are measured; • To explain how the equilibrium exchange rate is determined; and • To examine the factors that affect the equilibrium exchange rate. Measuring Exchange Rate Movements • 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. • On the days when some currencies appreciate while others depreciate against the dollar, the dollar is said to be “mixed in trading.” Measuring Exchange Rate Movements • The percentage change (% 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 % represents appreciation of the foreign currency, while a negative % represents depreciation. Fluctuation of the British Pound Over Time Approximate £ that could be Approximate Approximate Purchased with Spot Rate of £ Annual % $10,000 $ 1.80 20 % £ 7000 1.75 15 6800 1.70 10 6600 1.65 5 6400 1.60 0 6200 1.55 -5 1.50 -10 6000 1.45 -15 5800 1.40 -20 5600 1992 1996 2000 1992 1996 2000 1992 1996 2000 Online Application
• For the latest exchange rates, visit:
¤ http://www.bloomberg.com/ ¤ http://finance.yahoo.com/ ¤ http://money.cnn.com/ ¤ http://www.reuters.com/ Exchange Rate Equilibrium • An exchange rate represents the price of a currency, which is determined by the demand for that currency relative to the supply for that currency.
Value of £ S: Supply of £ $1.60 $1.55 equilibrium exchange rate $1.50 D: Demand for £
Quantity of £ Factors that Influence Exchange Rates Relative Inflation Rates
$/£ U.S. inflation S1 U.S. demand for S0 r1 British goods, and r0 hence £. D1 British desire for U.S. D0 goods, and hence the Quantity of £ supply of £. Factors that Influence Exchange Rates Relative Interest Rates
$/£ U.S. interest rates S0 U.S. demand for S1 r0 British bank deposits, r1 and hence £. D0 British desire for U.S. D1 bank deposits, and Quantity of £ hence the supply of £. Factors that Influence Exchange Rates Relative Interest Rates • A relatively high interest rate may actually reflect expectations of relatively high inflation, which discourages foreign investment. • It is thus useful to consider real interest rates, which adjust the nominal interest rates for inflation. Factors that Influence Exchange Rates Relative Interest Rates • real nominal interest interest – inflation rate rate rate • This relationship is sometimes called the Fisher effect. Factors that Influence Exchange Rates Relative Income Levels
$/£ U.S. income level U.S. demand for S0 ,S1 British goods, and r1 r0 hence £. D1 No expected change for D0 the supply of £. Quantity of £ Factors that Influence Exchange Rates 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. Factors that Influence Exchange Rates Expectations • Foreign exchange markets react to any news that may have a future effect. • Institutional investors often take currency positions based on anticipated interest rate movements in various countries. • Because of speculative transactions, foreign exchange rates can be very volatile. Factors that Influence Exchange Rates Expectations Signal Impact on $ Poor U.S. economic indicators Weakened Fed chairman suggests Fed is Strengthened unlikely to cut U.S. interest rates A possible decline in German Strengthened interest rates Central banks expected to Weakened intervene to boost the euro Factors that Influence Exchange Rates Interaction of Factors • Trade-related factors and financial factors sometimes interact. Exchange rate movements may be simultaneously affected by these factors. • For example, an increase in the level of income sometimes causes expectations of higher interest rates. Factors that Influence Exchange Rates Interaction of Factors • Over a particular period, different factors may place opposing pressures on the value of a foreign currency. • The sensitivity of the exchange rate to these factors is dependent on the volume of international transactions between the two countries. How Factors Can Affect Exchange Rates Trade-Related Factors U.S. demand for foreign 1. Inflation goods, i.e. demand for Differential foreign currency 2. Income Differential Foreign demand for U.S. 3. Gov’t Trade goods, i.e. supply of Exchange Restrictions foreign currency rate between foreign Financial U.S. demand for foreign currency Factors securities, i.e. demand and the 1. Interest Rate for foreign currency dollar Differential Foreign demand for U.S. 2. Capital Flow securities, i.e. supply of Restrictions foreign currency Factors that Influence Exchange Rates How Factors Have Influenced Exchange Rates • Because the dollar’s value changes by different magnitudes relative to each foreign currency, analysts often measure the dollar’s strength with an index. • The weight assigned to each currency is determined by its relative importance in international trade and/or finance. Value of Foreign Currency Index Over Time With Respect to the Dollar large Higher 250 $ due to balance Persian U.S. strengthens $ weakens
relatively high of trade Gulf War interest
200 U.S. inflation deficit rates & growth 150 U.S. interest rates 100 high U.S. relatively high U.S. interest rates, a interest rates, & 50 somewhat depressed lower balance of U.S. economy, & low trade deficit inflation 0 1972 1976 1980 1984 1988 1992 1996 2000
Note: The index reflects equal weights of £, ¥, French franc, German mark, and Swiss franc. Online Application
• Exchange rate releases and historical data
may be found at the Federal Reserve website http://www.federalreserve.gov/. MONETARY COUNTRY UNIT Oct. 1 Oct. 2 Oct. 3 Oct. 4 Oct. 5 *AUSTRALIA DOLLAR 0.4923 0.4953 0.4971 0.4975 0.5060 BRAZIL REAL 2.6870 2.7000 2.7290 2.7290 2.7540 CANADA DOLLAR 1.5794 1.5696 1.5688 1.5680 1.5626 CHINA, P.R. YUAN 8.2768 8.2768 8.2768 8.2768 8.2768 DENMARK KRONE 8.1151 8.1267 8.0968 8.1339 8.1115 *EMU MEMBERS EURO 0.9159 0.9149 0.9181 0.9141 0.9168 DOLLAR 7.7992 7.7993 7.7995 7.7998 7.7999 RUPEE 48.03 48.03 47.96 48.04 48.05 YEN 120.27 120.78 120.67 120.63 120.37 .8003 3.8003 3.8005 Speculating on Anticipated Exchange Rates Chicago Bank expects the exchange rate of the New Zealand dollar to appreciate from its present level of $0.50 to $0.52 in 30 days.
Borrows at 7.20% for 30 days 1. Borrows 4. Holds $20 million $20,912,320 Returns $20,120,000 Profit of $792,320 Exchange at Exchange at $0.50/NZ$ $0.52/NZ$ Lends at 6.48% 2. Holds for 30 days 3. Receives NZ$40 million NZ$40,216,000 Speculating on Anticipated Exchange Rates Chicago Bank expects the exchange rate of the New Zealand dollar to depreciate from its present level of $0.50 to $0.48 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 Exchange at $0.50/NZ$ $0.48/NZ$ Lends at 6.72% 2. Holds for 30 days 3. Receives $20 million $20,112,000 Impact of Exchange Rates on an MNC’s Value
Inflation Rates, Interest Rates,
Income Levels, Government Controls, Expectations
m n E CFj , t E ER j , t j 1 Value = t =1 1 k t E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at Online Application
