Exchange Rate Determination (Note 07; Ch 7)

I. II. Market Efficiency Fun amenta! "na!y#i#

III. Fun amenta! Factor# I$. Fun amenta! Mo e!#

I. Market Efficiency A market is efficient if prices reflect available information (i.e., requires people to process information and form reasonable expectations). Degrees of Informational Efficiency a. eak!form efficiency" prices reflect #istorical information only.

b. $emi strong!form efficiency" prices reflect #istorical and publicly available information. c. $trong!form efficiency" prices reflect #istorical, public and private information. %enerally, empirical evidence finds t#at t#e market is &eak to semi!strong form efficient. #at does it mean by '( forecasting if '( markets are efficient) $uppose market is semi!strong" exc#ange rate #as already reflected all relevant information, and &ill only c#ange &#en ne& information is revealed. $ince information is unpredictable, t#e exc#ange rate &ill be random over time. II. Fun amenta! "na!y#i# $tudy t#e basic economic factors &#ic# are important to exc#ange rate determination *. +#e components from t#e international parity conditions (i.e., for&ard rates, relative inflation rates, and relative interest rates) ,. Examine t#e underlying factors be#ind t#e fundamentals (i.e., relative money supplies, -./ positions, central bank be#avior) +#ere are t#ree general approac#es for exc#ange rate determination"

*) International parity conditions" see t#e c#apter0notes for international parity conditions. ,) Asset approac#" emp#asis on investment and capital flo& of t#e currency +#e extent t#at investors are &illing to #old foreign claims depends on relative interest rates and a country1s financial outlook (economic prospects, profitability)2 liquidity (can you sell assets quickly at fair market value)) political stability2 t#e credibility of corporate governance 3) -alance of /ayments (-./) approac#" emp#asis on t#e interaction bet&een -./ flo&s and exc#ange rate c#ange $urplus on financial and current account typically creates an increase in reserve #oldings (gold, and per#aps '4s)2 deficit on account is typically t#e reverse 'ocus on supply 5 demand of currency

6eminder" /roblems *!*7 of 4# 8

III. Fun amenta! Factor# $ome macroeconomic fundamentals" *) 6elative inflation rates ! #ig#er inflation rates implies currency depreciation (///) ,) 6elative interest rates ! #ig#er nominal interest rates implies currency depreciation ('is#er! open or uncovered I6/2 assuming real interest rates are t#e same across countries) ! #ig#er real interest rate implies capital inflo& &#ic# implies currency appreciation (usually in t#e s#ort!run) 3) 6elative money supplies ! t#e increase in relative money supply implies #ig#er relative inflation rate (quantity t#eory of money) 7) %overnment spending ! t#e increase in government spending implies increased pressure on inflation 9) 'oreign exc#ange reserves ! reduction in reserves signal do&n&ard pressure on currency :) -./ ! indicators of imbalances suc# as current account and trade balance (defined as exports ; imports) are useful in examining currency movement ! t#e increase in current account or trade balance implies increase in demand for domestic currency &#ic# implies appreciation (t#e converse #olds)

8) %D/ gro&t# (%D/ < 4 = I = % = (%&M), &#ere 4<consumption or consumer spending, I<investment, %<government spending, (<exports, ><imports) +#e increase in %D/ ?eading to more consumption because of #ig#er disposable income >ore likely creating an increase in demand for imports &#ic# &ould imply currency depreciation2 #o&ever, economic gro&t# typically attracts capital inflo&s, per#aps offsetting part of currency depreciation @) /olitical factors ! government restrictions on t#e use of foreign currency ! independence of central bank ! increased spread bet&een official rate and black market rate &ill indicate pressure for devaluation (depreciation)

