Exchange Rate Movements

Meaning of Exchange Rate

Value of one currency in units of another currencyA decline in a currency’s value is referred to as

depreciation and an increase in currency’s value is called appreciation.

If currency A can buy you more units of foreign currency, currency A has appreciated and foreign currency depreciated

If currency A can buy you less units of foreign currency, currency A has depreciated and foreign currency appreciated

Appreciation/Depreciation

Percentage change in value US $New Value of Foreign Currency per unit of $ - Old value of foreign currency per $

-------------------------------------------------- X 100

Old value of Foreign Currency per $

Percentage change in value of Foreign Currency

New Value of $ per units of Foreign Currency - Old value of $ per unit of foreign currency

-------------------------------------------------- X 100

Old value of $ per unit of Foreign Currency

Factors that influence the Exchange Rate

Expectations of the MarketPolitical Events Relative Inflation RatesRelative Interest RatesRelative Income Levels

Exchange rate is the results of an interaction of these factors

Market Expectations

Expectations about future exchange rate changes on the basis of current and future political and economic conditions

1960s Strong $Between 1960s and 1970s: weak $Strong $ in 1999 – 2001Weak Dollar today 20051995 European Exchange Rate MechanismDevaluation of Asian Currencies

Political Events

Fall of Berlin Wall and unification of East and West Germany

Rumors about resignation of Mikhail Gorbachov

Tiannanmon SquarePersian Gulf WarSeptember 11, 2001

Relative Inflation

High inflation relative to a foreign country, decline in value of currency—Why?

Low inflation relative to a foreign country, increase in value of currency—Why?

Relative Interest Rates

High interest rates in home country relative to a foreign country may cause domestic currency to appreciate—Why?

Relative Income Levels

Increase in domestic income relative to foreign income may lead to a decline in the value of domestic currency– Why?

Exchange rate determination is complex.The following exhibit provides an overview of the

many determinants of exchange rates.This road map is first organized by the three major

schools of thought (parity conditions, balance of payments approach, asset market approach), and secondly by the individual drivers within those approaches.

These are not competing theories but rather complementary theories.

Determination of Exchange Rates

Determination of Exchange Rates

The theory of purchasing power parity is the most widely accepted theory of all exchange rate determination theories:– PPP is the oldest and most widely followed of the

exchange rate theories.

– Most exchange rate determination theories have PPP elements embedded within their frameworks.

– PPP calculations and forecasts are however plagued with structural differences across countries and significant data challenges in estimation.

Parity Conditions Approach

The theory of purchasing power parity is the most widely accepted theory of all exchange rate determination theories:– PPP is the oldest and most widely followed of the

exchange rate theories.

– Most exchange rate determination theories have PPP elements embedded within their frameworks.

– PPP calculations and forecasts are however plagued with structural differences across countries and significant data challenges in estimation.

Parity Conditions Approach

The balance of payments approach is the second most utilized theoretical approach in exchange rate determination:– The basic approach argues that the equilibrium exchange

rate is found when currency flows match up current and financial account activities.

– This framework has wide appeal as BOP transaction data is readily available and widely reported.

– Critics may argue that this theory does not take into account stocks of money or financial assets.

Balance of Payments Approach

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.

Asset Market Approach

MeasuringExchange 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.

On the days when some currencies appreciate while others depreciate against a particular currency, that currency is said to be “mixed in trading.”

MeasuringExchange Rate MovementsThe percentage change (% in the value of

a foreign currency is computed asSt – 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.

$$$

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.

Exchange Rate Equilibrium

Forces of Demand and SupplyDemand for foreign currency negatively

related to the price of foreign currencySupply of foreign currency positively

related to the price of foreign currencyForces of demand and supply together

determine the exchange rate

Value of £

Quantity of £

$1.55

$1.50

$1.60Equilibrium exchange rate

D: Demand for £

S: Supply of £

Exchange Rate Equilibrium

Exchange Rate Equilibrium

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.

Factors that InfluenceExchange Rates Movements

e = percentage change in the spot rate

INF = change in the relative inflation rate

INT = change in the relative interest rate

INC = change in the relative income level

GC = change in government controls

EXP = change in expectations of future exchange rates

EXPGCINCINTINFfe ,,,,

$/£

Quantity of £

S0

D0

r0

U.S. inflation U.S. demand for British

goods, and hence £.

D1

r1

S1

Factors that InfluenceExchange Rates Movements

Relative Inflation Rates

British desire for U.S. goods, and hence the supply of £.

$/£

Quantity of £

r0

S0

D0

S1

D1

r1

U.S. interest rates U.S. demand for British

bank deposits, and hence £.

Factors that InfluenceExchange Rates MovementsRelative Interest Rates

British desire for U.S. bank deposits, and hence the supply of £.

Relative Interest Rates

Factors that InfluenceExchange Rates Movements

• It is thus useful to consider the real interest rate, which adjusts the nominal interest rate for inflation.

• A relatively high interest rate may actually reflect expectations of relatively high inflation, which may discourage foreign investment.

Relative Interest Rates

Factors that InfluenceExchange Rates Movements

• This relationship is sometimes called the Fisher effect.

• real nominalinterest interest – inflation rate rate rate

$/£

Quantity of £

S0

D0

r0

U.S. income level U.S. demand for British

goods, and hence £.

D1

r1

Factors that InfluenceExchange Rates MovementsRelative Income Levels

No expected change for the supply of £.

,S1

Government ControlsGovernments 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.

Factors that InfluenceExchange Rates Movements

ExpectationsForeign 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.

