Fin4328 – Moore
Chapter 2 Notes
Determination of Exchange Rates
Chapter 2 - Lecture Notes
Learning Outcome and Key Points




Understanding how Equilibrium Spot Exchange Rates are set
The Role of Expectations on Current and Future Exchange Rates
Models for Pricing Exchange Rates
Understanding how Central Bank Intervention Affects Exchange Rates
Background and Basics
1. What is Money (Economic Definition) ?
 Unit of Measure
 S
 M
a. Why do we care?
b. How does our perspective change in going from a purely domestic to
an international/multinational context?
2. What is an Exchange Rate?
 Price of one country’s currency in terms of another country’s
3. How do Exchange Rates Behave over time?
 Static?
 Dynamic?
a. Why do individuals, businesses, or governments care?
b. What factors cause exchange rates or currency values to change over
time?
c. Are there formal theoretical models that handle exchange rate and
currency valuations? What are they?
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Fin4328 – Moore
Chapter 2 Notes
Why this Chapter is Important.
Recurring Themes that will be investigated throughout this course
• Exchange Rate Determination
– What is an exchange rate?
– How does the exchange rate change?
• Exchange Rate Risk Measurement
– Why do we care about changing exchange rates?
• Exchange Rate Risk Management
– What can we do to manage our exchange rate risk?
• Multinational Finance
– How does the above affect capital budgeting?
– How does the above affect individual investment decisions?
Exchange Rate Basics
• Exchange rate = Price
Major Currency Cross Rates
Major Currency Cross Rates
Currency
Last Trade
U.S. $
¥en
N/A
Euro
Can $
U.K. £
AU $
Swiss Franc
10:20am ET 10:19am ET 10:20am ET 10:18am ET 10:19am ET
10:19am ET
1 U.S. $
=
1
110.1500
0.8022
1.1864
0.5481
1.3159
1.2388
1 ¥en
= 0.009079
1
0.007283
0.010771
0.004976
0.011946
0.011246
1 Euro
=
1.2466
137.3130
1
1.4790
0.6832
1.6404
1.5443
1 Can $
=
0.8429
92.8439
0.6761
1
0.4620
1.1091
1.0442
1 U.K. £
=
1.8246
200.9798
1.4637
2.1647
1
2.4009
2.2603
1 AU $
=
0.7600
83.7085
0.6096
0.9016
0.4165
1
0.9414
1 Swiss Franc =
0.8072
88.9167
0.6475
0.9577
0.4424
1.0622
1
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Fin4328 – Moore
Chapter 2 Notes
• Fixed vs Floating Rates (and Hybrids)
– Fixed (Pegged) Rates – Set by the Government
– Floating Rate Systems – Free Hand of Market
Currency boards and currency board-like systems as of June 2002
Country
Population GDP (US$) Began Exchange rate / remarks
Bermuda [UK]
63,000
Bosnia
3.8 million $6.2 billion 1997
1.95583 convertible marks = 1 euro / Currency
board-like
Brunei
336,000
Brunei $1 = Singapore $1 / Currency board-like
Bulgaria
7.8 million $35 billion
$2 billion
1915
$5.6 billion 1952
Bermuda $1 = US$1 / Loose capital controls
1997
1.95583 leva = 1 euro / Currency board-like
Cayman Islands [UK] 35,000
$930
million
1972
Cayman $1 = US$1.20
Djibouti
450,000
$550
million
1949
177.72 Djibouti francs = US$1 / Currency
board-like
Estonia
1.4 million $7.9 billion 1992
8 kroons = 0.51129 euro / Currency board-like
Falkland Islands
[UK]
2,800
unavailable 1899
Falklands £1 = UK£1
Faroe Islands
[Denmark]
45,000
$700
million
1940
1 Faroese krone = 1 Danish krone
Gibraltar [UK]
29,000
$500
million
1927
Gibraltar £1 = UK£1
Hong Kong [China]
7.1 million $158 billion 1983
Hong Kong $7.80 = US$1 / More orthodox
since 1998
Lithuania
3.6 million $17 billion
3.4528 litai = 1 euro / Currency board-like
1994
Source of population and GDP data: CIA World Factbook
• Real Exchange Rates
• Appreciation/Depreciation (Floating Currencies)
- Also known as Weakening and Strengthening
- Applies to home currency perspective
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Fin4328 – Moore
Chapter 2 Notes
Factors Affecting Currency Values and Relative Exchange Rates
• Demand for Currency
o Purchases of Goods, Services, Financial or Real Assets originating
from another country
• Supply of Currency
o Purchases of Foreign Goods, Services, Financial or Real Assets
originating from “home” country
• Inflation Rates (both absolute and relative)
• Interest Rates (both absolute and relative)
o Real (inflation adjusted) interest rates
• Economic Growth Rates (absolute and relative)
• Political and Economic risk
Computational Models
Exchange Rate Gains/Losses
• Example: Australia vs. US since January 2003 (St. Louis Fed)
(.7600 - .5829)/.5829 = 30.38% Australian Appreciation
Compute Dollar appreciation or depreciation? Is it the same?
