CHAPTER 4 Exchange Rate Determination
© 2000 South-Western College Publishing
Chapter Objectives • To explain how exchange rate movements • •
are measured; To explain how the equilibrium exchange rate is determined; and To examine the factors that affect the equilibrium exchange rate.
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Measuring Exchange Rate Movements • An exchange rate measures the value of one •
currency in units of another currency. A decline in a currency’s value is referred to as depreciation, while an increase is referred to as appreciation. % ∆ in foreign currency value = (S - St-1) / St-1
• • A positive % ∆ represents appreciation of the foreign currency, while a negative % ∆ represents depreciation.
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Exchange Rate Equilibrium Value of £
S
equilibrium exchange rate D Quantity of £
• An exchange rate represents the price of a currency, which is determined by the demand for that currency relative to supply. 4
Factors that Influence Exchange Rates S2 S
Value of £ r2 r
D2 D Quantity of £
• Relative Inflation Rates ¤
¤
A relative increase in U.S. inflation will increase the U.S. demand for British goods, and hence the U.S. demand for British pounds. In addition, the British desire for U.S. goods, and hence the supply of pounds, will drop.
Factors that Influence Exchange Rates Value of £
S S2
r r2
D D2 Quantity of £
• Relative Interest Rates ¤ ¤
A relative rise in U.S. interest rates will decrease the U.S. demand for British pounds. In addition, the supply of pounds by British corporations will increase. 6
Factors that Influence Exchange Rates Real Interest Rates ¤ A relatively high interest rate may reflect expectations of relatively high inflation, which may discourage foreign investment. ¤ Real interest rates adjusts nominal interest rates for inflation: real nominal interest = interest – inflation rate rate rate This relationship is sometimes called the Fisher effect. 7
Factors that Influence Exchange Rates Value of £
S
r2 r
D2 D Quantity of £
• Relative Income Levels ¤
¤
A relative increase in the U.S. income level will increase the U.S. demand for British goods, and hence the demand for British pound. The supply of pounds does not change. 8
Factors that Influence Exchange Rates
• Government Controls ¤
Governments can influence the equilibrium exchange rate in many ways, including : the imposition of foreign exchange barriers, the imposition of foreign trade barriers, intervening in the foreign exchange market, and affecting macro variables such as inflation, interest rates, and income levels. 9
Factors that Influence Exchange Rates
• Expectations ¤ ¤
¤
Foreign exchange markets react to any news that may have a future effect. Institutional investors often take currency positions based on anticipated interest rate movements in various countries too. Because of speculative transactions, foreign exchange rates can be very volatile.
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Factors that Influence Exchange Rates Trade-Related Factors 1. Inflation Differential 2. Income Differential 3. Gov’t Trade Restrictions Financial Factors 1. Interest Rate Differential 2. Capital Flow Restrictions
U.S. demand for foreign goods, i.e. demand for foreign currency Foreign demand for U.S. goods, i.e. supply of foreign currency U.S. demand for foreign securities, i.e. demand for foreign currency Foreign demand for U.S. securities, i.e. supply of foreign currency
Exchange rate between foreign currency and the dollar
Factors that Influence Exchange Rates
• Interaction of Factors ¤
¤
Traderelated factors and financial factors sometimes interact. For example, an increase in income levels sometimes causes expectations of higher interest rates. 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. 12
Dollar’s Index
How Factors Have Influenced Exchange Rates 180
high U.S. interest rates, a somewhat depressed U.S. economy, and low inflation
high U.S. interest rates
140 100 60 1972
Persian Gulf War large balance of trade deficit
high U.S. inflation 1977
1982
1987
1992
1997
Year ¤
Because the dollar’s value changes by different magnitudes relative to each foreign currency, analysts measure the dollar’s strength with an index. 13
Speculating on Anticipated Exchange Rates Chicago Bank expects the exchange rate of the New Zealand dollar to appreciate from its present level of $0.50 to $0.52 in 30 days.
1. Borrows $20 million
Borrows at 7.20% for 30 days
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Speculating on Anticipated Exchange Rates Chicago Bank expects the exchange rate of the New Zealand dollar to appreciate from its present level of $0.50 to $0.52 in 30 days.
1. Borrows $20 million
Borrows at 7.20% for 30 days
Exchange at $0.50/NZ$ 2. Holds NZ$40 million 15
Speculating on Anticipated Exchange Rates Chicago Bank expects the exchange rate of the New Zealand dollar to appreciate from its present level of $0.50 to $0.52 in 30 days.
1. Borrows $20 million
Borrows at 7.20% for 30 days
Exchange at $0.50/NZ$ 2. Holds NZ$40 million
Lends at 6.48% for 30 days
3. Receives NZ$40,216,000 16
Speculating on Anticipated Exchange Rates Chicago Bank expects the exchange rate of the New Zealand dollar to appreciate from its present level of $0.50 to $0.52 in 30 days.
1. Borrows $20 million Exchange at $0.50/NZ$ 2. Holds NZ$40 million
Borrows at 7.20% for 30 days Returns $20,120,000 Profit of $792,320
Lends at 6.48% for 30 days
4. Holds $20,912,320 Exchange at $0.52/NZ$ 3. Receives NZ$40,216,000 17
Speculating on Anticipated Exchange Rates Chicago Bank expects the exchange rate of the New Zealand dollar to depreciate from its present level of $0.50 to $0.48 in 30 days.
1. Borrows NZ$40 million
Borrows at 6.96% for 30 days
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Speculating on Anticipated Exchange Rates Chicago Bank expects the exchange rate of the New Zealand dollar to depreciate from its present level of $0.50 to $0.48 in 30 days.
1. Borrows NZ$40 million
Borrows at 6.96% for 30 days
Exchange at $0.50/NZ$ 2. Holds $20 million 19
Speculating on Anticipated Exchange Rates Chicago Bank expects the exchange rate of the New Zealand dollar to depreciate from its present level of $0.50 to $0.48 in 30 days.
1. Borrows NZ$40 million
Borrows at 6.96% for 30 days
Exchange at $0.50/NZ$ 2. Holds $20 million
Lends at 6.72% for 30 days
3. Receives $20,112,000 20
Speculating on Anticipated Exchange Rates Chicago Bank expects the exchange rate of the New Zealand dollar to depreciate from its present level of $0.50 to $0.48 in 30 days.
1. Borrows NZ$40 million Exchange at $0.50/NZ$ 2. Holds $20 million
Borrows at 6.96% for 30 days
4. Holds NZ$41,900,000
Returns NZ$40,232,000 Profit of NZ$1,668,000 Exchange at or $800,640 $0.48/NZ$ Lends at 6.72% for 30 days
3. Receives $20,112,000 21
Impact of Factors that Influence Exchange Rates on an MNC’s Value
[
Inflation rates Interest rates Income levels Government controls Expectations
m ∑ E ( CFj , t ) × E ( ER j , t ) n j =1 Value = ∑ t =1 ( 1 + k) t
]
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 = the weighted average cost of capital of the U.S. parent 22
Chapter Review • Measuring Exchange Rate Movements • Exchange Rate Equilibrium ¤ ¤
Demand for a Currency Supply of a Currency for Sale
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Chapter Review • Factors that Influence Exchange Rates Relative Inflation Rates ¤ Relative Interest Rates ¤ Relative Income Levels ¤ Government Controls ¤ Expectations ¤ Interaction of Factors ¤ How Factors Have Influenced Exchange Rates Speculating on Anticipated Exchange Rates How Exchange Rate Determination Affects an MNC’s Value ¤
• •
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