4 Exchange Rate Determination

Chapter Objectives

▪ Explain how exchange rate movements are measured.

▪ Explain how the equilibrium exchange rate is
determined.
▪ Examine factors that determine the equilibrium
exchange rate.
▪ Explain the movement in cross exchange rates.
▪ Explain how financial institutions attempt to capitalize
on anticipated exchange rate movements.
 Key Definitions

▪ The exchange rate is the number of units of one

currency (called the price or quote currency) that
one unit of another currency (called the base
currency) will buy.
• A spot rate is the price at which currencies are
traded for immediate delivery; actual delivery
takes place two days later.
• A forward rate is the price at which foreign
exchange is quoted for delivery at a specified
future date.

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 Direct and indirect exchange rates

• A direct currency quote takes the domestic

country as the price currency and the foreign
country as the base currency.
• Indirect quotes are just the inverse of the direct
quote GBP/EUR.
• The euro–US dollar exchange rate means the
number of US dollars per one euro (USD/EUR).
• The two-sided price quoted by the dealer is in
terms of buying/selling the base currency.

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 Measuring Exchange Rate Movements

▪ Comparing foreign currency spot rates over two

points in time, S and St-1
𝑆 − 𝑆𝑡−1
Percent Δ in foreign currency value =
𝑆𝑡−1
• A positive percent change indicates that the currency
has appreciated.
• A negative percent change indicates that it has
depreciated.

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 Forward Quotations

• Forward rates can be expressed in two ways.

• Commercial customers are usually quoted the actual
price, otherwise known as the outright rate.
• In the interbank market, however, dealers quote the
forward rate only as a discount from, or a premium
on, the spot rate.
• This forward differential is known as the swap rate.
• A forward discount exists if the forward rate
expressed in the price currency is below the spot rate
• A forward premium exists if the forward rate is above
the spot rate
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 Forward Quotations

• For example, the Japanese yen is quoted at a spot

rate of $0.013023, whereas 180-day forward yen is
priced at $0.013055.
• Based on these rates, the swap rate for the 180-day
forward yen is quoted as a 32-point premium
(0.013055 − 0.013023), where a point, or “pip”,
refers to the last digit quoted.

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 Forward Quotations

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 Forward Quotations

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 Forward Quotations

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 Forward Quotations

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 Forward Quotations

• The swap rates do not carry plus or minus signs, you

can determine whether the forward rate is at a
discount or a premium using the following rule:
when the forward bid in points is smaller than the
ask rate in points, the forward rate is at a premium
and the points should be added to the spot price to
compute the outright quote.
• Conversely, if the bid in points exceeds the ask rate
in points, the forward rate is at a discount and the
points must be subtracted from the spot price to get
the outright quotes.
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 Forward Quotations

• Calculating the forward premium or discount

F −S 360
= × × 100
S 𝑛

where F = the forward rate of exchange

S= the spot rate of exchange
n= the number of days in the forward contract

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 Forward Quotations

• Suppose that the spot Japanese yen on September

16, 2011, sold at $0.013023, whereas 180-day
forward yen were priced at $0.013055.
• Find the annualized percentage deviation from the
spot rate.

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 Forward Quotations

• Suppose that the spot Japanese yen on September

16, 2011, sold at $0.013023, whereas 180-day
forward yen were priced at $0.013055.
• Find the annualized percentage deviation from the
spot rate.
• Forward premium or discount annualized=
0.013055 − 0.013023 360
× × 100 ≅ 0.49%
0.013023 180

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 Forward Quotations

• Suppose that the 90-day British pound was quoted at

$1.5773, whereas the spot pound was $1.5788.
• Find the annualized percentage deviation from the
spot rate.

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 Forward Quotations

• Suppose that the 90-day British pound was quoted at

$1.5773, whereas the spot pound was $1.5788.
• Find the annualized percentage deviation from the
spot rate.
• Forward premium or discount annualized=
1.5773 − 1.5788 360
= × × 100 ≅ −0.38%
1.5788 90

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 Exchange Rate Equilibrium

• The exchange rate represents the price of a

currency, or the rate at which one currency can
be exchanged for another.
• Demand for a currency:
• Derived from the demand for foreign country’s
goods, services, and financial assets.
• Increases when the value of the currency
decreases, leading to a downward sloping
demand schedule.

