forex determination.st

8/12/2019 Forex Determination.st

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Foreign Exchange Rate Determination:Expectations and the Asset Market

Model

International FinancialManagement

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 exchangerate?

What is the role of expectations?

How do central banks intervene in the foreignexchange market?


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Potential Foreign Exchange Rate

DeterminantsParity Conditions

1. Relative inflation rates

2. Relative interest rates

3. Forward exchange rates

4. Exchange rate regimes

5. Official monetary reserves

Infrastructure

1. Strength of banking system

2. Strength of securities markets

3. Outlook for growth and profitability

Speculation

1. Currencies

2. Securities

3. Uncovered interest arbitrage

4. Real estate

5. Commodities

Cross-Border Investment

1. Foreign direct investment

2. Portfolio investment

Political Risk

1. Capital controls

2. Black market in currencies

3. Exchange rate spreads

4. Risk premium on securities

and FDI

Spot Exchange Rate


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Measuring Exchange Rate

MovementsAppreciation

DepreciationPercent Change in the Foreign

Currency Value

Percent Change in the HomeCurrency 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 ForeignExchange Market

Affecting macro variables, such asinflation, interest rates, and incomelevels


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Expectations

Foreign exchange markets react to any newsthat may have a future effect.

Institutional investors often take currency

positions based on anticipated interest ratemovements 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 indicators

Fed chairman suggests Fed isunlikely to cut U.S. interest rates

A possible decline in German

interest ratesCentral banks expected tointervene to boost the euro


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Interaction of Factors

Trade-Related Factors

Financial Factors

Trade-related factors and financialfactors sometimes interact.


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Factors Affecting Exchange

RatesInflation Differential

Income Differential

Govt Trade Restrictions

Interest Rate Differential

Capital Flow Restrictions

U.S. DemandFor Foreign Goods

Foreign DemandFor U.S. Goods

U.S. DemandFor FC

Supply of FCFor Sale

U.S. DemandFor ForeignSecurities

Foreign DemandFor U.S. Securities

U.S. DemandFor FC

Supply of FCFor 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 Intervention

Nonsterilized InterventionTo 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 areaffected by expectationsof thesevariables.


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Central Bank Behavior

Reputable central banks: Are trusted by markets to maintain a

currencys purchasing power through soundmonetary policy.

Tend to be independent.

Have currencies that are more highly valued

than those issued by less reputable banks.

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