Exchange rate behaviour

1. Exchange Rate Behavior
Existing spot
exchange rates
at other locations
Existing cross
exchange rates
of currencies
Existing inflation
rate differential
Future exchange
rate movements
Existing spot
exchange rate
Existing forward
exchange rate
Existing interest
rate differential
locational
arbitrage
triangular
arbitrage
purchasing power parity
international
Fisher effect
covered interest arbitrage
covered interest arbitrage
Fisher
effect
1

2. Exchange Rate Systems
 Exchange rate systems can be classified according
to the degree to which the rates are controlled by
the government.
 Exchange rate systems normally fall into one of the
following categories:
 fixed
 freely floating
 managed float
 pegged
2

3. Fixed
Exchange Rate System
 In a fixed exchange rate system, exchange rates are
either held constant or allowed to fluctuate only
within very narrow bands.
 The Bretton Woods era (1944-1971) fixed each
currency’s value in terms of gold.
 The 1971 Smithsonian Agreement which followed
merely adjusted the exchange rates and expanded
the fluctuation boundaries. The system was still
fixed.
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4. Fixed
Exchange Rate System
 Pros: Work becomes easier for the MNCs.
 Cons: Governments may revalue their currencies. In
fact, the dollar was devalued more than once after
the U.S. experienced balance of trade deficits.
 Cons: Each country may become more vulnerable to
the economic conditions in other countries.
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5. Freely Floating
Exchange Rate System
 In a freely floating exchange rate system, exchange
rates are determined solely by market forces.
 Pros: Each country may become more insulated
against the economic problems in other countries.
 Pros: Central bank interventions that may affect the
economy unfavorably are no longer needed.
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6. Freely Floating
Exchange Rate System
 Pros: Governments are not restricted by exchange
rate boundaries when setting new policies.
 Pros: Less capital flow restrictions are needed, thus
enhancing the efficiency of the financial market.
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7. Freely Floating
Exchange Rate System
 Cons: MNCs may need to devote substantial
resources to managing their exposure to exchange
rate fluctuations.
 Cons: The country that initially experienced
economic problems (such as high inflation, increasing
unemployment rate) may have its problems
compounded.
7

8. Managed Float
Exchange Rate System
 In a managed (or “dirty”) float exchange rate
system, exchange rates are allowed to move freely
on a daily basis and no official boundaries exist.
However, governments may intervene to prevent the
rates from moving too much in a certain direction.
 Cons: A government may manipulate its exchange
rates such that its own country benefits at the
expense of others.
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9. Pegged
Exchange Rate System
 In a pegged exchange rate system, the home
currency’s value is pegged to a foreign currency or
to some unit of account, and moves in line with that
currency or unit against other currencies.
 The European Economic Community’s snake
arrangement (1972-1979) pegged the currencies
of member countries within established limits of
each other.
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10. Pegged
Exchange Rate System
 The European Monetary System which followed in
1979 held the exchange rates of member countries
together within specified limits and also pegged
them to a European Currency Unit (ECU) through the
exchange rate mechanism (ERM).
 The ERM experienced severe problems in 1992, as
economic conditions and goals varied among member
countries.
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11. Pegged
Exchange Rate System
 In 1994, Mexico’s central bank pegged the peso to
the U.S. dollar, but allowed a band within which the
peso’s value could fluctuate against the dollar.
 By the end of the year, there was substantial downward
pressure on the peso, and the central bank allowed the
peso to float freely. The Mexican peso crisis had just
began ...
11

