Chapter 2

Exchange Rate Determination

JEFF MADURA. International Financial Management.

Cengage Learning (11th edition). 2012
 Before we start some
concepts to contextualize
 The exchange rate CONCEPTS
An exchange rate (reference currency).
$1.09/ 1.09$/ 1=1.09$
1/1.09 = 0.92/$

Spot rate (immediate delivery) vs. forward rate (delivery in a

specified future date)
Free floating exchange rate (depreciation and appreciation)

Foreign exchange market intervention (devaluation and

revaluation in a fixed exchange rate)

Bid rate (to buy) and ask rate (to sell)

Dealers benefit from the spread (buying low and selling high)
 The exchange rate

Factors that affect the equilibrium exchange rate

Relative inflation rates (PPP P1 * e = P2)
Relative interest rates
Relative economic growth rates
Political and economic risks
 The exchange rate
Short position:
Selling securities or other financial instruments that are not currently
owned, and subsequently repurchasing them ("covering").

Long position
Buying securities or other financial instruments

Traders or fund managers may hedge a long

position or a portfolio through one or more short
positions.
 Examples
1. A farmer who has just planted his corn wants to lock in the price at
which he can sell after the harvest.
He would take a short position in corn futures.

2. A market maker in corporate bonds is constantly trading bonds

when clients want to buy or sell. This can create substantial bond
positions. The largest risk is that interest rates overall move. The
trader can hedge this risk by
selling government bonds short against his long positions in corporate
bonds. In this way, the risk that remains is credit risk of the corporate
bonds.
Lets start
 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.

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
 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.

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
 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.

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
 Measuring Exchange Rate
Movements (2)
Relativeness
E.g. e0= 1.5/$ (1$=1.5) e1 = 1.4 /$

dollar depreciates against euro

(e1 e0 )/e0 = (1.4-1.5)/1.5) = -6.6%

euro appreciates against dollar

(e0 e1 )/e1 = (1.5-1.4)/1.4) = 7.1%%

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
Calculating the exchange rate
If the /$ exchange rate goes
from 1 = $0.93 to 1 = 0.99,
calculate the euro appreciation or depreciation?
 During 1995, the yen went from $0.0125 to $0.0095238. By how
much did the yen depreciate against the dollar (vice versa)?

On July 2, 1997, the Thai baht fell 17% against the dollar. By how
much has the dollar appreciated against the baht?

April 1,1998, was an ill-fated date in Yugoslavia. On that day, the

government devalued the Yugoslav dinar, setting its new rate in
10.92 dinar to the dollar, from 6. By how much has the dinar
devalued against the dollar?
 Factors that Influence
Exchange Rates (1)
e f DINF , DINT , DINC , DGC , DEXP )

e = percentage change in the spot rate

DINF = change in the relative inflation rate
D INT = change in the relative interest rate
DINC = change in the relative income level
DGC = change in government controls
DEXP = change in expectations of future
exchange rates
For use with International Financial Management, 3e
Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
 Foreign exchange market

Sterling market
$
S0 Supply of = Demand for $

r0

D0 Demand for = Supply of $

Quantity of

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
 Factors that Influence
Exchange Rates (2)
Relative Inflation Rates
U.S. inflation
U.S. demand for
$ S1 British goods, and
S0
r1 hence .
r0
D1 British desire for U.S.
D0
goods, and hence the
Quantity of supply of .
For use with International Financial Management, 3e
Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
 Factors that Influence
Exchange Rates (2)
Relative Inflation Rates
U.S. inflation
$ S1 Imp US goods D$ S
S0
r1 Exp UK goods D S$
r0
D1
D0

Quantity of

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
 Factors that Influence
Exchange Rates (2)
Relative Inflation Rates
U.S. inflation
Depreciation of the dollar
$ S1 relative to the pound or 7
S0 Appreciation of the pound
r1 relative to the dollar
r0
D1
From r0 to r1 (appreciation of pound)
D0
Note : to hold PPP
Quantity of P$ = e$/* P Big Mac: 2$ = 1.33*1.5

