Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 16-1 Chapter 16 Foreign Exchange: Factors that Influence the Exchange Rate

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 16-2 Learning Objectives Explain how an equilibrium exchange rate is determined Describe the factors responsible for movements in the exchange rate Identify economic variables affecting an exchange rate and the mechanisms through which this occurs Understand the relationship between variables affecting an exchange rate

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 16-3 Chapter Organisation 16.1 FX Markets and an Equilibrium Exchange Rate 16.2 Factors that Influence Exchange Rate Movements 16.3 Measuring Exchange Rate Sensitivity to Changes in Economic Variables 16.4 Summary

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger FX Market and the Equilibrium Exchange Rate Previous chapter –Focused on the structure and operations of the FX markets This chapter –Focuses on the factors that influence the value of a currency (in a floating exchange rate regime) in order to attempt to forecast future exchange rates with some reliability and accuracy

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger FX Market and the Equilibrium Exchange Rate (cont.) Floating exchange rate regime –One in which the value of the currency is determined by demand and supply conditions Pegged exchange rate regime –Where a domestic currency is locked into a specified multiple of another currency such as the USD, e.g. Hong Kong dollar

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger FX Market and the Equilibrium Exchange Rate (cont.) Demand for a currency –To purchase Australian goods and services foreigners must buy AUD –Downward-sloping demand curve occurs as the devaluation of AUD results in a greater demand by foreigners  For foreigners, a fall in the price of the AUD is equivalent to a reduction in the price of everything in Australia

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger FX Market and the Equilibrium Exchange Rate (cont.) Supply of a currency –Upward-sloping supply curve occurs as the quantity of AUDs supplied to the FX market increases as the price of the AUD increases –As the AUD appreciates, the price of foreign currency falls, making foreign goods cheaper for Australian residents –The demand for foreign currency increases and, therefore, so does the supply of AUD

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger FX Market and the Equilibrium Exchange Rate (cont.) Equilibrium exchange rate –The equilibrium exchange rate is the rate at which the quantity of AUD supplied to the market is equal to the demand for AUD –It shows the unique rate at which both the demanders and suppliers of AUD will be satisfied

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger FX Market and the Equilibrium Exchange Rate (cont.)

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Chapter Organisation 16.1 FX Markets and an Equilibrium Exchange Rate 16.2 Factors that Influence Exchange Rate Movements 16.3 Measuring Exchange Rate Sensitivity to Changes in Economic Variables 16.4 Summary

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Factors that Influence Exchange Rate Movements Main factors influencing exchange rate movements –Relative inflation rates –Relative national income growth rates –Relative interest rates –Exchange rate expectations –Government or central bank intervention

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Relative inflation rates Relative inflation rates influence the price and, therefore, the demand for foreign goods by residents The change in demand for imported goods, in turn, affects the demand for foreign currency used to buy these goods –This view of the determination of the value of a currency is called purchasing power parity (PPP) and is discussed in detail later

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Relative inflation rates (cont.) Example: increase in US rate of inflation relative to Australia –Effect for Australian residents  US imports more expensive, decreasing demand for these goods; therefore, reducing the supply of AUD –Effect for US residents  Some US demand for goods and services, and assets will switch to Australian items, increasing demand for AUD to pay for these items –Net effect is an appreciation of the AUD

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Relative inflation rates (cont.)

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Relative national income growth rates Example: Australian income growth rates rise relative to the US –Australian demand for imports increases, increasing the supply of AUD, which, in turn, causes the AUD to depreciate –A secondary effect could be an increase in foreign investment in Australia, increasing the demand for AUD, causing the AUD to recover some value

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Relative national income growth rates (cont.)

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Relative interest rates Example: if Australian interest rates rise relative to the US –Effect for US residents  US residents and companies may redirect some of their cash into Australian interest-bearing instruments, increasing the demand for the AUD –Effect for Australian residents  Australian investors and businesses are more likely to keep their surplus funds invested in Australia, causing a decrease in the supply of the AUD –Net effect  AUD will appreciate

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Relative interest rates (cont.)

