Download - Slide 1 of 38 Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Slide 1 of 38
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Slide 2 of 38
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Overview
Measure exchange ratesMeasure exchange rates Determine equilibrium exchange ratesDetermine equilibrium exchange rates Examine factors affecting exchange ratesExamine factors affecting exchange rates
Slide 3 of 38
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Measuring Exchange Rate Movements
Exchange rateExchange rate– value of one currency in units of anothervalue of one currency in units of another– eg. One dollar U.S. = 1.44 CDNeg. One dollar U.S. = 1.44 CDN
Fluctuating valueFluctuating value– appreciationappreciation
increase in currency value relative to anotherincrease in currency value relative to another
– depreciationdepreciation decrease in currency value relative to anotherdecrease in currency value relative to another
Slide 4 of 38
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Exchange Rate Movement Price of a currencyPrice of a currency , or,,,,,,,, how much a currency cost, or,,,,,,,, how much a currency cost “… “… an exchange rate at a given point in an exchange rate at a given point in
time represents a price of a currency…”time represents a price of a currency…”page 106page 106
price, like any product, is a function of price, like any product, is a function of demanddemand
demand relative to the supplydemand relative to the supply
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Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Exchange Rate Equilibrium
Supply for a currencySupply for a currency– e.ge.g., supply of British pound., supply of British pound
the greater the price offered, the greater the supply the greater the price offered, the greater the supply
quantityquantity
valuevalue
SS
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Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Exchange Rate Equilibrium
Spot exchange rateSpot exchange rate– price of a currency at a specific timeprice of a currency at a specific time
price set by supply and demand for the currencyprice set by supply and demand for the currency
Demand for currencyDemand for currency– e.ge.g., US demand for pound sterling ., US demand for pound sterling
DD
valuevalue
quantityquantity
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Slide 10 of 38
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Exchange Rate Equilibrium
Exchange rate reflects supply and demandExchange rate reflects supply and demand– lower $US means cheaper US goods for Britishlower $US means cheaper US goods for British– increased demand for US goods implies greater increased demand for US goods implies greater
demand for $USdemand for $US
DD
valuevalue
SS
quantityquantity
Slide 11 of 38
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Factors Influencing Exchange Rates
Relative inflation ratesRelative inflation rates Relative interest ratesRelative interest rates Relative income levelsRelative income levels Government controlsGovernment controls ExpectationsExpectations
Slide 12 of 38
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Factors that influence Exchange Rates
Relative inflation ratesRelative inflation rates page 109page 109
changes in inflation rates can affect changes in inflation rates can affect international trade activity, which influences international trade activity, which influences the demand and supply of currenciesthe demand and supply of currencies
if inflation is high, price of products is rising fast and the if inflation is high, price of products is rising fast and the economy will have a lot of money to buy foreign productseconomy will have a lot of money to buy foreign products
if they buy foreign products, there is need for currencies if they buy foreign products, there is need for currencies other than the currency they have, so demand is highother than the currency they have, so demand is high
Slide 13 of 38
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Factors that influence Exchange Rates
Inflation means the price of goods and Inflation means the price of goods and services rises quicklyservices rises quickly
a consequence is that people are also a consequence is that people are also making more money and relative to goods making more money and relative to goods and services from other countries, they can and services from other countries, they can afford to import moreafford to import more
Slide 14 of 38
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Factors that influence Exchange Rates
In reality, “… the true equilibrium exchange In reality, “… the true equilibrium exchange rate will reflect several factors rate will reflect several factors simultaneously…”simultaneously…”
Slide 15 of 38
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Factors that influence Exchange Rates
1. Relative Interest Rates1. Relative Interest Ratespage 110page 110
changes in relative interest rates affect changes in relative interest rates affect investment in foreign securities, which investment in foreign securities, which influence the demand and supply of influence the demand and supply of currenciescurrencies
Slide 16 of 38
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Factors Influencing Exchange Rates
Relative inflation ratesRelative inflation rates– affects supply and demand for currencyaffects supply and demand for currency– impacts international tradeimpacts international trade– e.g., British inflation rises against US inflatione.g., British inflation rises against US inflation
British goods become more expensive relative to USBritish goods become more expensive relative to US decrease of US demand for pound sterlingdecrease of US demand for pound sterling increase in British demand for “cheaper” US goodsincrease in British demand for “cheaper” US goods increase in British demand for $USincrease in British demand for $US increase in supply of pounds on sale for $USincrease in supply of pounds on sale for $US British pound declines in value against the $USBritish pound declines in value against the $US
