Chapter 4
Exchange Rate Determination
Specific Objectives
•
•
•
Explain how exchange rate movements are measured
Explain how the equilibrium exchange rate is determined
Examine factors that affect the equilibrium exchange rate
Outline
Measuring Exchange Rate Movements
• Exchange rate is value of one currency in units of another currency
—the "price" of a currency
— appreciation
— depreciation
• Percentage change calculation
• MNCs who understand forces that affect a currency's value can prepare better for effects on
their revenues and expenses
Exchange Rate Equilibrium
• Determined by supply and demand
— in equilibrium, supply equals demand
• Demand schedule - downward sloping
• Supply schedule - upward sloping
• Impact of liquidity
— liquidity affects the sensitivity of the exchange rate to specific transactions
— if the spot market is liquid, the exchange rate is less sensitivity to large transactions
— the equilibrium rate of illiquid currencies adjusts to even minor changes in supply and
demand conditions
Factors Influencing Supply and Demand
• Relative inflation rates
— high U.S. inflation puts upward pressure on foreign currency
• Relative interest rates
— high U.S. interest rates put downward pressure on foreign currency
— influence of third country
— should use real interest rates
• Fisher effect
• Relative income levels
— high U.S. income puts upward pressure on foreign currency
• supply of foreign currency is not affected
• Government controls
— e.g., forex barriers, foreign trade barriers, government intervention
• Expectations
— is the forex market efficient? If so, any movements are based on expectations
— impact of signals on currency speculations
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Exchange Rate Determination
47
• Interaction of factors
— Foreign exchange markets facilitate either trade or financial flows
—Trade-related transactions are less responsive to news
— Financial flow transactions are very responsive to news
— The influence of any one factor depends on the amount of trade and financial flows two
countries conduct with each other
Speculating on Anticipated Exchange Rates
• If your forecasts are sufficiently different from market consensus, then you may profit from
exchange rate movements
— if you expect appreciation of foreign currency...
• borrow U.S. dollars
• convert to foreign currency
• lend the foreign currency
• volume (negative)
• convert proceeds to dollars and repay U.S. dollar-loan
— if you expect depreciation of foreign currency...
• borrow foreign currency
• convert foreign currency to dollars
• lend dollars
• volume (negative)
• use needed proceeds from dollar investment to repay foreign currency loan
Key Terms Matching
In the following exercise, place a letter from the right column with the correct number in the left
column.
Key Term
1. Appreciation
2. Depreciation
3. Equilibrium Exchange
Rate
4. Real Interest Rate
Definition
a. the decline in a currency's value
b. the exchange rate at which demand for a currency is
equal to the currency's supply
c. the increase in a currency's value
d. the nominal interest rate less the rate of inflation
Answers to Key Terms Matching
3. b
4. d
1. c
2. a
Summary of Formulas
1) Conversion of annualized interest rate (ia ) to interest rate ( im ) for M days
iM=la x
M
360
Chapter 4
48
2) Factors that influence a currency's spot rate
e= f (AINF , AINT , AINC , AGC , AEXP)
•
3) Percent change in foreign currency value
—
St-1
4) Real interest rate
Real interest rate = Nominal interest rate — Inflation rate
Definitional Problems
1. A decline in a currency's value is referred to as
value is referred to as
; an increase in a currency
2. As far as the sign of the change in a currency's value is concerned, a
percentage change represents appreciation of a foreign currency.
3. The price (or exchange rate) of a currency is determined by the
relative to its
4. The
equal to its supply.
exchange rate is that exchange at which the currency's demand is
5. The shape of the demand curve for a currency is
sloping.
supply curve for a currency is
6.
for that currency
•
sloping; the shape of the
currencies tend to exhibit more volatile exchange rate movements, as the
equilibrium prices of their currencies adjust to even minor changes in supply and demand
conditions.
