causing currency to be temporarily overvalued or undervalued.
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20 3. Factors That Influence Exchange Rates Interaction of Factors: some factors place upward pressure while other factors place downward pressure.
Influence of Factors across Multiple Currency Markets: common for
European currencies to move in the same direction against the dollar.
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3. Factors That Influence Exchange Rates
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22 4. Movements in Cross Exchange Rates If currencies A and B move in same direction, there is no change in the cross exchange rate.
When currency A appreciates against the dollar by a greater (smaller) degree than currency B, then currency A appreciates (depreciates) against B.
When currency A appreciates (depreciates) against the 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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4. Movements in Cross Exchange Rates
Example: One year ago, you observed that the British pound (£) was valued at $1.52 while the Swiss franc (SF) was valued at $0.80. Today, the pound is valued at $1.50 and the Swiss franc is worth $0.75. This information allows you to determine how the British pound changed against the Swiss franc over the last year:
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24 5. Capitalizing on Expected Exchange Rate Movements Institutional speculation based on expected appreciation
When financial institutions believe that a currency is valued lower than it should be in the foreign exchange market, they may invest in that currency before it appreciates.
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5. Capitalizing on Expected Exchange Rate Movements
Example
Chicago Financial Co. expects the exchange rate of the New Zealand dollar (NZ$) 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.
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26 5. Capitalizing on Expected Exchange Rate Movements Example
Present short-term interest rates (annualized) in the interbank market are as given in the table
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5. Capitalizing on Expected Exchange Rate Movements
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.
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28 5. Capitalizing on Expected Exchange Rate Movements Example: Assume that Carbondale Co. expects an exchange rate of $0.48 for the New Zealand dollar on day 30. It can borrow New Zealand dollars, convert them to U.S. dollars, and lend the U.S. dollars out. On day 30, it will close out these positions. Assume that the firm can borrow NZ$40 million and present short-term interest rates (annualized) in the interbank market are as given in the table
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END OF CHAPTER 4 FACULTY OF FINANCE AND BANKING - UEL - 2022 30
