Chapter 4 for International Financial Management/

1. Exchange Rate
Determination

2. Key Points
 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.

3. Measuring Exchange 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 the dollar, the dollar is said to be “mixed in trading.

4. Measuring Exchange Rate Movements
 The percentage change (% ∆) in the value of a foreign currency is
computed as
𝑆𝑡 − 𝑆 𝑡 − 1
𝑆 𝑡 − 1
 where St denotes the spot rate at time t.
 A positive % ∆ represents appreciation of the foreign currency, while a
negative % ∆ represents depreciation.

5. 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.
 At any point in time, a currency should exhibit the price at which the
demand for that currency is equal to supply, and this represents the
equilibrium exchange rate.

6. Exchange Rate Equilibrium

7. Exchange Rate Equilibrium
 At exchange rates lower than equilibrium, the quantity of pounds
demanded would exceed the supply of pounds for sale; consequently, the
banks that provide foreign exchange services would experience a shortage
of pounds.
 Conversely, at exchange rates higher than equilibrium, the quantity of
pounds supplied would exceed demand; banks would experience a surplus
of pounds at this rate.

8. Exchange Rate Equilibrium
 The liquidity of currency effects 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.

9. Factors that Influence Exchange Rates
 The following equation summarizes the factors that can influence a
currency’s spot rate:

10. 1- Relative Inflation Rates
U.S. inflation
 U.S. demand for British goods, and
hence £.
 British desire for U.S. goods, and
hence the supply of £.

11. 2- Relative Interest Rates
 U.S. interest rate
 U.S. demand for British bank
deposits, and hence £.
 British desire for U.S. bank
deposits, and hence the supply of
£.

12. 2- Relative Interest Rates
 A relatively high interest rate may actually reflect expectations of relatively
high inflation, which discourages foreign investment.
 It is thus useful to consider real interest rates, which adjust the nominal
interest rates for inflation.

13. 2- Relative Interest Rates
Real Nominal
Interest ≈ Interest - Inflation
rate rate
 This relationship is sometimes called the Fisher effect.

14. 3- Relative Income Levels
 U.S. income level increases
 It increases U.S. demand for British
goods, and hence £.
 No expected change for the supply
of £.

15. 4- Government Controls
 Governments may influence the equilibrium exchange rate by:
 imposing foreign exchange barriers
 imposing foreign trade barriers
 intervening in the foreign exchange market
 affecting macro variables such as inflation, interest rates, and income levels

16. 5- Expectations
 Foreign exchange markets react to any news that may have a future effect.
 News of potential surge in U.S. inflation may cause currency traders to sell
dollars.
 Institutional investors often take currency positions based on anticipated
interest rate movements in various countries.
 Because of speculative transactions, foreign exchange rates can be very
volatile.

17. 5- Expectations
 Economic signals that effect 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.

18. Interaction of Factors
 Trade-related factors and financial factors sometimes interact. Exchange
rate movements may be simultaneously affected by these factors.
 For example, an increase in the level of income sometimes causes
expectations of higher interest rates.

19. Interaction of Factors
 Over a particular period, different factors may place opposing pressures on
the value of a foreign currency.
 The sensitivity of the exchange rate to these factors is dependent on the
volume of international transactions between the two countries.

20. How Factors Affect Exchange Rates

21. How Factors Affect Exchange Rates
 Assume the simultaneous increase of U.S. inflation and U.S. interest rates.
 Increase in U.S. inflation will place upward pressure on the pound’s value.
 Increase in the U.S. interest rates will place downward pressure on the
pound’s value.
 The sensitivity of an exchange rate to these factors is dependent on the
volume of international transactions between the two countries.

22. How Factors Affect Exchange Rates
 If the two countries engage in a large volume of trade but very small
international capital flows, the relative inflation rates will likely be more
influential.
 If the two countries engage in a large volume of capital flows, interest rate
fluctuations may be most influential.

23. How Factors Affect Exchange Rates
 Because the dollar’s value changes by different magnitudes relative to
each foreign currency, analysts often measure the dollar’s strength with an
index in which several currencies are consolidated into a single composite.
 The weight assigned to each currency is determined by its relative
importance in international trade and/or finance.

24. 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

25. 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.

26. 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.

27. 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.

28. 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.

29. Speculating on Anticipated 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.

30. Thank you!