FINC3240 International Finance Exchange Rate and Determination Chapter 4 6 7 8 1 Objectives A Explain how the equilibrium exchange rate is determined B Examine factors that determine the equilibrium exchange rate 2 Exchange Rate Movements when one currency depreciates against another the other must appreciate Appreciation vs Depreciation 3 Exchange Rate Equilibrium How exchange rates reach equilibrium 1 Demand for a Foreign Currency derived from the local buyers who are willing and able to purchase foreign goods but who must convert their local currencies 4 Demand Schedule for British Pounds Exhibit 4 2 page 87 5 Exchange Rate Equilibrium 2 Supply of a Foreign Currency derived from the foreigners who are willing and able to supply foreign currency and convert to local currency 6 Supply Schedule of British Pounds for Sale Exhibit 4 3 page 88 7 Equilibrium Exchange Rate Determination Exhibit 4 4 page 89 8 Exchange Rates Determinants 1 Relative Purchasing Power 2 Relative Inflation Rates 2 Relative Interest Rates 3 Relative Income Levels 4 Government Influence 9 Purchasing Power Parity PPP implication 1 Consumers shift their demand to wherever prices are lower for the same or similar goods considering the transportation costs 10 PPP Example 1 USD CHY 6 2000 Country US China Price per pound 2 USD 5 CHY Assuming the transportation cost is zero firms will import chicken from China and need to exchange USD for CHY until the prices in U S and China are close As a result demand in CHY will lead to appreciation in CHY and depreciation in USD 11 Purchasing Power Parity implication 2 Inflation affects currency s purchasing power The exchange rate should adjust to offset the difference in the inflation rates of the two countries 12 PPP Example 2 U S and U K initially had zero inflation Now assume that the U S experiences a 9 inflation rate while U K experiences a 5 inflation rate What happens to the exchange rate between GBP and USD considering zero transportation cost PPP theory suggests that the British pound should appreciate by approximately 4 the differential in inflation rates The reason is that lower inflation in U K means the price of the same goods produced in U K is relatively lower US consumers will buy more UK goods The increasing consumption of British goods by US consumers would persist until the pound appreciates by about 4 so that the prices of UK good are increased by the same percentage 13 PPP Derivation 1 Home country price indexes Ph Foreign country price indexes Pf Assume Ph Pf Over time Home country inflation rate Foreign country inflation rate I Ih If I If h f and the exchange rate between the currencies does not change then the consumer s purchasing power is greater on foreign goods than on home goods If I h I f and the exchange rate between the currencies does not change then the consumer s purchasing power is greater on home goods than on foreign goods 14 PPP Derivation 2 Foreign price index from the home consumer s perspective Pf 1 I f 1 e f Where e f is the percentage change in the value of the foreign currency Home price index from the home consumer s perspective Ph 1 I h PPP suggests the percentage change in the foreign currency should change to maintain parity in the new price indexes of the two countries Therefore Pf 1 I f 1 e f Ph 1 I h 15 PPP Derivation 3 Pf 1 I f 1 e f Ph 1 I h 1 ef Ph 1 I h Pf 1 I f Ph 1 I h ef 1 Pf 1 I f Since Ph Pf because price indexes were initially assumed equal in both countries ef 1 I h 1 1 I f 16 PPP Derivation 4 1 I h ef 1 1 I f If I h I f then e 0 So foreign currency will f appreciate f If I h I f then e 0 So foreign currency will depreciate 17 PPP Application Assume an initial equilibrium where GBP s spot rate is 1 60 US inflation and British inflation are both 3 If US inflation suddenly increase to 5 the GBP will appreciate against the dollar by approximately 2 according to PPP The rational is after US prices rises US demand for British goods will increase placing upward pressure on the GBP s value 18 Interest Rate Parity Interest Rate Parity Theorem IRP The exchange rate will adjust by a sufficient amount to offset the interest rate differential between two currencies 19 IRP Example 1 Euro spot rate EUR USD 0 60 Euro 6 months interest rate 8 p a USD 6 month interest rate 4 p a What is the theoretical price of Euro 6 months from today Forward Rate Intuition returns from investing in USD denominated fixedincome securities should equal returns from such an alternative strategy that exchanging USD for EUR investing in EUR denominated fixed income securities and then after 6 months exchanging EUR back to USD 20 IRP Example 2 Returns cash inflow from investing 100 in denominated fixed income securities 0 04 100 1 2 Returns from alternative strategy 1 0 08 100 1 F6 m 0 6 2 Therefore 1 0 08 0 04 100 1 F6 m 100 1 0 6 2 2 The 6 month forward rate theoretical fair price based on IRP F6 m 0 5885 21 IRP Derivation 1 Amount of the home currency to be invested A Spot rate in home currency S Interest rate on home deposit ih Interest rate on foreign deposit i f Forward rate in home currency F Compare the amount of home currency received at the end of the period Strategy A A 1 ih Strategy B A 1 i f F S 22 IRP Derivation 2 A A 1 ih 1 i f F S 1 ih F S 1 i f If ih if then F S which means in the future home currency will depreciate while foreign currency will appreciate Why If ih if then F S which means in the future home currency will appreciate while foreign currency will depreciate Why 23 Premium vs Discount 1 i F S h 1 if F 1 ih S 1 if F 1 ih 1 1 S 1 if F S 1 ih 1 S 1 if 1 ih Pr emium Discount 1 1 if 24 IRP Application 1 Strategy 1 invest in USD for 180 days Strategy 2 a sell USD for EUR at spot rate buy a forward USD contract b invest EUR for 180 days in Germany 3 after 180 days sell EUR for USD through the forward contract Q Does IRP holds 25 Testing IRP When Assessing Interest Rate Parity should also consider a Transaction Costs b Political Risk c Differential Tax Laws 26 International Fisher Effect A currency s exchange rate will depreciate against another currency when its interest rate and therefore expected inflation rate is higher than that of the other currency 27 Relative Income Levels Because income can affect the amount of imports demanded it can …