Unit 2 – Exchange Rate Determination

Session Delivered by

Mr. Uday kumar Jagannathan

ujagannathan.ms.mc@msruas.ac.in

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 Topic Objectives
Exchange Rate Determination

At the end of this topic, students will be able to:

 Explain Structural Models of Exchange Rate Determination
 Describe the Fischer effect and its influence on exchange rates
 Discuss Interest Rate Parity (IRP) and Purchasing Power Parity
(PPP)

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 Structural Models of Exchange Rate Determination

SUPPLY AND DEMAND MODEL (FLOW MODEL)

 Demand originates in home country citizens wanting to
purchase foreign goods and services
 Residents of home country wishing to acquire assets,
both real and financial, denominated in the foreign
currency and wishing to service foreign currency liabilities
incurred earlier
 Central banks intervening in the foreign exchange market
to buy the foreign currency because the home currency is
over valued
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 Mundell Fleming Model (Flow model)

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 Structural Models of Exchange Rate Determination

CURRENT ACCOUNT MONETARY MODEL (ASSET MARKET MODEL)

S = k + (ma – mb) - φ (ya – yb ) + λ(ia – ib )

 If ma rises then A’s citizens want to get rid of excess money stock and buy foreign
assets and hence A’s currency depreciates and foreign currency appreciates. This in
turn raises foreign goods prices and thus increases prices at home to restore PPP
 An increase in ia depreciates the A currency. In the monetary model the nominal
interest rate (given ib ) can only rise when the expected depreciation of A rises
 General empirical testing of the model has yielded dismal results
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 Structural Models of Exchange Rate Determination

CAPITAL ACCOUNT MONETARY MODEL (ASSET MARKET MODEL)

^ ^ ^ ^
S = (ma – mb) -θφ (ya – yb ) -αλ(ia – ib )+β(πae - πbe )

 If ma rises then A’s citizens want to get rid of excess money stock and buy foreign
assets and hence A’s currency depreciates and foreign currency appreciates. This in
turn raises foreign goods prices and thus increases prices at home to restore PPP
 The counter-intuitive effect of the interest rate effect in the current account model
has been removed and the negative effect of interest rate now appears
 These are long run conditions as opposed to current account model which
emphasizes short run conditions 6
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 Expectations, EMH and the Role of News
 Recall EMH from Portfolio Management
 Current exchange rate reflects all past information
 New information will cause immediate jumps to the exchange rate
 The exchange rate fluctuation can be broken down into two
components Expected change and Unexpected change
 Expected change consists of a discounted sum of expected changes in
the fundamentals
 Unexpected change is due to the changes in expectations about the
future value of the fundamentals
 Regress to get St+1= A1 + A2Ft,t+1+ ut and test the hypothesis for A1 and to
be zero and A2 to be 1 if forward rate is unbiased

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 Expectations, EMH and the Role of News

The departure of Forward rate from future spot rate

happens because of several reasons:
 Expectation is a theory and has been proven wrong on many occasions
 Time taken by market to absorb news
 Speculations by traders
 Market intervention by Central Banks (increases volatility)

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 Structural Models of Exchange Rate Determination

PORTFOLIO BALANCE MODEL (ASSET MARKET MODEL)

 Earlier two models assumed money was the only asset
 However, Domestic and foreign bonds may also be traded by the investor
 Problem starts to look like an asset diversification one
 Basic rule that an asset’s supply changes influence the return on that asset
 If UK Central Bank issues fresh bonds, then interest rate in UK should rise. In the short
run the pound should weaken against the dollar (Current account monetary model)
 Once the pound weakens investors would move bonds from UK to US
 This portfolio rebalancing will cause interest rates to rise in UK and fall in US
 In the long run, investors will be attracted to higher interest rates in UK and lower
interest rate in US and portfolio allocation will be restored (Capital Account model)
 Empirical verification of this model has not been satisfactory