I$. Fun amenta! Mo e!# Econometric models quantify t#e relations#ip bet&een exc#ange rates and economic fundamentals. 4onsider t#e follo&ing multivariate regression model" $t < bA = b* (>Bt ; >t) = b, (CBt ; Ct) = b3 (rBt ; rt) = b7 (DBt ; Dt) = b9 (4ABt ; 4At) = et #ere"
B

denotes foreign country

$t < '40E >t < >oney supply Ct < %D/ rt < interest rate Dt < inflation rate 4At < 4urrent account balance Determine regression coefficients to explain c#anges in t#e spot exc#ange rate

'he im(act of exchange rate# on e)uity an Rea ing+ pp. ,9F, 7A3!7A92 798!79@

e*t+

Exam(!e (co#t of e*t)+ $uppose a firm borro&s G*,AAA,AAA at 9H for one year, &it# $A < E*.7A0G and $t < * yr < E*.:A0G. (a) #at is t#e amount of E proceeds at t#e beginning of t#e period) (b) #at is t#e amount of E payable at t#e end of t#e period) (c) #at is t#e E cost of debt) ,o!ution#+ (a) E proceeds < G*,AAA,AAAB(E*.7A0G) < -./000/000. (b) G*,AAA,AAAB(*=A.A9) < G*,A9A,AAA payable in one year E to be repaid in one year is G*,A9A,AAAB(E*.:A0G) < -./120/000 (c) +#e E cost of debt kEd < (E*,:@A,AAA0E*,7AA,AAA) ! * < 304. Note+ In general, E principal < G principal B $A(E0G) E payable < G principal B (* = k'4d) B $* E cost of debt < kEd < (G principalB(* = k'4d)B$*)0(G principalB$A) ! * < I(* = k'4d)B$*0$AJ ! * < I(* = k'4d)B(* = s)J ! * s < H c#ange of '4 appreciation0depreciation (note" per s#are concept) s < (*.:!*.7)0*.7 < *7.,FH, kEd < (*=A.A9)B(*=A.*7,F);* < 304 Exam(!e (co#t of e*t)+ A K.$. firm borro&s $fr*,9AA,AAA for one year at 9.AAH p.a.2 t#e franc appreciates from $fr*.9AA0E to $fr*.77A0E. Initial dollar amount borro&ed
$fr*,9AA,AAA = E*,AAA,AAA $fr*.9AA0E

At t#e end of t#e year, t#e K.$. firm repays t#e interest plus principal
$fr*,9AA,AAA B*.A9 = E*,AF3,89A $fr*.770E

+#e actual dollar cost of t#e loan is not t#e nominal 9.AAH paid in $&iss francs, but 5.6774 &#ic# is (*,AF3,89A!*,AAA,AAA)0*,AAA,AAA. Note+ $&iss franc appreciates by 7.*::8H &#ic# equals to (*.9A!*.77)0*.77. (*=A.A9)B(*=A.A7*::8) ; * < 5.6774

Exam(!e (*orro8ing FC& enominate e*t)+ $iam 4ement, t#e -angkok! based cement manufacturer #ad been pursuing a very aggressive gro&t# strategy in t#e mid!*FFAs, taking on massive quantities of foreign currency denominated debt (primarily K.$. dollars). $iam 4ement took out a E*A million loan in Lune *FF8 at t#e interest rate of @.AH and t#e spot rate in Lune *FF8 &as -,9.A0E. $iam 4ement #ad to repay t#e loan plus interest payment in one year &#en t#e spot exc#ange rate #ad stabiliMed at -7,.A0E. (a) #at &ould t#e total payment be in +#ai ba#t if t#e future spot rate &as -,9.A0E in Lune *FF@) (b) Due to t#e devaluation of +#ai ba#t, &#at &as t#e foreign exc#ange loss (in +#ai ba#t) incurred on t#e dollar!denominated loan of E*A million) (c) #at &as t#e H appreciation of E against +#ai ba#t) (d) #at &as t#e effective cost of funds (in +#ai ba#t)) (Note" t#e effective cost of funds < (+#ai ba#t needed to pay in one year)0 (t#e current loan in +#ai ba#t terms)!*) ,o!ution#+ (a) E*A,AAA,AAAB(*=A.A@)B-,9.A0E < 9370/000/000 (b) E*A,AAA,AAAB(*=A.A@)B-7,.A0E < -793,:AA,AAA (793,:AA,AAA!,8A,AAA,AAA) < 9.26/100/000 (c) (7,!,9)0,9 < 124 Note" *@3,:AA,AAA0,8A,AAA,AAA < :@H < (7,!,9)0,9 < t#e H appreciation of E against +#ai ba#t. (d) E*A,AAA,AAAB(*=A.A@)B-7,.A0E < -793,:AA,AAA (+#ai ba#t needed to pay in one year) E*A,AAA,AAAB-,9.A0E < -,9A,AAA,AAA (t#e current loan in +#ai ba#t terms) (793,:AA,AAA0,9A,AAA,AAA)!* < 2..004 Note" E ('4 in t#is example) appreciated by :@H &#ic# equals to (7,! ,9)0,9. (*=A.A@)B(*=A.:@);* < 2..004