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Relative interest rates (cont.) Expectations about the value of the currency during the investment period –So far, the role of interest rates on the exchange rate has ignored expectations about the value of the currency during the investment period –Table 16.1 illustrates the interaction of interest rate differentials and expected changes in the exchange rate over the investment period on currency value

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Relative interest rates (cont.)

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Relative interest rates (cont.) From Table 16.1 the following impact on the value of the AUD would be evident –Scenario 1: AUD would depreciate  The 3% benefit obtained from placing funds in the Australian money market would be more than offset by the 5% depreciation of the AUD –Scenario 2: AUD would appreciate  The 3% benefit obtained from placing funds in the Australian money market would only be partly offset by the 2% depreciation of the AUD

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Relative interest rates (cont.) Reason for change in nominal interest rate –The analysis has ignored whether a change in the nominal interest rate is due to a change in the  Real rate of return or  Inflation expectations premium

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Relative interest rates (cont.) Example: if nominal interest rates rise due to an increase in the inflation expectations premium –The currency may not appreciate, and could depreciate due to  The effect of inflationary expectations (PPP theory)  Businesses and individuals seeking to invest cash holdings in overseas’ securities to avoid a loss of value Example: if nominal interest rates rise due to an increase in the real rate of return –The currency may appreciate due to an inflow of funds from the rest of the world

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Exchange rate expectations Motivation for turnover in the FX market –Only part of the turnover in the FX market is accounted for by transactions associated with exports, imports and financial assets –A significant portion of turnover is motivated by changes in exchange rate expectations

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Exchange rate expectations (cont.) Exchange rate expectations are based on expectations about future changes in –Relative inflation –Relative income growth –Relative interest rates

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Exchange rate expectations (cont.) Example: AUD expected to depreciate –Effect for Australian residents  Seek to buy foreign currency before AUD falls  Increasing supply of AUD on FX markets –Effect for foreign residents  Defer purchases of the AUD  Reduces demand for AUD –Net effect  AUD depreciates as expected

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Exchange rate expectations (cont.)

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Government or central bank intervention Policies by foreign and/or domestic governments may affect the relative rate of inflation, income growth or interest rates between countries Also, the market participants’ expectations that the government will alter its policy affecting these variables in the future

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Government or central bank intervention (cont.) A central bank may also influence the currency by –Intervening in international trade flows –Intervening in foreign investment flows –Directly intervening in the FX market

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Government or central bank intervention (cont.) International trade flows –Intervention aimed at increasing exports and/or reducing imports by using  Subsidies to exporters, making exports more competitive Increases demand for Australian exports and demand for AUD  Intervention on the import side Tariffs—charge levied on imports increasing their prices Quotas—restriction on the amount imported Embargo—prohibition on import of specified goods or services

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Government or central bank intervention (cont.) Foreign investment flows –Governments alter the exchange rate by altering the flow of investment funds between countries by  Prohibitions on the outflow of funds from a country  Imposing penalty taxes on Residents who earn income offshore Non-residents’ interest income earned in the home country

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Government or central bank intervention (cont.) Direct FX market intervention –Involves purchases or sales of currency –Two motivations for doing this  Smoothing RBA tries to remove volatility in the currency caused by speculators  Exchange rate targeting RBA tries to push the equilibrium exchange rate to some level

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Government or central bank intervention (cont.)

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Chapter Organisation 16.1 FX Markets and an Equilibrium Exchange Rate 16.2 Factors that Influence Exchange Rate Movements 16.3 Measuring Exchange Rate Sensitivity to Changes in Economic Variables 16.4 Summary

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Measuring Exchange Rate Sensitivity to Changes in Economic Variables Regression analysis can be used to assess how changes in economic variables affect the exchange rate –It is a statistical technique that determines the relationship between a dependent variable (the exchange rate) and independent variables (relative growth, inflation and interest rates etc.)

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Chapter Organisation 16.1 FX Markets and an Equilibrium Exchange Rate 16.2 Factors that Influence Exchange Rate Movements 16.3 Measuring Exchange Rate Sensitivity to Changes in Economic Variables 16.4 Summary

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Summary Demand and supply determine the value of a currency in a floating exchange rate regime Factors influencing the demand and/or supply of a currency –Relative inflation rates (PPP) –Relative national income growth rates –Relative interest rates –Exchange rate expectations –Central bank or government intervention