Lecture 4

Determining Foreign
Exchange Rates
 Theories of Exchange
• Efficient Exchange Markets
• The Theory of Purchasing Power Parity
• The Fisher Effect
• The International Fisher Effect
• The Theory of Interest-Rate Parity
• The Forward Rate and the Future Spot
Rate
 Foreign Exchange Rates
• There are various ways the prices of foreign
currencies can be determined
– The prices could be fixed
– They may be allowed to vary according to purely
market forces
• Under the flexible exchange rate system, the
determination of exchange rates is a complex
economic phenomenon incorporating
domestic and global economic factors
 Efficient Exchange Markets
• Efficient exchange markets exist when
exchange rates reflect all available
information and adjust quickly to new
information.
• The concept of efficient exchange markets
depends on three hypotheses:
1. Market prices such as product prices, interest
rates, spot rates, and forward rates should
reflect the market's consensus estimate of the
future spot rate.
 Efficient Exchange Markets
Cont…
2. Investors should not earn unusually large profits
in forward speculation. Because exchange-rate
forecasts based on market prices are accurate,
publicly available forecasts of the future spot rate
do not lead to unusual profits in forward
speculation.

3. It is impossible for any market analyst to beat the

market consistently.
There are many indications that support the
efficient market hypothesis for international
financial and exchange markets.
The Theory of Purchasing Power Parity
• Based on the Law of One Price
• According to this law, if transportation costs
are relatively small, the price of an
internationally traded commodity must be the
same in all locations (Ceteris peribus)
• There are of two types:
– Absolute Version
– Relative Version
 The PPP Theory Cont…
 The absolute version of the PPP theory
maintains that the equilibrium exchange rate
between domestic and foreign currencies equals
the ratio between domestic and foreign prices.

Example
How many TZS equal to one US Dollar if,
 A basket of maize grain cost TZS 10,000 or

10 USD?
 Implications
• If the purchasing power of the dollar is
always the same at home and abroad, then
the exchange rate would be constant.

• The nominal exchange rate between the

currencies of two countries must reflect the
different price levels in those countries and
the real exchange rate would be equal to 1.
 Relative PPP Theory
 The relative version of the PPP doctrine indicates
that in the long run, exchange rates reflect the
relative purchasing power of currencies.
 In the long run, the currencies of countries that
experience significant inflation will tend to
depreciate. (Inflation: increases in price level)
Example
How many TZS equal one US Dollar if,
 Price of a basket of grain in Tanzania increases

from TZS 10,000 to 20,000 while in the US the

price is USD 10?
 Relative PPP Theory Cont…
 What happen to the value of the TZS? To
USD?
 Nominal exchange rate increased from
1,000 to 2,000 TZS/USD
– TZ currency depreciated (its value has
decreased—losing purchasing power)
– US currency appreciated
 Relative PPP Theory Cont…
• Changes in relative prices in two countries will
change the exchange rate of their currencies;
the country with the highest price inflation
should see its currency decline in value.
• Relative inflation rate levels and trends can
predict relative exchange rate movements
– PPP suggests that changes in relative
prices between countries will lead to
exchange rate changes.
 Food for Thought

Find out the empirical tests of the

Relative PPP theory.
Some Challenges of the PPP Theory
• The PPP assumes that goods are easily
traded. This is not the case for such
goods as housing and medical services.

• The PPP theory assumes that tradable

goods are identical across countries.
Some Challenges of the PPP Theory
 It is not possible to compare a similar basket of
goods in each country with its trading partners in
order to test the PPP theory.

 Many other factors influence exchange rates

besides relative prices

 Difficult to establish which one comes first, price

change or exchange rate change?
 The Fisher Effect
• The Fisher Effect assumes that the nominal
interest rate in each country is equal to a real
interest rate plus an expected rate of inflation:
Nominal Interest Rate = Real Interest Rate
+ Inflation
• The nominal interest rate embodies an
inflation premium sufficient to compensate
lenders or investors for an expected loss of
purchasing power. Consequently, nominal
interest rates are higher when people expect
higher rates of inflation and are lower when
people expect lower rates of inflation.
 The Fisher Effect Cont…
 The real interest rate in one country is thought
to be relatively stable over time.

Food for Thought

What are the implications and Challenges

of the Fisher Effect Theory?
 The International Fisher Effect
• The International Fisher Effect states that the
future spot rate should move in an amount
equal to, but in a different direction from, the
difference in interest rates between two
countries.

• A future spot rate of a currency with a higher

interest rate would depreciate in the long run;
a future spot rate of a currency with a lower
interest rate would appreciate in the long run.
 The International Fisher Effect
Cont…
 The International Fisher Effect holds that the
interest differential between two countries
should be an unbiased predictor of the future
change in the spot rate.
Short-Run Behavior
a. The short-run behavior of interest and
exchange rates, quite contrary to their long-run
behavior, shows that the exchange rate moves
in the same direction as the difference in
interest rates between two countries.
 The International Fisher Effect
Cont…
b. In other words, currencies of countries with
higher interest rates than the United States
tend to appreciate in value against the dollar.

c. By the same token, currencies of countries

with lower interest rates than the United
States tend to depreciate in value against the
dollar.
The Theory of Interest-Rate Parity
• According to the interest parity theory, the spread
between a forward rate and a spot rate should be
equal but opposite in sign to the difference in
interest rates between two countries.
Note:
For assets of equal risk and maturity
• In other words, the interest-rate parity theory
holds that the difference between a forward rate
and a spot rate equals the difference between a
domestic interest rate and a foreign interest rate.
 The Forward Rate and the Future Spot Rate
• If speculators think that a forward rate is higher
than their prediction of a future spot rate, they will
sell the foreign currency forward.
– This speculative transaction will bid down the forward
rate until it equals the expected future spot rate.
• By the same token, if speculators believe that a
forward rate is lower than an expected future spot
rate, they will buy a foreign currency forward.
– This speculative transaction will bid up the forward
rate until it reaches the expected future spot rate.
 Arbitrages

