Currency Exchange Rates - Factors Affecting Rates & Risk Mitigation Techniques

Question 1

What are the factors that affect exchange rates?

Answer 1

The 5 factors that affect currency exchange rates can be classified as three trade-related and two financial factors:

Trade-related factors

1. Relative inflation rates
2. Relative income levels
3. Government intervention

Note: Trade-related factors influence the demand for goods, demand for and supply of currency and ultimately determines the exchange rate

Financial factors

1. Relative interest rates
2. Ease of capital flow

Note: Financial related factors influence the demand for securities, demand for and supply of currency and ultimately determines the exchange rate

Question 2

How does relative inflation rates affect exchange rates?

Trade-related factor

Answer 2

When the rate of inflation in a given country rises relative to the rates of other countries, the demand for that country’s currency falls

This inward shift of the demand curve results from the lowered desirability of that currency (a result of its falling purchasing power)

As investors unload this currency, there is more of it available (reflected in an outward shift of the supply curve)

A new equilibrium point will be reached at a lower price in terms of investors’ domestic currencies

An investor’s domestic currency has gained purchasing power in the country where inflation is worse

Question 3

How does relative income levels affect exchange rates?

Trade-related factor

Answer 3

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

Question 4

How does government intervention affect exchange rates?

Trade-related factor

Answer 4

Actions by national governments, such as trade barriers and currency restrictions, complicate the process of exchange rate determination

Question 5

How does relative interest rates affect exchange rates?

Financial factor

Answer 5

When interest rates in a given country rise relative to those of other countries, the demand for that country’s currency rises

This 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)

A new equilibrium point will be reached at a higher price in terms of investors’ domestic currencies

An investor’s domestic currency has lost purchasing power in the country paying higher returns

Question 6

How does ease of capital flow affect exchange rates?

Financial factor

Answer 6

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 speed with which capital can be moved electronically and the huge amounts involved in the “wired” global economy easily dominate the effects of the trade-related factors

Question 7

What is the Interest rate parity (IRP) theory?

Simultaneous effects on exchange rates - Differential interest rates

Answer 7

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

Note: This theory deals with the forward rate and the explanatory variable is interest rates

Question 8

What is the Purchasing power parity (PPP) theory?

Simultaneous effects on exchange rates - Differential inflation rates

Answer 8

Purchasing power parity (PPP) theory explains differences in exchange rates as the result of the differing inflation rates in the two countries

Note: This theory deals with the % change in sport rate and the explanatory variable is inflation rates

Question 9

What is the International Fisher Effect (IFE) theory?

Simultaneous effects on exchange rates

Answer 9

International Fisher Effect (IFE) theory focuses on how the sport rate will change over time, but it uses 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

Note: This theory deals with the % change in spot rate and the explanatory variable is interest rates

Question 10

What does the Interest rate parity (IRP) theory suggest about high-inflation currencies?

Answer 10

Interest rate parity (IRP) theory suggest that high-inflation currencies usually trade at large forward discounts

Question 11

What does the Purchasing power parity (PPP) theory suggest about high-inflation currencies?

Answer 11

Purchasing power parity (PPP) theory suggest that high-inflation currencies will weaken over time

Question 12

What does the International Fisher Effect (IFE) theory suggest about high-inflation currencies?

Answer 12

International Fisher Effect (IFE) theory suggest that:

a. High-inflation currencies will weaken over time
b. Their (high-inflation) economies will have high interest rates

Question 13

How are long-term exchange rates dictated by the Purchasing power parity (PPP) theorem?

(Exchange rate fluctuations over time)

Answer 13

In the long run, 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 real world, exchange rates do NOT perfectly reflect purchasing-power parity, but relative price levels are clearly important determinants of those rates

Question 14

How are medium-term exchange rates dictated by the economic activity in a country?

(Exchange rate fluctuations over time)

Answer 14

When the U.S. is in a recession, spending on imports (as well as domestic goods) will decrease. This reduced spending on imports shifts the supply curve for dollars to the left, causing the equilibrium value of the dollar to increase (assuming the demand for dollars is constant); that is, at any given exchange rate, the supply to foreigners is less

If more goods are exported because of an increased preference for U.S. goods, the demand curve for dollars shifts to the right, causing upward pressure on the value of the dollar

An increase in imports or a decrease in exports will have effects opposite to those described above

Question 15

How are short-term exchange rates dictated by interest rates?

(Exchange rate fluctuations over time)

Answer 15

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)

The reverse holds true for a decline in real interest rates because that currency will be sold as investors move their money out of the country

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. Also, nominal interest rates increase when inflation rates are expected to increase

Question 16

What is risk when a firm sells merchandise to a foreign customer?

