1 Foreign Exchange Rate Determination: Expectations and the Asset Market Model International Financial Management Dr. A. DeMaskey

2 Learning Objectives  What are the determinants of exchange rates?  Are changes in exchange rates predictable?  What factors affect the equilibrium exchange rate?  What is the role of expectations?  How do central banks intervene in the foreign exchange market?

3 Potential Foreign Exchange Rate Determinants Parity Conditions 1.Relative inflation rates 2.Relative interest rates 3.Forward exchange rates 4.Exchange rate regimes 5.Official monetary reserves Infrastructure 1.Strength of banking system 2.Strength of securities markets 3.Outlook for growth and profitability Speculation 1.Currencies 2.Securities 3.Uncovered interest arbitrage 4.Real estate 5.Commodities Cross-Border Investment 1.Foreign direct investment 2.Portfolio investment Political Risk 1.Capital controls 2.Black market in currencies 3.Exchange rate spreads 4.Risk premium on securities and FDI Spot Exchange Rate

4 Measuring Exchange Rate Movements  Appreciation  Depreciation  Percent Change in the Foreign Currency Value  Percent Change in the Home Currency Value

5 Exchange Rate Equilibrium  Demand  Supply  Equilibrium Exchange Rate

6 Equilibrium Exchange Rate S£S£ D£D£ $1.50 Dollar Value of £ Quantity of £

7 Macro-Economic Factors Influencing Exchange Rates  Relative Inflation Rates  Relative Interest Rates  Relative Income Levels

8 Impact of Rising U.S. Inflation on the Equilibrium Value of the British Pound S£S£ D£D£ $1.50 Dollar Value of £ Quantity of £

9 Impact of Rising U.S. Interest Rates on the Equilibrium Value of the British Pound S£S£ D£D£ $1.50 Dollar Value of £ Quantity of £

10 Impact of Rising U.S. Income on the Equilibrium Value of the British Pound S£S£ D£D£ $1.50 Dollar Value of £ Quantity of £

11 Government Controls  Foreign Exchange Barriers  Foreign Trade Barriers  Government Intervention in Foreign Exchange Market  Affecting macro variables, such as inflation, interest rates, and income levels

12 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.

13 Role of Expectations SignalImpact on $ Poor U.S. economic indicators Fed chairman suggests Fed is unlikely to cut U.S. interest rates A possible decline in German interest rates Central banks expected to intervene to boost the euro

14 Interaction of Factors  Trade-Related Factors  Financial Factors  Trade-related factors and financial factors sometimes interact.

15 Factors Affecting Exchange Rates Inflation Differential Income Differential Gov’t Trade Restrictions Interest Rate Differential Capital Flow Restrictions U.S. Demand For Foreign Goods Foreign Demand For U.S. Goods U.S. Demand For FC Supply of FC For Sale U.S. Demand For Foreign Securities Foreign Demand For U.S. Securities U.S. Demand For FC Supply of FC For Sale Exchange Rate Between the Foreign Currency And the Dollar

16 Government Intervention  Reasons  Direct l Sterilized l Non-Sterilized  Indirect Government Policy Government Barriers

17 Central Bank Intervention Nonsterilized Intervention To Strengthen the C$ Federal Reserve Banks Participating In the Foreign Exchange Market C$$ Sterilized Intervention To Strengthen the C$ Federal Reserve Banks Participating In the Foreign Exchange Market Financial Institutions That Invest In Treasury Securities $C$ Treasury Securities $

18 Impact of Currency Value  Government Deficit  Government Policy Tool l Weak Home Currency l Strong Home Currency

19 Effect of Expectations  Currency values are determined by: l Inflation l Interest rates l Economic and political stability l GDP growth l Reputation of central bank  In reality, however, exchange rates are affected by expectations of these variables.

20 Central Bank Behavior  Reputable central banks: l Are trusted by markets to maintain a currency’s purchasing power through sound monetary policy. l Tend to be independent. l Have currencies that are more highly valued than those issued by less reputable banks.