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Chapter 04

International financial management Foreign currency derivatives

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6 views

Chapter 04

International financial management Foreign currency derivatives

Uploaded by

LuckyAwmi
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Chapter

4
EXCHANGE RATE DETERMINATION
MEASURING EXCHANGE RATE MOVEMENTS
 An exchange rate measures the value of one
currency in units of another currency.
 When a currency declines in value, it is said to
depreciate. When it increases in value, it is said
to appreciate.
 On the days when some currencies appreciate
while others depreciate against the dollar, the
dollar is said to be “mixed in trading.”
MEASURING EXCHANGE RATE MOVEMENTS
 The percentage change (% D) in the value of a
foreign currency is computed as
St – St-1
St-1
where St denotes the spot rate at time t.
• A positive % D represents appreciation of the
foreign currency, while a negative % D represents
depreciation.
EXCHANGE RATE EQUILIBRIUM
 An exchange rate represents the price of a
currency, which is determined by the demand
for that currency relative to the supply for that
currency.
Value of £
S: Supply of £
$1.60
equilibrium
$1.55
exchange rate
$1.50
D: Demand for £

Quantity of £
FACTORS THAT INFLUENCE EXCHANGE RATES

Relative Inflation Rates

$/£ U.S. inflation 


S1   U.S. demand for
S0
r1 British goods, and
r0 hence £.
D1   British desire for U.S.
D0
goods, and hence the
Quantity of £ supply of £.
FACTORS THAT INFLUENCE EXCHANGE RATES

Relative Interest Rates

U.S. interest rates 


$/£ S0   U.S. demand for
S1
r0 British bank deposits,
r1 and hence £.
D0   British desire for U.S.
D1
bank deposits, and
Quantity of £ hence the supply of £.
FACTORS THAT INFLUENCE EXCHANGE RATES
Relative Interest Rates
• A relatively high interest rate may actually
reflect expectations of relatively high inflation,
which discourages foreign investment.
• It is thus useful to consider real interest rates,
which adjust the nominal interest rates for
inflation.
FACTORS THAT INFLUENCE EXCHANGE RATES

Relative Interest Rates


• real nominal
interest  interest – inflation rate
rate rate
• This relationship is sometimes called the
Fisher effect.
FACTORS THAT INFLUENCE EXCHANGE RATES

Relative Income Levels

U.S. income level 


$/£
  U.S. demand for
S0 ,S1
British goods, and
r1
r0 hence £.
D1  No expected change for
D0
the supply of £.
Quantity of £
FACTORS THAT INFLUENCE EXCHANGE RATES
Government Controls
 Governments may influence the equilibrium
exchange rate by:
 imposing foreign exchange barriers,
 imposing foreign trade barriers,

 intervening in the foreign exchange market, and

 affecting macro variables such as inflation, interest


rates, and income levels.
FACTORS THAT INFLUENCE EXCHANGE RATES

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.
FACTORS THAT INFLUENCE EXCHANGE RATES
Expectations
Signal Impact on $
Poor U.S. economic indicators Weakened
Fed chairman suggests Fed is Strengthened
unlikely to cut U.S. interest rates
A possible decline in German Strengthened
interest rates
Central banks expected to Weakened
intervene to boost the euro
FACTORS THAT INFLUENCE EXCHANGE RATES
Interaction of Factors
 Trade-related factors and financial factors
sometimes interact. Exchange rate movements
may be simultaneously affected by these factors.
 For example, an increase in the level of income
sometimes causes expectations of higher interest
rates.
FACTORS THAT INFLUENCE EXCHANGE RATES
Interaction of Factors
• Over a particular period, different factors may
place opposing pressures on the value of a
foreign currency.
• The sensitivity of the exchange rate to these
factors is dependent on the volume of
international transactions between the two
countries.
HOW FACTORS CAN AFFECT EXCHANGE RATES

Trade-Related
Factors U.S. demand for foreign
1. Inflation goods, i.e. demand for
Differential foreign currency
2. Income
Differential Foreign demand for U.S. Exchange
3. Gov’t Trade goods, i.e. supply of rate
Restrictions foreign currency between
foreign
Financial U.S. demand for foreign currency
Factors securities, i.e. demand and the
for foreign currency dollar
1. Interest Rate
Differential Foreign demand for U.S.
2. Capital Flow securities, i.e. supply of
Restrictions foreign currency
FACTORS THAT INFLUENCE EXCHANGE RATES

How Factors Have Influenced Exchange Rates


 Because the dollar’s value changes by different
magnitudes relative to each foreign currency,
analysts often measure the dollar’s strength with
an index.
 The weight assigned to each currency is
determined by its relative importance in
international trade and/or finance.
SPECULATING ON ANTICIPATED EXCHANGE
RATES
Chicago Bank expects the exchange rate of the New
Zealand dollar to appreciate from its present level of
$0.50 to $0.52 in 30 days.

Borrows at 7.20%
for 30 days
1. Borrows 4. Holds
$20 million $20,912,320
Returns $20,120,000
Profit of $792,320
Exchange at Exchange at
$0.50/NZ$ $0.52/NZ$
Lends at 6.48%
2. Holds for 30 days 3. Receives
NZ$40 million NZ$40,216,000
SPECULATING ON ANTICIPATED EXCHANGE
RATES
Chicago Bank expects the exchange rate of the New
Zealand dollar to depreciate from its present level of
$0.50 to $0.48 in 30 days.

Borrows at 6.96%
for 30 days
1. Borrows 4. Holds
NZ$40 million NZ$41,900,000
Returns NZ$40,232,000
Profit of NZ$1,668,000
Exchange at or $800,640 Exchange at
$0.50/NZ$ $0.48/NZ$
Lends at 6.72%
2. Holds for 30 days 3. Receives
$20 million $20,112,000
Thank You

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