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Determining Exchange Rates
South-Western/Thomson Learning 2006
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Exchange Rate
Movement: Measurement An exchange ratemeasures the valueof one currency in units of anothercurrency.
When a currency declines in value, itis said to depreciate. When itincreases in value, it is said toappreciate.
On the days hen some currenciesappreciate hile others depreciateagainst a particular currency, that
currency is said to !e "mixed in#
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Exchange Rate
Movement: Measurement $he percentage change %& )in
the value of a foreign currencyiscomputed as
St St 1
St 1
here 'tdenotes the spot rate at time t. A positive % represents appreciation ofthe foreign currency, while a negative %
represents depreciation.
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Annual (hanges
in the )alue of the Euro
Date Exchange Rate Annual
& *+*+--- *.--*+/0
*+*+--* .12+/0 3.*&
*+*+-- .41+/0 5.6&
*+*+--6 *.-5+/7*4.-&
*+*+--2 *.3+/7-.-&
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Exchange Rate E8uili!rium
An exchange rate represents theprice of a currency, hich isdetermined !y the demand for that
currency relative to the supply forthat currency.
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Value of
Quantity of
$1.55
$1.50
$1.0!"uili#riuechange rate
D& 'eand for
S& (upply of
Exchange Rate E8uili!rium
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Exchange Rate E8uili!rium
$he li8uidityof a currency affectsthe sensitivity of the exchange rateto specific transactions.
With many illing !uyers andsellers, even large transactions can!e easily accommodated.
(onversely, illi8uid currencies tendto exhi!it more volatileexchangerate movements.
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9actors that nfluence
Exchange Rates
e ;percentage change in the spot rate
INF;change in the relative inflation rateINT; change in the relative interest rate
INC
; change in the relative income levelGC; change in government controlsEXP;change in expectations of futureexchange rates
( )EXPGCINCINTINFfe = ,,,,
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$)
Quantity of
(0
'0
r0
U.S. inflation U.S. demand for
British goods, and
hence .
'1
r1
(1
9actors that nfluence
Exchange RatesRelative nflation Rates
British desire for U.S.goods, and hence the
decrease in supply of .
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$)
Quantity of
r0
(0
'0
(1
'1
r1
U.S. interest rates U.S. demand for
British bank deposits,
and hence .
9actors that nfluence
Exchange RatesRelative nterest Rates
British desire for U.S.bank deposits, and
hence the supply of .
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9actors that nfluence
Exchange RatesRelative nterest Rates
*t is thus useful to consider the realinterest rate, which ad+usts the noinal
interest rate for inflation.
A relatively high interest rate ay actuallyreflect epectations of relatively highinflation, which ay discourage foreign
investent.
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9actors that nfluence
Exchange RatesRelative nterest Rates
his relationship is soeties called the
-isher effect.
real noinalinterest interest inflation rate rate rate
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$)
Quantity of
(0
'0
r0
U.S. income level U.S. demand for
British goods, and
hence .'
1
r1
9actors that nfluence
Exchange RatesRelative ncome
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9actors that nfluence
Exchange Rates=overnment (ontrols
=overnments may influence the
e8uili!rium exchange rate !y: imposing foreign exchange !arriers,
imposing foreign trade !arriers,
intervening in the foreign exchangemar>et, and
affecting macro varia!les such asinflation, interest rates, and incomelevels.
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9actors that nfluence
Exchange RatesExpectations
9oreign exchange mar>ets react to
any nes that may have a futureeffect.
?es of a potential surge in @.'.
inflation may cause currency tradersto sell dollars.
Many institutional investors ta>ecurrency positions !ased onantici ated interest rate
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9actors that nfluence
Exchange RatesExpectations
!conoic signals that affect echange
rates can change "uic/ly, such thatspeculators ay overreact initially and
then find that they have to a/e a
correction.
(peculation on the currencies of eergingar/ets can have a su#stantial ipact on
their echange rates.
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9actors that nfluence
Exchange Rates9actor nteraction $he various factors sometimes
interact and simultaneously affectexchange rate movements.
9or example, an increase in incomelevels sometimes causesexpectations of higher interest rates,thus placing opposing pressures onforeign currency values.
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radeelated
-actors1. *nflation
'ifferential2. *ncoe
'ifferential3. 4ovt rade
estrictions
-inancial
-actors1. *nterest ate
'ifferential
2. 6apital -low
estrictions
o 9actors (an Affect Exchange Rates
7.(. deand for foreigngoods, i.e. deand for
foreign currency
-oreign deand for 7.(.goods, i.e. supply offoreign currency
7.(. deand for foreign
securities, i.e. deandfor foreign currency
-oreign deand for 7.(.securities, i.e. supply of
foreign currency
!changerate
#etweenforeign
currency
and thedollar
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9actors that nfluence
Exchange Rates9actor nteraction
!arge volume of international trade relative inflation rates may be more influential
!arge volume of capital flo"s interest ratefluctuations may be more influential
he sensitivity of an echange rate to the
factors is dependent on the volue ofinternational transactions #etween the two
countries.
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9actors that nfluence
Exchange Rates9actor nteraction
An understanding of echange rate
e"uili#riu does not guarantee accurateforecasts of future echange rates
#ecause that will depend in part on how
the factors that affect echange rates will
change in the future.
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Anticipated Exchange Rates'peculation
Many commercial !an>s attempt tocapitaliBe on their forecasts ofanticipated exchange rate
movements in the foreign exchangemar>et.
$he potential returns from foreign
currency speculation are high for!an>s that have large !orroingcapacity.
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!change at
$0.52)89$
:. ;olds$20,
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Anticipated Exchange Rates 'peculation
6hicago =an/ epects the echange rate of the 8ew
9ealand dollar to depreciate fro its present level of$0.50 to $0.:@ in 30 days.
!change at
$0.:@)89$
:. ;olds89$:1,
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Anticipated Exchange Rates'peculation
Exchange rates are very volatile, anda poor forecast can result in a largeloss.
One ellC>non !an> failure, 9ran>lin?ational an> in *12, as primarilyattri!uted to massive speculative
losses from foreign currencypositions.
an> ?egaraFs