Exam(!e (:::/ e;a!uation/ an co#t of e*t)+ +#e East Asiatic 4ompany (EA4), a Danis# company &it# subsidiaries all over Asia, #as been funding its -angkok subsidiary primarily &it# K.$.!dollar debt because of t#e cost and availability of dollar capital as opposed to +#ai ba#t (-) funds. +#e treasurer of EA4!+#ailand is considering a one!year bank loan for E39A,AAA. +#e current spot exc#ange rate is -7,.@70E, and t#e dollar!based interest is @.@@9H for t#e one!year period. +#e expected inflation rates over one year are 7.9H in +#ailand and ,.,H in t#e Knited $tates, respectively. (a) -ased on ///, &#at s#ould t#e exc#ange rate be at t#e end of one year (-0E)) (b) -ased on ///, &#at is t#e effective cost of funds in +#ai ba#t terms) (c) it#out using /// in part (a) and (b) but analyMing t#e possible government intervention, EA41s foreign exc#ange advisors believe strongly t#at t#e +#ai government &is#es to pus# t#e value of t#e ba#t do&n against t#e dollar by *AH over t#e coming year (to promote its export competitiveness in dollar markets), &#at &ould t#e effective cost of funds be in +#ai ba#t terms based on t#e devaluation of *AH) ,o!ution#+ (a) +#e expected one!year spot rate < -7,.@70EB(*=7.9H)0(*=,.,H) < 906.200.<(b) E39A,AAAB(*=@.@@9H) < E3@*,AF@ (need to be paid in one year) E39A,AAAB -7,.@70E < -*7,FF7,AAA (t#e current loan in +#ai ba#t terms) E3@*,AF@B -73.@A7*0E < -*:,:F3,:3:.:9 (+#ai ba#t needed to pay in one year) -*:,:F3,:3:.:90-*7,FF7,AAA ! * < ...64 Note" E ('4 in t#is example) appreciated by ,.,9H &#ic# equals to (73.@A7*!7,.@7)07,.@7. (*=@.@@9H)B(*=,.,9H) ; * < ...64 (c) E39A,AAAB(*=@.@@9H) < E3@*,AF@ (need to be paid in one year) E39A,AAAB -7,.@70E < -*7,FF7,AAA (t#e current loan in +#ai ba#t terms) +#e expected one!year spot rate < (-7,.@70E)0(*!*AH) < -78.:0E (Note" (7,.@7!()0( < !*AH and t#en solve () E3@*,AF@B -78.:0E < -*@,*7A,,7* (+#ai ba#t needed to pay in one year) (-*@,*7A,,7*0-*7,FF7,AAA) ; * < 30.524

Note+ E ('4 in t#is example) appreciated by **.**H &#ic# equals to (78.:! 7,.@7)07,.@7. (*=@.@@9H)B(*=**.**H) ; * < 30.524