12. Currency Boards
 A currency board is a system for maintaining the
value of the local currency with respect to some
other specified currency.
 For example, Hong Kong has tied the value of the
Hong Kong dollar to the U.S. dollar (HK$7.8 = $1)
since 1983, while Argentina has tied the value of its
peso to the U.S. dollar (1 peso = $1) since 1991.
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13. Currency Boards
 For a currency board to be successful, it must have
credibility in its promise to maintain the exchange
rate.
 It has to intervene to defend its position against the
pressures exerted by economic conditions, as well as
by speculators who are betting that the board will
not be able to support the specified exchange rate.
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14. Exposure of a Pegged Currency to
Interest Rate Movements
 A country that uses a currency board does not have
complete control over its local interest rates, as the
rates must be aligned with the interest rates of the
currency to which the local currency is tied.
 Note that the two interest rates may not be exactly
the same because of different risks.
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15. Exposure of a Pegged Currency to
Exchange Rate Movements
 A currency that is pegged to another currency will
have to move in tandem with that currency against
all other currencies.
 So, the value of a pegged currency does not
necessarily reflect the demand and supply
conditions in the foreign exchange market, and may
result in uneven trade or capital flows.
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16. Dollarization
 Dollarization refers to the replacement of a local
currency with U.S. dollars.
 Dollarization goes beyond a currency board, as the
country no longer has a local currency.
 For example, Ecuador implemented dollarization in
2000.
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17. Countries using the U.S.dollar exclusively
 British Virgin Islands
 Caribbean Netherlands (from 1 January 2011)
 East Timor (uses its own coins)
 Ecuador (uses its own coins in addition to U.S. coins;
Ecuador adopted the U.S. dollar as its legal tender in 2000.
 El Salvador
 Marshall Islands
 Federated States of Micronesia (Micronesia used the U.S.
dollar since 1944
 Palau (Palau adopted the U.S. dollar since 1944
 Panama (uses its own coins in addition to U.S. coins. This
country has adopted the U.S. dollar as legal tender since
1904)
 Turks and Caicos Islands
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18. Countries using the U.S.dollar alongside
other currencies
 Bahamas
 Belize (Belizien Dollar pegged 2/1 but USD is accepted)
 Uruguay
 Nicaragua
 Cambodia (uses Cambodian Riel for many official transactions but most
businesses deal exclusively in dollars)
 Lebanon (along with the Lebanese pound)
 Liberia (was fully dollarized until 1982 the year the National Bank of
Liberia started to issue five dollar coins; U.S. dollar still in common usage
alongside Liberian dollar)
 Zimbabwe
 Haiti (uses the U.S Dollar alongside its domestic currency called Gourde)
 Vietnam (along with the Vietnamese Dong)
 Somalia (along with the Somali Shilling)
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19. €
A Single European Currency
 In 1991, the Maastricht treaty called for a single
European currency. On Jan 1, 1999, the euro was
adopted by Austria, Belgium, Finland, France,
Germany, Ireland, Italy, Luxembourg, Netherlands,
Portugal, and Spain. Greece joined the system in
2001.
 By 2002, the national currencies of the 12
participating countries will be withdrawn and
completely replaced with the euro.
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20. A Single European Currency
 Within the euro-zone, cross-border trade and
capital flows will occur without the need to convert
to another currency.
 European monetary policy is also consolidated
because of the single money supply. The Frankfurt-
based European Central Bank (ECB) is responsible
for setting the common monetary policy.
€
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21. A Single European Currency
 The ECB aims to control inflation in the participating
countries and to stabilize the euro within reasonable
boundaries.
 The common monetary policy may eventually lead
to more political harmony.
 Note that each participating country may have to
rely on its own fiscal policy (tax and government
expenditure decisions) to help solve local economic
problems.
€
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22. A Single European Currency
 As currency movements among the European
countries will be eliminated, there should be an
increase in all types of business arrangements, more
comparable product pricing, and more trade flows.
 It will also be easier to compare and conduct
valuations of firms across the participating
European countries.
€
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23. A Single European Currency
 Stock and bond prices will also be more
comparable and there should be more cross-border
investing. However, non-European investors may not
achieve as much diversification as in the past.
 Exchange rate risk and foreign exchange
transaction costs within the euro-zone will be
eliminated, while interest rates will have to be
similar.
€
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24. A Single European Currency
 Since its introduction in 1999, the euro has declined
against many currencies.
 This weakness was partially attributed to capital
outflows from Europe, which was in turn partially
attributed to a lack of confidence in the euro.
 Some countries had ignored restraint in favor of
resolving domestic problems, resulting in a lack of
solidarity.
€
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25. Government Intervention
 Each country has a government agency (called the
central bank) that may intervene in the foreign
exchange market to control the value of the
country’s currency.
 In the United States, the Federal Reserve System
(Fed) is the central bank.
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26. Government Intervention
 Central banks manage exchange rates
 to smooth exchange rate movements,
 to establish implicit exchange rate boundaries, and/or
 to respond to temporary disturbances.
 Often, intervention is overwhelmed by market
forces. However, currency movements may be even
more volatile in the absence of intervention.
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27. Government Intervention
 Direct intervention refers to the exchange of
currencies that the central bank holds as reserves
for other currencies in the foreign exchange market.
 Direct intervention is usually most effective when
there is a coordinated effort among central banks.
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28. Government Intervention
 When a central bank intervenes in the foreign
exchange market without adjusting for the change
in money supply, it is said to engaged in
nonsterilized intervention.
 In a sterilized intervention, Treasury securities are
purchased or sold at the same time to maintain the
money supply.
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29. Government Intervention
 Some speculators attempt to determine when the
central bank is intervening, and the extent of the
intervention, in order to capitalize on the
anticipated results of the intervention effort.
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30. Government Intervention
 Central banks can also engage in indirect
intervention by influencing the factors that determine
the value of a currency.
 For example, the Fed may attempt to increase
interest rates (and hence boost the dollar’s value)
by reducing the U.S. money supply.
 Note that high interest rates adversely affects local
borrowers.
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31. Government Intervention
 Governments may also use foreign exchange