(Risks of exchange rate fluctuation)

Answer 16

When a firm sells merchandise to a foreign customer, the firm’s receivable might be denominated in the customer’s currency

The downside risk to a foreign-denominated receivable is that the foreign currency might depreciate against the firm’s domestic currency

If the foreign currency has depreciated by the settlement date, the firm will receive fewer units of its domestic currency than it would have if the transaction had been settled at the time of sale

Question 17

What is the risk when a firm buys merchandise from a foreign supplier?

(Risks of exchange rate fluctuation)

Answer 17

When a firm buys merchandise from a foreign supplier, the firm’s payable might be denominated in the supplier’s currency

The downside risk to a foreign-denominated payable is that the foreign currency might appreciate against the firm’s domestic currency

If the foreign currency has appreciated by the settlement date, the firm will be forced to buy more units of the foreign currency to settle the payable than it would have if the transaction had been settled at the time of purchase

Question 18

How can hedging be used as a tool against uncertainty?

Answer 18

When hedging, some amount of possible upside is foregone in order to protect against the potential downside

Hedging thus embodies the old sayings, “A bird in the hand is worth two in the bush”

Question 19

How can hedging be used to hedge a foreign-denominated receivable?

Answer 19

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

Question 20

How can hedging be used to hedge a foreign-denominated payable?

Answer 20

When the 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

Question 21

How can firms manage net receivable and payable positions?

Answer 21

A firm can reduce its exchange rate risk by maintaining a position in each foreign currency of receivables and payables that net to near zero

On the other hand, the firm may wish to actively manage its foreign-denominated receivables and payables:

1. The firm maintains a net receivables position in currencies expected to appreciate and a net payables position in currencies expected to depreciate
2. This speculative approach carries risk on its own

Large multinational corporations often establish multinational netting centers as special departments to execute whichever strategy is selected

They enter into foreign currency futures contracts when necessary to achieve balance

Question 22

How can a firm use money market hedges as a tool for mitigating exchange rate risk?

(Short-term - mitigating exchange rate risk)

Answer 22

The least complex tool for hedging exchange rate risk is the money market hedge

A firm with a receivable denominated in a foreign currency can borrow the amount and convert it to its domestic currency now, then pay off the foreign loan when the receivable is collected

A firm with a payable denominated in a foreign currency can buy a money market instrument denominated in that currency that is timed to mature when the payable is due. Exchange rate fluctuations between the transaction date and the settlement date are avoided

Question 23

How can a firm use futures contracts as a tool for mitigating exchange rate risk?

(Short-term - mitigating exchange rate risk)

Answer 23

Futures contracts can be used as a way to mitigate exchange rate risk

Whereas forward contracts are negotiated individually between the parties on a one-by-one basis, futures contracts are essentially commodities that are traded on an exchange, making them available to more parties

Question 24

What are Currency options?

Short-term - mitigating exchange rate risk

Answer 24

Currency options can be used as a way to mitigate exchange rate risk

A currency option differs from a currency futures contract in that a futures contract is (as the name implies) a binding contract; both parties must perform

An option is exercised only if the party purchasing the option chooses to

Futures contracts have 4 settlement dates in the course of a year. Options offer one settlement every month

Question 25

What are the two types of currency options available for a firm to use to mitigate exchange rate risk?

Answer 25

Two types of options are available:

1. A call option gives the holder the right to buy (i.e. call for) a specified amount of currency in a future month at a specified price

Call options are among the many tools available to hedge payables

2. A put option gives the holder the right to sell (i.e. put onto the market) a specified amount of currency in a future month at a specified price

Put options are among the many tools available to hedge receivables

Question 26

What are the sources where currency options are available?

Answer 26

Currency options are available from 2 sources:

a. Options exchanges (similar to those for future contracts
b. Over-the-counter market

As with futures contracts, exchange-traded options are only available for predefined quantities of currency

Options available in over-the-counter markets are provided by commercial banks and brokerage houses

Question 27

How can a firm use forward contracts as a tool for mitigating exchange rate risk?

(Long-term - mitigating exchange rate risk)

Answer 27

Large corporations that have close relationships with major banks are able to enter into contracts for individual transactions concerning large amounts. These contracts are unavailable to smaller firms or firms without a history with a particular bank

The bank guarantees that it will make available to the firm a given quantity of a certain currency at a definite rate at some point in the future. The price charged by the bank for this guarantee is called the premium

Question 28

How can a firm use currency swaps as a tool for mitigating exchange rate risk?

(Long-term - mitigating exchange rate risk)

Answer 28

A broker brings together two parties who would like to hedge exchange rate risk by swapping cash flows in each other’s currency