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 Exchange Rate Determinants

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 Short-Run Determinants

 Generally dependent on bandwagon effects, over-reaction to news,

speculation, technical analysis
 Trend following Behaviour is the tendency for the market to follow
a trend. Increase in exchange rate is likely to be followed by
another increase
 Investor Sentiment is based on the consensus of the market. A
bullish market on the dollar is likely to strengthen it against other
currencies
 Order Flow : There is evidence of positive correlation between
exchange rate movements and order flows in the inter-dealer
market and with movements in customer – order flow

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 Long-Run Determinants

 Purchasing Power Parity or PPP [Price Ratio] and Relative PPP

[Difference in Inflation rates ]
 Structural Changes
 Investment Spending : increased investment will help strengthen the
currency
 Fiscal Stimulus : Government Spending can help strengthen a country’s
currency
 Private Savings: Japan’s savings rate has helped the country’s currency
strengthen
 Terms of Trade
 The price of a good that trades in international markets will have an impact
of the associated country’s currency e.g. oil prices can impact the Venezuelan
Bolivar
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 Medium Run Determinants (MRD)

• International Parity Conditions

• Current Account Trends
• Capital Flows
• Monetary Policy
• Fiscal Policy
• Economic Growth
• Central Bank Interventions

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 MRD - International Parity Conditions
Interest Rate Parity (IRP)

Market forces cause the forward rate to differ from the

spot rate by an amount that is sufficient to offset the
interest rate differential between the two currencies
Then, covered interest arbitrage is no longer feasible, and
the equilibrium state achieved is referred to as Interest
Rate Parity (IRP)

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 MRD - International Parity Conditions

Interpretation of IRP

• When IRP exists, it does not mean that both local and foreign
investors will earn the same returns
• What it means is that investors cannot use covered interest
arbitrage to achieve higher returns than those achievable in their
respective home countries

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 MRD - International Parity Conditions

An illustration:
• Assume that you are in US and need pounds in three months.
Realistically, you can do one of the following
 Buy a 90 day pound today, Keep the money in USD deposit
and convert after 90 days
 Buy pound today, invest in a pound fixed deposit maturing in
90 days

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 MRD - International Parity Conditions
Covered Interest Parity Theorem
• In Theory there should be no difference between two currencies
or else we could benefit from Covered Interest Arbitrage
 S is the USD/GBP spot rate
 Fn is the USD/GBP forward rate for n-year
 iGBP is the Annualized interest rate on sterling deposits of
maturity for n years
 iUSD is the Annualized interest rate on Eurodollar deposits of
maturity for n years

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 MRD - International Parity Conditions
Covered Interest Parity Theorem
Two clear choices (if I start with 1 USD)
i. Invest in USA for n years which will give (1+n iUSA ) in n years and
enter nto forward after n years at the Fn rate
ii. Convert at S now, get 1/S GBP now, invest in Pounds, get (1+n
iGBP ) in n years,
and There should be no difference between the two therefore (by
simple Rearrangement)

(1+n iGBP ) = (S) x (1+n iUSD ) x (1/Fn)

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 MRD- International Parity Conditions
Covered Interest Parity Theorem

If we assume that
(1+n iGBP ) > (S) x (1+n iUSD ) x (1/Fn)
The following would result
Assume for a moment
If LHS exceeds RHS i. Upward pressure on iUSD
i. Investors would borrow ii. Depreciation of dollar so S
dollars would increase
ii. Convert to GBP iii. Downward pressure on iGBP
iii. Invest in GBP iv. Rising demand for USD
iv. Enter into Fn contract forward implies Fn will fall
v. Till… RHS = LHS
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 MRD- International Parity Conditions
Covered Interest Parity Theorem

Therefore in the absence of restriction on capital

flows and transaction costs

(1+n iA )/(1+n iB ) = Fn /S

Using approximation, when niB is small enough

(n iA - n iB ) = (Fn - S)/S
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 MRD - International Parity Conditions
An example on Covered Interest Parity
Assume
S USD/Pound = 1.5000
F6 month USD/Pound = 1.4625
i USD = 1.50% and i Pound = 4.00 %

