IFM Chapter 04.ppt

7/24/2019 IFM Chapter 04.ppt

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Exchange Rate DeterminationChapter: 04

PowerPoint Lecture Presentationto accompany

International Financial anagementDr! "amiul Par#e$ %hme&' %ssistant Pro(essor' In&epen&ent )ni#ersity' *angla&esh


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Chapter +,-ecti#es

.o explain how exchange rate mo#ementsare measure&/

.o explain how the euili,rium exchangerate is &etermine&/ an&

.o examine the (actors that a((ect theeuili,rium exchange rate!


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easuring

Exchange Rate o#ements %n exchange ratemeasures the #alue o(

one currency in units o( another currency!

Depreciate

Appreciate

Mixed in trading


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easuring

Exchange Rate o#ements

where Stdenotes the spot rate at time t and St-1denotes exchange rate at an earlier period.


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easuring


% positi#e 1 represents appreciation o(

the (oreign currency' while a negati#e 1represents &epreciation!

Foreign exchange rate mo#ements ten& to,e larger (or longer time hori$ons!


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easuring



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Exchange Rate Euili,rium

%lthough it is easy to measure the percentage change in the #alue o(a currency' it is more &i((icult to explain why the #alue change& or to

(orecast how it may change in the (uture!

.o achie#e either o( these o,-ecti#es' the concept o( an euili,riumexchange rate must ,e un&erstoo&' as well as the (actors that a((ectthe euili,rium rate!

Deman& 2s! "upply


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Deman& (or a Currency: )!"! &eman&(or *ritish Poun&


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"upply o( a Currency (or "ale

Exhi,it 4!3 shows the uantity o( poun&s (orsale supplie& to the (oreign exchange mar5et

in exchange (or &ollars6 correspon&ing to

each possi,le exchange rate at a gi#en point

in time! see next sli&e6!


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"upply o( a Currency (or "ale


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Euili,rium


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Factors that In(luence Exchange Rates

.he euili,rium exchange rate will change o#er

time as supply an& &eman& sche&ules change!.he (ollowing euation summari$es the (actors

that can in(luence a currency7s spot rate:


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Factors: Relati#e In(lation Rates

Example: 8ol&ing all other (actors constant' )!"!in(lation su&&enly increase& su,stantially while

*ritish in(lation remaine& the same! %ssume

that ,oth *ritish an& )!"! (irms sell goo&s that

can ser#e as su,stitutes (or each other!6


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Factors: Relati#e Exchange Rates .he increase& )!"! &eman& (or poun&s an& the re&uce&

supply o( poun&s (or sale place upwar& pressure on the

#alue o( the poun&!


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Relati#e Interest Rates

Changes in relati#e interest rates a((ect in#estment in(oreign securities' which in(luences the &eman& (oran& supply o( currencies an& there(ore in(luences

exchange rates!

Example: %ssume that )!"! interest rates rise while*ritish interest rates remain constant! In this case' )!"!

in#estors will li5ely re&uce their &eman& (or poun&s'

since )!"! rates are now more attracti#e relati#e to

*ritish rates' an& there is less &esire (or *ritish ,an5

&eposits!


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R l i I R


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In some cases' an exchange rate ,etween two countries7currencies can ,e a((ecte& ,y changes in a thir& country7s

interest rate!

Example: 9hen the Cana&ian interest rate increases' it can,ecome more attracti#e to *ritish in#estors than the )!"! rate!

.his encourages *ritish in#estors to purchase (ewer &ollar

&enominate& securities! .hus' the supply o( poun&s to ,eexchange& (or &ollars woul& ,e smaller than it woul& ha#e ,een

without the increase in Cana&ian interest rates' which places

upwar& pressure on the #alue o( the poun& against the )!"!

&ollar!

R l I t t R t


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Real Interest Rates

%lthough a relati#ely high interest rate may attract(oreign in(lows to in#est in securities o((ering high

yiel&s6' the relati#ely high interest rate may re(lect

expectations o( relati#ely high in(lation! *ecause high

in(lation can place &ownwar& pressure on the local

currency' some (oreign in#estors may ,e &iscourage&

(rom in#esting in securities &enominate& in that

currency! For this reason' it is help(ul to consi&er the

real interest rate' which a&-usts the nominal interest rate

(or in(lation:

.his relationship is sometimes calle& the Fisher e((ect!


