Chapter 2 Exchange Rate Determination
JEFF MADURA. International Financial Management. Cengage Learning (11th edition). 2012
Before we start… some
concepts to contextualize
The exchange rate CONCEPTS curren cy). • An exchange rate (reference currency). $1.09/ € 1.09$/ € 1 €=1.09$ € 1/1.09 = 0.92 €/$ • Spot rate (immediate delivery) vs. forward rate (delivery in a
specified future date) • Free floating exchange rate (depreciation and appreciation) • Foreign exchange market intervention (devaluation and
revaluation in a fixed exchange rate)
• Bid rate (to buy) and ask rate
(to sell)
• Dealers benefit from the spread
(buying low and selling high)
The exchange rate • Factors that affect the equilibrium exchange rate – Relative inflation rates (PPP
– Relative interest rates – Relative economic growth rates – Political and economic risks
P1 * e = P2)
The exchange rate • Short position: Selling securities or other financial instruments that are not currently owned, and subsequently repurchasing them ("covering").
• Long position Buying securities or other financial instruments
Traders or fund managers may hedge a long position or a portfolio through one or more short positions.
Examples 1. A farmer who has just planted his corn wants to lock in the price at which he can sell after the harvest. – He would take a short position in corn futures.
2. A market maker in corporate bonds is constantly trading bonds when clients want to buy or sell. This can create substantial bond positions. The largest risk is that interest rates overall move. The trader can hedge this risk by … – selling government bonds short against his long positions in corporate bonds. In this way, the risk that remains is credit risk of the corporate bonds.
Let’s start
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.
For use with International Financial Management, 3e
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.
For use with International Financial Management, 3e
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 %
represents appreciation of the foreign currency, while a negative % represents depreciation.
For use with International Financial Management, 3e
Measuring Exchange Rate Movements (2) • Relativeness
E.g. e0= 1.5 €/$ (1$=1.5 €)
e1 = 1.4 €/$
dollar depreciates against euro
(e1 – e0 )/e0 =
(1.4-1.5)/1.5) = -6.6%
euro appreciates against dollar
(e0 – e1 )/e1 =
(1.5-1.4)/1.4) = 7.1%%
For use with International Financial Management, 3e
Calculating the exchange rate If the €/$ exchange rate goes from €1 = $0.93 to €1 = 0.99, calculate the euro appreciation or depreciation?
•
During 1995, the yen went from $0.0125 to $0.0095238. By how much did the yen depreciate against the dollar (vice versa)?
•
On July 2, 1997, the Thai baht fell 17% against the dollar. By how much has the dollar appreciated against the baht?
• April 1,1998, was an ill-fated date in Yugoslavia. On that day, the
government devalued the Yugoslav dinar, setting its new rate in 10.92 dinar to the dollar, from 6. By how much has the dinar devalued against the dollar?
Factors that Influence Exchange Rates (1) e f D INF e
D INF D INT D INC D GC D EXP
,
D INT , D INC , DGC , D 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 For use with International Financial Management, 3e
)
Foreign exchange market $
Sterling market S0
Supply of ₤ = Demand for $
D0
Demand for ₤ = Supply of $
r 0
Quantity of £
For use with International Financial Management, 3e
Factors that Influence Exchange Rates (2) Relative Inflation Rates U.S. inflation U.S. demand for $ S1 British goods, and S0 hence £. r 1 r 0
D1 D0 Quantity of £
British desire for U.S. goods, and hence the supply of £.
For use with International Financial Management, 3e
Factors that Influence Exchange Rates (2) Relative Inflation Rates U.S. inflation $ r 1 r 0
S1 S0
Imp US goods
D$
S£
Exp UK goods
D£
S$
D1 D0 Quantity of £ For use with International Financial Management, 3e
Factors that Influence Exchange Rates (2) Relative Inflation Rates $ r 1 r 0
U.S. inflation Depreciation of the dollar relative to the pound or 7 Appreciation of the pound relative to the dollar
S1 S0 D1 D0 Quantity of £
From r 0 to r 1 (appreciation of pound) Note : to hold PPP P$ =
e$/£* P£
Big Mac: 2$ = 1.33*1.5 €
For use with International Financial Management, 3e
Factors that Influence Exchange Rates (3) Relative Interest Rates U.S. interest rates $ r 0 r 1
S0 S1
D0 D1
Quantity of £
U.S. demand for British bank deposits, and hence £. British desire for U.S. bank deposits, and hence the supply of £.
For use with International Financial Management, 3e
Factors that Influence Exchange Rates (2) Relative Interest Rates U.S. interest rates $ r 0 r 1
S0 Invest US deposits D $ S1 Invest UK deposits D£ D0 D1 Quantity of £ For use with International Financial Management, 3e
S£ S$
Factors that Influence Exchange Rates (3) Relative Interest Rates $ r 0 r 1
S0 S1 D0 D1
U.S. interest rates Depreciation of the pound relative to the dollar Appreciation of the dollar relative to the pound From r 0 to r 1 (depreciation of pound)
Quantity of £ For use with International Financial Management, 3e
Factors that Influence Exchange Rates (4) Relative Interest Rates Countereffect
• 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.
For use with International Financial Management, 3e
Factors that Influence Exchange Rates (5) Relative Interest Rates •
real interest rate
nominal interest – inflation rate rate
Nominal = real + inflation 8% = 3% + 5% 10% = 3% + 7% For use with International Financial Management, 3e
Country A
Country B comment
1½%
1½%
No reason for there to be a difference
1%
1%
We choose investments in each country that have low risk
= Real rate
2½%
2½%
Real rates should be the same
+ inflation
4½%
2½%
Different economic policies are inevitable
7%
5%
Time preference + Risk
= interest rate
The difference in inflation rates explains the difference in interest rates!