Parity condition requires

(1 + i USD)/(1 + i Pound ) = F USD/Pound /S USD/Pound
Þ F USD/Pound = S USD/Pound x (1 + i USD )/ (1 + iPound )
Þ F USD/Pound = 1.5000 x (1.0075/1.02) = 1.4816
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 MRD- International Parity Conditions
An example on Covered Interest Parity
Since the F6 month USD/Pound = 1.4625 < 1.4816
We should borrow in Pounds, convert now to USD, invest in
i USD enter into Forward contract, pay interest in i Pound and
convert back to USD

i) Borrow 1 million Pound, convert to USD

ii) Invest 1.5 million USD and get 1.0075 x 1.5 million = 1.51125 USD
iii) Convert it back to USD at the attractive rate of 1.4625 at the end of 6 months to get 1.033
million Pound
iv) Pay principal and interest back to British Bank of 1.02 million Pound
v) Pocket the difference of .0133 million Pounds!

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 MRD- International Parity Conditions
An example on Covered Interest Arbitrage
Eurodollar rate = 8.00 % per annum
Start End
$1,000,000 x 1.04 $1,040,000 Arbitrage
$1,044,638 Potential
Dollar money market

S =¥ 106.00/$ 180 days F180 = ¥ 103.50/$

Yen money market

.
¥ 106,000,000 . x 1.02 ¥ 108,120,000

Euroyen rate = 4.00 % per annum

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 Uncovered Interest Parity

(1+n iA )/(1+n iB )= [Sen (B/A ) /S(B/A )]

(n iA- niB )= [Sen (B/A ) - S(B/A )]/S(B/A )

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 MRD - International Parity Conditions
An example on Uncovered Interest Arbitrage
Investors borrow yen at 0.40% per annum
Start End
¥ 10,000,000 x 1.004 ¥ 10,040,000 Repay
¥ 10,500,000 Earn
Japanese yen money market ¥ 460,000 Profit

S =¥ 120.00/$ 360 days S360 = ¥ 120.00/$

US dollar money market

$ 83,333,333 x 1.05 $ 87,500,000

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 MRD : PPP Intro

S = PH/PF

[1 + (∆S/S)] = (1+πF)/(1+ πH)

Using Approximation,
(∆S/S) = (πF- πH)/(1+πH) = πF - πH

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 MRD - International Parity Conditions
Purchasing Power Parity and Exchange Rate Determination

When one country’s inflation rate rises relative to that of

another country, decreased exports and increased imports
depress the country’s currency
The theory of purchasing power parity (PPP) attempts to
quantify this inflation - exchange rate relationship

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 MRD - International Parity Conditions
Interpretations of PPP
• The absolute form of PPP, or the “law of one price,” suggests that
similar products in different countries should be equally priced
when measured in the same currency
• The relative form of PPP accounts for market imperfections like
transportation costs, tariffs, and quotas. It states that the rate of
price changes should be similar

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 MRD – PPP and Real Exchange Rate

Rt(B/A) = St(B/A)x PtB/PtA

Year India (A) USA (B)

CPI Rs/$ CPI
1997 100 36 100
2007 180 45 130

Rt(USD/INR) = 36 x 180/130 = 50
Thus the Rupee has shown real appreciation
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 MRD - International Parity Conditions
International Fisher Effect (IFE)
1. According to the Fisher effect, nominal risk-free interest rates contain a real rate
of return and an anticipated inflation (i = r + πe )
2. According to PPP, exchange rate movements are caused by inflation rate
differentials (∆S/S = πae - πbe )
3. Remember UIP states that (∆S/S = iae - ibe )

From 1, 2 and 3 above the Fischer Open Relation can be determined that ra = rb

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 Problem 1
Suppose that the treasurer of IBM has an extra cash reserve of $1,000,000 to invest for six
months. The six-month interest rate is 8% per annum in the U.S. and 6% per annum in
Canada. Currently, the spot exchange rate is C$1.60 per US dollar and the six-month forward
exchange rate is C$ 1.56 per US dollar. The treasurer of IBM does not wish to bear any
exchange risk. Where should he/she invest to maximize the return?