7. Three primary factors influencing exchange rates are relative
, and
8. Examples of government controls that may influence exchange rates are the imposition of
and/or the imposition of
9. The
10.
adjusts the nominal interest rate for inflation.
in foreign exchange markets occur because speculators are commonly taking
positions based on signals of future actions (rather than the confirmation of actions), and
these signals may be misleading.
11. Inflation, interest rate, and income differentials all affect exchange rates. However, the
affects exchange rates of countries engaging in frequent capital flow
transactions with the U.S. more than the other two factors.
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Exchange Rate Determination
49
12. When speculating on anticipated exchange rate movements, the speculator attempts to profit
from an expected appreciation in the foreign currency by borrowing
converting the proceeds, and lending the proceeds in the
13. When speculating on anticipated exchange rate movements, the speculator attempts to profit
from an expected depreciation in the foreign currency by borrowing
converting the proceeds, and lending the proceeds in the
14. In general, when speculating on exchange rate movements, the speculator will borrow the
currency that is expected to
and invest in the country whose currency is
expected to
Answers to Definitional Problems
1.
2.
3.
4.
5.
6.
7.
depreciation; appreciation
positive
demand; supply
equilibrium
downward; upward
Illiquid
inflation rates; interest rates; income
levels
8. foreign exchange barriers; foreign trade
barriers
9. real interest rate
10. Overreactions
11. interest rate differential
12. dollars; foreign country
13. the foreign currency; U.S.
14. depreciate; appreciate
True/False Problems
1. When the Japanese yen appreciates against the U.S. dollar, this means that the U.S. dollar is
strengthening relative to the yen.
2. A decline in a currency's value is referred to as appreciation.
3. The changes in a currency's value can have a major impact on costs and revenues of MNCs.
4. Illiquid currencies tend to exhibit less volatile exchange rate movements than liquid
currencies.
5. The liquidity of a currency affects the sensitivity of the exchange rate to specific transactions.
6. An increase in U.S. inflation relative to Singapore inflation places upward pressure on the
Singapore dollar.
7. When expecting a foreign currency to depreciate, a possible way to speculate on this
movement is to borrow dollars, convert the proceeds to the foreign currency, lend in the
foreign country, and use the proceeds from this investment to repay the dollar loan.
8. The equilibrium exchange rate for a foreign currency is determined by the intersection of the
supply and demand curves of that currency.
9. The exchange rate of a currency reflects the price of that currency.
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Chapter 4
10. Since supply and demand for a currency are constant (primarily due to government
intervention), currency values seldom fluctuate.
11. The supply curve for a currency is downward sloping since U.S. corporations would be
encouraged to purchase more foreign goods when the foreign currency is worth less.
12. The supply curve for a currency is upward sloping because foreign consumers and firms
would likely supply a greater amount of their currency to the U.S. market.
13. Movements in U.S. inflation rates and interest rates will always have an effect on a
currency's value, no matter what the inflation rates and interest rates are in the foreign
country.
14. Relatively high U.S. interest rates may result in an increased demand for dollars and a
reduced supply of dollars in foreign countries.
15. Relatively high Japanese inflation may result in an increase in the supply of yen for sale and a
reduction in the demand for yen.
16. The real interest rate is computed by subtracting the inflation rate from the nominal interest
rate.
17. If the British government desires an appreciation in its currency with respect to the U.S.
dollar, it would consider intervening in the foreign exchange market by buying dollars with
pounds.
18. Although existing and observable factors can always be used to predict currency movements,
institutional investors often take currency positions based on anticipated interest rate
movements.
19. Assume that the nominal interest rate differential between the U.S. and Denmark changes
(due to higher nominal interest rates in the U.S.), but that the real interest rate differential
between the two countries remains unchanged. The Danish kroner will probably not
depreciate against the dollar.
20. Country X frequently engages in trade flows with the U.S. (such as imports and exports).
Country Y frequently engages in financial flows with the U.S. (such as financial
investments). Everything else held constant, an increase in U.S. interest rates would affect the
exchange rate of Country X's currency more than the exchange rate of Country Y's currency.
