1. Chapter 4 Exchange Rate Determination and Related Issues

2. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 2 Objectives To identify the factors causing changes in the exchange rate. To illustrate the effect of arbitrage and speculation. To explain how the bid-offer spread and the forward spread are determined. To examine the AUD exchange rate determination.

3. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 3 Some Stylised Facts The exchange rate follows approximately a random walk with little or no drift. The spot and forward rates tend to move in the same direction and by approximately the same amount. There is no correspondence between exchange rates and prices.

4. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 4 Some Stylised Facts (cont.) There is no strong relationship between the exchange rate and the current account. Rapid monetary expansion leads to rapid currency depreciation.

5. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 5 The Equilibrium Exchange Rate S(d/f)S(d/f) Sf Df Q f

6. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 6 Factors Affecting the Supply of and Demand for FX Relative inflation rates Relative interest rates Relative growth rates The government Expectations

7. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 7 The Effect of a Higher Domestic Inflation Rate S(d/f)S(d/f) Sf Df Q f

8. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 8 The Effect of a Higher Domestic Interest Rate S(d/f)S(d/f) Sf Df Q f

9. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 9 Arbitrage in the FX Market Arbitrage is the simultaneous purchase and sale of currencies to capitalise on anomalies in quoted exchange rates. It is triggered by the violation of an equilibrium condition.

10. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 10 Two-Point Arbitrage Also known as spatial or locational arbitrage, it arises when the following condition is violated:

11. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 11 Three-Point (Triangular) Arbitrage It is trigged when cross exchange rates are inconsistent, i.e. when the following condition is violated:

12. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 12 The Profitable Sequence x z y (a) Unprofitable sequence z x y (b) Profitable sequence

13. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 13 Multipoint Arbitrage The condition precluding multipoint arbitrage is:

14. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 14 Five-Point Arbitrage AUD (a) Clockwise USD EUR GBP JPY

15. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 15 Five-Point Arbitrage (cont.) (b) Anti-clockwise AUD USD EUR GBP JPY

16. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 16 Speculation in the FX Market Speculators buy and sell currencies on the basis of certain expectations about the future movements of exchange rates.

17. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 17 Destabilising and Stabilising Speculation Destabilising speculation occurs when speculators buy a currency when it is appreciating and sell it when it is depreciating.

18. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 18 Destabilising and Stabilising Speculation (cont.) Stabilising speculation occurs when speculators buy a currency when it is depreciating and sell it when it is appreciating.

19. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 19 Determination of the Bid-Offer Spread The bid rate is determined by the market maker’s demand and the customer’s supply. The offer rate is determined by the market maker’s supply and the customer’s demand.

20. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 20 Arbitrage and Speculation with Bid- Offer Spread It can be shown that the profitability of speculation and arbitrage is lower in the presence of the bid-offer spread than when dealing on the basis of the mid-rate.

21. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 21 Two-Point Arbitrage with Bid-Offer Spread

22. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 22 Speculation with Bid-Offer Spread

23. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 23 Determination of the Forward Spread The naive model assumes that there are independent demand and supply forces in the spot and forward markets and that there are separate markets for forward contracts of different maturities.

24. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 24 Factors Affecting the AUD Exchange Rates Interest rates Commodity prices and the terms of trade Inflation The external account The role of the RBA

25. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 25 Australian Dollar Exchange Rates (December 1983 = 100)

26. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 26 Australian and US Short-Term Interest Rates

27. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 27 US Dollar Commodity Price Index (1994/1995 = 100)

28. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 28 Consumer Prices (December 1983 = 100)