controls (such as restrictions on currency exchange)
as a form of indirect intervention.
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32. Exchange Rate Target Zones
 Many economists have criticized the present
exchange rate system because of the wide swings in
the exchange rates of major currencies.
 Some have suggested that target zones be used,
whereby an initial exchange rate will be
established with specific boundaries (that are wider
than the bands used in fixed exchange rate
systems).
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33. Exchange Rate Target Zones
 The ideal target zone should allow rates to adjust to
economic factors without causing wide swings in
international trade and fear in the financial
markets.
 However, the actual result may be a system no
different from what exists today.
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34. Intervention as a Policy Tool
 Like tax laws and money supply, the exchange rate
is a tool which a government can use to achieve its
desired economic objectives.
 A weak home currency can stimulate foreign
demand for products, and hence local jobs.
However, it may also lead to higher inflation.
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35. Intervention as a Policy Tool
 A strong currency may cure high inflation, since the
intensified foreign competition should cause
domestic producers to refrain from increasing prices.
However, it may also lead to higher unemployment.
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36. Impact of Central Bank Intervention
on an MNC’s Value
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E (CFj,t ) = expected cash flows in currency j to be received
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E (ERj,t ) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k = weighted average cost of capital of the parent
Direct Intervention
Indirect Intervention
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37. International Arbitrage
 Arbitrage can be loosely defined as capitalizing on
a discrepancy in quoted prices. Often, the funds
invested are not tied up and no risk is involved.
 In response to the imbalance in demand and supply
resulting from arbitrage activity, prices will realign
very quickly, such that no further risk-free profits
can be made.
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38. International Arbitrage
Locational arbitrage is possible when a bank’s
buying price (bid price) is higher than another
bank’s selling price (ask price) for the same
currency.
Example:
Bank C Bid Ask Bank D Bid Ask
NZ$ $.635 $.640 NZ$ $.645 $.650
Buy NZ$ from Bank C @ $.640, and sell it to Bank D @
$.645. Profit = $.005/NZ$.
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39. International Arbitrage
Triangular arbitrage is possible when a cross
exchange rate quote differs from the rate
calculated from spot rates.
 Example: Bid Ask
British pound (£) $1.60 $1.61
Malaysian ringgit (MYR) $.200 $.202
£ MYR8.1 MYR8.2
Buy £ @ $1.61, convert @ MYR8.1/£, then sell MYR @
$.200. Profit = $.01/£. (8.1.2=1.62)
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40. International Arbitrage
 When the exchange rates of the currencies are not
in equilibrium, triangular arbitrage will force them
back into equilibrium.
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41. International Arbitrage
 Triangular arbitrage (sometimes called triangle arbitrage)
refers to taking advantage of a state of imbalance
between three foreign exchange markets: a combination of
matching deals are struck that exploit the imbalance, the
profit being the difference between the market prices.
 Triangular arbitrage offers a risk-free profit (in theory), so
opportunities for triangular arbitrage usually disappear
quickly, as many people are looking for them, or simply
never occur as everybody knows the pricing relation.
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42. International Arbitrage
 Consider the three foreign exchange rates among the Canadian dollar, the U.S. dollar, and the
Australian dollar. Triangular arbitrage will produce a profit whenever the following relation does not
hold:
 CD$/US$ * AU$/CD$ = AU$/US$.
 For example if you can trade at these exchange rates
 the Canadian Dollar (CD$) against the US dollar (US$) is CD$1.13/US$1.00 (1 US$ gets you CD$1.13)
 the Australian Dollar (AU$) against the US dollar (US$) is AU$1.33/US$1.00 (1 US$ gets you AU$1.33)
 the Australian Dollar (AU$) against the Canadian Dollar (CD$) is AU$1.18/CD$1.00 (1 CD$ gets you
AU$1.18)
 1.13 * 1.18 = 1.3334 > 1.3300, thus mispricing has occurred.
 To take advantage of the mispricing, starting with US$10,000 to invest:
 1st buy Canadian Dollars with his US Dollars: US$10,000 * (CD$1.13/US$1) = CD$11,300
 2nd buy Australian Dollars with his Canadian Dollars: CD$11,300 * (AU$1.18/CD$1.00) = AU$13,334
 3rd buy US Dollars with his Australian Dollars: AU$13,334 / (AU$1.33/US$1.0000) = US$10,025
 Net risk free profit: US$25.00
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43. International Arbitrage
Covered interest arbitrage is the process of
capitalizing on the interest rate differential
between two countries, while covering for exchange
rate risk.
 Covered interest arbitrage tends to force a
relationship between forward rate premiums and
interest rate differentials.
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44. International Arbitrage
 Example:
£ spot rate = $1.50 90-day forward rate = $1.60
U.S. 90-day interest rate = 2%
U.K. 90-day interest rate = 2%
Borrow $ at 3%, or use existing funds which are
earning interest at 2%. Convert $ to £ at $1.60/£
and engage in a 90-day forward contract to sell £
at $1.60/£. Lend £ at 4%.
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45. International Arbitrage
 Locational arbitrage ensures that quoted exchange
rates are similar across banks in different locations.
 Triangular arbitrage ensures that cross exchange
rates are set properly.
 Covered interest arbitrage ensures that forward
exchange rates are set properly.
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46. International Arbitrage
 Any discrepancy will trigger arbitrage, which will
then eliminate the discrepancy. Arbitrage thus
makes the foreign exchange market more orderly.
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47. Interest Rate Parity (IRP)
 Market forces cause the forward rate to differ from
the spot rate by an amount that is sufficient to offset
the interest rate differential between the two
currencies.
 Then, covered interest arbitrage is no longer
feasible, and the equilibrium state achieved is
referred to as interest rate parity (IRP).
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48. Derivation of IRP
 When IRP exists, the rate of return achieved from
covered interest arbitrage should equal the rate of
return available in the home country.
 End-value of a $1 investment in covered interest
arbitrage = (1/S)(1+iF)F
= (1/S)(1+iF)[S(1+p)]
= (1+iF)(1+p)
where p is the forward premium.
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49. Derivation of IRP
 End-value of a $1 investment in the home country
= 1 + iH
 Equating the two and rearranging terms:
p = (1+iH)
– 1
(1+iF)
i.e.
forward
= (1 + home interest rate)
– 1
premium (1 + foreign interest rate)
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50. Determining the Forward Premium
Example:
 Suppose 6-month ipeso = 6%, i$ = 5%.
 From the U.S. investor’s perspective,
forward premium = 1.05/1.06 – 1  -.0094
 If S = $.10/peso, then
6-month forward rate = S  (1 + p)
 .10  (1
_
.0094)
 $.09906/peso
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51. Determining the Forward Premium
 Note that the IRP relationship can be rewritten as
follows:
F – S
= S(1+p) – S
= p = (1+iH)
– 1 = (iH–iF)
S S (1+iF) (1+iF)
 The approximated form, p  iH–iF, provides a
reasonable estimate when the interest rate
differential is small.
51