Factors that Influence Exchange Rates (6) Relative Income Levels U.S. income level $ r 1 r 0
S ,S1 0
D1 D0 Quantity of £
U.S. demand for British goods, and hence £. D£
No expected change for
the supply of £.
For use with International Financial Management, 3e
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.
For use with International Financial Management, 3e
Factors that Influence Exchange Rates (7) Government Controls Example… • Suppose US real interest rates rose relative to the pound… • That would increase D$ and increase S£ • If the UK places a heavy tax on interest of income
earned from foreign investments Discourage exchange of pounds for dollars For use with International Financial Management, 3e
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.
For use with International Financial Management, 3e
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.
For use with International Financial Management, 3e
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 .
S$ • expectations higher r D$ S$ • Increase US income level
For use with International Financial Management, 3e
depreciation $ appreciation $
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
For use with International Financial Management, 3e
Central Bank • A central bank is the nation´s official monetary authority – Objectives: price stability, low interest rate or a target currency
value
• Central bank independence = price stability and low
inflation rate
• Central bank lack of independence = monetize the deficit
Central Bank independence, inflation and economic growth
Currency boards • Not a central bank • Currency board issues notes and coins convertible on
demand and at a fixed rate into foreign currency (normally US dollar),. • It provides an anchor to local currency (similar to previous gold standard) • Not printing of notes allowed • Besides price stability, it also compels government to follow a responsible fiscal policy. E.G Argentinian peso (until it collapsed in 2002)
Dollarization • Dollarization is the complete replacement of the local
currency with the US dollar • Panama (since 1904, annual inflation 1.7% for the past
30 years) • Ecuador (plunging currency, accelerating capital flight, a
bankrupt banking system, huge budget deficits) : January 9, 2000 (25,000 sucres / $) • Disadvantages: the lost of seignorage
Exchange rate arrangements • Central bank policies • Currency boards • Dollarization • These arrangements cannot substitute good
macroeconomic policies: • Examples are the Mexican peso crises, Asian currency crisis, Argentinian currency board collapse….
Real exchange rate and competitiveness • Appreciation of the exchange rate • Depreciation of the exchange rate Asian
currency Crisis (1997)
Currencies attached to the dollar • Good until 1995 $ appreciated (50%) respect the Yen and other
+ •
The competitiveness of China with a devaluated Yuan
Asian
currency crisis
Asian crisis From 1990-1997 Asian countries high economic growth Summer 1997 Asian crisis (IMF bailouts) Thailand's high growth, high spending, lead to high inflation and to maintain PPP depreciation. However, the bath was pegged to the dollar… therefore foreign investors could earn high interest rates and be
protected from depreciation. That provided Thai banks with large capital inflows , more than the could use for making loans that led to risky loans The government tried to defend currency peg sterilizing the effect of the massive inflows… Reducing money supp ly: • Open-market operations -selling treasury bills- (can backfire raising interest rates and attracting higher inflows) “Tai bankers were borrowing at 6% in dollars and lending at 12% in bath..
what a money-maker machine so long as the value of the bath relative to the dollar was constant”
Thailand: - Less co mpetitive (commercially) (as bath pegged to dollar) growing current account deficit - High interest rates and high capital inflow s , risky investments… - High external debt (tripled from US$29 billion in 1990 to US$94 billion by mid-1997 - By end of 1996 the bath w as consi derable appreciated against nonUS currencies activate speculation speculative attacks began - Rumors about an imminent bath devaluation in response to the large debt … intensified the attack (speculation against the bath)
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Foreign investors short on bath against $, causing serious liquidity shortage in the domestic money market. - downward pressure on the bath forward rate. Authorities still tried to maintain the bath pegged to the dollar: • Increasing interest rates • Long bath positions spending half billion US dollars form reserve to defend the bath • Finally collapsed on 2 July 1997 the bath was detached from $ • On 5 August 1997 $16 billion bailout (IMF, Japan and other countries)
Foreign exchange market intervention It refers to official purchases and sales of foreign exchange that nations undertake through their central banks to influence their currencies • Unsterilized intervention – An increase/decrease in the supply of money • Will sell dollars against euros to devaluate the dollar • Will buy dollars against euros to appreciate the dollar
The central bank as the printer of the currency creates the reserve of dollars to use on the exchange markets. Increases money supply
Foreign exchange market intervention • Sterilize intervention
Open market operation is the sale/purchase of Treasury securities to neutralize the impact of the intervention in the foreign exchange market The selling of $ against € + selling of US Treasury bonds (decreasing back $ supply) • The purchase of $ selling € + purchase of US Treasury bonds (increasing back $ supply) •
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.
For use with International Financial Management, 3e
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 £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
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. 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
Speculating on Anticipated Exchange Rates •
Currency Carry trades: Between 2 currencies borrow in the weaker currency and invest in the stronger currency providing that the interest rate difference is not too adverse
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Exchange rates are very volatile, and a poor forecast can result in a large loss.
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One well-known bank failure, Franklin National Bank in 1974, was primarily attributed to massive speculative losses from foreign currency positions.
Key points •
1. Absent government intervention, exchange rates respond to the forces of supply and demand, which, in turn, depend on relative inflation rates , interest r ates , and GNP grow th rates .
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2. Monetary poli cy is crucial. If the central bank expands the money supply at a faster rate than money demand, the purchasing power of money declines both at home (inflation) and abroad (currency depreciation). –
PPP P$ *
e €/$ = P €
•
3.
The healthier the economy is, the stronger the currency is likely to be.
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4. Exchange rates are crucially affected by expectations of future exchange rate changes, which depend on forecasts of future economic and political conditions.