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International Finance 2019

Section no.4

Georgia Section - Fourth Year Groups

Part 1: The International Financial Environment

Presenter: Amin Ahmed Amin

Chapter 4: Exchange Rate Determination

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Main Concepts

1. 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 a
particular currency, that currency is said to be “mixed in trading.”

Where:

S denotes the spot rate at the more recent date.

St-1 denotes the spot rate at the earlier date.

A positive % delta change represents appreciation of the foreign currency, while a

negative % delta change represents depreciation.

2. 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.

Although it is easy to measure the percentage change in the value of a currency, it is

more difficult to explain why the value changed or to forecast how it may change in
the future.

To achieve either of these objectives, the concept of an equilibrium exchange rate must
be understood, as well as the factors that affect the equilibrium rate.

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A. Demand for a Currency

B. Supply of a Currency for Sale

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C. Equilibrium

* Impact of Liquidity

The liquidity of a currency affects the sensitivity of the exchange rate to specific
transactions. With many willing buyers and sellers, even large transactions can be
easily accommodated. Conversely, illiquid currencies tend to exhibit more volatile
exchange rate movements.

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3. Factors That Influence Exchange Rates

The equilibrium exchange rate will change over time as supply and demand schedules
change.

The following equation summarizes the factors that can influence a currency’s spot
rate:

A. Relative Inflation Rates

Changes in relative inflation rates can affect international trade activity, which
influences the demand for and supply of currencies and therefore influences exchange
rates.

B. Relative Interest Rates

Changes in relative interest rates affect investment in foreign securities, which

influences the demand for and supply of currencies and therefore influences exchange
rates.

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* Real Interest Rates

Although a relatively high interest rate may attract foreign inflows (to invest in
securities offering high yields), the relatively high interest rate may reflect
expectations of relatively high inflation.

C. Relative Income Levels

A third factor affecting exchange rates is relative income levels. Because income can
affect the amount of imports demanded, it can affect exchange rates.

Changing income levels can also affect exchange rates indirectly through effects on
interest rates.

D. Government Controls

A fourth factor affecting exchange rates is government controls. The governments of

foreign countries can influence the equilibrium exchange rate in many ways,
including:

(1) imposing foreign exchange barriers.

(2) imposing foreign trade barriers.

(3) intervening (buying and selling currencies) in the foreign exchange markets.

(4) affecting macro variables such as inflation, interest rates, and income levels.

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E. Expectations

A fifth factor affecting exchange rates is market expectations of future exchange rates.
Like other financial markets, foreign exchange markets react to any news that may
have a future effect.

Many institutional investors (such as commercial banks and insurance companies) take
currency positions based on anticipated interest rate movements in various countries.

* Interaction of Factors

The various factors sometimes interact and simultaneously affect exchange rate
movements. For example, an increase in income levels sometimes causes expectations
of higher interest rates, thus placing opposing pressures on foreign currency values.

4. Speculating on Anticipated Exchange Rates

Many commercial banks attempt to capitalize on their forecasts of anticipated

exchange rate movements in the foreign exchange market. The potential returns from
foreign currency speculation are high for banks that have large borrowing capacity.

Exchange rates are very volatile, and a poor forecast can result in a large loss. One
well-known bank failure, Franklin National Bank in 1974, was primarily attributed to
massive speculative losses from foreign currency positions.

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Summary of How Factors Can Affect Exchange Rates

Questions

1. In general, when speculating on exchange rate movements, the speculator will borrow the
currency that is expected to appreciate and invest in the country whose currency is expected
to depreciate.

Answer: FALSE

Note: The speculator will borrow the currency that is expected to depreciate and invest in
the country whose currency is expected to appreciate.

2. The exchange rates of smaller countries are very stable because the market for their
currency is very liquid.

Answer: FALSE

Note: The exchange rates of smaller countries with illiquid market are unstable, sensitive,
and severely affected by large transactions and tend to exhibit more volatile exchange rate
movements.

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Questions

3. An increase in U.S. inflation relative to Singapore inflation places upward pressure

on the Singapore dollar.

Answer: TRUE

4. When expecting a foreign currency to depreciate, a possible way to speculate on this

movement is to borrow dollars, convert the proceeds to the foreign currency, lend in
the foreign country, and use the proceeds from this investment to repay the dollar loan.

Answer: FALSE

Note: When expecting a foreign currency to depreciate the speculator will borrow that
currency and invest in the dollar, then use the proceeds from this investment to repay
the foreign currency loan (after the depreciation happens).

Questions

5. Since supply and demand for a currency are constant (primarily due to government
intervention), currency values seldom fluctuate.

Answer: FALSE

Note: The supply and demand for any currency are changeable (it's never to be
constant), but the government intervention can influence the equilibrium exchange rate
in many ways to match supply and demand at the targeted level.

6. Relatively high Japanese inflation may result in an increase in the supply of yen for
sale and a reduction in the demand for yen.

Answer: TRUE

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Questions

7. The main effect of interest rate movements on exchange rates is through their effect on
international trade.

Answer: FALSE

Note: Changes in relative interest rates affect investment in foreign securities, which
influences the demand for and supply of currencies and therefore influences exchange rates.

