Chapter 4

Exchange Rate Determination

Cost and Management

International
Accounting:
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Management, 2nd7th
Introduction, edition
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Jeff
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 Chapter Objectives

• To explain how exchange rate

movements are measured.
• To explain how the equilibrium
exchange rate is determined.
• To examine the factors that affect the
equilibrium exchange rate.

Cost and Management

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Accounting:
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Management, 2nd7th
Introduction, edition
edition
Jeff
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 Measuring Exchange Rate
Movements (1)
• An exchange rate measures the value of one
currency in units of another currency.
• When a currency declines in value, it is said to
depreciate. When it increases in value, it is
said to appreciate.
• On the days when some currencies appreciate
while others depreciate against a particular
currency, that currency is said to be “mixed in
trading.”
Cost and Management
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Accounting:
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Management, 2nd7th
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 Foreign Exchange Rate
Determination
• Exchange rate determination is complex.
• Some argue that there are three major schools
of thought (parity conditions, balance of
payments approach, asset market approach)
• These are not competing theories but rather
complementary theories. Without the depth and
breadth of the various approaches combined,
our ability to capture the complexity of the global
market for currencies is lost.

Cost and Management Accounting: An Introduction, 7th edition

Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
The Determinants of Foreign Exchange Rates

Cost and Management Accounting: An Introduction, 7th edition

Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
 Exchange Rate Determination:
The Theoretical Thread
• The theory of purchasing power parity is a
widely accepted theory of exchange rate
determination:
– PPP is the oldest and most widely followed of the
exchange rate theories, and deals with exchange
rates and inflation. Countries who suffer from high
inflation, will se a deterioration in the value of their
currency
– Most exchange rate determination theories have PPP
elements embedded within their frameworks.
– We will look at PPP in more detail in chapter 8
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
 Exchange Rate Determination:
The Theoretical Thread
• The balance of payments approach is also a
widely utilized theoretical approach in exchange
rate determination:
– The basic approach argues that the equilibrium
exchange rate is found currency flows match up vis a
vis current and financial account activities.
– If a country suffers from prolonged BOP deficits, the
value of its currency will fall

Cost and Management Accounting: An Introduction, 7th edition

Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
 Exchange Rate Determination: The
Theoretical Thread
• The asset market approach argues that
exchange rates are determined by the
supply and demand for a wide variety of
financial assets:
– Shifts in the supply and demand for financial
assets alter exchange rates.
– Changes in monetary and fiscal policy alter
expected returns and perceived relative risks
of financial assets, which in turn alter
exchange rates.
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
 Measuring Exchange Rate
Movements (2)
• The percentage change (% D) in the
value of a foreign currency is
computed as
St – St – 1
St – 1
where St denotes the spot rate at time t.
• A positive % D represents appreciation of the foreign
currency, while a negative % D represents
depreciation.
Cost and Management
International
Accounting:
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Management, 2nd7th
Introduction, edition
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 Annual Changes
in the Value of the Euro
Date Exchange Rate Annual %
D
1/1/2012 $1.001/€ –
1/1/2013 $.94/€ – 6.1%
1/1/2014 $.89/€ – 5.3%
1/1/2015 $1.05/€ +18.0%
1/1/2016 $1.26/€ +20.0%
Cost and Management
International
Accounting:
FinancialAn
Management, 2nd7th
Introduction, edition
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Jeff
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Madura
Drury
and Roland Fox
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ISBN 978-1-4080-3229-9
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 Exchange Rate Equilibrium (1)
• An exchange rate represents the price of a
currency, which is determined by the
demand for that currency relative to the
supply for that currency.

Cost and Management

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 Exchange Rate Equilibrium (2)

Value of
£
S: Supply of £

$1.60
$1.55 Equilibrium
exchange rate
$1.50

D: Demand for £

Quantity of £
Cost and Management
International
Accounting:
FinancialAn
Management, 2nd7th
Introduction, edition
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 Exchange Rate Equilibrium (3)
• The liquidity of a currency affects the
sensitivity of the exchange rate to specific
transactions.
• With many willing buyers and sellers, even
large transactions can be easily
accommodated.
• Conversely, illiquid currencies tend to
exhibit more volatile exchange rate
movements.

