Slide 1 of 38 Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson

Slide 1 of 38

Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson

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Overview

Measure exchange ratesMeasure exchange rates Determine equilibrium exchange ratesDetermine equilibrium exchange rates Examine factors affecting exchange ratesExamine factors affecting exchange rates

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Measuring Exchange Rate Movements

Exchange rateExchange rate– value of one currency in units of anothervalue of one currency in units of another– eg. One dollar U.S. = 1.44 CDNeg. One dollar U.S. = 1.44 CDN

Fluctuating valueFluctuating value– appreciationappreciation

increase in currency value relative to anotherincrease in currency value relative to another

– depreciationdepreciation decrease in currency value relative to anotherdecrease in currency value relative to another

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Exchange Rate Movement Price of a currencyPrice of a currency , or,,,,,,,, how much a currency cost, or,,,,,,,, how much a currency cost “… “… an exchange rate at a given point in an exchange rate at a given point in

time represents a price of a currency…”time represents a price of a currency…”page 106page 106

price, like any product, is a function of price, like any product, is a function of demanddemand

demand relative to the supplydemand relative to the supply

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Exchange Rate Equilibrium

Supply for a currencySupply for a currency– e.ge.g., supply of British pound., supply of British pound

the greater the price offered, the greater the supply the greater the price offered, the greater the supply

quantityquantity

valuevalue

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Spot exchange rateSpot exchange rate– price of a currency at a specific timeprice of a currency at a specific time

price set by supply and demand for the currencyprice set by supply and demand for the currency

Demand for currencyDemand for currency– e.ge.g., US demand for pound sterling ., US demand for pound sterling

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valuevalue

quantityquantity

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Exchange rate reflects supply and demandExchange rate reflects supply and demand– lower $US means cheaper US goods for Britishlower $US means cheaper US goods for British– increased demand for US goods implies greater increased demand for US goods implies greater

demand for $USdemand for $US

DD

valuevalue

SS

quantityquantity

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Factors Influencing Exchange Rates

Relative inflation ratesRelative inflation rates Relative interest ratesRelative interest rates Relative income levelsRelative income levels Government controlsGovernment controls ExpectationsExpectations

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Factors that influence Exchange Rates

Relative inflation ratesRelative inflation rates page 109page 109

changes in inflation rates can affect changes in inflation rates can affect international trade activity, which influences international trade activity, which influences the demand and supply of currenciesthe demand and supply of currencies

if inflation is high, price of products is rising fast and the if inflation is high, price of products is rising fast and the economy will have a lot of money to buy foreign productseconomy will have a lot of money to buy foreign products

if they buy foreign products, there is need for currencies if they buy foreign products, there is need for currencies other than the currency they have, so demand is highother than the currency they have, so demand is high

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Inflation means the price of goods and Inflation means the price of goods and services rises quicklyservices rises quickly

a consequence is that people are also a consequence is that people are also making more money and relative to goods making more money and relative to goods and services from other countries, they can and services from other countries, they can afford to import moreafford to import more

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In reality, “… the true equilibrium exchange In reality, “… the true equilibrium exchange rate will reflect several factors rate will reflect several factors simultaneously…”simultaneously…”

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1. Relative Interest Rates1. Relative Interest Ratespage 110page 110

changes in relative interest rates affect changes in relative interest rates affect investment in foreign securities, which investment in foreign securities, which influence the demand and supply of influence the demand and supply of currenciescurrencies

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Relative inflation ratesRelative inflation rates– affects supply and demand for currencyaffects supply and demand for currency– impacts international tradeimpacts international trade– e.g., British inflation rises against US inflatione.g., British inflation rises against US inflation

British goods become more expensive relative to USBritish goods become more expensive relative to US decrease of US demand for pound sterlingdecrease of US demand for pound sterling increase in British demand for “cheaper” US goodsincrease in British demand for “cheaper” US goods increase in British demand for $USincrease in British demand for $US increase in supply of pounds on sale for $USincrease in supply of pounds on sale for $US British pound declines in value against the $USBritish pound declines in value against the $US