8. Increases in relative income in one country vs. another, result in an increase in that
country’s currency value.

Answer: FALSE

Note: The increase in relative income in one country vs. another, will result in a decrease in
that country’s currency value. Because increase in relative income will result in an increase
in the amount of imports demanded from that foreign country, and will lead to currency
depreciation (decrease in the equilibrium exchange rate).

Questions

9. Signals regarding future actions of market participants in the foreign exchange

market sometimes result in overreactions.

Answer: TRUE

10. The markets that have a smaller amount of foreign exchange trading for
speculatory purposes than for trade purposes will likely experience more volatility
than those where trade flows play a larger role.

Answer: TRUE

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Questions

11. The value of the Australian dollar (A$) today is $0.73. Yesterday, the value of the
Australian dollar was $0.69. The Australian dollar _______ by _______%.

A) depreciated; 5.80

B) depreciated; 4.00

C) appreciated; 5.80

D) appreciated; 4.00

Answer: C

($0.73 – $0.69) / $0.69 = 5.80%

Questions

12. If a currency’s spot rate market is _______, its exchange rate is likely to be
_______ to a single large purchase or sale transaction.

A) liquid; highly sensitive

B) illiquid; insensitive

C) illiquid; highly sensitive

D) none of these

Answer: C

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Questions

13. _______ is not a factor that causes currency supply and demand schedules to
change.

A) Relative inflation rates

B) Relative interest rates

C) Relative income levels

D) Expectations

E) All of these are factors that cause currency supply and demand schedules to change.

Answer: E

Questions

14. An increase in U.S. interest rates relative to German interest rates would likely
_______ the U.S. demand for euros and _______ the supply of euros for sale.

A) reduce; increase

B) increase; reduce

C) reduce; reduce

D) increase; increase

Answer: A

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Questions

15. When the “real” interest rate is relatively low in a given country, then the currency
of that country is typically expected to be:

A) weak, since the country’s quoted interest rate would be high relative to the inflation
rate.

B) strong, since the country’s quoted interest rate would be low relative to the inflation
rate.

C) strong, since the country’s quoted interest rate would be high relative to the
inflation rate.

D) weak, since the country’s quoted interest rate would be low relative to the inflation
rate.

Answer: D

Questions

16. Assume that the inflation rate becomes much higher in the U.K. relative to the U.S.
This will place _______ pressure on the value of the British pound. Also, assume that
interest rates in the U.K. begin to rise relative to interest rates in the U.S. The change
in interest rates will place _______ pressure on the value of the British pound.

A) upward; downward

B) upward; upward

C) downward; upward

D) downward; downward

Answer: C

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Questions

17. The equilibrium exchange rate of pounds is $1.70. At an exchange rate of $1.72 per
pound:

A) U.S. demand for pounds would exceed the supply of pounds for sale and there would be
a shortage of pounds in the foreign exchange market.

B) U.S. demand for pounds would be less than the supply of pounds for sale and there
would be a shortage of pounds in the foreign exchange market.

C) U.S. demand for pounds would exceed the supply of pounds for sale and there would be
a surplus of pounds in the foreign exchange market.

D) U.S. demand for pounds would be less than the supply of pounds for sale and there
would be a surplus of pounds in the foreign exchange market.

E) U.S. demand for pounds would be equal to the supply of pounds for sale and there would
be a shortage of pounds in the foreign exchange market.

Answer: D

Questions

18. The real interest rate adjusts the nominal interest rate for:

A) exchange rate movements.

B) income growth.

C) inflation.

D) government controls.

E) none of these.

Answer: C

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Questions

19. Which of the following is not mentioned in the text as a factor affecting exchange
rates?

A) relative interest rates.

B) relative inflation rates.

C) government controls.

D) expectations.

E) All of these are mentioned in the text as factors affecting exchange rates.

Answer: E

Questions

20. Baylor Bank believes the New Zealand dollar will appreciate over the next five
days from $.48 to $.50. The following annual interest rates apply:
Currency Lending Rate Borrowing Rate
Dollars 7.10% 7.50%
New Zealand dollar (NZ$) 6.80% 7.25%

Baylor Bank has the capacity to borrow either NZ$10 million or $5 million. If Baylor
Bank’s forecast if correct, what will its dollar profit be from speculation over the five-
day period (assuming it does not use any of its existing consumer deposits to capitalize
on its expectations)?

A) $521,325. B) $500,520. C) $104,262. D) $413,419. E) $208,044.

Answer: E

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Questions

Solution in Steps:

1. Borrow $5 million.

2. Convert to NZ$: $5,000,000/$.48 = NZ$10,416,667.

3. Invest the NZ$ at an annualized rate of 6.80% over five days.

NZ$10,416,667 × [1 + 6.80% (5/360)] = NZ$10,426,505

4. Convert the NZ$ back to dollars: NZ$10,426,505 × $.50 = $5,213,252

5. Repay the dollars borrowed. The repayment amount is:

$5,000,000 × [1 + 7.5% (5/360)] = $5,000,000 × [1.00104] = $5,005,208

6. After repaying the loan, the remaining dollar profit is:

$5,213,252 – $5,005,208 = $208,044

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