• Geographic Arbitrage
• Two-Point Arbitrage
• A Three-Point Arbitrage
 Arbitrages
• Arbitrage is the purchase of something in
one market and its sale in another market
to take advantage of a price differential.
• Professional arbitragers quickly transfer
funds from one currency to another in
order to profit from discrepancies between
exchange rates in different markets.
 Geographic Arbitrage
1.Geographic arbitrage could arise when
local demand-and-supply conditions might
create temporary discrepancies among
various markets.
2.Arbitrage specialists would buy the
currency in a market where its price is
lower and then sell the currency where its
price is higher.
 Two-point Arbitrage
1. A two-point arbitrage is the arbitrage
transaction between two currencies.

2. The basic economic principle of "buy low-

sell high" dominates the arbitrage
transaction of buying and selling
currencies in two national money markets.
 A Three-Point Arbitrage

• A three-point arbitrage, commonly known

as a triangle arbitrage, is the arbitrage
transaction among three currencies.

• This type of arbitrage can occur if any of

the three cross rates is out of line.
 Determination of Foreign Exchange
Rates
• In basic Economics theory – demand and supply
are the key determinants of the equilibrium price
of a product
– All those factors that affect the demand and supply of
a product determine its price
– It is vital for managers to understand the direction of
changes in exchange rates arsing from
macroeconomic policy changes, to enable them to
take appropriate precautions and limit exposures, and
determine the desirability of managing such
exposures
 Distinguishing Features of Exchange
Rate Markets
• Unlike commodities, demand and supply
of foreign currency are characterized by
many unique features that let factors of
demand and supply operate more
efficiently than in the market for
commodities
 Distinguishing Features of
Exchange Rate Markets
• Some basic differences in commodity and
foreign exchange markets relating to their
structural features are:
– Universal and uniform utility, and unlimited appetite
– Constraints of supply
– Absence of transportation cost
– Non perishability
– Hoarding
Factors Affecting Demand and Supply

• Like any other commodity, the price of forex

would be determined by the intersection of the
demand and supply schedules of the foreign
currency
– The price of the dollar in terms of the TZS is governed
by all the factors affecting the demand and supply of
the dollar in Tanzania
– Demand for foreign currency is broadly determined by
importers wanting to import goods and services
– Supply of the dollar is made by exporters who sell
goods and services outside of Tanzania
 Price of Foreign Exchange
Price
(TZS/US$)
Supply

P0

Demand

Q0 Quantity of FE ($)
• All economic policies that affect the propensity to
buy imported goods and services have an
impact on foreign exchange rates
– Restrictions on imports through law, or discouraging
imports by imposing and increasing custom duties,
must lead to reduced demand for foreign currency
(e.g. the dollar in Tanzania) leading to reductions in
its price
– This is called depreciation of the foreign currency (the
dollar) or appreciation of the local currency (the
Shilling)
• Any policy changes directed towards increasing exports, such
as subsidies and tax holidays, would help generate more
foreign exchange, bringing down the price of the foreign
currency (the dollar)
• Any policy change resulting in reduction or withdrawal of
incentives would make Tanzanian goods more expensive
abroad, reducing the demand for Tanzanian goods, and thus,
the supply of the foreign currency (the dollar)
• Apart from Tanzanian policies regarding exports, Foreign
policies (e.g. American) policies governing imports would also
dictate the ultimate supply position of foreign currency, and
hence, the exchange rates.
Appreciation of Foreign Exchange (Currency)
Decreased Supply
Price D’ S’
TZS/US$ D
S

P1 B A

P0

Increased Demand

Q’ Q0 Q1 Quantity of FE ($)

Any increase in demand or decrease in supply causes appreciation

(increase in value) of the foreign currency.
Appreciation means more units of local currency are required to buy the
same amount of foreign currency
• Any increase in demand for foreign currency
would shift the demand schedule upwards from
D to D’
– If supply remains unchanged at S, the intersection
with the supply schedule would be at A, reflecting the
exchange rate change from P0 to P1 with P1 > P0
– The equilibrium quantity of demand and supply would
be at Q1, instead of Q0
– This indicates appreciation of the dollar and
depreciation of the shilling
• Any decrease in supply would cause appreciation
of foreign currency
• A decrease in supply of the dollar shifts the supply
schedule upwards from S to S’ intersecting with
the unchanged demand schedule at B. which
corresponds to the exchange rate level of P1.
• The equilibrium quantity of demand and supply is
at Q’, which is lower than the original quantity
demanded, Q0
Depreciation of Foreign Exchange (Currency)
Price D S
TZS/US$ D’
S’
Increased Supply
P0 0
P1 A B

Decreased Demand

Q’ Q0 Q1 Quantity of FE ($)
• Besides exports and imports, another source of supply and
demand for the currencies is derived from the desire to
invest in one another’s capital and money markets
– If returns in the capital markets of one country are greater, this would
attract increased outflow of the other country’s currency.
– The consequent increase in the supply of that currency leads to its
depreciation
• Thus:
• Exports, FDI, and portfolio investments are major sources of supply
of foreign exchange
• Imports, foreign outward investments, and withdrawal of portfolio
investments constitute demand for foreign currency
Macro and Micro Economic and
Monetary factors impacting Forex
• Inflation Rates
• Interest Rates
• Policy Initiatives