Slide 17 of 38
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Factors that influence Exchange Rates
if interest rates in a country are low, if interest rates in a country are low, portfolio investments there will also be portfolio investments there will also be proportionately lowproportionately low
therefore making ROI - return on therefore making ROI - return on investments lowinvestments low
therefore people will sell the securities and therefore people will sell the securities and demand will declinedemand will decline
Slide 18 of 38
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Factors that influence Exchange Rates
ExampleExampletext page 110 - 111text page 110 - 111
the reunification of East and West the reunification of East and West Germany, and the resulting rise in German Germany, and the resulting rise in German interest ratesinterest rates
U.S. investors invested in German U.S. investors invested in German securities due to the higher ROIsecurities due to the higher ROI
Slide 19 of 38
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Factors that influence Exchange Rates
2. Real Interest Rates2. Real Interest Rates ““while a relatively high interest rate may while a relatively high interest rate may
attract foreign inflows - high interest rate attract foreign inflows - high interest rate might indicate high inflationmight indicate high inflation
- which would scare people off by - which would scare people off by discouraging them to investdiscouraging them to invest
real interest rate = nominal interest rate - real interest rate = nominal interest rate - inflation rateinflation rate
Page 112Page 112
Slide 20 of 38
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Factors Influencing Exchange Rates
Relative interest Relative interest realreal rates rates– affects investment in foreign securitiesaffects investment in foreign securities– e.ge.g., British interest rises relative to US interest., British interest rises relative to US interest
British MNCs shift deposits to British banksBritish MNCs shift deposits to British banks decline in British supply of pounds for sale for $USdecline in British supply of pounds for sale for $US increase in British MNC demand for poundsincrease in British MNC demand for pounds pound rises in value relative to $US pound rises in value relative to $US
Slide 21 of 38
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Factors that influence Exchange Rates
3. Relative Income Levels3. Relative Income Levels if income in a country increases, if income in a country increases,
globalization will increase demand for globalization will increase demand for foreign products foreign products
demand for foreign products will increase demand for foreign products will increase demand for the currency of the countries demand for the currency of the countries where those products come fromwhere those products come from
Page 112Page 112
Slide 22 of 38
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Factors that influence Exchange Rates
3. Relative Income Levels3. Relative Income Levels
in the late 1980’s and early 1990’s, income in the late 1980’s and early 1990’s, income levels in North America caused massive levels in North America caused massive imports of Japanese consumer products, imports of Japanese consumer products, making the Japanese yen rise very highmaking the Japanese yen rise very high
Page 112Page 112
Slide 23 of 38
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Factors Influencing Exchange Rates
Relative income levelsRelative income levels– e.ge.g., British income rises relative to US income., British income rises relative to US income
demand schedule for pound remains the samedemand schedule for pound remains the same supply of pounds for sale for $US should risesupply of pounds for sale for $US should rise
– British buy more US goodsBritish buy more US goods
British pound falls against the $USBritish pound falls against the $US
Slide 24 of 38
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Factors that influence Exchange Rates
4. Government Intervention4. Government Intervention
Reasons for interventionReasons for intervention– smooth exchange rate movementssmooth exchange rate movements– establish implicit exchange rate boundariesestablish implicit exchange rate boundaries– react to temporary disturbancesreact to temporary disturbances
Page 112Page 112
Slide 25 of 38
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Factors Influencing Exchange Rates
Government controlsGovernment controls– foreign exchange barriersforeign exchange barriers– foreign trade barriersforeign trade barriers– central bank interventioncentral bank intervention– intervention may affect inflation, interest rates intervention may affect inflation, interest rates
and income levelsand income levels
Slide 26 of 38
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Factors that influence Exchange Rates
4. Government Intervention4. Government Intervention
What will the government do ?What will the government do ?1 impose 4X barriers1 impose 4X barriers
2 impose foreign trade barriers2 impose foreign trade barriers
3 intervene by buying and selling currencies3 intervene by buying and selling currencies
4 do things to effect inflation rate and interest 4 do things to effect inflation rate and interest ratesrateseg. Alter bank rate, or print money (monetary policy)eg. Alter bank rate, or print money (monetary policy)
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Slide 27 of 38
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Factors that influence Exchange Rates
5. Expectations5. Expectations
Market expectations of future ratesMarket expectations of future rates
4X markets react to news that might effect 4X markets react to news that might effect future eventsfuture events
