Chapter 4

Chapter 4
Exchange Rate Determination

Copyright 2010 McGraw-Hill Australia Pty Ltd
PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
Objectives
To identify the factors causing changes in the
exchange rate.
To describe purchasing power parity and the
monetary model of exchange rates.
To explain how the bid-offer spread and the forward
spread are determined.
To examine the factors affecting the PKR exchange
rate.
4-2
Some stylised facts
The exchange rate follows approximately a random
walk with little or no drift.
The spot and forward rates tend to move in the same
direction and by approximately the same amount.
There is no correspondence between exchange
rates and prices.
(cont.)
4-3
Some stylised facts (cont.)
The relation between the exchange rate and the
current account is not strong .
Rapid monetary expansion leads to rapid currency
depreciation.
(cont.)
4-4
Some stylised facts (cont.)
The behaviour of exchange rates is often described
as bubbles followed by crashes.
Volatility clustering. Periods of calm are followed by
periods of calm, and periods of turbulence are
followed by periods of turbulence.
Exchange rates move in cycles with significant
random variation.
4-5

The equilibrium exchange rate
S(d/f)
Sf
Df
0
S
Q f
4-6
Factors affecting the supply of and demand for
FX
Relative inflation rates: A country that has a higher
inflation rate than its trading partners will experience
a depreciating currency.
(cont.)
4-7

The effect of a higher domestic inflation rate
S(d/f)
Sf
Df
0
S
Q f
1
S
4-8
FX (cont.)
Relative interest rates: Higher interest rates lead to
currency appreciation.
Distinction must be made between nominal and real
exchange rates.
4-9
The effect of a higher domestic interest rate

S(d/f)
Sf
Df
0
S
Q f
1
S
4-10
FX (cont.)
Relative growth rates: The effect of growth is
ambiguous since it affects the current account and
financial account in different directions.
(cont.)
4-11
FX (cont.)
The role of the government: The government affects
exchange rates by determining the exchange rate
regime, through central bank intervention, by
imposing and removing trade barriers, and by
affecting the variables that determine exchange
rates.
(cont.)
4-12
FX (cont.)
The role of expectations: Speculators buy and sell
currencies on the basis of expectations.
4-13
Speculation
Speculators participate in the foreign exchange
market, buying and selling currencies by anticipating
future movements of exchange rates.
By their actions, speculators affect the supply of and
demand for currencies and therefore exchange
rates.

(cont.)
4-14
Speculation (cont.)
Destabilising speculation, which drives the exchange
rate away from its equilibrium value, occurs when
speculators buy a currency when it is high and sell it
when it is low.
This kind of behaviour arises, for example, when
speculators believe that there is a bubble in the
market .

(cont.)
4-15
Speculation (cont.)
Stabilising speculation occurs when speculators buy
a depreciating currency and sell an appreciating
currency.
4-16
Purchasing power parity
The theory of purchasing power parity (PPP)
describes the relation between prices and exchange
rates.
PPP is important for international business firms
because the validity of this theory precludes the
possibility of real currency appreciation and
depreciation and hence the presence of exposure to
economic risk.

4-17
Deriving PPP
*
SP P | o + =
0 = o
1 = |
*
SP P
0 0
=
*
SP P
1 1
=
(cont.)
4-18
Deriving PPP (cont.)

-
-
-
-
=
+ + = +
=
P P S
P S P
P
P
S
S
P
P

) 1 )( 1 ( ) 1 (
0
1
0
1
0
1
4-19
Deriving PPP from the S-D model

|
|
.
|
\
|
=
=
- -
-
-
0 1
0 1
0 1
0 0
1 1
0
1
/
/
/
/
P P
P P
S S
P P
P P
S
S
(cont.)
4-20
Deriving PPP from the S-D model (cont.)

(
+
+
=
-
P
P
S S

1
1
0 1
4-21
The PPP exchange rate

(
=
- -
0
0
0
/
/
P P
P P
S S
t
t
t
4-22
Derivation from PPP

(

=
S
S S
D 100
4-23
PPP and the real exchange rate

) / (
) / (
1 1 1 1
0 0 0 0
P P S Q
P P S Q
-
-
=
=
(cont.)
4-24
PPP and the real exchange rate (cont.)

) 1 (
) 1 (
) 1 (
0 1
0 1
0 1
- - -
+ =
+ =
+ =
P P P
P P P
S S S
(cont.)
4-25
PPP and the real exchange rate (cont.)

0 1
0
0
0
) 1 (
) 1 (
) 1 (
Q Q
P P
P P
S S
=
+
+
= +
- -

4-26
The empirical validity of PPP
There is little empirical evidence to support the
validity of PPP, particularly in the short run.
There is some evidence for PPP under hyperinflation
and over long periods of time.

4-27
Monthly exchange rate

0.40
0.50
0.60
0.70
0.80
0.90
1.00
1983Q4 1987Q2 1990Q4 1994Q2 1997Q4 2001Q2 2004Q4 2008Q2
Actual PPP
4-28
Monthly changes in Exchange rate
-40
-30
-20
-10
0
10
20
30
1983Q4 1987Q2 1990Q4 1994Q2 1997Q4 2001Q2 2004Q4 2008Q2
4-29

PPP as a trading rule
) , , , (
2 1 n
X X X S F S
P
P
f S
=
|
.
|
\
|
=
-
Buy when and sell when S S >
S S <
4-30
The monetary model of exchange rates

Y kP
M
S
kY
M
P
kPY M
d
-
=
=
=
4-31
Predictions of the monetary model
A monetary expansion leads to depreciation of the
domestic currency.
A rise in income leads to appreciation of the
domestic currency.
A rise in foreign prices leads to appreciation of the
domestic currency.

4-32
Determination of the bid-offer spread
Since the bid rate is the rate at which the dealer buys
and the customer sells, it is determined by the
intersection of the dealers demand curve and the
customers supply curve.
Conversely, the offer rate is determined by the
intersection of the customers demand curve and the
dealers supply curve.
4-33
Determination of the forward spread
The nave model is based on the assumption that
there are independent demand and supply forces in
the spot and forward markets.
It also assumes that there is a separate market with
independent supply and demand forces for forward
contracts with different maturities.

(cont.)
4-34
Determination of the forward spread (cont.)
The equilibrium spot exchange rate is determined in
the spot market, whereas the equilibrium forward
rate (for a particular maturity) is determined in the
forward market.
The forward spread is the difference between the
forward and spot rates.
4-35
Factors affecting the PKR exchange rates
Interest rates
Commodity prices and the terms of trade
Inflation
The external account
The role of the State bank of Pakistan
4-36
Pakistan exchange rates

4-37
The role of the State bank of Pakistan
The SBP intervenes in the foreign exchange market
for three reasons:
(i) to calm the market when it tends to become
disorderly;
(ii) to help reverse exchange rate overshooting;
(iii) to give monetary policy greater room
(cont.)
4-38
The role of the SBP (cont.)
Direct intervention by the SBP takes the form of
smoothing and testing transactions.
Smoothing transactions aims to ease the volatility of
the currencys path in reaction to news to prevent
exchange rate overshooting.
By testing, SBP tries to discern market volatility
from trends.
4-39

Chapter 4

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Exchange Rate Determination

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