Solution: The market conditions are summarized as follows:

I$ = 4%; iC$ = 3%; S = 1.60 C$/USD; F = 1.56 C$/ USD
If $1,000,000 is invested in the U.S., the maturity value in six months will be
$1,040,000 = $1,000,000 (1 + .04).
Alternatively, $1,000,000 can be converted into C$ and invested at the Canada interest
rate, with the Canada maturity value sold forward. In this case the dollar maturity
value will be
$1,056,410 = ($1,000,000 x 1.60)(1 + .03)(1/1.56)
Clearly, it is better to invest $1,000,000 in Canada with exchange risk hedging.
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 Problem 2
While you were visiting London, you purchased a Jaguar for £35,000, payable in three months. You have enough
cash at your bank in New York City, which pays 0.35% interest per month, compounding monthly, to pay for the
car. Currently, the spot exchange rate is $1.45/£ and the three-month forward exchange rate is $1.40/£. In
London, the money market interest rate is 2.0% for a three-month investment. There are two alternative ways of
paying for your Jaguar.
(a) Keep the funds at your bank in the U.S. and buy £35,000 forward.
(b) Buy a certain pound amount spot today and invest the amount in the U.K. for three months so that the
maturity value becomes equal to £35,000.
Evaluate each payment method. Which method would you prefer? Why?
Option a:
When you buy £35,000 forward, you will need $49,000 in
three months to fulfill the forward contract. The present value
 Solution: The problem situation is of $49,000 is computed as follows:
summarized as follows: $49,000/(1.0035)3 = $48,489.
A/P = £35,000 payable in three months Thus, the cost of Jaguar as of today is $48,489.
iNY = 0.35%/month, compounding monthly Option b:
iLD = 2.0% for three months The present value of £35,000 is £34,314 = £35,000/(1.02). To
buy £34,314 today, it will cost $49,755 = 34,314x1.45. Thus the
S = $1.45/£; F = $1.40/£. cost of Jaguar as of today is $49,755.
You should definitely choose to use “option a”, and save
$1,266, which is the difference between $49,755 and $48489.

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 Summary
 Central banks intervene in the foreign exchange market to buy the
foreign currency because the home currency is over valued
 In the monetary model the nominal interest rate ia (given ib ) can only
rise when the expected depreciation of A rises
 The counter-intuitive effect of the interest rate effect in the current
account model has been removed and the negative effect of interest
rate appears in the capital account model
 Departure from Expectation can occur because of
 Time taken by market to absorb news
 Speculations by traders
 Market intervention by Central Banks (increases volatility)

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 Summary

• Investor Sentiment is based on the consensus of the market. A

bullish market on the dollar is likely to strengthen it against other
currencies. This is a major short run determinant of exchange rates
• Long run determinants of exchange rates can include parity of
interest rates, difference in inflation levels of two countries and
structural elements such as policy
• Medium run determinants include International Parity Conditions,
Current Account Trends, Capital Flows, Monetary Policy, Fiscal
Policy, Economic Growth, Central Bank Interventions
• The absolute form of PPP, or the “law of one price,” suggests that
similar products in different countries should be equally priced
when measured in the same currency

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 Summary

• The relative form of PPP accounts for market imperfections like

transportation costs, tariffs, and quotas. It states that the rate of
price changes should be similar
• The Fischer open relation states that the percent change in spot
rate is equal to the difference in inflation between the two
countries
• Central Bank Intervene for reasons that Forex markets may not use
all information available, Forex markets may be dominated by trend
following traders, Excessive speculation is happening in the market

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