8.4 Exchange Rates - Factors and Mitigation Flashcards
The five factors Affecting Exchange Rates
Trade-related factors
(THESE CREATE A DEMAND FOR GOOD) I,I,I
Relative Inflation rates
Relative Income levels
Government Intervention
Financial factors
(THESE CREATE A DEMAND FOR SECURITIES) I,Ease
Relative Interest rates
Ease of capital flow
Trade-Related Factors That Affect Exchange Rates
Relative Inflation Rates
Inflation Rise> demand for that country’s currency falls
- inward shift of the demand curve results from the lowered desirability
- As investors unload this currency, there is more of it available, reflected in an outward shift of the supply curve.
- An INVESTOR’s domestic currency has GAINED PURCHASING POWER in the country where inflation is worse
Trade-Related Factors That Affect Exchange Rate
Relative Income Levels
- Citizens with higher incomes look for new consumption opportunities in other countries, driving up the demand for those currencies and shifting the demand curve to the right.
- Thus, as incomes rise in one country, the prices of foreign currencies rise as well, and the LOCAL currency will depreciate
Trade-Related Factors That Affect Exchange Rates
Government Intervention
Actions by national governments, such as
TRADE BARRIERS
CURRENCY RESTRICTIONS
complicate the process of exchange rate determination
Financial Factors That Affect Exchange Rates
Relative Interest Rates
When the interest rates in a given country rise, demand for that country’s currency rises
- outward shift of the demand curve results from the influx of other currencies seeking the higher returns available in that country.
- As more and more investors buy up the high-interest country’s currency with which to make investments, there is less of it available, reflected in an inward shift of the supply curve
- An INVESTORS domestic currency has LOST purchasing power in the country paying higher returns.
Financial Factors That Affect Exchange Rates
Ease of Capital Flow
If a country with high real interest rates loosens restrictions against the cross-border movement of capital, the demand for the currency will rise as investors seek higher returns
THE MOST IMPORTANT of the five factors listed.
Differential Interest Rates
Interest Rate Parity (IRP)
theory holds that exchange rates will settle at an equilibrium point where the difference between the forward rate and the spot rate (i.e., the forward premium or discount) equals the exact amount necessary to offset the difference in interest rates between the two countries.
With regard to high-INFLATION currencies, IRP theory suggests that they usually trade at large forward discounts.
Differential Inflation Rates
Purchasing power parity (PPP)
Purchasing power parity (PPP) theory explains differences in exchange rates as the result of the differing inflation rates in the two countries.
With regard to high-INFLATION currencies, PPP and IFE theory suggest that they will weaken over time.
International Fisher Effect (IFE) Theory
IFE theory also focuses on how the spot rate will change over time, but it uses the interplay between real and nominal interest rates to explain the change.
If all investors require a given real rate of return, then differences between currencies can be explained by EACH country’s EXPECTED INFLATION RATE.
With regard to high-INFLATION currencies, PPP and IFE theory suggest that they will weaken over time.
Long-term exchange rates are dictated by the purchasing-power parity theorem
Real prices should be the same worldwide (net of government taxes or trade barriers and transportation costs) for a given good. Exchange rates will adjust until purchasing-power parity is achieved.
in other words, relative price levels determine exchange rates IN THE LONG RUN
Medium-term exchange rates are dictated by the economic activity in a country
-recession, spending on imports (as well as domestic goods) will decrease.
- This reduced spending on IMPORTS shifts the supply curve for Domestic to the left
- causing the equilibrium value of the dollar to increase
- that is, at any given exchange rate, the supply to foreigners is less
An increase in imports or a decrease in exports will have effects opposite to those described above.
Short-term exchange rates are dictated by interest rates.
- Big corporations and banks invest their large reserves of cash where the real interest rate is highest
- A rise in the real INTEREST rate in a country will lead to an appreciation of the currency because it will be demanded for investment at the higher real interest rate, thereby shifting the DEMAND curve to the right (outward)
***However, the interplay of interest rates and inflation must also be considered. Inflation of a currency relative to a second currency causes the first currency to depreciate relative to the second. Moreover, nominal interest rates INCREASE when INFLATION rates are expected to increase
transaction exposure
if its payables or receivables are denominated in a foreign currency.
- downside risk to a foreign-denominated RECEIVABLE is that the FOREIGN CURRENCY might depreciate. Takes more of foreign currency to by a single unit of D.
- downside risk to a foreign-denominated PAYABLE is that the foreign currency might appreciate against the firm’s domestic currency. Takes more D to buy a unit of F.
Hedging a Foreign-Denominated Receivable
When the downside risk is that the foreign currency will Depreciate by the settlement date, the hedge is to SELL the foreign currency forward to lock in a definite price.
- Hedging is the same direction
A/R Sell
Hedging - Sell a Forward
The firm wants to be sure that it will be able to sell the pesos it will be receiving in 30 days.The company is buying a guarantee that it will be able to sell at a price F in 30 days at a specified price.
AP Buy
Hedge - Buy a Forward
Hedging a Foreign-Denominated Payable
downside risk is that the foreign currency will appreciate by the settlement date, the hedge is to purchase the foreign currency forward to lock in a definite price.
A U.S. company knows that it will need 100,000 Canadian dollars in 60 days to pay an invoice. The firm thus hedges by purchasing 100,000 Canadian dollars 60 days forward. at set price. So It knows how many Canadian it will be getting to settle the Canadian AP.