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 Demand Schedule for British Pounds

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 Balance of Payments and the Exchange Rate

Credits Debits Exchange rate $

Current Account
1 Exports $3,044.1 P S
2 Imports ($3,362.1)
3 Unilateral Transfers $128.6 ($273.6)
Balance on Current Account ($463.0)
Financial Account
4 Direct Investment $379.4 ($348.6)
5 Portfolio Investment $276.3 ($154)
6 Other Investments $270.9 $235.1 D
Balance on Financial Account $188.9
7 Errors and omissions $267.8
Q

As U.S. citizens export, others demand dollars at the FOREX market.

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 Exchange Rate Equilibrium

• Supply of a currency
• Derived from the foreign country’s demand for
local goods.
• Increases when the value of the currency
increases, leading to an upward sloping supply
schedule.
• Equilibrium equates the quantity of the
currency demanded with the supply of the
currency for sale.
• In liquid spot markets, exchange rates are not
highly sensitive to large currency transactions.
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 Supply Schedule of British Pounds for Sale

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 Balance of Payments and the Exchange Rate

Credits Debits Exchange rate $

Current Account
1 Exports $3,044.1 P S
2 Imports ($3,362.1)
3 Unilateral Transfers $128.6 ($273.6)
Balance on Current Account ($463.0)
Financial Account
4 Direct Investment $379.4 ($348.6)
5 Portfolio Investment $276.3 ($154)
6 Other Investments $270.9 $235.1 D
Balance on Financial Account $188.9
7 Errors and omissions $267.8
Q
As U.S. citizens import, they supply dollars to the FOREX market.
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 Equilibrium Exchange Rate Determination

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 Factors That Influence Exchange Rates

The equilibrium exchange rate will change over time

as supply and demand schedules change.
𝑒 = 𝑓(Δ𝐼𝑁𝐹, Δ𝐼𝑁𝑇, Δ𝐼𝑁𝐶, Δ𝐺𝐶, Δ𝐸𝑋𝑃)
where,
𝑒 = percentage change in the spot rate
Δ𝐼𝑁𝐹
= change in the differential between U.S. inflation and the foreign
country′s inflation
Δ𝐼𝑁𝑇
= change in the differential between the U.S. interest rate and the foreign
country′s interest rate
Δ𝐼𝑁𝐶
= change in the differential between the U.S. income level and the foreign
country′s income level
Δ𝐺𝐶 = change in government controls
Δ𝐸𝑋𝑃 = change in expectations of future exchange rates
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 Factors That Influence Exchange Rates

Relative Inflation:
• Changes in relative inflation rates can affect
international trade activity, which influences the
demand for and supply of currencies and therefore
affects exchange rates.
• Increase in U.S. inflation leads to increase in U.S.
demand for foreign goods, an increase in U.S. demand
for foreign currency, and an increase in the exchange
rate for the foreign currency.

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 Impact of Rising U.S. Inflation on the Equilibrium Value of
the British Pound

U.S. inflation 
 U.S. demand for
British goods, and
hence £.
 British desire for
U.S. goods, and
hence the supply of £.

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 Factors That Influence Exchange Rates

Relative Interest Rates:

• Changes in relative interest rates affect investment in
foreign securities, which influences the demand for
and supply of currencies and thus affects the
equilibrium exchange rate.
• Increase in U.S. rates leads to increase in demand for
U.S. deposits and a decrease in demand for foreign
deposits, leading to an increase in demand for dollars
and an increased exchange rate for the dollar.
Fisher Effect:
Real interest rate  Nominal interest rate − Inflation rate
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 Impact of Rising U.S. Interest Rates on the Equilibrium Value
of the British Pound

U.S. interest rates 

 U.S. demand for
British bank deposits,
and hence £.
 British desire for
U.S. bank deposits, and
hence the supply of £.