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if interest rates in a country are low, if interest rates in a country are low, portfolio investments there will also be portfolio investments there will also be proportionately lowproportionately low

therefore making ROI - return on therefore making ROI - return on investments lowinvestments low

therefore people will sell the securities and therefore people will sell the securities and demand will declinedemand will decline

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ExampleExampletext page 110 - 111text page 110 - 111

the reunification of East and West the reunification of East and West Germany, and the resulting rise in German Germany, and the resulting rise in German interest ratesinterest rates

U.S. investors invested in German U.S. investors invested in German securities due to the higher ROIsecurities due to the higher ROI

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2. Real Interest Rates2. Real Interest Rates ““while a relatively high interest rate may while a relatively high interest rate may

attract foreign inflows - high interest rate attract foreign inflows - high interest rate might indicate high inflationmight indicate high inflation

- which would scare people off by - which would scare people off by discouraging them to investdiscouraging them to invest

real interest rate = nominal interest rate - real interest rate = nominal interest rate - inflation rateinflation rate

Page 112Page 112

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Relative interest Relative interest realreal rates rates– affects investment in foreign securitiesaffects investment in foreign securities– e.ge.g., British interest rises relative to US interest., British interest rises relative to US interest

British MNCs shift deposits to British banksBritish MNCs shift deposits to British banks decline in British supply of pounds for sale for $USdecline in British supply of pounds for sale for $US increase in British MNC demand for poundsincrease in British MNC demand for pounds pound rises in value relative to $US pound rises in value relative to $US

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3. Relative Income Levels3. Relative Income Levels if income in a country increases, if income in a country increases,

globalization will increase demand for globalization will increase demand for foreign products foreign products

demand for foreign products will increase demand for foreign products will increase demand for the currency of the countries demand for the currency of the countries where those products come fromwhere those products come from

Page 112Page 112

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3. Relative Income Levels3. Relative Income Levels

in the late 1980’s and early 1990’s, income in the late 1980’s and early 1990’s, income levels in North America caused massive levels in North America caused massive imports of Japanese consumer products, imports of Japanese consumer products, making the Japanese yen rise very highmaking the Japanese yen rise very high

Page 112Page 112

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Relative income levelsRelative income levels– e.ge.g., British income rises relative to US income., British income rises relative to US income

demand schedule for pound remains the samedemand schedule for pound remains the same supply of pounds for sale for $US should risesupply of pounds for sale for $US should rise

– British buy more US goodsBritish buy more US goods

British pound falls against the $USBritish pound falls against the $US

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4. Government Intervention4. Government Intervention

Reasons for interventionReasons for intervention– smooth exchange rate movementssmooth exchange rate movements– establish implicit exchange rate boundariesestablish implicit exchange rate boundaries– react to temporary disturbancesreact to temporary disturbances

Page 112Page 112

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Government controlsGovernment controls– foreign exchange barriersforeign exchange barriers– foreign trade barriersforeign trade barriers– central bank interventioncentral bank intervention– intervention may affect inflation, interest rates intervention may affect inflation, interest rates

and income levelsand income levels

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4. Government Intervention4. Government Intervention

What will the government do ?What will the government do ?1 impose 4X barriers1 impose 4X barriers

2 impose foreign trade barriers2 impose foreign trade barriers

3 intervene by buying and selling currencies3 intervene by buying and selling currencies

4 do things to effect inflation rate and interest 4 do things to effect inflation rate and interest ratesrateseg. Alter bank rate, or print money (monetary policy)eg. Alter bank rate, or print money (monetary policy)

Page 112Page 112

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5. Expectations5. Expectations

Market expectations of future ratesMarket expectations of future rates

4X markets react to news that might effect 4X markets react to news that might effect future eventsfuture events

eg. News of possible inflation in a country - due eg. News of possible inflation in a country - due to some crisis, may cause currency traders to to some crisis, may cause currency traders to dump that currency before it declines in valuedump that currency before it declines in value

Page 113Page 113

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5. Expectations5. Expectations

Institutional investors take currency positions Institutional investors take currency positions based on anticipated interest rate based on anticipated interest rate movementsmovements

