CHAPTER 4: Exchange Rate Behavior

The specific objectives of this chapter are to:

■ Describe the exchange rate systems used by various governments;
■ Explain how government intervention in the foreign exchange market
can affect economic conditions;
■ explain the conditions that will result in various forms of international
arbitrage;
■ explain the concept of interest rate parity and how it prevents
arbitrage opportunities
■ explain the concept of purchasing power parity and its implications
for exchange rates

The Exchange Rate Systems (According to the degree which they are controlled by
the Government)
1. Fixed Exchange Rate

Exchange rates are either held constant or allowed to fluctuate only within
very narrow boundaries. A fixed exchange rate would be beneficial to a
country for the following reasons. First, exporters and importers could engage
in international trade without concern about exchange rate movements of the
currency to which their local currency is linked. Any firms that accept the
foreign currency as payment would be insulated from the risk that the
currency could depreciate over time. In addition, any firms that need to obtain
that foreign currency in the future would be insulated from the risk of the
currency appreciating over time. Another benefit is that firms could engage in
direct foreign investment, without concern about exchange rate movements of
that currency. They would be able to convert their foreign currency earnings
into their home currency without concern that the foreign currency
denominating their earnings might weaken over time. Thus, the management
of an MNC would be much easier

If an exchange rate begins to move too much, governments intervene to

maintain it within the boundaries. In some situations, a government will
devalue or reduce the value of its currency against other currencies. In other
situations, it will revalue or increase the value of its currency against other
currencies. A central bank’s actions to devalue a currency in a fixed exchange
rate system is referred to as devaluation.

Devaluation refers to a downward adjustment of the exchange rate by the

central bank. Conversely, revaluation refers to an upward adjustment of the
exchange rate by the central
Bank.

2. Freely Floating Exchange Rate

 Exchange rate values are determined by market forces without
intervention by governments. Whereas a fixed exchange rate system
allows no flexibility for exchange rate movements, a freely floating exchange rate
system allows complete flexibility. A freely floating exchange rate adjusts on a
continual basis in response to demand and supply conditions for that currency.

3. Managed Float Exchange Rate

The exchange rate system that exists today for some currencies lies
somewhere between fixed and freely floating. It resembles the freely floating
system in that exchange rates are allowed to fluctuate on a daily basis and there
are no official boundaries. It is similar to the fixed rate system in that
governments can and sometimes do intervene to prevent their currencies from
moving too far in a certain direction. This type of system is known as a managed
float or “dirty” float (as opposed to a “clean” float where rates float freely
without government intervention)

4. Pegged Exchange Rate

Home currency’s value is pegged to a foreign currency or to some unit of
account. While the home currency’s value is fixed in terms of the foreign currency
(or unit of account) to which it is pegged, it moves in line with that currency
against other currencies.
Some governments peg their currency’s value to that of a stable currency,
such as the dollar, because that forces the value of their currency to be stable.
First, this forces their currency’s exchange rate with the dollar to be fixed.
Second, their currency will move against nondollar currencies by the same
degree as the dollar. Since the dollar is more stable than most currencies, it will
make their currency more stable than most currencies.
Examples of Exchange Rate Arrangements of Foreign Countries
 GOVERNMENT INTERVENTION
• Each country has a central bank that may intervene in the foreign exchange
markets to control its currency’s value. In the Philippines, we have the
“Bangko Sentral ng Pilipinas”, in US they have the “Federal Reserve System”.

Reasons for Government Intervention:

1. To smooth exchange rate movements
2. To establish implicit exchange rate boundaries
3. To respond to temporary disturbances

Smooth Exchange Rate Movements. If a central bank is concerned that its economy
will be affected by abrupt movements in its home currency’s value, it may attempt to
smooth the currency movements over time. Its actions may keep business cycles less
volatile. The central bank may also encourage international trade by reducing exchange
rate uncertainty. Furthermore, smoothing currency movements may reduce fears in the
financial markets and speculative activity that could cause a major decline in a
currency’s value.
Establish Implicit Exchange Rate Boundaries. Some central banks attempt to
maintain their home currency rates within some unofficial, or implicit, boundaries.
Analysts are commonly quoted as forecasting that a currency will not fall below or rise
above a particular benchmark value because the central bank would intervene to
prevent that. The Federal Reserve periodically intervenes to reverse the U.S. dollar’s
upward or downward momentum.
Respond to Temporary Disturbances. In some cases, a central bank may intervene
to insulate a currency’s value from a temporary disturbance. In fact, the stated objective
of the Fed’s intervention policy is to counter disorderly market conditions.