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Fin4328 – Moore
Chapter 2 Notes
Models to Explain Rates
• Currencies are long-lived financial assets and should be modeled as
such.
o Good Analogy: Current Oil and Gas Shortage caused by hurricane.
- Gas prices have topped $3 per gallon
- Should Oil producers asset values increase accordingly?
- Disentangle long and short-run effects
• Asset Based Model (Not formalized in equilibrium or equation)
•
•
•
•
•
•
•
Demand for Currency
Supply of Currency
Inflation Rates (both absolute and relative)
Interest Rates (both absolute and relative)
Economic Growth Rates (absolute and relative)
Political and Economic risk
Expectations
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Fin4328 – Moore
Chapter 2 Notes
• “Simplified” Model based on Present Values
(r−rf )·T
F0 = S0 · e
(1)
Define rf as the value of this foreign risk-free interest rate for a maturity T with
continuous compounding. As before, r is the domestic risk-free rate for this
maturity.
Example: Suppose that the six-month interest rates in the United States and
Japan are 5% and 1% per annum, respectively. The current yen/dollar exchange
rate is quote as 100. This means that there are 100 yen per dollar or 0.01 dollars
per yen. For a six-month forward contract on the yen S0 =0.01, r =0.05, rf =0.01, T
=0.5. From equation (1), the forward foreign exchange rate as:
0.01e
(0.05−0.01)·0.5
=0.01020
(2)
This would be quoted as 1/0.010202 or 98.02.
Now, what will cause the rate to change?
Role of Central Banks and Governments
• Central Bank is nation’s official monetary authority (FED)
• Fiscal Policy (government) vs. Monetary Policy (Central Bank)
o Both Fiscal and Monetary Policy affect currency value
• Potential Goals and Policies
o Tightening, relaxing, or stabilizing Supply of Money
o Strengthening, Weakening or stabilizing relative value of currency
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Fin4328 – Moore
Chapter 2 Notes
• Mechanisms
o Foreign Exchange Market Intervention (buy or sell foreign currency)
o Unsterilized Intervention
- Does Not Insulate (Protect) domestic money supplies from
foreign exchange transactions
- Sell your currency in the open market (Dollars for Yen)
- Buy foreign Currency in Open Market with Foreign currency
- Impact: Money Supplies, inflation, interest rates all change
o Sterilized Intervention
• Open Market Operation (selling or purchasing Treasuries)
• Purchases by Fed increases US money supply (cash for IOU)
• Sales by the Fed decreases US money supply (IOU for cash)
o Effectiveness of interventions is open to debate
• Ineffective if market doesn’t believe it (expectations)
• Irresponsible if it sets up artificial barriers to trade
Relevant Information Links
http://finance.yahoo.com/
http://www.cia.gov/cia/publications/factbook/
http://research.stlouisfed.org/fred2/
http://www.oanda.com/
http://www.cme.com/
http://www.sfe.com.au/
http://edgarscan.pwcglobal.com/recruit/other.html
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