Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Chapter 4 Exchange Rate Determination International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Chapter Objectives To explain how exchange rate movements are measured. To explain how the equilibrium exchange rate is determined. To examine the factors that affect the equilibrium exchange rate. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Measuring Exchange Rate Movements (1) 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 a particular currency, that currency is said to be “mixed in trading.” International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA 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.

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA The Determinants of Foreign Exchange Rates

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA 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

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA 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

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA 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.

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Measuring Exchange Rate Movements (2) The percentage change (%  in the value of a foreign currency is computed as S t – S t – 1 S t – 1 where S t denotes the spot rate at time t. A positive %  represents appreciation of the foreign currency, while a negative %  represents depreciation. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Annual Changes in the Value of the Euro Date Exchange Rate Annual %  1/1/2000$1.001/€– 1/1/2001$.94/€– 6.1% 1/1/2002$.89/€– 5.3% 1/1/2003$1.05/€+18.0% 1/1/2004$1.26/€+20.0% International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Exchange Rate Equilibrium (1) 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. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Value of £ Quantity of £ $1.55 $1.50 $1.60 Equilibrium exchange rate D: Demand for £ S: Supply of £ Exchange Rate Equilibrium (2) International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Exchange Rate Equilibrium (3) The liquidity of a currency affects the sensitivity of the exchange rate to specific transactions. With many willing buyers and sellers, even large transactions can be easily accommodated. Conversely, illiquid currencies tend to exhibit more volatile exchange rate movements. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Factors that Influence Exchange Rates (1) 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 International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA $/ £ Quantity of £ S0S0 D0D0 r0r0 U.S. inflation    U.S. demand for British goods, and hence £. D1D1 r1r1 S1S1 Factors that Influence Exchange Rates (2) Relative Inflation Rates   British desire for U.S. goods, and hence the supply of £. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA $/£ Quantity of £ r0r0 S0S0 D0D0 S1S1 D1D1 r1r1 U.S. interest rates    U.S. demand for British bank deposits, and hence £. Factors that Influence Exchange Rates (3) Relative Interest Rates   British desire for U.S. bank deposits, and hence the supply of £. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Factors that Influence Exchange Rates (4) Relative Interest Rates It is thus useful to consider the real interest rate, which adjusts the nominal interest rate for inflation. A relatively high interest rate may actually reflect expectations of relatively high inflation, which may discourage foreign investment. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Factors that Influence Exchange Rates (5) Relative Interest Rates This relationship is sometimes called the Fisher effect. real nominal interest  interest – inflation rate rate rate International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA $/£ Quantity of £ S0S0 D0D0 r0r0 U.S. income level    U.S. demand for British goods, and hence £. D1D1 r1r1 Factors that Influence Exchange Rates (6) Relative Income Levels  No expected change for the supply of £.,S1,S1 International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Factors that Influence Exchange Rates (7) Government Controls Governments may influence the equilibrium exchange rate by: –imposing foreign exchange barriers, –imposing foreign trade barriers, –intervening in the foreign exchange market, and –affecting macro variables such as inflation, interest rates, and income levels. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Factors that Influence Exchange Rates (8) Expectations Foreign exchange markets react to any news that may have a future effect. –News of a potential surge in U.S. inflation may cause currency traders to sell dollars. Many institutional investors take currency positions based on anticipated interest rate movements in various countries. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Factors that Influence Exchange Rates (9) Expectations Economic signals that affect exchange rates can change quickly, such that speculators may overreact initially and then find that they have to make a correction. Speculation on the currencies of emerging markets can have a substantial impact on their exchange rates. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Factors that Influence Exchange Rates (10) I nteraction of Factors The various factors sometimes interact and simultaneously affect exchange rate movements. For example, an increase in income levels sometimes causes expectations of higher interest rates, thus placing opposing pressures on foreign currency values. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Trade-Related Factors 1. Inflation Differential 2. Income Differential 3. Gov’t Trade Restrictions Financial Factors 1. Interest Rate Differential 2. Capital Flow Restrictions How Factors Can Affect Exchange Rates 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 International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Factors that Influence Exchange Rates (11) Interaction of Factors Large volume of international trade  relative inflation rates may be more influential Large volume of capital flows  interest rate fluctuations may be more influential The sensitivity of an exchange rate to the factors is dependent on the volume of international transactions between the two countries. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Factors that Influence Exchange Rates (12) Interaction of Factors An understanding of exchange rate equilibrium does not guarantee accurate forecasts of future exchange rates because that will depend in part on how the factors that affect exchange rates will change in the future. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA 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. International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Exchange at £0.38/NZ$ 4. Holds £21,831, Holds NZ$57,142,857 Exchange at £0.35/NZ$ Speculating on Anticipated Exchange Rates London Bank expects the exchange rate of the New Zealand dollar to appreciate against the £ from its present level of £0.35 to £0.38 in 30 days. 1. Borrows £20 m Borrows at 7.20% for 30 days Lends at 6.48% for 30 days 3. Receives NZ$57,451,428 Repays £20,120,000 A profit of 21,831,543 – 20,120,000 = 1,711,543 International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA 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 euros to 0.48 euros in 30 days. Exchange at 0.48 euros/NZ$ 4. Holds NZ$41,900, Holds 20 m euros Exchange at 0.50 euros/NZ$ 1. Borrows NZ$40 million Borrows at 6.96% for 30 days Lends at 6.72% for 30 days 3. Receives 20,112,000 euros Returns NZ$40,232,000 Profit of NZ$1,668,000 or 800,640 euros International Financial Management, 2 nd edition Jeff Madura and Roland Fox ISBN © 2011 Cengage Learning EMEA

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA 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

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA SEK NOK GBP NZD Effective exchange rates (1990 = 100)

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA What made the NOK appreciate? The NOK appreciated a lot from 2000 until January 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

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Exchange rates and interest differentials Exchange rate (KKI, right axis) Interest differential (left axis) Index Percent

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA 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 NOK exchange rate has been highly correlated with the US stock market

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Exchange rates and US stock prices Exchange rate (left axis) Stock prices (right axis)

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA Exchange rate and oil prices The oil price increased a lot since late It is often argued that higher oil prices cet. par. lead to an appreciation of NOK

Cost and Management Accounting: An Introduction, 7 th edition Colin Drury ISBN © 2011 Cengage Learning EMEA How good is our model?