CHAPTER 4 Exchange Rate Determination A. Measuring Exchange Rate Movements B. Exchange Rate Equilibrium C. Factors That Influence Exchange Rates D. Government Controls E. Expectations F. Supplemental factors G. Speculating on Anticipated Exchange Rates Chapter Overview This chapter will: A. Explain how exchange rate movements are measured B. Explain how the equilibrium exchange rate is determined C. Examine factors that determine the equilibrium exchange rate Chapter 4 Objectives Geographical extent of the foreign exchange market ◦ Major world trading starts in Sydney, Tokyo, move west to Hong Kong and Singapore, passes on to Bahrain, then shifts to Frankfurt, Zurich, London, then to NYC and Chicago and ends in San Francisco and LA. Geographical extent of the foreign exchange market Foreign exchange dealer’s day (in Europe): ◦ Trading activities in the past few hours in NYC and far east. ◦ New economic and political development. ◦ The bank’s own exchange position. Foreign Exchange Market Continuous operation: 24 hours a day except weekends. low margins of relative profit compared with other markets of fixed income. Use of leverage to enhance profit margins with respect to account size Average daily turnover in global foreign exchange markets is estimated at $3.98 trillion. Trading in the world's main financial markets accounted for $3.21 trillion of this. This approximately $3.21 trillion in main foreign exchange market turnover was broken down as follows: ◦ ◦ ◦ ◦ $1.005 trillion in spot transactions $362 billion in forwards. $1.714 trillion in foreign exchange swaps. $129 billion estimated gaps in reporting On the spot market, the most heavily traded products were: ◦ EURUSD: 27% ◦ USDJPY: 13% ◦ GBPUSD (also called cable): 12% Foreign Exchange Market Most traded currency A foreign exchange rate is the price of one currency expressed in terms of another currency. Direct quote: is a home currency price of a unit of foreign currency, e.g. SF1.60/$. ◦ SF1.60/$ read as “1.60 Swiss francs per dollar”. ◦ $1000 is equivalent to $1000*SF1.60/$=$1600 Indirect quote: is a foreign currency price of a unit of home currency, e.g. $0.63/SF. ◦ $0.63/SF read as “$0.63 per Swiss francs”. ◦ $1000is equivalent to $1000 / ($0.63/SF)=$1600. More discussion about exchange rate 1. Basic Movements in Rates -when one currency depreciates against another, the other must appreciate. Let St-1 = the original rate S = the current rate Percent Δ in foreign currency value =(S- St-1)/St-1 a. Appreciation: increase in currency value. b. Depreciation: decrease in currency value. Quiz: $1.5/€$1.6/€. Is it appreciated or depreciated to $, and to €? A. Measuring Exchange Rate Movements How exchange rates reach equilibrium? 1. Demand for a Currency a. derived from the local buyers who are willing and able to purchase foreign goods but who must convert their local currencies, such as, i. foreign country’s (GB) interest rate is high ii. Home country’s inflation (US) is high domestic products’ prices (US) increase. iii. Residents (US) get richer. b. An indirect relationship exists between the cost of foreign currency and amount demanded When foreign currency (GBP) gets cheaper, the demand for it is higher. c. Graphically, a downward-sloping demand curve B. Exchange Rate Equilibrium Demand Schedule for British Pounds Exhibit 4.2 page 87 2. Supply of a Currency for Sale a. derived from the foreigners who are willing and able to supply foreign currency that must be converted first in order to purchase local goods. i. foreign country’s interest rate (US) is high ii. Home country’s inflation (GB) is high domestic products’ prices increase. iii. Residents (GB) get richer. b. A direct relationship exists between cost of the foreign currency and the amount supplied. c. Graphically, an upward-sloping supply curve B. Exchange Rate Equilibrium Supply Schedule of British Pounds for Sale Exhibit 4.3 page 88 3. Equilibrium Supply of a currency = Demand of a currency. What will happen, if supply is greater than demand? And vice versa? B. Exchange Rate Equilibrium Equilibrium Exchange Rate Determination Exhibit 4.4 page 89 e=f(ΔINF, ΔINT, ΔINC, ΔGC, ΔEXP) – p89. ΔINF: inflation differentials between two countries. ΔINT: interest rate differentials. ΔINC: income level differentials. ΔGC: change in government controls. ΔEXP: change in expectations of future exchange rate. 1. Relative Inflation Rates 2. Relative Interest Rates a. Real Interest Rates 3. Relative Income Levels C. Factors That Influence Exchange Rates 1. Relative Inflation Rates As a rule of thumb, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. Inflation is defined as the rate (%) at which the general price level of goods and services is rising, causing purchasing power to fall. Inflation occurs when most prices are rising by some degree across the whole economy. Countries with low inflation in the past decades: Japan, Germany, Switzerland, U.S. and Canada. Countries with higher inflation in the past: Mexico, Brazil, Russia, and many more. Those countries typically see depreciation in their currency in relation to the currencies of their trading partners. This is also usually accompanied by higher interest rate. C. Factors That Influence Exchange Rates 1. Relative inflation Rate When US’ inflation increases, while GB’s does not, then the demand of £ increases and the supply of £ decreases. The new £ price at equilibrium is $1.70/£. a. US inflation increases domestic products’ prices increase demand of GB’s products increases demand of £ increases demand line shifts outward. b. US inflation increases GB’s demand of US products decrease GB’s supply of £ decreases supply line shift upward. c. The new set of supply and demand lines cross at new equilibrium. d. £ appreciate and $ depreciate. Discussion: When GB’s inflation increases, what will happen? C. Factors That Influence Exchange Rates 2. Relative Interest Rates When US’ interest rate increases, while GB’s does not, then the demand of £ decreases and the supply of £ increases. The new £ price at equilibrium is $1.45/£. a. US interest rate increases Saving in $ increases Saving in £ decreases demand of £ decreases demand line shifts inward. b. US interest rate increases GB’s c. The new set of supply and saving in $ increases demand of demand lines cross at $ increase GB’s supply of £ new equilibrium. This is increases supply line shift the new currency price. downward. d. £ depreciate and $ appreciate. Discussion: When GB’s interest rate increases, what will happen? C. Factors That Influence Exchange Rates 2-a. Real Interest Rates 1. We should consider real interest rates, not nominal interest rate. 2. Fisher effect: real interest rate = nominal interest rate – inflation i. Higher interest rates attract foreign capital and cause the exchange rate to rise. ii. The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others. C. Factors That Influence Exchange Rates 3. Relative Income Level When US’ income level increases, while GB’s does not, then the demand of £ increases and the supply of £ is unchanged. The new £ price at equilibrium is $1.60/£. a. US income increases demand of foreign products increases demand of £ increases demand line shifts outward. b. US income increases GB is unaffected GB’s supply of £ is unaffected supply line is unaffected. c. The new set of supply and demand lines cross at new equilibrium. This is the new currency price. d. £ appreciate and $ depreciate (surprising?) Discussion: When GB’s income level increases, what will happen? C. Factors That Influence Exchange Rates Governments influence the equilibrium exchange rate in many ways, including 1. imposing foreign exchange barriers, 2. imposing foreign trade barriers, 3. intervening (buying and selling currencies) in the foreign exchange markets, 4. affecting macro variables such as inflation, interest rates, and income levels. D. Government Controls (chapter 6) 1. The Role of Information a. Impact of Signals on Currency Speculation 1.) commonly driven by signals of future interest rate movements 2.) by other factors such as signals of the future economic conditions that affect exchange rates E. Expectations Current-account deficits ◦ Current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends. ◦ Current account deficit shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. ◦ The country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. ◦ The excess demand for foreign currency lowers the country's exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests. F – Supplemental factors Public debt: ◦ Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. ◦ While such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors. ◦ The reason? A large debt encourages inflation, and if inflation is high, the debt will ultimately be paid off with cheaper real dollars in the future. ◦ In the worst case scenario, a government may print money to pay part of a large debt, but increasing the money supply inevitably causes inflation. F – Supplemental factors Political stability and economic performance: ◦ Foreign investors inevitably seek out stable countries with strong economic performance in which to invest their capital. ◦ A country with such positive attributes will draw investment funds away from other countries perceived to have more political and economic risk. ◦ Political turmoil, for example, can cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries. F – Supplemental factors 2. Interaction of Factors Many commercial banks attempt to capitalize on their forecasts of anticipated exchange rate movements in the foreign exchange market F. Speculating on Anticipated Exchange Rates Chicago bank expects the exchange rate of the NZ$ to appreciate from $0.50 to $0.52 in 30 days. Chicago bank can borrow $20m on a short term basis. Currency $ NZ$ Lending Rate Borrowing rate 6.72% 6.48% 7.20% 6.96% Question 1: If Chicago bank anticipate NZ$ to appreciate, how shall it trade? Question 2: If Chicago bank anticipate NZ$ to depreciate, how shall it trade? Example on page 95 Answer: ◦ NZ$ will appreciate, so you should buy NZ$ now and sell later. Borrow $ convert to NZ$ today lend it for 30 days convert to $ 30 days later payback the $ loan. ◦ Convert the borrowed $ to NZ$ today. So your NZ$ worth: $20m / 0.50 $/NZ$=40m NZ$. ◦ Lend NZ$ for 6.48% * 30/360=0.54% and get 40m NZ$ *(1+0.54%)=40,216,000 NZ$ 30 days later. ◦ Your borrowed $20m should be paid back for 20m *(1+7.2%* 30/360)=$20.12m. This equals to $20.12m / 0.52 $/NZ$=NZ$ 38,692,308. ◦ So the profit is: 40,206000-38,692,308 = NZ$1,523,692. Your $ profit is: NZ$1,523,692 *0.52$/NZ$=$792,320. Homework (page 98 – 100) Questions 1,2,3,4,6,7,9,10, 12, 13,15,16,20, 23. 20. Speculation. Blue Demon Bank expects that the Mexican peso will depreciate against the dollar from its spot rate of $.15 to $.14 in 10 days. The following interbank lending and borrowing rates exist: Lending Rate U.S. dollar 8.0% 8.3% Mexican peso 8.5% 8.7% Borrowing Rate Assume that Blue Demon Bank has a borrowing capacity of either $10 million or 70 million pesos in the interbank market, depending on which currency it wants to borrow. a. How could Blue Demon Bank attempt to capitalize on its expectations without using deposited funds? Estimate the profits that could be generated from this strategy. b. Assume all the preceding information with this exception: Blue Demon Bank expects the peso to appreciate from its present spot rate of $.15 to $.17 in 30 days. How could it attempt to capitalize on its expectations without using deposited funds? Estimate the profits that could be generated from this strategy. 21. Speculation. Diamond Bank expects that the Singapore dollar will depreciate against the dollar from its spot rate of $.43 to $.42 in 60 days. The following interbank lending and borrowing rates exist: Lending Rate Borrowing Rate U.S. dollar 7.0% 7.2% Singapore dollar 22.0% 24.0% Diamond Bank considers borrowing 10 million Singapore dollars in the interbank market and investing the funds in dollars for 60 days. Estimate the profits (or losses) that could be earned from this strategy. Should Diamond Bank pursue this strategy? Q23: Assessing the Euro’s Potential Movements. You reside in the U.S. and are planning to make a one-year investment in Germany during the next year. Since the investment is denominated in euros, you want to forecast how the euro’s value may change against the dollar over the one-year period. You expect that Germany will experience an inflation rate of 1% during the next year, while all other European countries will experience an inflation rate of 8% over the next year. You expect that the U.S. will experience an annual inflation rate of 2% during the next year. You believe that the primary factor that affects any exchange rate is the inflation rate. Based on the information provided in this question, will the euro appreciate, depreciate, or stay at about the same level against the dollar over the next year? Explain. 24. Weighing Factors That Affect Exchange Rates. Assume that the level of capital flows between the U.S. and the country of Zeus is negligible (close to zero) and will continue to be negligible. There is a substantial amount of trade between the U.S. and the country of Zeus. The main import by the U.S. is basic clothing purchased by U.S. retail stores from Zeus, while the main import by Zeus is special computer chips that are only made in the U.S. and are needed by many manufacturers in Zeus. Suddenly, the U.S. government decides to impose a 20% tax on the clothing imports. The Zeus government immediately retaliates by imposing a 20% tax on the computer chip imports. Second, the Zeus government immediately imposes a 60% tax on any interest income that would be earned by Zeus investors if they buy U.S. securities. Third, the Zeus central bank raises its local interest rates so that they are now higher than interest rates in the U.S. Do you think the currency of Zeus (called the zee) will appreciate or depreciate against the dollar as a result of all the government actions described above? Explain. 16. Impact of September 11. The terrorist attacks on the U.S. on September 11, 2001 were expected to weaken U.S. economic conditions, and reduce U.S. interest rates. How do you think the weaker U.S. economic conditions would affect trade flows? How would this have affected the value of the dollar (holding other factors constant)? How do you think the lower U.S. interest rates would have affected the value of the U.S. dollar (holding other factors constant)? 15.Impact of Crises. Why do you think most crises in countries (such as the Asian crisis) cause the local currency to weaken abruptly? Is it because of trade or capital flows?