Cost and Management

International
Accounting:
FinancialAn
Management, 2nd7th
Introduction, edition
edition
Jeff
Colin
Madura
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and Roland Fox
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 Factors that Influence
Exchange Rates (1)
e  f DINF , DINT , DINC , DGC, DEXP )

e = percentage change in the spot rate

DINF = change in the relative inflation rate
D INT = change in the relative interest rate
DINC = change in the relative income level
DGC = change in government controls
DEXP = change in expectations of future
exchange rates
Cost and Management
International
Accounting:
FinancialAn
Management, 2nd7th
Introduction, edition
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Jeff
Colin
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 Factors that Influence
Exchange Rates (2)
Relative Inflation Rates

U.S. inflation 
$/
£
S1   U.S. demand for
S0
r1 British goods, and
r0 hence £.
D1   British desire for U.S.
D0
goods, and hence the
Quantity of £ supply of £.
Cost and Management
International
Accounting:
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Management, 2nd7th
Introduction, edition
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Jeff
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 Factors that Influence
Exchange Rates (3)
Relative Interest Rates

U.S. interest rates 

$/£ S0   U.S. demand for
S1
r0 British bank deposits,
r1 and hence £.
D0   British desire for U.S.
D1
bank deposits, and
Quantity of £ hence the supply of £.
Cost and Management
International
Accounting:
FinancialAn
Management, 2nd7th
Introduction, edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
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2011 Cengage
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 Factors that Influence
Exchange Rates (4)
Relative Interest Rates
• A relatively high interest rate may actually
reflect expectations of relatively high
inflation, which may discourage foreign
investment.
• It is thus useful to consider the real interest
rate, which adjusts the nominal interest rate
for inflation.
Cost and Management
International
Accounting:
FinancialAn
Management, 2nd7th
Introduction, edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
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2011 Cengage
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 Factors that Influence
Exchange Rates (5)
Relative Interest Rates
• real nominal
interest = interest – inflation rate
rate rate
• This relationship is sometimes called the
Fisher effect.

Cost and Management

International
Accounting:
FinancialAn
Management, 2nd7th
Introduction, edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
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2011 Cengage
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 Factors that Influence
Exchange Rates (6)
Relative Income Levels

U.S. income level 

$/£
  U.S. demand for
S ,S1 British goods, and
r1
r0
0 hence £.
D1  No expected change for
D0
the supply of £.
Quantity of £
Cost and Management
International
Accounting:
FinancialAn
Management, 2nd7th
Introduction, edition
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Jeff
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 Factors that Influence
Exchange Rates (7)
Government Controls
• Governments may influence the equilibrium
exchange rate by:
– imposing foreign exchange barriers,
– imposing foreign trade barriers,
– intervening in the foreign exchange market, and
– affecting macro variables such as inflation,
interest rates, and income levels.

Cost and Management

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Accounting:
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Management, 2nd7th
Introduction, edition
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Jeff
Colin
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 Factors that Influence
Exchange Rates (8)
Expectations
• Foreign exchange markets react to any
news that may have a future effect.
– News of a potential surge in U.S. inflation may
cause currency traders to sell dollars.
• Many institutional investors take currency
positions based on anticipated interest rate
movements in various countries.

Cost and Management

International
Accounting:
FinancialAn
Management, 2nd7th
Introduction, edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
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2011 Cengage
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 Factors that Influence
Exchange Rates (9)
Expectations
• Economic signals that affect exchange rates can
change quickly, such that speculators may
overreact initially and then find that they have to
make a correction.
• Speculation on the currencies of emerging markets
can have a substantial impact on their exchange
rates.