eg. News of possible inflation in a country - due eg. News of possible inflation in a country - due to some crisis, may cause currency traders to to some crisis, may cause currency traders to dump that currency before it declines in valuedump that currency before it declines in value
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Slide 28 of 38
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Factors that influence Exchange Rates
5. Expectations5. Expectations
Institutional investors take currency positions Institutional investors take currency positions based on anticipated interest rate based on anticipated interest rate movementsmovements
They do detailed research on many aspects of a country to They do detailed research on many aspects of a country to determine if the currency is going to be in demand, or determine if the currency is going to be in demand, or not, and if it is going to be in demand, they buy large not, and if it is going to be in demand, they buy large amounts and sell it for a profit days or weeks in the futureamounts and sell it for a profit days or weeks in the future
Page 113Page 113
Slide 29 of 38
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Factors Influencing Exchange Rates
ExpectationsExpectations– e.g.e.g., news of potential increase in British , news of potential increase in British
inflationinflation market expects decline in value of poundmarket expects decline in value of pound institutional traders sell pound sterlinginstitutional traders sell pound sterling value of pound declines against the $USvalue of pound declines against the $US
Slide 30 of 38
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Factors Influencing Exchange Rates
Factors affecting demand for foreign goodsFactors affecting demand for foreign goods– inflation differentialinflation differential– income differentialincome differential– government’s trade restrictionsgovernment’s trade restrictions
Factors affecting demand for foreign Factors affecting demand for foreign securitiessecurities– interest rate differentialinterest rate differential– government’s capital flow restrictionsgovernment’s capital flow restrictions
Slide 31 of 38
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Speculating on Anticipated Rates
Speculating on anticipated changes in ratesSpeculating on anticipated changes in rates– e.ge.g., a bank’s expectation on the British pound:., a bank’s expectation on the British pound:
appreciate from $1.635 to $1.650 in 30 daysappreciate from $1.635 to $1.650 in 30 days develops a trading strategy based upon interest rate develops a trading strategy based upon interest rate
differentials and expected exchange rate movementdifferentials and expected exchange rate movement
Currency Lending Rate Borrowing Rate
US dollars 6.50 % 7.00 %
Pound sterling 6.26 % 6.75 %
Slide 32 of 38
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Speculating on Anticipated Rates, an Example
Borrow $30 million at 7.00 %Borrow $30 million at 7.00 %
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Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Speculating on Anticipated Rates, an Example
Borrow $30 million at 7.00 %Borrow $30 million at 7.00 % Convert $30 million to PS 18,348,624Convert $30 million to PS 18,348,624
– $30,000,000 / $1.635 = PS 18,348,624$30,000,000 / $1.635 = PS 18,348,624
Slide 34 of 38
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Speculating on Anticipated Rates, an Example
Borrow $30 million at 7.00 %Borrow $30 million at 7.00 % Convert $30 million to PS 18,348,624Convert $30 million to PS 18,348,624
– $30,000,000 / $1.635 = PS 18,348,624$30,000,000 / $1.635 = PS 18,348,624 Lend pounds at 6.26 % for 30 daysLend pounds at 6.26 % for 30 days
– PS 18,348,624 x [1+ (0.0626)(30/360)]PS 18,348,624 x [1+ (0.0626)(30/360)]– bank has PS 18,444,349 in 30 daysbank has PS 18,444,349 in 30 days
Slide 35 of 38
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Speculating on Anticipated Rates, an Example
Borrow $30 million at 7.00 %Borrow $30 million at 7.00 % Convert $30 million to PS 18,348,624Convert $30 million to PS 18,348,624
– $30,000,000 / $1.635 = PS 18,348,624$30,000,000 / $1.635 = PS 18,348,624 Lend pounds at 6.26 % for 30 daysLend pounds at 6.26 % for 30 days
– PS 18,348,624 x [1+ (0.0626)(30/360)]PS 18,348,624 x [1+ (0.0626)(30/360)]
– bank has PS 18,444,349 in 30 daysbank has PS 18,444,349 in 30 days Convert British pounds to $USConvert British pounds to $US
– PS 18,444,349 x $1.650 = $30,433,176PS 18,444,349 x $1.650 = $30,433,176
Slide 36 of 38
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Speculating on Anticipated Rates, an Example
Repay $US loan with proceeds from poundRepay $US loan with proceeds from pound– $30,000 x [1 + (0.07)(30/360)] = $30,174,990$30,000 x [1 + (0.07)(30/360)] = $30,174,990
Slide 37 of 38
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Speculating on Anticipated Rates, an Example
Repay $US loan with proceeds from poundRepay $US loan with proceeds from pound– $30,000 x [1 + (0.07)(30/360)] = $30,174,990$30,000 x [1 + (0.07)(30/360)] = $30,174,990
Calculate profit from speculationCalculate profit from speculation– (assumes pound rises to $1.65 in 30 days)(assumes pound rises to $1.65 in 30 days)– $30,433,176 - $30,174,990 = $258,186$30,433,176 - $30,174,990 = $258,186
Slide 38 of 38
Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson
Summary Exchange rate movements Exchange rate movements
– measured by percentage change in valuemeasured by percentage change in value Equilibrium exchange rateEquilibrium exchange rate
– determined by supply and demanddetermined by supply and demand economic and governmental factors affect economic and governmental factors affect
exchange ratesexchange rates– inflation and interest rates are factors most closely inflation and interest rates are factors most closely
monitored by financial marketsmonitored by financial markets all factors interact to affect exchange rates all factors interact to affect exchange rates