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 Factors That Influence Exchange Rates

Relative Income Levels

• Increase in U.S. income leads to increased in U.S.
demand for foreign goods and increased demand for
foreign currency relative to the dollar and an increase
in the exchange rate for the foreign currency.

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 Impact of Rising U.S. Income Levels on the Equilibrium
Value of the British Pound

U.S. income level 

 U.S. demand for British
goods, and hence £.
No expected change for
the supply of £.

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 Factors That Influence Exchange Rates

Government Controls via:

• Imposing foreign exchange barriers
• Imposing foreign trade barriers
• Intervening in foreign exchange markets
• Affecting macro variables such as inflation, interest
rates, and income levels.

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 Factors That Influence Exchange Rates

Exchange rates are also influenced by expectations

of central bank behavior.
Central bank is the nation’s official monetary
authority.
• its job is to use the instruments of monetary policy
to achieve one or more of the following objectives:
• price stability,
• low interest rates,
• a target currency value.
• Currency’s value is largely determined by the central
bank through its control of the money supply.
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 Factors That Influence Exchange Rates

Central banks should adopt rules for price stability that

are verifiable, unambiguous, and enforceable—along
with the independence and accountability.
When the bank limits its focus to price stability, it is
more likely to succeed in its goal.

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 Factors That Influence Exchange Rates

Expectations:
• Although currency values are affected by
current events and current supply and demand
flows in the foreign exchange market, they also
depend on expectations/ forecasts about future
exchange rate movements.

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 Factors That Influence Exchange Rates

Expectations:
• If investors expect interest rates in one country
to rise, they may invest in that country leading
to a rise in the demand for foreign currency and
an increase in the exchange rate for foreign
currency.
• Impact of signals on currency speculation.
Speculators may overreact to signals causing
currency to be temporarily overvalued or
undervalued.

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 The Nature of Money and Currency Values

• Money has value, which depends on its

purchasing power.
• Money also provides liquidity which facilitates
economic transactions
• Money represents both a store of value and a
store of liquidity.
• The demand for money depends on money’s
ability to maintain its value and on the level of
economic activity.

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 The Nature of Money and Currency Values

• Economic factors that affect a currency’s foreign

exchange value:
• Usefulness as a store of value, determined by its
expected rate of inflation (depends on the country’s
monetary policy)
• The demand for liquidity, determined by the volume of
transactions in that currency (depend on expected
economic growth and political and economic stability).
• The demand for assets denominated in that currency,
determined by the risk-return pattern on investment in
that nation’s economy and by the wealth of its residents
(depend on expected economic growth and political and
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economic stability).
 The Nature of Money and Currency Values

Soundness of a nation’s economic policies

• All three factors ultimately depend on the soundness
of the nation’s economic policies.
• The sounder these policies, the more valuable the
nation’s currency will be
• Conversely, the more uncertain a nation’s future
economic and political course, the riskier its assets
will be, and the more depressed and volatile its
currency’s value.

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 Factors that Influence Exchange Rates

Interaction of Factors:
• Trade-related foreign exchange transactions are
generally less responsive to news.
• In contrast, financial flow transactions are
extremely responsive to news because decisions to
hold securities denominated in a particular currency
often depend on anticipated changes in currency
values.
• Sometimes trade-related factors and financial
factors interact and simultaneously affect exchange
rate movements.
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 Summary of How Factors Can Affect Exchange Rates

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 Foreign Exchange Market Intervention

• Depending on their economic goals, some

governments will prefer an overvalued domestic
currency, whereas others will prefer an undervalued
currency.
• Still others just want a correctly valued currency, but
economic policymakers may feel that the exchange
rate set by the market is irrational; that is, they feel
they can better judge the correct exchange rate than
can the market.
• The tradeoffs faced by governments in terms of their
exchange rate objectives are illustrated by the
example of China’s yuan.
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 Foreign Exchange Market Intervention

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 Foreign Exchange Market Intervention

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