Exchange Rate Determination

South-Western/Thomson Learning 2003

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Measuring Exchange Rate Movements

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.

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Measuring Exchange Rate Movements

The percentage change (% ) 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 % represents appreciation of the foreign currency, while a negative % represents depreciation.
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Fluctuation of the British Pound Over Time

Approximate Spot Rate of
$ 1.80
1.75 1.70 1.65 1.60 1.55 1.50 1.45 1.40 1992 1996 2000

Approximate Annual %
20 % 15 10 5 0 -5 -10 -15 -20 1992 1996 2000

Approximate that could be Purchased with $10,000

7000
6800 6600 6400 6200 6000 5800 5600 1992 1996 2000
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Exchange Rate Equilibrium

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.
Value of $1.60 $1.55 $1.50 D: Demand for Quantity of
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S: Supply of equilibrium exchange rate

Factors that Influence Exchange Rates

Relative Inflation Rates
$/ r1 r0 S1 S0

D1 D0 Quantity of

U.S. inflation U.S. demand for British goods, and hence . British desire for U.S. goods, and hence the supply of .
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Factors that Influence Exchange Rates

Relative Interest Rates
$/ r0 r1 S0 S1

D0 D1 Quantity of

U.S. interest rates U.S. demand for British bank deposits, and hence . British desire for U.S. bank deposits, and hence the supply of .
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Factors that Influence Exchange Rates

Relative Interest Rates

A relatively high interest rate may actually

reflect expectations of relatively high inflation, which discourages foreign investment.

It is thus useful to consider real interest rates,

which adjust the nominal interest rates for inflation.
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Factors that Influence Exchange Rates

Relative Interest Rates

real interest rate Fisher effect.

nominal interest inflation rate rate

This relationship is sometimes called the

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Factors that Influence Exchange Rates

Relative Income Levels
$/ S0 ,S1 r1 r0

D1 D0 Quantity of

U.S. income level U.S. demand for British goods, and hence . No expected change for the supply of .

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Factors that Influence Exchange Rates

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.
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Factors that Influence Exchange Rates

Expectations

Foreign exchange markets react to any news

that may have a future effect.

Institutional investors often take currency

positions based on anticipated interest rate movements in various countries.

Because of speculative transactions, foreign

exchange rates can be very volatile.

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Factors that Influence Exchange Rates

Expectations Signal Poor U.S. economic indicators Impact on $ Weakened

Fed chairman suggests Fed is Strengthened unlikely to cut U.S. interest rates A possible decline in German interest rates Central banks expected to intervene to boost the euro Strengthened Weakened
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Factors that Influence Exchange Rates

Interaction of Factors

Trade-related factors and financial factors

sometimes interact. Exchange rate movements may be simultaneously affected by these factors.

For example, an increase in the level of

income sometimes causes expectations of higher interest rates.
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Factors that Influence Exchange Rates

Interaction of Factors

Over a particular period, different factors may

place opposing pressures on the value of a foreign currency.

The sensitivity of the exchange rate to these

factors is dependent on the volume of international transactions between the two countries.
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How Factors Can Affect Exchange Rates

Trade-Related Factors 1. Inflation Differential 2. Income Differential 3. Govt Trade Restrictions U.S. demand for foreign goods, i.e. demand for foreign currency Foreign demand for U.S. goods, i.e. supply of foreign currency

Financial Factors 1. Interest Rate Differential 2. Capital Flow Restrictions

U.S. demand for foreign securities, i.e. demand for foreign currency Foreign demand for U.S. securities, i.e. supply of foreign currency

Exchange rate between foreign currency and the dollar

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Factors that Influence Exchange Rates

How Factors Have Influenced Exchange Rates

Because the dollars value changes by

different magnitudes relative to each foreign currency, analysts often measure the dollars strength with an index.

The weight assigned to each currency is

determined by its relative importance in international trade and/or finance.
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Value of Foreign Currency Index Over Time

With Respect to the Dollar
250

strengthens $ weakens

200 150 100 50

$ due to relatively high U.S. inflation & growth

large balance Persian Gulf of trade War deficit

Higher U.S. interest rates

U.S. interest rates high U.S. interest rates, a somewhat depressed U.S. economy, & low inflation
1976 1980 1984

relatively high U.S. interest rates, & lower balance of trade deficit

0 1972

1988

1992

1996

2000

Note: The index reflects equal weights of , , French franc, German mark, and Swiss franc. C3 - 18

Speculating on Anticipated Exchange Rates

Chicago Bank expects the exchange rate of the New Zealand dollar to appreciate from its present level of $0.50 to $0.52 in 30 days.

Borrows at 7.20% for 30 days 1. Borrows $20 million Returns $20,120,000 Profit of $792,320 Exchange at $0.50/NZ$ Lends at 6.48% for 30 days Exchange at $0.52/NZ$ 4. Holds $20,912,320

2. Holds NZ$40 million

3. Receives NZ$40,216,000
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Speculating on Anticipated Exchange Rates

Chicago Bank expects the exchange rate of the New Zealand dollar to depreciate from its present level of $0.50 to $0.48 in 30 days.

Borrows at 6.96% for 30 days 1. Borrows NZ$40 million Returns NZ$40,232,000 Profit of NZ$1,668,000 or $800,640 Lends at 6.72% for 30 days 4. Holds NZ$41,900,000

Exchange at $0.50/NZ$

Exchange at $0.48/NZ$

2. Holds $20 million

3. Receives $20,112,000
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Kerjakan
Jika kurs rupiah-dolar awal tahun adalah Rp.2,000/$ dan
pada akhir tahun adalah Rp.4,000/$ berapa apresiasi/depresiasi rupiah terhadap dolar, dan apresiasi/depresiasi dolar terhadap rupiah?

Jika kurs Rp/$ adalah Rp.2,500/$ adalah Rp.2,500/$ pada

t=0, dan menjadi Rp.2,400/$ pada t = 1. Berapa apresiasi/depresiasi $ terhadap rupiah?

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Kerjakan
Blue Demon Bank expects that French Franc (FF) will depresiate againts
the dolar from its spot rate of $0.15 to $0.14 in 10 days. The following interbank lending and borrowing rate exist:

Lending Rate
US Dolar French Franc 8% 8.5%

Borrowing Rate
8.3% 8.7%

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Speculating on Anticipated Exchange Rates

Chicago Bank expects the exchange rate of the New Zealand dollar to depreciate from its present level of $0.15 to $0.14 in 30 days.

Borrows at 8.70% for 10 days 1. Borrows FF$70 million Returns FF75,166,666.7FF70,169,166.7 = FF 4,997,500 or $ 699,650 4. Holds FF$75,166,666.7

Exchange at $0.15/FF

Exchange at $0.14/FF$

2. Holds $10.5 million

Lends at 8% for 10 days

3. Receives $10,523,333.3
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 Assume that Blue demon bank has a borrowing capacity

of either $10.5 million or FF70 million in the interbank market, depending on which currency it wants to borrow.
1.

How could Blue demon bank attempt to capitalize on its expectations without using deposit funds? Estimate the profits that could be generated from this strategy. Assume all the preceding information, with this exception: blue demon bank expect the FF to appreciate from its present spot rate of $0.15 to $0.17 in 10 days. How could it attempt capitalize on its expectations without using deposited funds? Estimate the profits that could be generated from this strategy?

2.

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Thank You

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