Chapter 4
Exchange Rate Determination
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
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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.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
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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.”
Cost and Management
International
Accounting:
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Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
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and Roland Fox
ISBN 978-1-40803-213-9
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2011 Cengage
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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, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
The Determinants of Foreign
Exchange Rates
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 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, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 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, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 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, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Measuring Exchange Rate
Movements (2)
• 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.
Cost and Management
International
Accounting:
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Management,
Introduction,
2nd7th
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Jeff
Colin
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Drury
and Roland Fox
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2011 Cengage
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Annual Changes
in the Value of the Euro
Date
Exchange Rate
Annual %
D
1/1/2000
1/1/2001
1/1/2002
1/1/2003
1/1/2004
$1.001/€
$.94/€
$.89/€
$1.05/€
$1.26/€
–
– 6.1%
– 5.3%
+18.0%
+20.0%
Cost and Management
International
Accounting:
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Management,
Introduction,
2nd7th
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edition
Jeff
Colin
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Drury
and Roland Fox
ISBN 978-1-40803-213-9
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2011 Cengage
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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.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
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edition
Jeff
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ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
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2011 Cengage
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Exchange Rate Equilibrium (2)
Value of
£
$1.60
$1.55
$1.50
S: Supply of £
Equilibrium
exchange rate
D: Demand for £
Quantity of £
Cost and Management
International
Accounting:
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Management,
Introduction,
2nd7th
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Jeff
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2011 Cengage
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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.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
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2011 Cengage
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Factors that Influence
Exchange Rates (1)
e  f DINF , DINT , DINC , DGC, DEXP)
e
DINF
D INT
DINC
DGC
DEXP
= percentage change in the spot rate
= change in the relative inflation rate
= change in the relative interest rate
= change in the relative income level
= change in government controls
= change in expectations of future
exchange rates
Cost and Management
International
Accounting:
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Management,
Introduction,
2nd7th
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edition
Jeff
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ISBN 978-1-40803-213-9
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2011 Cengage
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Factors that Influence
Exchange Rates (2)
Relative Inflation Rates
$/
£
r1
r0
S1
S0
D1
D0
Quantity of £
U.S. inflation 
  U.S. demand for
British goods, and
hence £.
  British desire for U.S.
goods, and hence the
supply of £.
Cost and Management
International
Accounting:
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Management,
Introduction,
2nd7th
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Jeff
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and Roland Fox
ISBN 978-1-40803-213-9
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2011 Cengage
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Factors that Influence
Exchange Rates (3)
Relative Interest Rates
$/£
r0
r1
S0
S1
D0
D1
Quantity of £
U.S. interest rates 
  U.S. demand for
British bank deposits,
and hence £.
  British desire for U.S.
bank deposits, and
hence the supply of £.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
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2011 Cengage
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Factors that Influence
Exchange Rates (4)
Relative Interest Rates
• A relatively high interest rate may actually
reflect expectations of relatively high
inflation, which may discourage foreign
investment.
• It is thus useful to consider the real interest
rate, which adjusts the nominal interest rate
for inflation.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
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Factors that Influence
Exchange Rates (5)
Relative Interest Rates
•
real
nominal
interest 
rate
interest – inflation rate
rate
• This relationship is sometimes called the
Fisher effect.
Cost and Management
International
Accounting:
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Management,
Introduction,
2nd7th
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edition
Jeff
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2011 Cengage
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Factors that Influence
Exchange Rates (6)
Relative Income Levels
$/£
r1
r0
S ,S1
0
D1
D0
U.S. income level 
  U.S. demand for
British goods, and
hence £.
 No expected change for
the supply of £.
Quantity of £
Cost and Management
International
Accounting:
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Management,
Introduction,
2nd7th
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edition
Jeff
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ISBN 978-1-40803-213-9
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2011 Cengage
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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.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
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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.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
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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.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
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Factors that Influence
Exchange Rates (10)
Interaction 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.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
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How Factors Can Affect Exchange Rates
Trade-Related
Factors
1. Inflation
Differential
2. Income
Differential
3. Gov’t Trade
Restrictions
Financial
Factors
1. Interest Rate
Differential
2. Capital Flow
Restrictions
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
International Financial Management, 2nd edition
Jeff Madura and Roland Fox
ISBN 978-1-4080-3229-9 © 2011 Cengage Learning EMEA
Exchange
rate
between
foreign
currency
and the
dollar
Factors that Influence
Exchange Rates (11)
Interaction of Factors
• The sensitivity of an exchange rate to the
factors is dependent on the volume of
international transactions between the two
countries.
Large volume of international trade 
relative inflation rates may be more influential
Large volume of capital flows  interest rate
fluctuations may be more influential
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
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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.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
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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.
Cost and Management
International
Accounting:
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Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
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Drury
and Roland Fox
ISBN 978-1-40803-213-9
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2011 Cengage
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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.
Borrows at 7.20%
for 30 days
4. Holds
£21,831,543
1. Borrows
£20 m
Repays £20,120,000
A profit of 21,831,543 – Exchange at
20,120,000 = 1,711,543 £0.38/NZ$
Exchange at
£0.35/NZ$
2. Holds
NZ$57,142,857
Lends at 6.48%
for 30 days
3. Receives
NZ$57,451,428
Cost and Management
International
Accounting:
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Management,
Introduction,
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edition
Jeff
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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.
1. Borrows
NZ$40 million
Exchange at
0.50 euros/NZ$
2. Holds
20 m euros
Borrows at 6.96%
for 30 days
Returns NZ$40,232,000
Profit of NZ$1,668,000
or 800,640 euros
Lends at 6.72%
for 30 days
4. Holds
NZ$41,900,000
Exchange at
0.48 euros/NZ$
3. Receives
20,112,000 euros
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
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2011 Cengage
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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, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Effective exchange rates (1990 = 100)
120
120
110
110
GBP
100
100
NOK
90
90
NZD
80
80
SEK
70
60
1990
70
60
1992
1994
1996
1998
2000
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
2002
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
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Exchange rates and interest
differentials
5
Index
Percent
4
90
95
Interest differential
(left axis)
3
100
2
105
Exchange rate
(KKI, right axis)
1
110
0
115
1999
2000
2001
2002
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
2003
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, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Exchange rates and US stock
prices
110
1 500
105
1 300
Exchange rate
(left axis)
100
1 100
Stock prices
(right axis)
95
900
90
700
1999
2000
2001
2002
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
2003
Exchange rate and oil prices
• The oil price increased
a lot since late 2001.
• It is often argued that
higher oil prices cet.
par. lead to an
appreciation of NOK
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
How good is our model?
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA