Chapter 4 - Exchange Rate Determination

Question 1

Financial managers of multinational corporations (MNCs) that conduct international business must continuously:

Answer 1

monitor exchange rates because their cash flows are highly dependent on them. They need to understand what factors influence exchange rates so that they can anticipate how exchange rates may change in response to specific conditions. This chapter provides a foundation for understanding how exchange rates are determined.

Question 2

Measuring Exchange Rate Movements

Answer 2

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

–> Percentage change in foreign currency value=(St-St-1)/St-1
–> A positive percent change indicates that the currency has appreciated. A negative percent change indicates that it has depreciated. (Exhibit 4.1)
–> Real-time exchange rate quotations.

Note: Exchange rate movements affect an MNC’s value because they can affect the amount of cash inflows received from exporting products or services or from a subsidiary; likewise, they can affect the amount of cash outflows needed to pay for imports of products or services. An exchange rate measures the value of one currency in units of another currency. As economic conditions change, exchange rates can change substantially.

On some days, most foreign currencies appreciate against the dollar (albeit by different degrees); on other days, most currencies depreciate against the dollar (again, by different degrees). On still other days, some currencies appreciate while others depreciate against the dollar; the financial media describe this scenario by stating that “the dollar wasmixedin trading.”

Question 3

Exchange Rate Equilibrium

Answer 3

The exchange rate represents the price of a currency, or the rate at which one currency can be exchanged for another.

Demand for a currency increases when the value of the currency decreases, leading to a downward sloping demand schedule. (See Exhibit 4.2)

Supply of a currency for sale increases when the value of the currency increases, leading to an upward sloping supply schedule. (See Exhibit 4.3)

Equilibrium equates the quantity of pounds demanded with the supply of pounds for sale. (See Exhibit 4.4)

Note: it is more difficult to explain why the value changed or to forecast how it may change in the future. To achieve either of these objectives, an understanding of the concept of anequilibrium exchange rateis necessarily, along with recognition of the factors that affect this rate.

Like any other product sold in markets, the price of a currency is determined by the demand for that currency relative to its supply. Thus, for each possible price of a British pound (the United Kingdom’s currency), there is a corresponding demand for pounds and a corresponding supply of pounds for sale (to be exchanged for dollars). At any given moment, a currency should exhibit the price where the demand for that currency is equal to supply; this is the equilibrium exchange rate. Of course, conditions can change over time. These changes induce adjustments in the supply of or demand for any currency of interest, which in turn creates movement in the currency’s price.

Unless explicitly specified otherwise in this text, the “exchange rate” of any currency is the rate at which it can be exchanged for U.S. dollars.

Question 4

Change in the Equilibrium Exchange Rate

Answer 4

Increase in demand schedule: Banks (intermediaries) will increase the exchange rate to the level at which the amount demanded is equal to the amount supplied in the foreign exchange market.

Decrease in demand schedule: Banks will reduce the exchange rate to the level at which the amount demanded is equal to the amount supplied in the foreign exchange market.

Increase in supply schedule: Banks will reduce the exchange rate to the level at which the amount demanded is equal to the amount supplied in the foreign exchange market.

Decrease in supply schedule: Banks will increase the exchange rate to the level at which the amount demanded is equal to the amount supplied in the foreign exchange market.

Note:The exchange rate varies because the banks that serve as intermediaries in the foreign exchange market adjust the price at which they are willing to buy or sell a particular currency in the face of a sudden shortage or excess of that currency.

Question 5

Factors That Influence Exchange Rates

Answer 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

Note: These are the factors that change the supply and demand schedules of a currency

Question 6

Relative Inflation Rates:

Answer 6

Increase in U.S. inflation leads to increase in U.S. demand for foreign goods, an increase in U.S. demand for foreign currency, and an increase in the exchange rate for the foreign currency.

Question 7

Relative Interest Rates:

Answer 7

Increase in U.S. interest rates leads to increase in demand for U.S. deposits and a decrease in demand for foreign deposits, leading to an increase in demand for dollars and a decreased exchange rate for the foreign currency. (See Exhibit 4.7)

Although a relatively high interest rate may attract foreign inflows, a high rate may reflect expectations of relatively high inflation. In such cases, it is useful to consider the real interest rate, which adjusts the nominal interest rate for inflation:

Real Interest Rates
–> Fisher Effect: Real Interest Rate /= Nominal Interest Rate - Inflation Rate

Question 8

Impact of Rising U.S. Inflation on the Equilibrium Value of the British Pound

Answer 8

When US inflation increases, US products price increases, leading to:

US demand of foreign products to increase–> demand of foreign currency to increase –> demand curve of foreign currency shifts outward (to the right)

foreign demand of US products to decrease  supply of foreign currency to decrease  supply curve of foreign currency shifts inward (to the left)

Equilibrium Exchange Rate goes up –> Pound Appreciates against the dollar

Question 9

Impact of Rising U.S. Interest Rates on the Equilibrium Value of the British Pound

Answer 9

When US interest rate increases, leading to:

US demand of foreign deposit to decrease–> demand of foreign currency to decrease –> demand curve of foreign currency shifts inward (to the left)

foreign demand of US deposit to increase –> supply of foreign currency to increase –> supply curve of foreign currency shifts outward (to the right)

Equilibrium Exchange Rate goes down –> Pound Depreciates Against the Dollar

Question 10

Relative Income Levels:

Answer 10

Increase in U.S. income leads to an increase in U.S. demand for foreign goods, an increased demand for foreign currency relative to the dollar, and an increase in the exchange rate for the foreign currency.

When US income increases, US purchasing power increases, leading to:
US demand of foreign products to increase–> demand of foreign currency to increase –> demand curve of foreign currency shifts outward (to the right)

Equilibrium goes up –> Pound Appreciates Against the dollar

Question 11

Government Controls via: (4)

Answer 11

Imposing foreign exchange barriers

Imposing foreign trade barriers

Intervening in foreign exchange markets

Affecting macro variables such as inflation, interest rates, and income levels

Question 12

Expectations: of Future Exchange Rates

Answer 12

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.

Note: Like other financial markets, foreign exchange markets react to any news that may affect future transactions.

Question 13

Interaction of Factors:

Answer 13

Some factors place upward pressure while other factors place downward pressure.

Question 14

Influence of Factors across Multiple Currency Markets:

Answer 14

common for European currencies to move in the same direction against the dollar.

Question 15

Influence of Liquidity on Exchange Rate adjustment:

Answer 15

If a currency’s spot market is liquid then its exchange rate will not be highly sensitive to a single large purchase or sale.

Question 16

Summary of How Factors Affect Exchange Rates:

Answer 16

The factors can be categorized into trade-related and financial factors.
–> Trade Related Factors: Inflation Differential, Income Differential, Government Trade Restrictions
–> Financial Factors: Interest Rate Differential, Capital Flow Restrictions, Exchange Rate Expectations

Trade-related foreign exchange transactions generally respond less dramatically to news.

In contrast, financial flow transactions are extremely responsive to news because decisions to hold securities denominated in a particular currency often depend on anticipated changes in currency values. Sometimes trade-related factors and financial factors interact and simultaneously affect exchange rate movements.

Question 17

Movements in Cross Exchange Rates

Answer 17

If currencies A (e.g. GBP) and B (e.g. SFR) move in same direction by the same degree, 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.

Each exchange rate has its own market, meaning its own demand and supply conditions. For example, the value of the British pound in dollars is influenced by the U.S. demand for pounds and the amount of pounds supplied to the market (by British consumers and firms) in exchange for dollars. Likewise, the value of the Swiss franc in dollars is influenced by the U.S. demand for francs and the amount of francs supplied to the market (by Swiss consumers and firms) in exchange for dollars.

Question 18

Capitalizing on Expected Exchange Rate Movements

Answer 18

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.

Question 19

The “Carry Trade”

Answer 19

— Where investors attempt to capitalize on the differential in interest rates between two countries. One of the most common strategies

Specifically, this strategy involves borrowing a currency with a low interest rate and investing the funds in a currency with a high interest rate. The investor may execute a carry trade for only a day or for several months. The term “carry trade” is derived from the phrase “cost of carry,” which in financial markets represents the cost of holding (or carrying) a position in some asset.

Impact of appreciation in the investment currency: Increased trade volume can have a major influence on exchange rate movements over a short period. There is upward pressure on the exchange rate of the currency being purchased and enhance investors’ profit

Risk of the Carry Trade: Exchange rates may move opposite to what the investors expected.

Note: When many investors executing carry trades share the same expectations about a particular currency, they execute similar types of transactions, and their trading volume can have a major influence on exchange rate movements over a short period. Over time, as many carry traders borrow one currency and convert it into another, there is downward pressure on the currency being converted (sold) and upward pressure on the currency being purchased. This type of pressure on the exchange rate may enhance investor profits.

Note: Notice the large return to Hampton over a single month, even though the interest rate on its investment is only0.5%percentabove its borrowing rate. Such a high return on its investment over a one-month period is possible when Hampton borrows a large portion of the funds used for its investment. This illustrates the power of financial leverage.