*A

Exam(!e (e)uity in;e#tment return)+ A K.$. international mutual fund invested in a stock traded on t#e +okyo $tock Exc#ange (+$E) using E*,AAA,AAA on ,0*0,AA,. +#e spot rate &as O*3A0E on t#at day. +#e fund purc#ased :,9AA s#ares valued at O,A,AAA0s#are. In one year, t#e international fund sold all t#e s#ares at a price of O,9,AAA0s#are. .n ,0*0,AA3, t#e spot rate &as O*,90E. (a) #at &as t#e investment return in O) (b) -y &#at percentage did O c#ange in value over t#e period of one year) (c) #at &as t#e investment return in E) (d) If t#e stock paid a cas# dividend of O,AA during t#e investment period, &#at is t#e total investment return (including dividends) in E) ,o!ution#+ (a) +#e international mutual fund receives a O return of ,9H on investment ((,9,AAA!,A,AAA)0(,A,AAA) < 374) (b) O is t#e numerator currency (*3A!*,9)0*,9 < 04 (c) E amount received < (:,9AAB,9,AAA)0*,9 < E*,3AA,AAA (*,3AA,AAA!*,AAA,AAA)0*,AAA,AAA < 604 Note+ In general, E initial investment B $A (O0E) < O initial investment +#e ending portfolio value (in O) < O initial investmentB(*= 6s#are) +#e ending portfolio value (in E) < O initial investmentB(*= 6s#are)0$*(O0E) < E initial investment B $A (O0E) B(*= 6s#are)0$*(O0E) 6E < (*=
S A S* S*

)B(*= 6s#are) ! *

< (*= s)B(*= 6s#are) ! * s < H c#ange of '4 appreciation0depreciation (note" per s#are concept) In t#e above example, s < (*3A!*,9)0*,9 < 7H, 6s#are < (,9,AAA!,A,AAA)0(,A,AAA) < ,9H 6 E = [(* + A.A7 )(* + A.,9)] * = A.3A (d) 6s#are < (,9,AAA!,A,AAA=,AA)0(,A,AAA) < ,:H R E = I(* + A.A7) B (* + A.,:)J * = 3*.A7H

**

Exam(!e (e)uity in;e#tment return)+ %iri Iyer is a European analyst and strategist for +ristar 'unds, a Ne& Cork!based mutual fund company. %iri is currently evaluating t#e recent performance of s#ares in /acific ietM, a publicly traded specialty c#emical company in %ermany listed on t#e 'rankfurt DA(. +#e baseline investment amount used by +ristar is E*AA,AAA. Pe gat#ers t#e follo&ing quotes" Lan. * Dec. 3* Distributions /urc#ase $ale $#are price G*,9.AA G*9A.AA G*A.AA Exc#ange E*.A::A0G E*.7:970G ! rate (a) Po& many s#ares did +ristar buy on Lanuary *st) (6ounded to t#e nearest integer) (b) #at &as t#e percentage total return on t#e security in G terms) (c) #at &as t#e percentage total return on t#e security in E terms) (d) #at &as t#e end!of!period proceeds (in E) to +ristar based on t#e number of s#ares +ristar boug#t and exc#ange rate on December 3*) ,o!ution#+ (a) (*AA,AAA0*.A::A)0*,9 < 770 #hare# (b) (*9A!*,9=*A)0*,9 < 324 (c) (*.7:97!*.A::A)0*.A::A < 38.7:8,H2 +#e percentage total E return < (*=A.387:8,)B(*=A.,@) ! * < 77.514 (d) +#e end!of!period proceeds (in E) < 89AB(*9A=*A)B*.7:97 < -.77/202 4#eck" t#e E amount used &#en buying 89A s#ares 89AB*,9B*.A::A < FF,F38.9 E percentage return < (*89,@7@0FF,F38.9) ! * < 89.F:H