21. Trade-related foreign exchange transactions are generally less responsive to news than
financial flow transactions.
22. Trade-related factors and financial factors rarely interact and affect exchange rate movements
simultaneously.
Exchange Rate Determination
51
Answers to True/False Problems
1. F
2. F
3. T
4. F
5. T
6. T
7. F
8. T
9. T
10. F
11. F
12. T
13. F
14. T
15. T
16. T
17. F
18. F
19. T
20. F
21. T
22. F
Multiple Choice Problems
•
1. A decline in a currency's value is known as
a. Depletion
b. Depreciation
c. Deterioration
d. Appreciation
e. None of the above
2. The Norwegian kroner's (NOK) value yesterday was $0.08133. Today, its value is $0.08006.
Thus, the kroner
by
%.
a. Depreciated; 1.56
b. Appreciated; 1.56
c. Depreciated; 1.59
d. Appreciated; 1.59
e. Depreciated; 1.27
3. In today's Wall Street Journal, you see the Sudanese dinar (SDD) quoted at $0.003735.
Yesterday, it was quoted at $0.003621. The dinar
by
%.
a. Depreciated; 3.15
b. Appreciated; 3.15
c. Depreciated; 3.05
d. Appreciated; 3.05
e. Depreciated; 1.14
4. The demand curve for a currency is
•
a.
b.
c.
d.
e.
Upward sloping; downward sloping
Upward sloping; upward sloping
Downward sloping; downward sloping
Downward sloping; upward sloping
Convex; concave
, while the supply curve for a currency is
Chapter 4
52
5. The equilibrium exchange rate is the price of a currency at which its supply is
its demand.
a. Slightly less than
b. Equal to
c. Slightly greater than
d. Substantially less than
e. Substantially greater than
6.
a.
b.
c.
d.
e.
highly sensitive to a
If a currency's spot market is liquid, its exchange rate will
single large purchase or sale of the currency. Therefore, the change in the equilibrium
exchange rate will be relatively
Not be; large
Not be; small
Be; large
Be; small
None of the above
a.
b.
c.
d.
e.
Illiquid currencies tend to exhibit
volatile exchange rate movements, as the
equilibrium prices of their currencies adjust to
changes in supply and demand
conditions.
Less; even minor
Less; only large
More; even minor
More; only large
None of the above
8.
a.
b.
c.
d.
e.
Which of the following is not mentioned in the text as a factor affecting exchange rates?
Relative interest rates
Relative inflation rates
Government controls
Expectations
All of the above are mentioned in the text as factors affecting exchange rates
9.
a.
b.
c.
d.
Which of the following events would most likely result in an appreciation of the U.S. dollar?
U.S. inflation is very high.
The Fed indicates that it will raise U.S. interest rates.
Future U.S. interest rates are expected to decline.
Japan is expected to increase interest rates in the near future.
7.
•
10. Which of the following interactions will likely have the least effect on the dollar's value?
Assume everything else is held constant.
a. A reduction in U.S. inflation accompanied by an increase in real U.S. interest rates.
b. A reduction in U.S. inflation accompanied by an increase in nominal U.S. interest rates.
c. An increase in U.S. inflation accompanied by an increase in nominal, but not real, U.S.
interest rates.
d. An increase in Singapore's inflation accompanied by an increase in real U.S. interest rates.
e. An increase in Singapore's interest rates accompanied by an increase in U.S. inflation.
•
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Exchange Rate Determination
53
11. Assume that Britain and the U.S. conduct a large volume of international trade, but rarely
engage in financial flows. Conversely, Japan and the U.S. conduct a large volume of financial
flow transactions, but rarely engage in trade flows. Under this scenario, everything else held
would affect the value of the pound, and a change
constant, a change in the U.S.
would affect the value of the yen.
in the U.S.
a. Interest rate; inflation rate
b. Interest rate; income level
c. Inflation rate; interest rate
d. a and b
e. None of the above
12. A speculator expecting an appreciation in the Thai baht would begin his or her transaction by
a. Borrowing baht.
b. Borrowing dollars.
c. Lending dollars.
d. Converting dollars into baht.
e. None of the above
The following information refers to questions 13 through 16.
