BBK3273 International Finance

Transcription

1 BBK3273 International Finance Prepared by Dr Khairul Anuar L2: Exchange Rate Determination

2 Contents 1. Measuring Exchange Rate Movements 2. How Exchange Rate Movements Measured 3. Exchange Rate Equilibrium 4. Factors That Influence Exchange Rates 5. Anticipation of Exchange Rate Movements Summary 2

3 1. Measuring Exchange Rate Movements Exchange rate movements affect an MNCs value because they can affect the amount of cash inflows received from exporting or from a subsidiary and the amount needed to pay for imports. A decline in a currency s value is referred to as depreciation Increase in a currency s value is referred to as appreciation When a foreign currency's spot rates at two specific points in time are compared, the spot rate at the more recent date is denoted as S ad the spot rate at the earlier date is denoted as St-1. The percentage change in the value of the foreign currency is computed as follows: S S Percent in foreign currency value S t 1 t 1 A positive percent change indicates that the currency has appreciated. A negative percent change indicates that it has depreciated. 3

4 2. How Exchange Rate Movements Measured The exchange rate for the Canadian dollar and the euro are shown in the second and fourth column of the figure below for the months from 1st January to 1st July. Notice that the direction of the movement may persist for consecutive months in some cases or may not persist in other cases. The magnitude of the movement tends to vary every month, although the range of percentage movements over these months may be a reasonable indicator of the range of percentage movements in future months. A comparison of the movements in these two currencies suggest that they appear to move independently of each other. Figure 1: How Exchange Rate Movements and Volatility Are Measured 4

5 3. Exchange Rate Equilibrium The exchange rate represents the price of a currency, or the rate at which one currency can be exchanged for another. Demand for a currency increases when the value of the currency decreases, leading to a downward sloping demand schedule. (See Figure 2) Supply of a currency increases when the value of the currency increases, leading to an upward sloping supply schedule. (See Figure 3) Equilibrium equates the quantity of pounds demanded with the supply of pounds for sale. (Figure 4) In liquid spot markets, exchange rates are not highly sensitive to large currency transactions. 5

6 3. Exchange Rate Equilibrium Figure 2 shows a hypothetical number of pounds that would be demanded under various possibilities of the exchange rate. At any one point time, there is only one exchange rate. The demand schedule is downward sloping because US corporations is likely to purchase more British pound when the pound is worthless, as it will take a fewer dollars to obtain the desired amount of pounds. Figure 2: Demand Schedule for British Pounds 6

7 3. Exchange Rate Equilibrium Figure 3 shows the quantity of pounds for sale (supplied to the foreign exchange market in exchange for dollars) corresponding to each possible exchange rate at a given point in time. Notice from the supply schedule that there is a positive relationship between the value of the British pound ad the quantity of British pounds for sale (supplied). When the pound is valued high, British consumers and firms are more likely to purchase US goods. Hence, they supply a greater number of pounds to the market, to be exchanged for dollars. Conversely, when the pounds for sale is smaller, reflecting less British desire to obtain US goods. Figure 3: Supply Schedule of British Pounds for Sale 7

8 3. Exchange Rate Equilibrium Figure 4 shows the combined demand and supply schedules for British pounds. At an exchange rate of $1.50, the quantity of pounds demanded would exceed the supply of pounds for sale. At an exchange rate of $1.60, the quantity of pounds demanded would be less than the supply of pounds for sale. Figure 4 shows that the equilibrium exchange rate of $1.55 because this rate equates the quantity of pounds demanded with the supply for sale. Figure 4: Equilibrium Exchange Rate Determination 8

9 4. Factors That Influence Exchange Rates The equilibrium exchange rate will change over time as supply and demand schedules change. The following summarizes the factors which can influence a currency s spot rate: e f ( INF, INT, INC, GC, EXP) where e percentagechangein the spot rate INF changein the differential between U. S.inflation and the foreign country' s inflation INT changein the differential between the U.S.interest rate and the foreign country' s interest rate INC changein the differential between the U.S.incomelevel and the foreign country' s incomelevel GC changein governmentcontrols EXP changein expectations of futureexchangerates 9

10 4. Factors That Influence Exchange Rates 1. Relative Inflation: Changes in relative inflation rates can affect international trade activity, which influences the demand for and supply of currencies and therefore influences exchange rates. See Figure 5 shows an increase in U.S. inflation leads to increase in U.S. demand for foreign goods, an increase in U.S. demand for foreign currency, and an increase in the exchange rate for the foreign currency. If British inflation increased (rather than U.S. inflation), thye opposite forces would occur. 2. Relative Interest Rates: Changes in relative interest rates affect investment in foreign securities, which influences the demand for and supply of currencies and therefore influences exchange rates. Figure 6 shows an increase in U.S. rates leads to increase in demand for U.S. deposits and a decrease in demand for foreign deposits, leading to a increase in demand for dollars and an increased exchange rate for the dollar. In some cases, an exchange rate between two countries currencies can be affected by changes in a third country s interest rate. 10

