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Foreign Exchange Rate Determination:Expectations and the Asset Market

Model

International Financial Management

Dr. A. DeMaskey

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Learning Objectives

What are the determinants of exchange rates?

Are changes in exchange rates predictable?

What factors affect the equilibrium exchange rate?

What is the role of expectations? How do central banks intervene in the

foreign exchange market?

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Potential Foreign Exchange Rate Determinants

Parity Conditions1. Relative inflation rates2. Relative interest rates3. Forward exchange rates4. Exchange rate regimes5. Official monetary reserves

Infrastructure1. Strength of banking system2. Strength of securities markets3. Outlook for growth and profitability

Speculation1. Currencies2. Securities3. Uncovered interest arbitrage4. Real estate5. Commodities

Cross-Border Investment1. Foreign direct investment2. Portfolio investment

Political Risk1. Capital controls2. Black market in currencies3. Exchange rate spreads4. Risk premium on securities and FDI

Spot Exchange RateSpot Exchange Rate

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Measuring Exchange Rate Movements

Appreciation Depreciation Percent Change in the Foreign

Currency Value Percent Change in the Home

Currency Value

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Exchange Rate Equilibrium

Demand

Supply

Equilibrium Exchange Rate

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Equilibrium Exchange Rate

S£

D£

$1.50

Dollar Value of £

Quantity of £

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Macro-Economic Factors Influencing Exchange Rates

Relative Inflation Rates

Relative Interest Rates

Relative Income Levels

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

S£

D£

$1.50

Dollar Value of £

Quantity of £

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

S£

D£

$1.50

Dollar Value of £

Quantity of £

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

S£

D£

$1.50

Dollar Value of £

Quantity of £

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Government Controls

Foreign Exchange Barriers Foreign Trade Barriers Government Intervention in

Foreign Exchange Market Affecting macro variables, such as

inflation, interest rates, and income levels

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Expectations Foreign exchange markets react to any

news that may have a future effect. Institutional investors often take

currency positions based on anticipated interest rate movements in various countries.

Because of speculative transactions, foreign exchange rates can be very volatile.

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Role of Expectations

Signal Impact on $Poor U.S. economic indicatorsFed chairman suggests Fed isunlikely to cut U.S. interest rates

A possible decline in Germaninterest rates

Central banks expected tointervene to boost the euro

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Interaction of Factors

Trade-Related Factors Financial Factors Trade-related factors and financial

factors sometimes interact.

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Factors Affecting Exchange Rates

Inflation Differential

Income Differential

Gov’t Trade Restrictions

Interest Rate Differential

Capital Flow Restrictions

U.S. DemandFor Foreign Goods

Foreign DemandFor U.S. Goods

U.S. DemandFor FC

Supply of FC For Sale

U.S. DemandFor Foreign Securities

Foreign DemandFor U.S. Securities

U.S. DemandFor FC

Supply of FC For Sale

Exchange RateBetween theForeign CurrencyAnd the Dollar

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Government Intervention

Reasons Direct

Sterilized Non-Sterilized

Indirect Government Policy Government Barriers

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Central Bank InterventionNonsterilized Intervention

To Strengthen the C$

Federal Reserve

Banks ParticipatingIn the Foreign

Exchange Market

C$$

Sterilized InterventionTo Strengthen the C$

Federal Reserve

Banks ParticipatingIn the ForeignExchange Market

FinancialInstitutionsThat InvestIn TreasurySecurities

$ C$

Treasury Securities

$

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Impact of Currency Value

Government Deficit

Government Policy Tool Weak Home Currency

Strong Home Currency

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Effect of Expectations

Currency values are determined by: Inflation Interest rates Economic and political stability GDP growth Reputation of central bank

In reality, however, exchange rates are affected by expectations of these variables.

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Central Bank Behavior

Reputable central banks: Are trusted by markets to maintain a

currency’s purchasing power through sound monetary policy.

Tend to be independent. Have currencies that are more highly

valued than those issued by less reputable banks.