Government Adjustment of Interest Rates

When countries experience substantial net outflows of funds (which places
severe downward pressure on their currency), they commonly intervene indirectly by
raising interest rates to discourage excessive outflows of funds and therefore limit any
downward pressure on the value of their currency. However, this strategy adversely
affects local borrowers (government agencies, corporations, and consumers) and may
weaken the economy.

Summary of Impact of Government Intervention

Exercises:
1. Compare and contrast the fixed, freely floating, and managed float exchange rate
systems. What are some advantages and disadvantages of a freely floating
exchange rate system versus a fixed exchange rate system?
 2. What is the impact of a weak home currency on the home economy, other things
being equal? What is the impact of a strong home currency on the home
economy, other things being equal?

International Arbitrage
• capitalizing on a discrepancy in quoted prices by making a riskless profit.

Illustration:

Two coin shops buy and sell coins. If Shop A is willing to sell a particular coin for $120,
while Shop B is willing to buy that same coin for $130, a person can execute arbitrage by purchasing
the coin at Shop A for $120 and selling it to Shop B for $130. The prices at coin shops can vary
because demand conditions may vary among shop locations. If two coin shops are not aware of each
other’s prices, the opportunity for arbitrage may occur.

The act of arbitrage will cause prices to realign. In our example, arbitrage would
cause Shop A to raise its price (due to high demand for the coin). At the same time,
Shop B would reduce its bid price after receiving a surplus of coins as arbitrage occurs.

Triangular Arbitrage:
Cross exchange rates represent the relationship between two currencies that are
different from one’s base currency. In the United States, the term cross exchange rate
refers to the relationship between two nondollar currencies.

Illustration:

If the British pound (£) is worth $1.60, while the Canadian dollar (C$) is worth $.80, the
value of the British pound with respect to the Canadian dollar is calculated as follows:

Value of £ in units of C$ = $1.60/$.80 = 2.0

The value of the Canadian dollar in units of pounds can also be determined from the cross-
exchange rate formula:

Value of C$ in units of £ = $.80/$1.60 = .50

Notice that the value of a Canadian dollar in units of pounds is simply the reciprocal of the
value of a pound in units of Canadian dollars.

Exercise:
Quoted Price
Value of Canadian dollar in U.S. dollars $.90
Value of New Zealand dollar in U.S. dollars $.30
Value of Canadian dollar in New Zealand dollars NZ$3.02

Given this information, is triangular arbitrage possible? If so, explain the steps that
would reflect triangular arbitrage, and compute the profit from this strategy if you had $1
million to use?

Interest Rate Parity (IRP)

Once market forces cause interest rates and exchange rates to adjust such that
covered interest arbitrage is no longer feasible, there is an equilibrium state referred to
as interest rate parity (IRP). In equilibrium, the forward rate differs from the spot rate
by a sufficient amount to offset the interest rate differential between two currencies.

The interest rate parity (IRP) is a theory regarding the relationship between the
spot exchange rate and the expected spot rate or forward exchange rate of two
currencies, based on interest rates. The theory holds that the forward exchange rate
should be equal to the spot currency exchange rate times the interest rate of the home
country, divided by the interest rate of the foreign country.
As with many other theories, the equation can be rearranged to solve for any
single component of the equation to draw different inferences. If IRP holds true, then
you should not be able to create a profit simply by borrowing money, exchanging it into
a foreign currency, and exchanging it back to your home currency at a later date.

Derivation of Interest Rate Parity:

The investor’s return from using covered interest arbitrage can be determined given the
following:

• Amount of home currency initially invested .

• The spot rate (S) in dollars when the foreign currency is purchased
• The interest rate on the foreign deposit
• The forward rate (F) in dollars at which the foreign currency will be converted
back to U.S. dollars

The amount of the home currency received at the end of the deposit period due to such
a strategy (called ) is:

Since F is simply S times one plus the forward premium (called p), we can rewrite this
equation as:
The rate of return from this investment (called R) is as follows

If IRP exists, then the rate of return achieved from covered interest arbitrage (R) should
be equal to the rate available in the home country. Set the rate that can be achieved
from using covered interest arbitrage equal to the rate that can be achieved from an
investment in the home country (the return on a home investment is simply the home
interest rate called ):

By substituting into the formula the way in which R is determined, we obtain:

By rearranging terms, we can determine what the forward premium of the foreign
currency should be under conditions of IRP:

Thus, given the two interest rates of concern, the forward rate under conditions of IRP
can be derived. If the actual forward rate is different from this derived forward rate, there
may be potential for covered interest arbitrage.