Factors that InfluenceExchange Rates Movements

Expectations

Factors that InfluenceExchange Rates Movements

• 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.

Interaction of FactorsThe 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.

Factors that InfluenceExchange Rates Movements

Trade-Related Factors 1. Inflation Differential 2. Income Differential 3. Gov’t Trade Restrictions

Financial Factors1. Interest Rate Differential2. Capital Flow Restrictions

How Factors Can Affect Exchange Rates Movements

U.S. demand for foreign goods, i.e. demand for foreign currency

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

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

Interaction of Factors

Factors that InfluenceExchange Rates Movements

Large volume of international trade relative inflation rates may be more influential

Large volume of capital flows interest ratefluctuations may be more influential

• The sensitivity of an exchange rate to the factors is dependent on the volume of international transactions between the two countries.

Interaction of Factors

Factors that InfluenceExchange Rates Movements

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.

Speculating onAnticipated 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.

Exchange at $0.52/NZ$

4. Holds $20,912,320

2. Holds NZ$40 million

Exchange at $0.50/NZ$

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.

1. Borrows $20 million

Borrows at 7.20% for 30 days

Lends at 6.48% for 30 days 3. Receives

NZ$40,216,000

Returns $20,120,000Profit of $792,320

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.

Exchange at $0.48/NZ$

4. Holds NZ$41,900,000

2. Holds $20 million

Exchange at $0.50/NZ$

1. Borrows NZ$40 million

Borrows at 6.96% for 30 days

Lends at 6.72% for 30 days 3. Receives

$20,112,000

Returns NZ$40,232,000Profit of NZ$1,668,000or $800,640

Speculating onAnticipated Exchange Rates

Exchange rates are very volatile, and a poor forecast can result in a large loss.

One well-known bank failure, Franklin National Bank in 1974, was primarily attributed to massive speculative losses from foreign currency positions.

What Is A Currency Swap?

A currency swap is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates

Swaps are transacted – between international businesses and their banks

– between banks

– between governments when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange rate risk

What Is The Nature Of The Foreign Exchange Market?

The foreign exchange market is a global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems– the most important trading centers are London,

New York, Tokyo, and Singapore– the market is always open somewhere in the

world—it never sleeps

How Are Exchange Rates Determined?

Exchange rates are determined by the demand and supply for different currencies

Three factors impact future exchange rate movements

1. A country’s price inflation

2. A country’s interest rate

3. Market psychology

How Do Prices Influence Exchange Rates? The law of one price states that in competitive markets

free of transportation costs and barriers to trade, identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency

Purchasing power parity theory (PPP) argues that given relatively efficient markets (markets in which few impediments to international trade and investment exist) the price of a “basket of goods” should be roughly equivalent in each country– predicts that changes in relative prices will result in a change in

exchange rates

How Do Prices Influence Exchange Rates? A positive relationship exists between the inflation rate

and the level of money supply When the growth in the money supply is greater than the

growth in output, inflation will occur PPP theory suggests that changes in relative prices

between countries will lead to exchange rate changes, at least in the short run– a country with high inflation should see its currency depreciate

relative to others Empirical testing of PPP theory suggests that it is most

accurate in the long run, and for countries with high inflation and underdeveloped capital markets

How Do Interest Rates Influence Exchange Rates?The International Fisher Effect states that for

any two countries the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between two countries

In other words: (S1 - S2) / S2 x 100 = i $ - i ¥

where i $ and i ¥ are the respective nominal interest rates in two countries (in this case the US and Japan), S1 is the spot exchange rate at the beginning of the period and S2 is the spot exchange rate at the end of the period

How Does Investor Psychology Influence Exchange Rates?The bandwagon effect occurs when

expectations on the part of traders turn into self-fulfilling prophecies - traders can join the bandwagon and move exchange rates based on group expectations– government intervention can prevent the

bandwagon from starting, but is not always effective

How Are Exchange Rates Predicted?

There are two schools of thought on forecasting

1. Fundamental analysis draws upon economic factors like interest rates, monetary policy, inflation rates, or balance of payments information to predict exchange rates

2. Technical analysis charts trends with the assumption that past trends and waves are reasonable predictors of future trends and waves

How Can Managers Minimize Exchange Rate Risk? To minimize transaction and translation exposure,

managers should 1. Buy forward2. Use swaps3. Lead and lag payables and receivables

– lead strategy - attempt to collect foreign currency receivables early when a foreign currency is expected to depreciate and pay foreign currency payables before they are due when a currency is expected to appreciate

– lag strategy - delay collection of foreign currency receivables if that currency is expected to appreciate and delay payables if the currency is expected to depreciate

– Lead and lag strategies can be difficult to implement

How Can Managers Minimize Exchange Rate Risk? To reduce economic exposure, managers should

1. Distribute productive assets to various locations so the firm’s long-term financial well-being is not severely affected by changes in exchange rates

2. Ensure assets are not too concentrated in countries where likely rises in currency values will lead to damaging increases in the foreign prices of the goods and services the firm produces

How Can Managers Minimize Exchange Rate Risk? In general, managers should 1. Have central control of exposure to protect resources

efficiently and ensure that each subunit adopts the correct mix of tactics and strategies

2. Distinguish between transaction and translation exposure on the one hand, and economic exposure on the other hand

3. Attempt to forecast future exchange rates4. Establish good reporting systems so the central finance

function can regularly monitor the firm’s exposure position

5. Produce monthly foreign exchange exposure reports