Assume the following information regarding U.S. and Canadian annualized interest rates:
•
Currency
U.S. Dollar ($)
Canadian Dollar (C$)
Lending Rate
5.89%
5.60%
Borrowing Rate
6.35%
6.00%
Piggy Bank can borrow either $20 million or C$30 million. Furthermore, Piggy Bank expects the
spot rate of the Canadian dollar to be $0.82 in 60 days (the current spot rate is $0.80).
13. What amount will the borrowed amount convert to today?
a. C$16 million
b. $16 million
c. C$25 million
d. $25 million
e. C$24.39 million
14. What is the profit or loss from Piggy Bank's speculation if the spot rate 60 days from now is
indeed $0.82?
a. $20.69 million
b. $20.21 million
c. $454,200
d. $502,166
e. $479,667
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Chapter 4
54
15. Malone Bank also plans to speculate on the Canadian dollar's currency movements, but it
expects the Canadian spot rate 60 days from now to be $0.78. Based on this information,
what amount will the borrowed amount convert to today?
a. C$24 million
b. $24 million
c. $16 million
d. C$ 16 million
e. $23.4 million
•
16. What is Malone Bank's profit or loss from speculation if the spot rate 60 days from now is
indeed $0.78?
a. C$601,600
b. $601,600
c. $24.24 million
d. C$24.24 million
e. $606,440
17. If a country experiences high inflation relative to the U.S., its exports to the U.S. should
pressure on its
, and there is
, its imports should
currency's equilibrium value.
a. Decrease; increase; upward
b. Decrease; decrease; upward
c. Increase; decrease; downward
d. Decrease; increase; downward
e. Increase; decrease; upward
18. If a country experiences an increase in interest rates relative to U.S. interest rates, the inflow
, the outflow of its funds to
of U.S. funds to purchase its securities should
pressure on its
, and there is
purchase U.S. securities should
currency's equilibrium value.
a. Increase; decrease; downward
b. Decrease; increase; upward
c. Increase; decrease; upward
d. Decrease; increase; downward
e. Increase; increase; upward
•
Answers to Multiple Choice Problems
1. b
2. a
$0.08006 - $0.08133
= -1.56%
$0.08133
3. b
$0.003735 - $0.003621
= 3.15%
$0.003621
4.
5.
6.
7.
d
b
b
c
8.
9.
10.
11.
12.
13.
e
b
c
c
b
c
$20 million/$0.80 = C$25 million
14. e
1. Borrow $20 million
2. Convert to Canadian dollars: $20
million/$0.80 = C$ 25 million
•
55
Exchange Rate Determination
•
3. Invest the CS at an annualized rate of
5.60% over 60 days: C$ 25,000,000 x [1
+ 5.60% (60/360)] = C$ 25,233,333.33
4. Convert the C$ back to dollars: C$
25,233,333.33 x $0.82 =
$20,691,333.33
5. Repay the dollars borrowed. The
repayment amount is: $20,000,000 x [1
+ (6.35% (60/360)] = $20,211,666.67
6. The dollar profit is: $20,691,333.33 $20,211,666.67 = $479,666.66
15. b
C$30 million x $0.80 = $24 million
16. b
1. Borrow C$30 million
•
2. Convert to dollars: C$30 million x
$0.80 = $24 million
3. Invest the dollars at an annualized rate
of 5.89% over 60 days: $24,000,000 x
[1 + 5.89% (60/360)] = $24,235,600
4. Determine Canadian dollars owed: C$
30,000,000 x (1 + [6% (60/360]) =
C$30,300,000
5. Determine dollars needed to repay
Canadian dollar loan: C$30,300,000 x
$0.78 = $23,634,000
6. The dollar profit is: $24,235,600 $23,634,000 = $601,600
17. d
18. c