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Relati#e Income Le#el

% thir& (actor a((ecting exchange rates isrelati#e income le#els! *ecause income

can a((ect the amount o( imports&eman&e&' it can a((ect exchange rates!


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Relati#e Income Le#el Example: %ssume that the )!"! income le#el rises su,stantially

while the *ritish income le#el remains unchange&! Consi&er

the impact o( this scenario on 6 the &eman& sche&ule (or

poun&s' ;6 the supply sche&ule o( poun&s (or sale' an& 36 the

euili,rium exchange rate! First' the &eman& sche&ule (or

poun&s will shi(t outwar&' re(lecting the increase in )!"!

income an& there(ore increase& &eman& (or *ritish goo&s!"econ&' the supply sche&ule o( poun&s (or sale is not

expecte& to change! .here(ore' the euili,rium exchange rate

o( the poun& is expecte& to rise' as shown in Exhi,it 4!


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Relati#e Income Le#el


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=o#ernment Control

.he go#ernments o( (oreign countries canin(luence the euili,rium exchange rate in manyways' inclu&ing 6 imposing (oreign exchange

,arriers' ;6 imposing (oreign tra&e ,arriers' 36

inter#ening ,uying an& selling currencies6 in the(oreign exchange mar5ets' an& 46 a((ecting

macro #aria,les such as in(lation' interest rates'

an& income le#els!


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=o#ernment Control

Example: Recall the example in which )!"! interestrates rose relati#e to *ritish interest rates! .heexpecte& reaction was an increase in the *ritish

supply o( poun&s (or sale to o,tain more )!"!

&ollars in or&er to capitali$e on high )!"! moneymar5et yiel&s6! >et' i( the *ritish go#ernment

place& a hea#y tax on interest income earne& (rom

(oreign in#estments' this coul& &iscourage the

exchange o( poun&s (or &ollars!


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Expectations

% (i(th (actor a((ecting exchange rates is mar5etexpectations o( (uture exchange rates! Li5e other

(inancial mar5ets' (oreign exchange mar5ets

react to any news that may ha#e a (uture e((ect!?ews o( a potential surge su&&en increase6 in

)!"! in(lation may cause currency tra&ers to sell

&ollars' anticipating a (uture &ecline in the

&ollar7s #alue! .his response places imme&iate&ownwar& pressure on the &ollar!


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Expectations

Example: In#estors may temporarily in#est(un&s in Cana&a i( they expect Cana&ianinterest rates to increase! "uch a rise may

cause (urther capital (lows into Cana&a' which

coul& place upwar& pressure on the Cana&ian&ollar7s #alue! *y ta5ing a position ,ase& on

expectations' in#estors can (ully ,ene(it (rom

the rise in the Cana&ian &ollar7s #alue ,ecause

they will ha#e purchase& Cana&ian &ollars,e(ore the change occurre&!


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Expectations (based on information)

Factors that In(luence

Exchange Rates

Fed chairman suggests Fed is Strengthenedunlikely to cut U.S. interest rates

A possible decline in German Strengthened

interest ratesEuropean Central bank Weakened

epected to inter!ene

to boost the euro

Signal "mpact on #

$oor U.S. economic indicators Weakened


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Interaction Factors

9hen more than one (actors interact with each other! .ransactions within the (oreign exchange mar5ets

(acilitate either tra&e or (inancial (lows! .ra&e@relate&

e!g! Export@import6 (oreign exchange transactions

are generally less responsi#e to news signal6!Financial (low transactions are #ery responsi#e to

news' howe#er' ,ecause &ecisions to hol& securities

&enominate& in a particular currency are o(ten

&epen&ent on anticipate& changes in currency #alues!


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+#er a particular perio&' &i((erent(actors may place opposing

pressures on the #alue o( a

(oreign currency!

Interaction Factors


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Interaction Factors

Example: interaction ,etween increase in income an&

expectations

%n increase in income le#els sometimes associate& withexpectationso( higher interest rates e!g! in the local

capital mar5et6! "o' e#en though a higher income le#el can

result in more imports' it may also in&irectly attract more(inancial in(lows assuming interest rates increase6!

*ecause the (a#ora,le (inancial (lows may o#erwhelm the

un(a#ora,le tra&e (lows' an increase in income le#els is

(reuently expecte& to strengthen the local currency!


