Exchange Rate Determination 4 Chapter Exchange Rate Determination BE 408 - International Finance

Foreign Exchange Rate Determination Exchange rate determination is complex. Some argue that there are three major schools of thought (parity conditions, balance of payments approach, asset market approach) These are not competing theories but rather complementary theories. Without the depth and breadth of the various approaches combined, our ability to capture the complexity of the global market for currencies is lost. BE 408 - International Finance

The Determinants of Foreign Exchange Rates BE 408 - International Finance

Exchange Rate Determination: The Theoretical Thread The theory of purchasing power parity is a widely accepted theory of exchange rate determination: PPP is the oldest and most widely followed of the exchange rate theories, and deals with exchange rates and inflation. Countries who suffer from high inflation, will se a deterioration in the value of their currency Most exchange rate determination theories have PPP elements embedded within their frameworks. We will look at PPP in more detail in chapter 8

Exchange Rate Determination: The Theoretical Thread The balance of payments approach is also a widely utilized theoretical approach in exchange rate determination: The basic approach argues that the equilibrium exchange rate is found currency flows match up vis a vis current and financial account activities. If a country suffers from prolonged BOP deficits, the value of its currency will fall

Exchange Rate Determination: The Theoretical Thread The asset market approach argues that exchange rates are determined by the supply and demand for a wide variety of financial assets: Shifts in the supply and demand for financial assets alter exchange rates. Changes in monetary and fiscal policy alter expected returns and perceived relative risks of financial assets, which in turn alter exchange rates.

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.” BE 408 - International Finance

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. BE 408 - International Finance

Exchange Rate Equilibrium Even if exchange rate models are very complex it is still true that 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. $$$

Exchange Rate Equilibrium Value of £ Quantity of £ $1.55 $1.50 $1.60 S: Supply of £ D: Demand for £ Equilibrium exchange rate

Factors that Influence Exchange Rates e = percentage change in the spot rate  INF = change in the relative inflation rate  INT = change in the relative interest rate  INC = change in the relative income level  GC = change in government controls  EXP = change in expectations of future exchange rates

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 £. BE 408 - International Finance

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 £. BE 408 - International Finance

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. BE 408 - International Finance

Factors that Influence Exchange Rates Relative Interest Rates real nominal interest  interest – inflation rate rate rate This relationship is sometimes called the Fisher effect. BE 408 - International Finance

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 £. BE 408 - International Finance

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. BE 408 - International Finance

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. BE 408 - International Finance

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. BE 408 - International Finance

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.K. demand for foreign goods, i.e. demand for foreign currency Foreign demand for U.K. goods, i.e. supply of foreign currency U.K. demand for foreign securities, i.e. demand for foreign currency Foreign demand for U.K. securities, i.e. supply of foreign currency Exchange rate between foreign currency and the dollar

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.

Example - speculation BE 408 - International Finance

Speculating on Anticipated Exchange Rates London 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 BE 408 - International Finance

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 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 BE 408 - International Finance

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 BE 408 - International Finance

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

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 BE 408 - International Finance

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 a sound economic situation The NOK exchange rate has been highly correlated with the US stock market BE 408 - International Finance

Exchange rates and US stock prices Exchange rate (left axis) Stock prices (right axis) BE 408 - International Finance

Exchange rate and oil prices The oil price has 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? BE 408 - International Finance