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
 Factors that Influence
Exchange Rates (3)
Relative Interest Rates
U.S. interest rates
$ S0 U.S. demand for British
S1 bank deposits, and hence .
r0
r1
D0 British desire for U.S. bank
D1 deposits, and hence the
supply of .
Quantity of

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
 Factors that Influence
Exchange Rates (2)
Relative Interest Rates
U.S. interest rates
$
S0 Invest US deposits D$ S
S1
r0 Invest UK deposits D S$
r1
D0
D1

Quantity of

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
 Factors that Influence
Exchange Rates (3)
Relative Interest Rates

U.S. interest rates

$
S0 Depreciation of the pound
S1 relative to the dollar
r0 Appreciation of the dollar
r1 relative to the pound
D0
D1
From r0 to r1 (depreciation of pound)
Quantity of

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
 Factors that Influence
Exchange Rates (4)
Relative Interest Rates
Countereffect
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.

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
 Factors that Influence
Exchange Rates (5)
Relative Interest Rates
real nominal
interest interest inflation rate
rate rate

Nominal = real + inflation

8% = 3% + 5%
10% = 3% + 7%

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
 Country A Country B comment
Time 1% 1% No reason for there
to be a difference
preference
+ Risk 1% 1% We choose
investments in each
country that have
low risk
= Real rate 2% 2% Real rates should
be the same
+ inflation 4% 2% Different economic
policies are
inevitable
= interest rate 7% 5% The difference in
inflation rates
explains the
difference in
interest rates!
 Factors that Influence
Exchange Rates (6)
Relative Income Levels
U.S. income level
$ U.S. demand for
S ,S1 British goods, and
r1 0
hence . D
r0
D1
D0 No expected change for
the supply of .
Quantity of

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
 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.

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
 Factors that Influence
Exchange Rates (7)
Government Controls

Example
Suppose US real interest rates rose relative to the
pound
That would increase D$ and increase S

If the UK places a heavy tax on interest of income

earned from foreign investments Discourage
exchange of pounds for dollars

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
 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.

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
 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.

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
 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.

Increase US income level S$ depreciation $

expectations higher r D$ S$ appreciation $

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
 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

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
 Central Bank
A central bank is the nations official monetary authority
Objectives: price stability, low interest rate or a target currency
value

Central bank independence = price stability and low

inflation rate

Central bank lack of independence = monetize the deficit

 Central Bank independence,
inflation and economic growth
 Currency boards
Not a central bank
Currency board issues notes and coins convertible on
demand and at a fixed rate into foreign currency
(normally US dollar),.
It provides an anchor to local currency (similar to
previous gold standard)
Not printing of notes allowed
Besides price stability, it also compels government to
follow a responsible fiscal policy.

E.G Argentinian peso (until it collapsed in 2002)

 Dollarization
Dollarization is the complete replacement of the local
currency with the US dollar

Panama (since 1904, annual inflation 1.7% for the past

30 years)

Ecuador (plunging currency, accelerating capital flight, a

bankrupt banking system, huge budget deficits) :
January 9, 2000 (25,000 sucres / $)

Disadvantages: the lost of seignorage

 Exchange rate arrangements
Central bank policies
Currency boards
Dollarization

These arrangements cannot substitute good

macroeconomic policies:
Examples are the Mexican peso crises, Asian currency
crisis, Argentinian currency board collapse.
 Real exchange rate and
competitiveness
Appreciation of the exchange rate
Depreciation of the exchange rate

Asian currency Crisis (1997)

Currencies attached to the dollar
Good until 1995 $ appreciated (50%) respect the Yen and other
+
The competitiveness of China with a devaluated Yuan

Asian currency crisis

 Asian crisis
From 1990-1997 Asian countries high economic growth
Summer 1997 Asian crisis (IMF bailouts)

Thailand's high growth, high spending, lead to high inflation and to

maintain PPP depreciation. However, the bath was pegged to the
dollar therefore foreign investors could earn high interest rates and be
protected from depreciation.
That provided Thai banks with large capital inflows, more than the could
use for making loans that led to risky loans
The government tried to defend currency peg sterilizing the effect of the
massive inflows
Reducing money supply:
Open-market operations -selling treasury bills- (can backfire
raising interest rates and attracting higher inflows)
Tai bankers were borrowing at 6% in dollars and lending at 12% in bath..
what a money-maker machine so long as the value of the bath relative to
the dollar was constant
Thailand:
- Less competitive (commercially) (as bath pegged to dollar) growing
current account deficit
- High interest rates and high capital inflows, risky investments
- High external debt (tripled from US$29 billion in 1990 to US$94 billion
by mid-1997
- By end of 1996 the bath was considerable appreciated against non-
US currencies activate speculation speculative attacks began
- Rumors about an imminent bath devaluation in response to the large
debt intensified the attack (speculation against the bath)
- Foreign investors short on bath against $, causing serious liquidity
shortage in the domestic money market.
- downward pressure on the bath forward rate.
Authorities still tried to maintain the bath pegged to the dollar:
Increasing interest rates
Long bath positions spending half billion US dollars form reserve to
defend the bath
Finally collapsed on 2 July 1997 the bath was detached from $
On 5 August 1997 $16 billion bailout (IMF, Japan and other
countries)
 Foreign exchange market
intervention

It refers to official purchases and sales of foreign exchange

that nations undertake through their central banks to
influence their currencies
Unsterilized intervention
An increase/decrease in the supply of money

Will sell dollars against euros to devaluate the dollar

Will buy dollars against euros to appreciate the dollar

The central bank as the printer of the currency creates the reserve of dollars to
use on the exchange markets. Increases money supply
 Foreign exchange market
intervention
Sterilize intervention
Open market operation is the sale/purchase of
Treasury securities to neutralize the impact of the
intervention in the foreign exchange market

The selling of $ against + selling of US Treasury bonds

(decreasing back $ supply)
The purchase of $ selling + purchase of US Treasury bonds
(increasing back $ supply)
 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.

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
 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
1. Borrows 21,831,543
20 m
Repays 20,120,000
A profit of 21,831,543 Exchange at
Exchange at 20,120,000 = 1,711,543 0.38/NZ$
0.35/NZ$
Lends at 6.48%
2. Holds for 30 days 3. Receives
NZ$57,142,857 NZ$57,451,428
 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.
Borrows at 6.96%
for 30 days
1. Borrows 4. Holds
NZ$40 million NZ$41,900,000
Returns NZ$40,232,000
Profit of NZ$1,668,000
Exchange at or 800,640 euros Exchange at
0.50 euros/NZ$ 0.48 euros/NZ$
Lends at 6.72%
for 30 days 3. Receives
2. Holds
20 m euros 20,112,000 euros
 Speculating on
Anticipated Exchange Rates
Currency Carry trades:
Between 2 currencies borrow in the weaker currency and invest in
the stronger currency providing that the interest rate difference is
not too adverse

Exchange rates are very volatile, and a poor forecast

can result in a large loss.

One well-known bank failure, Franklin National Bank in

1974, was primarily attributed to massive speculative
losses from foreign currency positions.
 Key points
1. Absent government intervention, exchange rates respond to the forces
of supply and demand, which, in turn, depend on relative inflation rates,
interest rates, and GNP growth rates.

2. Monetary policy is crucial. If the central bank expands the money

supply at a faster rate than money demand, the purchasing power of money
declines both at home (inflation) and abroad (currency depreciation).
PPP P$ * e/$ = P
3. The healthier the economy is, the stronger the currency is likely to be.

4. Exchange rates are crucially affected by expectations of future

exchange rate changes, which depend on forecasts of future economic and
political conditions.
 Key points
5. In order to achieve certain economic or political objectives,
governments often intervene in the currency markets to affect the
exchange rate. Although the mechanics of such intervention vary, the
general purpose of each variant is basically the same:
to increase the market demand for one currency by increasing the market supply
of another.
Alternatively, the government can control the exchange rate directly by setting a
price for its currency and then restricting access to the foreign exchange market.

6. A critical factor which helps explain the volatility of exchange rates is

that with a fiat money (it shall be) there is no anchor to a currency's value
(e.g. gold). Since people are unsure about what to expect, any new piece of
information can dramatically alter their beliefs. Thus, if the underlying
domestic economic policies are unstable, exchange rates will be volatile as
traders react to new information.