Exchange Rate Determination 4 Chapter Exchange Rate Determination South-Western/Thomson Learning © 2003

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.

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.”

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

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. Value of £ Quantity of £ D: Demand for £ $1.55 $1.50 $1.60 S: Supply of £ equilibrium exchange rate

The Determinants of Foreign Exchange Rates Parity Conditions 1. Relative inflation rates 2. Relative interest rates 3. Forward exchange rates 4. Interest rate parity Spot Exchange Rate Is there a sound and secure banking system in-place to support currency trading activities? Is there a well-developed and liquid money and capital market in that currency? Asset Approach 1. Relative real interest rates 2. Prospects for economic growth 3. Supply & demand for assets 4. Outlook for political stability 5. Speculation & liquidity 6. Political risks & controls Balance of Payments 1. Current account balances 2. Portfolio investment 3. Foreign direct investment 4. Exchange rate regimes 5. Official monetary reserves

Foreign Exchange Rate Determination It is important to remember that these three theories are not competing, but rather are complementary to each other. Without the depth and breadth of the various approaches combined, our ability to capture the complexity of the global market for currencies is lost.

The Balance of Payments (BOP) Approach Fixed Exchange Rate Countries: Under a fixed exchange rate system, the government bears the responsibility to ensure a BOP near zero. To ensure a fixed exchange rate, the government must intervene in the foreign exchange market and buy or sell domestic currencies (or sell gold) to bring the BOP back to near zero. It is very important for a government to maintain significant foreign exchange reserve balances to allow it to intervene in the foreign exchange market effectively.

Thailand’s Deteriorating Balance of Payments, 1991-1998 Source: International Financial Statistics, International Monetary Fund, Washington DC, monthly.

The Balance of Payments (BOP) Approach Floating Exchange Rate Countries: Under a floating exchange rate system, the government of a country has no responsibility to peg its foreign exchange rate. The fact that current and capital account balances do not sum to zero will automatically (in theory) alter the exchange rate in the direction necessary to obtain a BOP near zero.

The Balance of Payments (BOP) Approach Managed Floats: Countries operating with managed floats, while still relying on market conditions for day-to-day exchange rate determination, often find it necessary to take action to maintain their desired exchange rate values. They seek to alter the market’s valuation of a specific exchange rate by influencing the motivators of market activity, rather through direct intervention in the foreign exchange markets. The primary action taken by such governments is to change relative interest rates.

The Asset Market Approach The asset market approach assumes that whether foreigners are willing to hold claims in monetary form depends on an extensive set of investment considerations or drivers (among others): Relative real interest rates Prospects for economic growth Capital market liquidity A country’s economic and social infrastructure Political safety Corporate governance practices

The Asset Market Approach Foreign investors are willing to hold securities and undertake foreign direct investment in highly developed countries based primarily on relative real interest rates and the outlook for economic growth and profitability. The asset market approach is also applicable to emerging markets, however in these cases a number of additional variables contribute to exchange rate determination (previous slide).

Factors that Influence Exchange Rates Relative Inflation Rates U.S. inflation   U.S. demand for British goods, and hence £. $/£ Quantity of £ S0 D0 r0 S1 D1 r1  British desire for U.S. goods, and hence the supply of £.

Factors that Influence Exchange Rates Relative Interest Rates U.S. interest rates   U.S. demand for British bank deposits, and hence £. $/£ Quantity of £ r0 S0 D0 S1 D1 r1  British desire for U.S. bank deposits, and hence the supply of £.

Factors that Influence Exchange Rates 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.

Factors that Influence Exchange Rates Relative Interest Rates real nominal interest  interest – inflation rate rate rate This relationship is sometimes called the Fisher effect.

Factors that Influence Exchange Rates Relative Income Levels U.S. income level   U.S. demand for British goods, and hence £. $/£ Quantity of £ S0 D0 r0 D1 ,S1 r1 No expected change for the supply of £.

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. Because of speculative transactions, foreign exchange rates can be very volatile.

Factors that Influence Exchange Rates 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.

Factors that Influence Exchange Rates 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.

How Factors Can Affect Exchange Rates Trade-Related Factors 1. Inflation Differential 2. Income 3. Gov’t Trade Restrictions Financial 1. Interest Rate 2. Capital Flow 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

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 $0.52/NZ$ 4. Holds $20,912,320 Returns $20,120,000 Profit of $792,320 2. Holds NZ$40 million Exchange at $0.50/NZ$ Lends at 6.48% for 30 days 3. Receives NZ$40,216,000

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 $0.48/NZ$ 4. Holds NZ$41,900,000 Returns NZ$40,232,000 Profit of NZ$1,668,000 or $800,640 2. Holds $20 million Exchange at $0.50/NZ$ Lends at 6.72% for 30 days 3. Receives $20,112,000

Norwegian Kroner (NOK) Until a few years ago, the operational objective behind monetary policy in Norway was to stabilise the exchange rate Now, most Central Banks have price stability as their number one priority. The Norwegian Central Bank sets interest rates so as to reach an inflation rate of 2.5%. The exchange rate will then have to become more unstable

Effective exchange rates (1990 = 100) GBP NOK NZD SEK Figuren viser utviklingen i effektive nominelle valutakurser for Norge, Sverige, Storbritannia og New Zealand. Stigende kurve i diagrammet viser sterkere kurs. Månedstall.

What made the NOK appreciate? The NOK appreciated a lot from 2000 until January 2003. Market players have suggested several explanations as to why this happened: The exchange rate was particularly driven by the interest rate differential. Foreign interest rates fell while Norwegian remained high

Exchange rates and interest differentials Index Percent Interest differential (left axis) Exchange rate (KKI, right axis) Figuren viser forskjellen i tre måneders pengemarkedsrenter mellom Norge og handelspartnerne. Rentene hos handelspartnerne etter konkurransevekter. Utviklingen i kronekursen er målt ved konkurransekursindeksen (1990 = 100). Stigende kurve betyr sterkere kronekurs. Månedstall.

Falling stock markets The adverse developments in many major international stock markets made investors more risk averse Many investors wanted to put their money into interest paying papers, and NOK was considered a very good asset due to high interest rates and sound economic situation The NOX exchange rate has been highly correlated with the US stock market

Exchange rates and US stock prices Exchange rate (left axis) Stock prices (right axis)

Exchange rate and oil prices The oil price increased a lot since late 2001. It is often argued that higher oil prices cet. par. lead to an appreciation of NOK

How good is our model?

Impact of Exchange Rates on an MNC’s 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 Inflation Rates, Interest Rates, Income Levels, Government Controls, Expectations