11 4. Factors That Influence Exchange Rates Figure 5: Impact of Rising U.S. Inflation on the Equilibrium Value of the British Pound 11

12 4. Factors That Influence Exchange Rates Figure 6: Impact of Rising U.S. Interest Rates on the Equilibrium Value of the British Pound 12

13 4. Factors That Influence Exchange Rates Real Interest Rates: Although a relatively high interest rate may attract foreign inflows (to invest in securities offering high yields) the relatively high interest rate may reflect expectations of relatively high inflation. Because high inflation can place downward pressure on the local currency, some foreign investors may be discouraged from investing in securities denominated in that currency. For this reason, it is helpful to consider the real interest rate, which adjusts the nominal interest rate for inflation: Real interest rate Nominalinterest rate Inflation rate The relationship is sometimes referred to as the Fisher effect. 13

14 4. Factors That Influence Exchange Rates 3. Relative Income Levels: A third factor affecting exchange rates is relative income levels. Because income can affect the amount of imports demanded, it can affect exchange rates. Figure 7 shows an increase in U.S. income leads to increased in U.S. demand for foreign goods and increased demand for foreign currency relative to the dollar and an increase in the exchange rate for the foreign currency. 14

15 4. Factors That Influence Exchange Rates Figure 7: Impact of Rising U.S. Income Levels on the Equilibrium Value of the British Pound 15

16 4. Factors That Influence Exchange Rates 4. Government Control: The fourth factor affecting the exchange rate is government controls. The government of foreign countries can influence the equilibrium exchange rate in many ways, including: i. imposing foreign exchange barriers; ii. imposing foreign trade barriers iii. intervening in foreign exchange markets iv. affecting macro variables such as inflation, interest rates, and income levels. 16

17 4. Factors That Influence Exchange Rates 5. Expectations: The fifth factor affecting exchange rates is market expectation of future exchange rates. If investors expect interest rates in one country to rise, they may invest in that country leading to a rise in the demand for foreign currency and an increase in the exchange rate for foreign currency. Impact of signals on currency speculation day-to-day speculation on future exchange rate movements is commonly driven by signals of future interest rate movements, but it can also be driven by other factors. Speculators may overreact to signals causing currency to be temporarily overvalued or undervalued. 17

18 4. Factors That Influence Exchange Rates Interaction of Factors: Transactions within the foreign exchange markets facilitate trade or financial flows. Trade-related foreign exchange transactions are generally less responsive to news. Financial flow transaction are very responsive to news, however, because decisions to hold securities denominated in a particular currency are often dependent on anticipated changes in currency values. Sometimes trade related factors and financial factors interact and simultaneously affect exchange rate movements. Figure 8 separates payment flows between countries into trade-related and finance-related flows and summarizes the factors that affect these flows. Over a period, some factors may place upward pressure on the value of a foreign currency while other factors place downward pressure on the pound s value. 18

19 4. Factors That Influence Exchange Rates Figure 8: Summary of How Factors Can Affect Exchange Rates 19

20 5. Anticipation of Exchange Rate Movements Institutional speculation based on expected appreciation - When financial institutions believe that a currency is valued lower than it should be in the foreign exchange market, they may invest in that currency before it appreciates. Institutional speculation based on expected depreciation - If financial institutions believe that a currency is valued higher than it should be in the foreign exchange market, they may borrow funds in that currency and convert it to their local currency now before the currency s value declines to its proper level. Speculation by individuals Individuals can speculate in foreign currencies. The Carry Trade Where investors attempt to capitalize on the differential in interest rates between two countries. 20

21 6. Summary Exchange rate movements are commonly measured by the percentage change in their values over a specified period, such as a month or a year. MNCs closely monitor exchange rate movements over the period in which they have cash flows denominated in the foreign currencies of concern. The equilibrium exchange rate between two currencies at any point in time is based on the demand and supply conditions. Changes in the demand for a currency or the supply of a currency for sale will affect the equilibrium exchange rate. The key economic factors that can influence exchange rate movements through their effects on demand and supply conditions are relative inflation rates, interest rates, and income levels, as well as government controls. As these factors cause a change in international trade or financial flows, they affect the demand for a currency or the supply of currency for sale and therefore affect the equilibrium exchange rate. 21

22 6. Summary Unique international trade and financial flows between every pair of countries dictate the unique supply and demand conditions for the currencies of the two countries, which affect the equilibrium cross exchange rate. The movement in the exchange rate between two non-dollar currencies can be determined by considering the movement in each currency against the dollar and applying intuition. Financial institutions can attempt to benefit from expected appreciation of a currency by purchasing that currency. Conversely, they can attempt to benefit from expected depreciation of a currency by borrowing that currency, exchanging it for their home currency, and then buying that currency back just before they repay the loan. 22