Determination of Forward Premium

Illustration:

Assume that the Mexican peso exhibits a 6-month interest rate of 6 percent, while the U.S.
dollar exhibits a 6-month interest rate of 5 percent. From a U.S. investor’s perspective, the U.S.
dollar is the home currency. According to IRP, the forward rate premium of the peso with respect to
the U.S. dollar should be:
Thus, the peso should exhibit a forward discount of about .94 percent. This implies that U.S.
investors would receive .94 percent less when selling pesos 6 months from now (based on a forward
sale) than the price they pay for pesos today at the spot rate. Such a discount would offset the interest
rate advantage of the peso. If the peso’s spot rate is $.10, a forward discount of .94 percent means
that the 6-month forward rate is as follows:

Implication: If the forward premium is equal to the interest rate differential as explained
above, covered interest arbitrage will not be feasible.

Illustration:

Use the information on the spot rate, the 6-month forward rate of the peso, and Mexico’s interest rate
from the preceding example to determine a U.S. investor’s return from using covered interest
arbitrage. Assume the investor begins with $1,000,000 to invest.

Step 1. On the first day, the U.S. investor converts $1,000,000 into Mexican pesos (MXP) at $.10
per peso:

$1,000,000/$.10 per peso = MXP10,000,000

Step 2. On the first day, the U.S. investor also sells pesos 6 months forward. The number of pesos to
be sold forward is the anticipated accumulation of pesos over the 6-month period, which is estimated
as:

MXP10,000,000 = (1 + .06) = MXP10,600,000

Step 3. After 6 months, the U.S. investor withdraws the initial deposit of pesos along with the
accumulated interest, amounting to a total of 10,600,000 pesos. The investor converts the pesos into
dollars in accordance with the forward contract agreed upon 6 months earlier. The forward rate was
$.09906, so the number of U.S. dollars received from the conversion is:

MXP10,600,000 x ($.09906 per peso) = $1,050,036

In this case, the investor’s covered interest arbitrage achieves a return of about 5 percent. Rounding
the forward discount to .94 percent causes the slight deviation from the 5 percent return. The results
suggest that, in this instance, using covered interest arbitrage generates a return that is about what
the investor would have received anyway by simply investing the funds domestically. This confirms
that covered interest arbitrage is not worthwhile if IRP exists.

Exercises:
Problem 1: Suppose that the current exchange rate, or spot exchange rate, between
the US and another country is $1.2544/1.00. Suppose that the US has an interest rate
of 4% and the second country has a rate of 2%. Compute for the forward exchange
rate.

Problem 2: You are provided with the following details

Calculate the forward exchange rate as per the interest rate parity concept.

Problem 3:
Spot rate of Mexican peso = $.100
180-day forward rate of Mexican peso = $.098
180-day Mexican interest rate = 6%
180-day U.S. interest rate = 5%
Given this information, is covered interest arbitrage worthwhile for Mexican investors
who have pesos to invest? Explain your answer.

Purchasing Power Parity (PPP)

When the law of one price is applied internationally to a standard commodity basket, we
obtain the theory of purchasing power parity (PPP). This theory states that the
exchange rate between currencies of two countries should be equal to the ratio of the
countries' price levels.
The concept of Purchasing Power Parity (PPP) is a tool used to make multilateral
comparisons between the national incomes and living standards of different countries.
Purchasing power is measured by the price of a specified basket of goods and services.
Thus, parity between two countries implies that a unit of currency in one country will buy
the same basket of goods and services in the other, taking into consideration price
levels in both countries.
A PPP ratio measures deviation from the condition of parity between two countries and
represents the total number of the baskets of goods and services that a single unit of a
country’s currency can buy.
The exchange rate between two currencies should equal the ratio of the countries’ price
levels.
When the country’s inflation rises, the demand of its currency and exports declineand
consumers and firms increase imports. Both of these forces place downward pressure
on high inflation country’s currency. The purchasing power parity (PPP) theory attempts
to quantify the inflation exchange rate relationship.
There are two popular techniques:
• Absolute PPP that states that similar products in different countries should be priced
equally when measured in common currency.
• Relative PPP that accounts for imperfections like transportation costs, tariffs and
quotas. It states that the rate of price changes should be similar.