Professional Documents
Culture Documents
IFM Chapter 04
IFM Chapter 04
Chapter: 04
Chapter Objectives
To explain how exchange rate movements
are measured;
Measuring
Exchange Rate Movements
An exchange rate measures the value of
one currency in units of another currency.
Depreciate
Appreciate
Mixed in trading
Measuring
Exchange Rate Movements
where St denotes the spot rate at time t and St-1
denotes exchange rate at an earlier period.
Measuring
Exchange Rate Movements
A positive % represents appreciation of
Measuring
Exchange Rate Movements
Equilibrium
Government Control
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, and (4) affecting
macro variables such as inflation, interest rates,
and income levels.
Government Control
Example: Recall the example in which U.S. interest
rates rose relative to British interest rates. The
expected reaction was an increase in the British
supply of pounds for sale to obtain more U.S.
dollars (in order to capitalize on high U.S. money
market yields). Yet, if the British government
placed a heavy tax on interest income earned from
foreign investments, this could discourage the
exchange of pounds for dollars.
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.
News of a potential surge (sudden increase) in
U.S. inflation may cause currency traders to sell
dollars, anticipating a future decline in the
dollars value. This response places immediate
downward pressure on the dollar.
Expectations
Example: Investors may temporarily invest
funds in Canada if they expect Canadian
interest rates to increase. Such a rise may
cause further capital flows into Canada, which
could place upward pressure on the Canadian
dollars value. By taking a position based on
expectations, investors can fully benefit from
the rise in the Canadian dollars value because
they will have purchased Canadian dollars
before the change occurred.
Strengthened
Weakened
Interaction Factors
When more than one factors interact with each other.
Transactions within the foreign exchange markets
facilitate either trade or financial flows. Trade-related
(e.g. Export-import) foreign exchange transactions
are generally less responsive to news (signal).
Financial flow transactions are very responsive to
news, however, because decisions to hold securities
denominated in a particular currency are often
dependent on anticipated changes in currency values.
Interaction Factors
Interaction Factors
Example: interaction between increase in income and
expectations
Interaction Factors
Example: interaction between inflation rate and
interest rate
Interaction Factors
The sensitivity of the exchange
rate to these factors is
dependent on the volume of
international transactions
between the two countries.
Points to be noted:
The bank would earn this speculative
profit without using any funds from
deposit accounts because the funds
would have been borrowed through the
interbank market.
1. Borrows
$20 million
Exchange at
$0.50/NZ$
2. Holds
NZ$40 million
Borrows at 7.20%
for 30 days
Returns $20,120,000
Profit of $792,320
Lends at 6.48%
for 30 days
4. Holds
$20,912,320
Exchange at
$0.52/NZ$
3. Receives
NZ$40,216,000
1. Borrows
NZ$40 million
Exchange at
$0.50/NZ$
2. Holds
$20 million
Borrows at 6.96%
for 30 days
4. Holds
NZ$41,900,000
Returns NZ$40,232,000
Profit of NZ$1,668,000
Exchange at
or $800,640
$0.48/NZ$
Lends at 6.72%
for 30 days
3. Receives
$20,112,000
E CF E ER
Value =
t =1
j 1
j, t
1 k
j, t
E (CFj,t )
=
expected cash flows in
currency j to be received by the U.S. parent at the
end of period t
E (ERj,t )
=
expected exchange rate at
which currency j can be converted to dollars at