*,

(Re;ie8)+ /acific %roup, a private equity firm #eadquartered out of Pouston, +exas, borro&s Q*,AAA,AAA for one year at t#e interest rate of :H, and during t#e year t#e pound appreciates from E*.@@0Q to E,.A30Q. (a) #at is t#e total payable (principal = interest) denominated in E in one year) (b) #at is t#e percentage c#ange in dollar value of Q over t#is period) (c) #at is t#e dollar cost of t#is debt) "n#8er#+ (a) Q*,AAA,AAAB(*=A.A:)B E,.A30Q < -3/.7./200 (b) (,.A3!*.@@)0*.@@B*AAH < 7.524 (c) +#e dollar cost of t#is debt < (*=A.A8F@)B(*=A.A:) ; * < .0.014 Alternatively, Q*,AAA,AAABE*.@@0Q < E*,@@A,AAA (principal in E) +#e dollar cost of t#is debt < (,,*9*,@AA0*,@@A,AAA)!* < .0.014

*3

(Re;ie8)+ $uppose EA4 in +#ailand took out a E: million loan at t#e interest rate of @.AH and t#e spot exc#ange rate &as -7*.A0E &#en t#e loan &as initiated. EA4 #ad to repay t#e loan plus interest payment in one year. (a) If t#e spot rate in one year is -77.A0E, &#at is t#e foreign exc#ange loss (in +#ai ba#t) incurred on t#e loan of E: million due to t#e c#ange in exc#ange rate) (b) #at is t#e effective cost of funds in +#ai ba#t terms in part (a)) (c) Assume +#ai government &is#es to pus# t#e E value of t#e +#ai ba#t do&n by *AH from -7*.A0E over t#e coming year to promote its export competitiveness in dollar markets, &#at is t#e ne& exc#ange rate follo&ing t#e devaluation of *AH) (d) #at is t#e effective cost of funds in +#ai ba#t terms based on t#e devaluation of *AH in part (c)) (Note" t#e effective cost of funds < (+#ai ba#t needed to pay in one year)0 (t#e current loan in +#ai ba#t terms)!*) "n#8er#+ (a) E:,AAA,AAAB(*=A.A@)B-7*0E < -,:9,:@A,AAA E:,AAA,AAAB(*=A.A@)B-770E < -,@9,*,A,AAA (,@9,*,A,AAA!,:9,:@A,AAA) < 9.5/000/000 (b) H appreciation of E against +#ai ba#t < (77!7*)07* < 8.3H (<*F,77A,AAA0,:9,:@A,AAA) (*=A.A@)B(*=A.A83) ; * < .7.54 (c) (7*!()0( < !A.*A 7*0( < (*!A.*) ( < 7*0A.F < 907.71<(d) H appreciation of E against +#ai ba#t < (79.9:!7*)07* < **.*,H (*=A.A@)B(*=A.***,) ; * < 30.04

*7

(Re;ie8)+ A K.$. international mutual fund invested in a stock traded on t#e +okyo $tock Exc#ange (+$E) using E*,AAA,AAA for t#e investment #oriMon of one year. +#e spot rate &as O*A90E and stock price &as O,*,AAA0s#are at t#e beginning of t#e investment #oriMon. In one year, t#e international fund sold all t#e s#ares at a price of O,3,*AA0s#are and t#e spot rate &as OF@0E. Also, t#e stock paid a cas# dividend of O,*A0s#are immediately before t#e end of one! year investment #oriMon. (a) Po& many s#ares did t#e fund buy initially) (b) #at &as t#e percentage total return (including dividend) on t#e stock in O) (c) -y &#at percentage did O c#ange in value over t#e period of one year) (d) #at &as t#e percentage total return (including dividend) on t#e stock in E) "n#8er#+ (a) *,AAA,AAAB*A90,*,AAA < 7/000 #hare# (b) +#e total return (H) in O < capital gain (H) = dividend yield (H) < (,3,*AA!,*,AAA=,*A)0,*,AAA < ..4 (c) O (foreign currency in t#is example) appreciation against E < (*A9!F@)0F@ < 7..04 (d) Investment return (H) in E < (*=A.**)B(*=A.A8*7) ! * < .2.564

*9