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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.
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