They do detailed research on many aspects of a country to They do detailed research on many aspects of a country to determine if the currency is going to be in demand, or determine if the currency is going to be in demand, or not, and if it is going to be in demand, they buy large not, and if it is going to be in demand, they buy large amounts and sell it for a profit days or weeks in the futureamounts and sell it for a profit days or weeks in the future

Page 113Page 113

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ExpectationsExpectations– e.g.e.g., news of potential increase in British , news of potential increase in British

inflationinflation market expects decline in value of poundmarket expects decline in value of pound institutional traders sell pound sterlinginstitutional traders sell pound sterling value of pound declines against the $USvalue of pound declines against the $US

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Factors affecting demand for foreign goodsFactors affecting demand for foreign goods– inflation differentialinflation differential– income differentialincome differential– government’s trade restrictionsgovernment’s trade restrictions

Factors affecting demand for foreign Factors affecting demand for foreign securitiessecurities– interest rate differentialinterest rate differential– government’s capital flow restrictionsgovernment’s capital flow restrictions

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Speculating on Anticipated Rates

Speculating on anticipated changes in ratesSpeculating on anticipated changes in rates– e.ge.g., a bank’s expectation on the British pound:., a bank’s expectation on the British pound:

appreciate from $1.635 to $1.650 in 30 daysappreciate from $1.635 to $1.650 in 30 days develops a trading strategy based upon interest rate develops a trading strategy based upon interest rate

differentials and expected exchange rate movementdifferentials and expected exchange rate movement

Currency Lending Rate Borrowing Rate

US dollars 6.50 % 7.00 %

Pound sterling 6.26 % 6.75 %

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Speculating on Anticipated Rates, an Example

Borrow $30 million at 7.00 %Borrow $30 million at 7.00 %

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Borrow $30 million at 7.00 %Borrow $30 million at 7.00 % Convert $30 million to PS 18,348,624Convert $30 million to PS 18,348,624

– $30,000,000 / $1.635 = PS 18,348,624$30,000,000 / $1.635 = PS 18,348,624

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– $30,000,000 / $1.635 = PS 18,348,624$30,000,000 / $1.635 = PS 18,348,624 Lend pounds at 6.26 % for 30 daysLend pounds at 6.26 % for 30 days

– PS 18,348,624 x [1+ (0.0626)(30/360)]PS 18,348,624 x [1+ (0.0626)(30/360)]– bank has PS 18,444,349 in 30 daysbank has PS 18,444,349 in 30 days

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– $30,000,000 / $1.635 = PS 18,348,624$30,000,000 / $1.635 = PS 18,348,624 Lend pounds at 6.26 % for 30 daysLend pounds at 6.26 % for 30 days

– PS 18,348,624 x [1+ (0.0626)(30/360)]PS 18,348,624 x [1+ (0.0626)(30/360)]

– bank has PS 18,444,349 in 30 daysbank has PS 18,444,349 in 30 days Convert British pounds to $USConvert British pounds to $US

– PS 18,444,349 x $1.650 = $30,433,176PS 18,444,349 x $1.650 = $30,433,176

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Repay $US loan with proceeds from poundRepay $US loan with proceeds from pound– $30,000 x [1 + (0.07)(30/360)] = $30,174,990$30,000 x [1 + (0.07)(30/360)] = $30,174,990

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Repay $US loan with proceeds from poundRepay $US loan with proceeds from pound– $30,000 x [1 + (0.07)(30/360)] = $30,174,990$30,000 x [1 + (0.07)(30/360)] = $30,174,990

Calculate profit from speculationCalculate profit from speculation– (assumes pound rises to $1.65 in 30 days)(assumes pound rises to $1.65 in 30 days)– $30,433,176 - $30,174,990 = $258,186$30,433,176 - $30,174,990 = $258,186

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Summary Exchange rate movements Exchange rate movements

– measured by percentage change in valuemeasured by percentage change in value Equilibrium exchange rateEquilibrium exchange rate

– determined by supply and demanddetermined by supply and demand economic and governmental factors affect economic and governmental factors affect

exchange ratesexchange rates– inflation and interest rates are factors most closely inflation and interest rates are factors most closely

monitored by financial marketsmonitored by financial markets all factors interact to affect exchange rates all factors interact to affect exchange rates

Documents

Slide 1 of 38 Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson