Chapter 4
Exchange Rate Determination
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Chapter Objectives
• Explain how exchange rate movements are measured.
• Explain how the equilibrium exchange rate is determined.
• Examine factors that determine the equilibrium exchange rate.
• Explain the movement in cross exchange rates.
• Explain how financial institutions attempt to capitalize on anticipated
exchange rate movements.
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Measuring Exchange Rate Movements
Depreciation: decline in a currency’s value
Appreciation: increase in a currency’s value
Comparing foreign currency spot rates over two points in time, S and St − 1
S - St -1
Percent D in foreign currency value =
St -1
A positive percent change indicates that the currency has appreciated. A
negative percent change indicates that it has depreciated. (Exhibit 4.1)
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Exhibit 4.1 How Exchange Rate Movements and
Volatility Are Measured
Value of Canadian Monthly % Change Monthly %
Dollar (C$) in C$ Value of Euro Change in Euro
Jan. 1 $0.70 — $1.18 —
Feb. 1 $0.71 +1.43% $1.16 −1.69%
March 1 $0.70 −0.99% $1.15 −0.86%
April 1 $0.70 −0.85% $1.12 −2.61%
May 1 $0.69 −0.72% $1.11 −0.89%
June 1 $0.70 +043% $1.14 +2.70%
July 1 $0.69 −1.29% $1.17 +2.63%
Standard deviation 1.04% 2.31%
of monthly changes
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Exhibit 4.2 Demand Schedule for British Pounds
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Exhibit 4.3 Supply Schedule of British Pounds for Sale
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Exhibit 4.4 Equilibrium Exchange Rate Determination
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Factors That Influence Exchange Rates (1 of 5)
The equilibrium exchange rate will change over time as supply and demand
schedules change.
e = f (ΔINF , ΔINT, ΔINC, ΔGC , ΔEXP)
where
e = percentage change in the spot rate
ΔINF = change in the differential between U. S . inflation and the foreign
country's inflation
ΔINT = change in the differential between the U.S. interest rate and the
foreign country's interest rate
ΔINC = change in the differential between the U.S. income level and the
foreign country's income level
ΔGC = change in government controls
ΔEXP = change in expectations of future exchange rates
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Exhibit 4.5 Impact of Rising U.S. Inflation on the
Equilibrium Value of the British Pound
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Exhibit 4.6 Impact of Rising U.S. Interest Rates on
the Equilibrium Value of the British Pound
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Exhibit 4.7 Impact of Rising U.S. Income Levels on
Equilibrium Value of the British Pound
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Factors That Influence Exchange Rates (3 of 5)
Government Controls via:
• Imposing foreign exchange barriers
• Imposing foreign trade barriers
• Intervening in foreign exchange markets
• Affecting macro variables such as inflation, interest rates, and income levels
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Factors That Influence Exchange Rates (4 of 5)
Expectations:
• Impact of favorable expectations: If investors expect interest rates in one
country to rise, they may invest in that country, leading to a rise in the
demand for foreign currency and an increase in the exchange rate for foreign
currency.
• Impact of unfavorable expectations: Speculators can place downward
pressure on a currency when they expect it to depreciate.
• Impact of signals on currency speculation: Speculators may overreact to
signals, causing currency to be temporarily overvalued or undervalued.
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Ex 4.8 Summary of How Factors Affect Exchange Rates
Interaction of Factors: Some factors place upward pressure while other factors place downward pressure
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Factors That Influence Exchange Rates (5 of 5)
Influence of Factors across Multiple Currency Markets: common for
European currencies to move in the same direction against the dollar.
Influence of Liquidity on Exchange Rate adjustment: If a currency’s spot
market is liquid then its exchange rate will not be highly sensitive to a single
large purchase or sale.
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Movements in Cross Exchange Rates (1 of 2)
If currencies A and B move in same direction, there is no change in the cross
exchange rate.
When currency A appreciates against the dollar by a greater (smaller) degree
than currency B, then currency A appreciates (depreciates) against B.
When currency A appreciates (depreciates) against the dollar, while currency B
is unchanged against the dollar, currency A appreciates (depreciates) against
currency B by the same degree as it appreciates (depreciates) against the
dollar.
Explaining Movements in Cross Exchange Rate.
• Changes are affected in the same way as types of forces explained earlier for
those that affect demand and supply conditions between two currencies.
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Exhibit 4.9 Example of How Forces Affect the Cross
Exchange Rate (1 of 2)
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Exhibit 4.9 Example of How Forces Affect the
Cross Exchange Rate (2 of 2)
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Capitalizing on Expected Exchange Rate Movements (1 of 2)
Institutional speculation based on expected appreciation: When financial
institutions believe that a currency is valued lower than it should be in the
foreign exchange market, they may invest in that currency before it
appreciates.
Institutional speculation based on expected depreciation: If financial
institutions believe that a currency is valued higher than it should be in the
foreign exchange market, they may borrow funds in that currency and convert it
to their local currency now before the currency’s value declines to its proper
level.
Speculation by individuals: Individuals can speculate in foreign currencies.
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Capitalizing on Expected Exchange Rate Movements (2 of 2)
The “Carry Trade” — Where investors attempt to capitalize on the differential
in interest rates between two countries.
• Impact of appreciation in the investment currency: Increased trade
volume can have a major influence on exchange rate movements over a
short period.
• Risk of the Carry Trade: Exchange rates may move opposite to what the
investors expected.
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copied or duplicated, or posted to a publicly accessible website, in whole or in part.
End
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