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Ch04 Exchange rate determination
This document discusses exchange rate determination and factors that influence exchange rates. It begins by explaining how exchange rates are measured in terms of currency appreciation and depreciation. The equilibrium exchange rate is then defined as being determined by the demand and supply of currencies. Several factors are described as influencing the equilibrium rate, including inflation rates, interest rates, income levels, government controls, and expectations about future exchange rates. The interaction of these factors and how they can both reinforce and offset each other is also discussed. The chapter concludes by examining how commercial banks can speculate on anticipated exchange rate movements.
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Ch04 Exchange rate determination
- 1. Chapter 4 Exchange RateDetermination Cost and Management Accounting: An Introduction,nd edition International Financial Management, 2 7th edition Jeff Madura and Roland Fox Colin Drury ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEAEMEA ISBN 978-1-4080-3229-9 © 2011 Cengage Learning
- 2. Chapter Objectives • • • To explainhow 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 Accounting: An Introduction,nd edition International Financial Management, 2 7th edition Jeff Madura and Roland Fox Colin Drury ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEAEMEA ISBN 978-1-4080-3229-9 © 2011 Cengage Learning
- 3. 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 Accounting: An Introduction,nd edition International Financial Management, 2 7th edition Jeff Madura and Roland Fox Colin Drury ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEAEMEA ISBN 978-1-4080-3229-9 © 2011 Cengage Learning
- 4. Measuring Exchange Rate Movements(2) • 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. Cost and Management Accounting: An Introduction,nd edition International Financial Management, 2 7th edition Jeff Madura and Roland Fox Colin Drury ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEAEMEA ISBN 978-1-4080-3229-9 © 2011 Cengage Learning
- 5. Annual Changes in theValue of the Euro ∆ Date Exchange Rate 1/1/2000 1/1/2001 1/1/2002 1/1/2003 1/1/2004 $1.001/€ $.94/€ $.89/€ $1.05/€ $1.26/€ Annual % – – 6.1% – 5.3% +18.0% +20.0% Cost and Management Accounting: An Introduction,nd edition International Financial Management, 2 7th edition Jeff Madura and Roland Fox Colin Drury ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEAEMEA ISBN 978-1-4080-3229-9 © 2011 Cengage Learning
- 6. 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 Accounting: An Introduction,nd edition International Financial Management, 2 7th edition Jeff Madura and Roland Fox Colin Drury ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEAEMEA ISBN 978-1-4080-3229-9 © 2011 Cengage Learning
- 7. Exchange Rate Equilibrium(2) Value of £ $1.60 $1.55 $1.50 S: Supply of £ Equilibrium exchange rate D: Demand for £ Quantity of £ Cost and Management Accounting: An Introduction,nd edition International Financial Management, 2 7th edition Jeff Madura and Roland Fox Colin Drury ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEAEMEA ISBN 978-1-4080-3229-9 © 2011 Cengage Learning
- 8. 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 Accounting: An Introduction,nd edition International Financial Management, 2 7th edition Jeff Madura and Roland Fox Colin Drury ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEAEMEA ISBN 978-1-4080-3229-9 © 2011 Cengage Learning
- 9. Factors that Influence ExchangeRates (1) e = f ( ∆INF , ∆INT , ∆INC , ∆GC , ∆EXP ) e ∆ INF ∆ INT ∆ INC ∆ GC ∆ EXP = percentage change in the spot rate = change in the relative inflation rate = change in the relative interest rate = change in the relative income level = change in government controls = change in expectations of future exchange rates Cost and Management Accounting: An Introduction,nd edition International Financial Management, 2 7th edition Jeff Madura and Roland Fox Colin Drury ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEAEMEA ISBN 978-1-4080-3229-9 © 2011 Cengage Learning
- 10. Factors that Influence ExchangeRates (2) 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 £. Cost and Management Accounting: An Introduction,nd edition International Financial Management, 2 7th edition Jeff Madura and Roland Fox Colin Drury ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEAEMEA ISBN 978-1-4080-3229-9 © 2011 Cengage Learning
- 11. Factors that Influence ExchangeRates (3) 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 £. Cost and Management Accounting: An Introduction,nd edition International Financial Management, 2 7th edition Jeff Madura and Roland Fox Colin Drury ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEAEMEA ISBN 978-1-4080-3229-9 © 2011 Cengage Learning
- 12. Factors that Influence ExchangeRates (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 Accounting: An Introduction,nd edition International Financial Management, 2 7th edition Jeff Madura and Roland Fox Colin Drury ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEAEMEA ISBN 978-1-4080-3229-9 © 2011 Cengage Learning