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Interaction Factors

Example: interaction ,etween in(lation rate an&interest rate

%ssume the simultaneous existence o( 6 a su&&enincrease in )!"! in(lation an& ;6 a su&&en increase in

)!"! interest rates! I( the *ritish economy is relati#elyunchange&' the increase in )!"! in(lation will place

upwar& pressure on the poun&7s #alue while the

increase in )!"! interest rates places &ownwar&

pressure on the poun&7s #alue!


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.he sensiti#ity o( the exchangerate to these (actors is&epen&ent on the #olume o(

international transactions

,etween the two countries!

Interaction Factors


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Factors that In(luence

Exchange Rates: Interactions


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"peculating on %nticipate& ExchangeRates: % step@,y@step example

Chicago *an5 expects the exchange rateo( the ?ew Aealan& &ollar ?AB6 to

appreciate (rom its present le#el o( B!0to B!; in 30 &ays!

Chicago *an5 is a,le to ,orrow B;0million on a short@term ,asis (rom other,an5s!


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Present short@term interest ratesannuali$e&6 in the inter,an5 mar5et are

as (ollows:


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"teps that the Chicago *an5 woul& (ollow:

! *orrow B;0 million!

;! Con#ert the B;0 million to ?AB40 millioncompute& as B;0'000'000B!06!


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3! Len& the ?ew Aealan& &ollars at !4percent annuali$e&' which represents a !

4 percent return o#er the 30@&ay perio&Gcompute& as !41 H 30306! %(ter 30

&ays' the ,an5 will recei#e ?AB40';'000

Gcompute& as ?AB40'000'000 H J !0046!


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4! )se the procee&s (rom the ?ew Aealan& &ollarloan repayment on &ay 306 to repay the )!"!

&ollars ,orrowe&! .he annual interest on the )!"!

&ollars ,orrowe& is


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%ssuming that the exchange rate on &ay30 is B!; per ?ew Aealan& &ollar as

anticipate&' the num,er o( ?ew Aealan&

&ollars necessary to repay the )!"! &ollar

loan is ?AB3'K;'30 compute& as

B;0';0'000B!; per ?ew Aealan& &ollar6!


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=i#en that the ,an5 accumulate&?AB40';'000 (rom len&ing ?ew Aealan&

&ollars' it woul& earn a speculati#e pro(it

o( ?AB';3'K; Gcompute& as

?AB40';'000 @ ?AB3'K;'30


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Points to ,e note&:

.he ,an5 woul& earn this speculati#e

pro(it without using any (un&s (rom&eposit accounts ,ecause the (un&s

woul& ha#e ,een ,orrowe& through the

inter,an5 mar5et!


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Exchange at

B0!;?AB

4! 8ol&sB;0'K;'3;0

;! 8ol&s?AB40 million

Exchange at

B0!0?AB

"peculating on %nticipate& Exchange Rates

Chicago *an5 expects the exchange rate o( the ?ew

Aealan& &ollar to appreciate (rom its present le#el o(B0!0 to B0!; in 30 &ays!

! *orrowsB;0 million

*orrows at

(or 30 &ays

Len&s at !41(or 30 &ays 3! Recei#es

?AB40';'000

Returns B;0';0'000Pro(it o( B


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"peculating on %nticipate& ExchangeRates: 9hat i( the Chicago *an5

expects that the ?ew Aealan& &ollarwill &epreciate

?ow' the situation woul& ,e other way

roun&!Repeat' present short@term interest rates

annuali$e&6 in the inter,an5 mar5et are

as (ollows:


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"peculating on %nticipate& Exchange Rates

Chicago *an5 expects the exchange rate o( the ?ew

Aealan& &ollar to &epreciate (rom its present le#el o(B0!0 to B0!4 in 30 &ays!

Exchange at

B0!4?AB

4! 8ol&s?AB4'K00'000

;! 8ol&sB;0 million

Exchange at

B0!0?AB

! *orrows?AB40 million

*orrows at !K1

(or 30 &ays

Len&s at !


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Impact o( Exchange Rates on an ?C7s 2alue

( ) ( )[ ]( )

+

=n

tt

m

j

tjtj

k%&

%''

%

E(ECFE&)alue

E CFj,t 6 M expecte& cash (lows in

currencyjto ,e recei#e& ,y the )!"! parent at theen& o( perio& tE ERj,t 6 M expecte& exchange rate at

In(lation Rates' Interest Rates'Income Le#els' =o#ernment Controls'Expectations

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IFM Chapter 04.ppt

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