topic 4 ex rate determiation.ppt

7/28/2019 Topic 4 Ex Rate Determiation.ppt

1/22

Topic

Exchange Rate Determination

M. M. Shah Khan


2/22

C4 - 2

Learning Objectives

To explain how exchange rate movements

are measured;

To explain how the equilibrium exchange

rate is determined; and

To examine the factors that affect the

equilibrium exchange rate.


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C4 - 3

Measuring

Exchange Rate Movements An exchange rate measures the value of

one currency in units of another currency.

When a currency declines in value, it issaid to depreciate. When it increases in

value, it is said to appreciate.

On the days when some currenciesappreciate while others depreciate against

the dollar, the dollar is said to be mixed

in trading.


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C4 - 4

Measuring

Exchange Rate Movements The percentage change (% D) in the value

of a foreign currency is computed as

St St-1St-1

where Stdenotes the spot rate at time t.

A positive % D represents appreciation ofthe foreign currency, while a negative % Drepresents depreciation.


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Value of IR

Qty. of IR

D: Demand for IR

PKR 1.55

PKR 1.50

PKR 1.60

S: Supply of IR

EquilibriumER

Exchange Rate Equilibrium

An exchange rate represents the price of a

currency, which is determined by the

demand for that currency relative to the

supply for that currency.


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PKR/IR

Quantity of IR

S0

D0

r0

PAK inflation

PAK demand for

Indian goods, and hence

Indian Rupee (IR).

D1

r1

S1

Factors that Influence

Exchange RatesRelative Inflation Rates

Indians desire for PAKgoods, and hence the

supply of Indian Rupee

(IR).


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PKR/IR

Quantity of IR

r0

S0

D0

S1

D1

r1

PAK. interest rates

PAK. demand for

Indian bank deposits,

and hence IR.


Exchange RatesRelative Interest Rates

Indians desire forPAK. bank deposits, and

hence the supply of IR.


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Relative Interest Rates


Exchange Rates

It is thus useful to considerreal interestrates, which adjust the nominal interest

rates for inflation.

A relatively high interest rate may actually

reflect expectations of relatively highinflation, which discourages foreign

investment.


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Relative Interest Rates


Exchange Rates

This relationship is sometimes called the

Fisher effect.

real nominal

interest interest inflation raterate rate


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PK/IR

Quantity of IR

S0

D0

r0

PAK income level

PAK demand for

Indian goods, and hence

IR.D

1

r1


Exchange RatesRelative Income Levels

No expected change forthe supply of IR.

,S1


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Government Controls

Governments may influence the

equilibrium exchange rate by: imposing foreign exchange barriers,

imposing foreign trade barriers,

intervening in the foreign exchange market,and

affecting macro variables such as inflation,

interest rates, and income levels.


Exchange Rates


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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.


Exchange Rates


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Expectations


Exchange Rates

SBP suggests It is unlikely to cut StrengthenedPak interest rates

A possible decline in Indian Strengthenedinterest rates

Central banks expected to Weakenedintervene to boost the euro

Signal Impact on Rs.

Poor PAK economic indicators Weakened


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Interaction of Factors

Trade-related factors and financial factors

sometimes interact. Exchange ratemovements may be simultaneously

affected by these factors.

For example, an increase in the level ofincome sometimes causes expectations of

higher interest rates.


Exchange Rates


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Exchange Rates

The sensitivity of the exchange rate to

these factors is dependent on the volumeof international transactions between the

two countries.

Over a particular period, different factors

may place opposing pressures on thevalue of a foreign currency.


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Trade-Related

Factors1. Inflation

Differential2. Income

Differential3. Govt TradeRestrictions

Financial

Factors1. Interest Rate

Differential

2. Capital Flow

Restrictions

How Factors Can Affect Exchange Rates

PK. demand for foreigngoods, i.e. demand for

foreign currency

Foreign demand for PK.goods, i.e. supply offoreign currency

PK demand for foreign

securities, i.e. demandfor foreign currency

Foreign demand for PKsecurities, i.e. supply of

foreign currency

Exchangerate

betweenforeign

currency

and thePKR


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How Factors Have Influenced Exchange Rates

Because the PKRs value changes by

different magnitudes relative to eachforeign currency, analysts often measure

the PKRs strength with an index.

The weight assigned to each currency isdetermined by its relative importance in

international trade and/or finance.


Exchange Rates


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Exchange at

PK0.52/BT

4. HoldsPK20,912,320

2. Holds BT40 million

Exchange at

PK0.50/BT

Speculating on Anticipated Exchange Rates

Habib Bank expects the exchange rate of the Bangali

Takka to appreciate from its present level of PK0.50 to

PK0.52 in 30 days.

1. BorrowsPK 20 m

Borrows at 7.20%

for 30 days

Lends at 6.48%for 30 days 3. Receives

BT40,216,000

Returns PK 20,120,000

Profit of PK792,320


19/22C4 - 19

Impact of Exchange Rates on an MNCs Value

) ) )

n

tt

m

j

tjtj

k1=

1

,,

1

ERECFE

=Value

E (CFj,t ) = expected cash flows in currencyj to be receivedby the U.S. parent at the end of period t

E (ERj,t ) = expected exchange rate at which currencyj canbe converted to dollars at the end of period t

k = weighted average cost of capital of the parent

Inflation Rates, Interest Rates,Income Levels, Government Controls,

Expectations


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Measuring Exchange Rate Movements

Exchange Rate Equilibrium Demand for a Currency

Supply of a Currency for Sale

Equilibrium

Topic Review


21/22C4 - 21

Topic Review

Factors that Influence Exchange Rates

Relative Inflation Rates

Relative Interest Rates Relative Income Levels

Government Controls

Expectations


How Factors Have Influenced Exchange

Rates


22/22

C4 22

Topic Review

Speculating on Anticipated Exchange

Rates

How Exchange Rates Affect an MNCsValue

topic 4 ex rate determiation.ppt

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