Factors Affecting Spot Exchange Rates

7/28/2019 Factors Affecting Spot Exchange Rates

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FACTORS AFFECTINGSPOT EXCHANGERATES


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Two approaches

Balance of payment

Aggregate variables


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Balance of payment

Supply and demand for foreigncurrency

Forecasting of accounts(also used foranalyzing different economic sectors)


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See exhibit 6.1

Trade in merchandise:

1. relative prices

2. relative incomes

3. Responsiveness of consumption andproduction


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Relative prices.

Price of one good expressed in termsof other good.

Prices change due to demand and

supply. Cost determine the price of good.

factors of production

productivity

Growth in income will determine theamount demanded.


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Relative incomes

As income expands, consumption andinvestment also tend to expand.

The increase in demand will put anupward pressure on prices unlessthere is some unutilized capacity in

the economy


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Responsiveness of consumptionand production

Change in price.

Some goods are very sensitive tochange in price.

Change in price also depends on Magnitude of price change

General level of income.


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Trade in services

Travel Transportation

Interest

Dividends

Ps: travel and transportation dependsupon the relative levels of income and

relative prices of vacations etc.


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Unilateral transfers

It is the mirror image of the migration

profile of the country


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Capital accounts

Direct investment

Portfolio investment

Short term investment.


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Direct investment

Investor control the management

Extension of business into foreignlands

Defensive move


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Portfolio investment

Investing in different securities ofmaturities more than one year.


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Short term investment.

Two major types:

1. Those made in connection with other

entries in bop.

2. Those made in search of profit.


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Official reserves

Short term capital account forgovernment of the country.

It depends upon

1. the exchange rate of currency

2. Demand and supply of currency


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Structure of BOP

It measures changes in flows Most similar to a statement of sources

and uses of funds.

Sources = supply of funds

Uses = demand of funds


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Purchasing power parity

Its key idea is that a currency canpurchase the same quantities ofgoods and services in different

countries. The Law of One Price

Example:Suppose again that ahammer costs $10 in Boston. If the

nominal exchange rate is 0.8 eurosper dollar, then $10 is worth 8 euros.The law of one price says a hammer

must cost 8 euros in Paris.


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Comparison of relative inflation ratesamong different countries.

According to PPP, if a countrysinflation rate accelerates relative to theother countries, the countrys currency

would tend to depriciate.

PPP doesnot hold in short term.


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Example

country Germany France

Car price More expensivethan France

Less expensive

Consumer

behavior

Import cars More people willbuy cars fromFrance

Demand and price Demand decreases,price decreases

Demand increases,price increases

Currency valuation

with respect to

other country

Depreciates Appreciates


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FACTORS AFFECTINGINTEREST RATES


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Profit and loss depend upon interestrates.

Two factors influence interest rates1. Creditworthiness of borrower

2. Liquidity of financial instrument


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Demand and supply for funds

interest rate is determined by the supplyand demand for loans.

The demand for loans equalsinvestment. A higher interest ratereduces the quantity of loans demanded.

The supply of loans equals saving plusnet capital inflows.

The equilibrium interest rate, is the rateatwhich the supply and demand forloans intersect.


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demand for loans = investment

supply of loans=saving + capital

inflows - capital outflows =saving + net capital

inflows


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Changes in money supply

Impact on loanable fund

Impact on expectations

inflation

monetary policy


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Impact on loanable funds

Level of money supply increases,

supply of loanable also increases,interest rate decreases.


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INFLATION

Money supply increases,

inflationary expectations increases

and observed interest rate tend to

increase.


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MONETARY POLICY

Central bank can control the level of

money supply through

a) Discount rate

b) Requires reserve requirement


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Market expectations

When interest rates are expected tolower in future:

1. Investor would prefer to invest

funds in longer maturities2. Borrower would prefer to borrow

funds for shorter maturities.


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Yeild curve

The relationship between interest

rate and term to maturity at aspecific time is describe by yield

curve.


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Short maturities

supply of funds demand for

funds

Longer maturities


funds


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Down ward sloping yieldcurve


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When interest rates are expected torise in future:

1. Investor would prefer to invest

funds in shorter maturities2. Borrower would prefer to borrow

funds for longer maturities.


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Short maturities


funds

Longer maturities


funds


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Other factors

If interest rates remains same thanyield curve would be upward

sloping because

1. Higher uncertainty. (credit risk)2. Higher liquidity risk

3. Compensation for the foregone

investment.


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Credit worthiness and marketliquidity


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The credit worthiness of a borrower

can be improved b securing acollateral.


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Longer term to maturity = higher

credibility risk and lesser itsliquidity.

Factors Affecting Spot Exchange Rates

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