International Finance – Chapter 4 An exchange rate measures the value of one currency in units of another currency. Percentage change in the value of the foreign currency: Percentage change in foreign currency value = πΊ−πΊπ−π πΊπ−π Where, S = spot rate at the more recent date St-1 = spot rate at the earlier date A positive percentage change indicates that the foreign currency has appreciated, while a negative percentage change indicates that it has depreciated At any point in time, a currency should exhibit the price at which the demand for that currency is equal to supply, and this represents the equilibrium exchange rate. For all currencies, the equilibrium exchange rate is reached through transactions in the foreign exchange market. The liquidity of a currency affects the sensitivity of the exchange rate to specific transactions. ο· ο· If the currency’s spot market is liquid, its exchange rate will not be highly sensitive If the currency’s spot market rate is illiquid, its exchange rate may be highly sensitive Factors that influence Exchange Rates The following equation summarizes the factors that can influence a currency’s spot rate: Fisher Effect: Real Interest Rate = Nominal Interest Rate – Inflation Rate Real Interest Rate in USA ο High Value of US Dollar ο High Factors Change in USA Change in Demand (GBP) Change in Supply (GBP) Inflation Higher Lower Higher Lower Higher Lower Higher Outward Shift Inward Shift Inward Shift Outward Shift Outward Shift Inward Shift Inward Shift Inward Shift Outward Shift Outward Shift Inward Shift Same Same Same Overall Change in Exchange Rate (USD) Appreciates Depreciates Depreciates Appreciates Appreciates Depreciates Depreciates Lower Outward Shift Same Appreciates Interest Rate Income Level Government Controls (USA against GB) Income level affects the exchange rate as it affects the amount of imports demanded. The governments of foreign countries can influence the equilibrium exchange rate in many ways, including: ο· ο· ο· ο· Imposing foreign exchange barriers Imposing foreign trade barriers Intervening in the foreign exchange markets Affecting macro variables such as inflation, interest rates and income levels Trade-related foreign exchange transactions are generally less responsive to news. Financial flow transactions are very responsive to news, however, because decisions to hold securities denominated in a particular currency are often dependent on anticipated changes in currency values. Interest rates are more influential when two countries engage in a large volume of capital flows. Inflation is more influential during large volumes of international trade. Cross Exchange Rates ο· ο· ο· ο· ο· When currencies A and B move by the same degree against the dollar, there is no change in the cross exchange rate. When currency A appreciates against the dollar by a greater degree than currency B appreciates against the dollar, then currency A appreciates against currency B. When currency A appreciates against the dollar by a smaller degree than currency B appreciates, then currency A depreciates against currency B. When currency A appreciates against the dollar, while currency B is unchanged against the dollar, currency A appreciates against currency B by the same degree as it appreciated against the dollar. When currency A depreciates against the dollar while currency B appreciates against the dollar, then currency A depreciates against currency B. Cross Exchange Rate (currency A in terms of currency B) = πππππ ππ ππππππππ π¨ ππ π πππππ πππππ ππ ππππππππ π© ππ π πππππ Speculation Based Math steps: 1. 2. 3. 4. 5. Borrow in currency expected to depreciate Convert to currency expected to appreciate Deposit in currency expected to appreciate Repay loan in currency expected to depreciate Calculate profit in original currency borrowed Carry Trades The strategy involves borrowing a currency that has a low interest rate, and investing the funds in a currency that has a high interest rate. 1. 2. 3. 4. Convert all currencies to currency with higher interest rate Calculate interest earned by investing this currency Calculate interest paid from loan of other currency (in currency with higher interest rate) Calculate profit in currency with higher interest rate Investors prefer to borrow a currency with a low interest rate that they expect will weaken Investors purchase a currency with a high interest rate that they expect will strengthen.