52. Test for the Existence of IRP
 To test whether IRP exists, collect the actual interest
rate differentials and forward premiums for various
currencies. Pair up data that occur at the same point
in time and that involve the same currencies, and
plot the points on a graph.
 IRP holds when covered interest arbitrage is not
worthwhile.
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53. Interpretation of IRP
 When IRP exists, it does not mean that both local
and foreign investors will earn the same returns.
 What it means is that investors cannot use covered
interest arbitrage to achieve higher returns than
those achievable in their respective home countries.
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54. Does IRP Hold?
 Various empirical studies indicate that IRP generally
holds.
 While there are deviations from IRP, they are often
not large enough to make covered interest
arbitrage worthwhile.
 This is due to the characteristics of foreign
investments, including transaction costs, political risk,
and differential tax laws.
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55. Considerations When Assessing IRP
Transaction Costs
 IRP may not be feasible after taking into consideration
transaction costs.
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56. Considerations When Assessing IRP
Political Risk
 A crisis in the foreign country could cause its
government to restrict any exchange of the local
currency for other currencies.
 Investors may also perceive a higher default risk on
foreign investments.
Differential Tax Laws
 If tax laws vary, after-tax returns should be considered
instead of before-tax returns.
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57. Explaining Changes in Forward Premiums
 During the 1997-98 Asian crisis, the forward
rates offered to U.S. firms on some Asian
currencies were substantially reduced for two
reasons.
The spot rates of these currencies declined
substantially during the crisis.
Their interest rates had increased as their
governments attempted to discourage investors
from pulling out their funds.
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58. Impact of Arbitrage on an MNC’s Value
    
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t
t
m
j
tjtj
k1=
1
,,
1
ERECFE
=Value
E (CFj,t ) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k = weighted average cost of capital of the parent
Forces of Arbitrage
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