Currency Exchange Rates - Factors Affecting Rates & Risk Mitigation Techniques Flashcards
What are the factors that affect exchange rates?
The 5 factors that affect currency exchange rates can be classified as three trade-related and two financial factors:
Trade-related factors
- Relative inflation rates
- Relative income levels
- 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
- Relative interest rates
- 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
How does relative inflation rates affect exchange rates?
Trade-related factor
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
How does relative income levels affect exchange rates?
Trade-related factor
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
How does government intervention affect exchange rates?
Trade-related factor
Actions by national governments, such as trade barriers and currency restrictions, complicate the process of exchange rate determination
How does relative interest rates affect exchange rates?
Financial factor
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
How does ease of capital flow affect exchange rates?
Financial factor
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
What is the Interest rate parity (IRP) theory?
Simultaneous effects on exchange rates - 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
Note: This theory deals with the forward rate and the explanatory variable is interest rates
What is the Purchasing power parity (PPP) theory?
Simultaneous effects on exchange rates - Differential inflation rates
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
What is the International Fisher Effect (IFE) theory?
Simultaneous effects on exchange rates
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
What does the Interest rate parity (IRP) theory suggest about high-inflation currencies?
Interest rate parity (IRP) theory suggest that high-inflation currencies usually trade at large forward discounts
What does the Purchasing power parity (PPP) theory suggest about high-inflation currencies?
Purchasing power parity (PPP) theory suggest that high-inflation currencies will weaken over time
What does the International Fisher Effect (IFE) theory suggest about high-inflation currencies?
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
How are long-term exchange rates dictated by the Purchasing power parity (PPP) theorem?
(Exchange rate fluctuations over time)
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
How are medium-term exchange rates dictated by the economic activity in a country?
(Exchange rate fluctuations over time)
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
How are short-term exchange rates dictated by interest rates?
(Exchange rate fluctuations over time)
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
What is risk when a firm sells merchandise to a foreign customer?
(Risks of exchange rate fluctuation)
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
What is the risk when a firm buys merchandise from a foreign supplier?
(Risks of exchange rate fluctuation)
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
How can hedging be used as a tool against uncertainty?
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”
How can hedging be used to hedge 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
How can hedging be used to hedge a foreign-denominated payable?
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
How can firms manage net receivable and payable positions?
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:
- The firm maintains a net receivables position in currencies expected to appreciate and a net payables position in currencies expected to depreciate
- 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
How can a firm use money market hedges as a tool for mitigating exchange rate risk?
(Short-term - mitigating exchange rate risk)
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
How can a firm use futures contracts as a tool for mitigating exchange rate risk?
(Short-term - mitigating exchange rate risk)
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
What are Currency options?
Short-term - mitigating exchange rate risk
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
What are the two types of currency options available for a firm to use to mitigate exchange rate risk?
Two types of options are available:
- 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
- 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
What are the sources where currency options are available?
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
How can a firm use forward contracts as a tool for mitigating exchange rate risk?
(Long-term - mitigating exchange rate risk)
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
How can a firm use currency swaps as a tool for mitigating exchange rate risk?
(Long-term - mitigating exchange rate risk)
A broker brings together two parties who would like to hedge exchange rate risk by swapping cash flows in each other’s currency