- 13. Factors that Influence ExchangeRates (5) Relative Interest Rates real nominal • interest ≅ rate interest – inflation rate rate • This relationship is sometimes called the Fisher effect. Cost and Management Accounting: An Introduction,nd edition International Financial Management, 2 7th edition Jeff Madura and Roland Fox Colin Drury ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEAEMEA ISBN 978-1-4080-3229-9 © 2011 Cengage Learning
- 14. Factors that Influence ExchangeRates (6) Relative Income Levels $/£ r1 r0 S0 ,S1 D1 D0 U.S. income level ↑ ⇒ ↑ U.S. demand for British goods, and hence £. ⇒ No expected change for the supply of £. Quantity of £ Cost and Management Accounting: An Introduction,nd edition International Financial Management, 2 7th edition Jeff Madura and Roland Fox Colin Drury ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEAEMEA ISBN 978-1-4080-3229-9 © 2011 Cengage Learning
- 15. Factors that Influence ExchangeRates (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 Accounting: An Introduction,nd edition International Financial Management, 2 7th edition Jeff Madura and Roland Fox Colin Drury ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEAEMEA ISBN 978-1-4080-3229-9 © 2011 Cengage Learning
- 16. Factors that Influence ExchangeRates (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 Accounting: An Introduction,nd edition International Financial Management, 2 7th edition Jeff Madura and Roland Fox Colin Drury ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEAEMEA ISBN 978-1-4080-3229-9 © 2011 Cengage Learning
- 17. Factors that Influence ExchangeRates (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 Accounting: An Introduction,nd edition International Financial Management, 2 7th edition Jeff Madura and Roland Fox Colin Drury ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEAEMEA ISBN 978-1-4080-3229-9 © 2011 Cengage Learning
- 18. Factors that Influence ExchangeRates (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 Accounting: An Introduction,nd edition International Financial Management, 2 7th edition Jeff Madura and Roland Fox Colin Drury ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEAEMEA ISBN 978-1-4080-3229-9 © 2011 Cengage Learning
- 19. How Factors CanAffect Exchange Rates Trade-Related Factors 1. Inflation Differential 2. Income Differential 3. Gov’t Trade Restrictions U.K. demand for foreign goods, i.e. demand for foreign currency Foreign demand for U.K. goods, i.e. supply of foreign currency Financial Factors 1. Interest Rate Differential 2. Capital Flow Restrictions U.K. demand for foreign securities, i.e. demand for foreign currency Foreign demand for U.K. securities, i.e. supply of foreign currency International Financial Management, 2nd edition Jeff Madura and Roland Fox ISBN 978-1-4080-3229-9 © 2011 Cengage Learning EMEA Exchange rate between foreign currency and the dollar
- 20. Factors that Influence ExchangeRates (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 Accounting: An Introduction,nd edition International Financial Management, 2 7th edition Jeff Madura and Roland Fox Colin Drury ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEAEMEA ISBN 978-1-4080-3229-9 © 2011 Cengage Learning
- 21. Factors that Influence ExchangeRates (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 Accounting: An Introduction,nd edition International Financial Management, 2 7th edition Jeff Madura and Roland Fox Colin Drury ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEAEMEA ISBN 978-1-4080-3229-9 © 2011 Cengage Learning
- 22. Speculating on Anticipated ExchangeRates • 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 Accounting: An Introduction,nd edition International Financial Management, 2 7th edition Jeff Madura and Roland Fox Colin Drury ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEAEMEA ISBN 978-1-4080-3229-9 © 2011 Cengage Learning
- 23. Speculating on AnticipatedExchange 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 £21,831,543 1. Borrows £20 m Repays £20,120,000 A profit of 21,831,543 – Exchange at 20,120,000 = 1,711,543 £0.38/NZ$ Exchange at £0.35/NZ$ 2. Holds NZ$57,142,857 Lends at 6.48% for 30 days 3. Receives NZ$57,451,428 Cost and Management Accounting: An Introduction,nd edition International Financial Management, 2 7th edition Jeff Madura and Roland Fox Colin Drury ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEAEMEA ISBN 978-1-4080-3229-9 © 2011 Cengage Learning
- 24. Speculating on AnticipatedExchange 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. 1. Borrows NZ$40 million Exchange at 0.50 euros/NZ$ 2. Holds 20 m euros Borrows at 6.96% for 30 days Returns NZ$40,232,000 Profit of NZ$1,668,000 or 800,640 euros Lends at 6.72% for 30 days 4. Holds NZ$41,900,000 Exchange at 0.48 euros/NZ$ 3. Receives 20,112,000 euros Cost and Management Accounting: An Introduction,nd edition International Financial Management, 2 7th edition Jeff Madura and Roland Fox Colin Drury ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEAEMEA ISBN 978-1-4080-3229-9 © 2011 Cengage Learning
- 25. Speculating on Anticipated ExchangeRates • 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. Cost and Management Accounting: An Introduction,nd edition International Financial Management, 2 7th edition Jeff Madura and Roland Fox Colin Drury ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEAEMEA ISBN 978-1-4080-3229-9 © 2011 Cengage Learning