Cost and Management

International
Accounting:
FinancialAn
Management, 2nd7th
Introduction, edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
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2011 Cengage
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 Factors that Influence
Exchange Rates (10)
Interaction of Factors
• The various factors sometimes interact and
simultaneously affect exchange rate
movements.
• For example, an increase in income levels
sometimes causes expectations of higher
interest rates, thus placing opposing pressures
on foreign currency values.

Cost and Management

International
Accounting:
FinancialAn
Management, 2nd7th
Introduction, edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
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ISBN 978-1-4080-3229-9
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 How Factors Can Affect Exchange Rates
Trade-Related
Factors U.K. demand for foreign
goods, i.e. demand for
1. Inflation foreign currency
Differential
2. Income Foreign demand for U.K.
Differential goods, i.e. supply of
3. Gov’t Trade foreign currency Exchange
Restrictions rate
between
Financial U.K. demand for foreign foreign
Factors securities, i.e. demand for currency
1. Interest Rate foreign currency and the
Differential Foreign demand for U.K. dollar
2. Capital Flow securities, i.e. supply of
foreign currency
Restrictions
International Financial Management, 2nd edition
Jeff Madura and Roland Fox
ISBN 978-1-4080-3229-9 © 2011 Cengage Learning EMEA
 Factors that Influence
Exchange Rates (11)
Interaction of Factors
• The sensitivity of an exchange rate to the
factors is dependent on the volume of
international transactions between the two
countries.
Large volume of international trade 
relative inflation rates may be more influential
Large volume of capital flows  interest rate
fluctuations may be more influential
Cost and Management
International
Accounting:
FinancialAn
Management, 2nd7th
Introduction, edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
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 Factors that Influence
Exchange Rates (12)
Interaction of Factors
• An understanding of exchange rate
equilibrium does not guarantee accurate
forecasts of future exchange rates because
that will depend in part on how the factors
that affect exchange rates will change in
the future.

Cost and Management

International
Accounting:
FinancialAn
Management, 2nd7th
Introduction, edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
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2011 Cengage
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 Speculating on
Anticipated Exchange Rates
• Many commercial banks attempt to capitalize on
their forecasts of anticipated exchange rate
movements in the foreign exchange market.
• The potential returns from foreign currency
speculation are high for banks that have large
borrowing capacity.
• The simple strategy is to get out of the currency
about to depreciate and into the currency that is
going to appreciate against it. Then reverse the
positions after the event to end up with more
than you started with.
Cost and Management
International
Accounting:
FinancialAn
Management, 2nd7th
Introduction, edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
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 Speculating on Anticipated Exchange Rates
London Bank expects the exchange rate of the New
Zealand dollar to appreciate against the £ from its
present level of £0.35 to £0.38 in 30 days.
Borrows at 7.20%
for 30 days 4. Holds
1. Borrows £21,831,543
£20 m
Repays £20,120,000
A profit of 21,831,543 – Exchange at
Exchange at 20,120,000 = 1,711,543 £0.38/NZ$
£0.35/NZ$
Lends at 6.48%
2. Holds for 30 days 3. Receives
NZ$57,142,857 NZ$57,451,428
Cost and Management
International
Accounting:
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Management, 2nd7th
Introduction, edition
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Jeff
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 Speculating on Anticipated Exchange Rates
London Bank expects the exchange rate of the New
Zealand dollar to depreciate from its present level of
0.50 euros to 0.48 euros in 30 days.
Borrows at 6.96%
for 30 days
1. Borrows 4. Holds
NZ$40 million NZ$41,900,000
Returns NZ$40,232,000
Profit of NZ$1,668,000
Exchange at or 800,640 euros Exchange at
0.50 euros/NZ$ 0.48 euros/NZ$
Lends at 6.72%
for 30 days 3. Receives
2. Holds
20 m euros 20,112,000 euros
Cost and Management
International
Accounting:
FinancialAn
Management, 2nd7th
Introduction, edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
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