Exchange Rate Determination

Measuring Exchange Rate Movements

An exchange rate measures the value of one currency in units of another currency. As economic
conditions change, exchange rates can change substantially. A decline in a currency’s value is known
as depreciation. When the British pound depreciates against the U.S. dollar, this means that the U.S.
dollar is strengthening relative to the pound. An increase in currency value is known as
appreciation.
• When a foreign currency’s spot rate at two different times are compared, the spot rate at the
more recent date is denoted S and the spot rate at the earlier date is denoted as St-l. The
percentage change in the value of the foreign currency over a specified period is then computed
as follows:

• A positive percentage change indicates that the foreign currency has appreciated over the period,
and a negative percentage change indicates that it has depreciated over the period.
 How Exchange Rate Movements and Volatility Are Measured

Foreign exchange rate movements tend to be larger for longer time horizons. Thus, if yearly
exchange rate data were assessed the movements would be more volatile for each currency than
what is shown here, but the euro’s movements would still be more volatile than the Canadian
dollar’s movements.
If daily exchange rate movements were assessed the movements would be less volatile for each
currency than shown here, but the euro’s movements would still be more volatile than the Canadian
dollar’s movements.
Exchange Rate Equilibrium
• Like any other product sold in markets, the price of a currency is determined by the demand for
that currency relative to its supply.
• Thus, for each possible price of a British pound, there is a corresponding demand for pounds and
a corresponding supply of pounds for sale (to be exchanged for dollars).
• At any given moment, a currency should exhibit the price at which the demand for that currency
is equal to supply; this is the equilibrium exchange rate.
 Demand for a Currency
• At any point in time, there is only one exchange rate; the
exhibit shows how many pounds would be demanded at
various exchange rates for a given time. This demand
schedule is downward sloping because corporations and
individuals in the United States would purchase more
British goods when the pound is worth less
• Conversely, if the pound’s exchange rate is high then
corporations and individuals in the United States are less
willing to purchase British goods.
 Supply of a Currency for Sale
It shows the quantity of pounds for sale corresponding to
each possible exchange rate at a given time.
One can clearly see a positive relationship between the
value of the British pound and the quantity of British
pounds for sale (supplied), which is explained as follows.
When the pound’s valuation is high, British consumers and
firms are more willing to exchange their pounds for dollars
to purchase U.S. products or securities; hence they supply a
greater number of pounds to the market to be exchanged
for dollars.
 Equilibrium Exchange Rate
• The demand and supply schedules for British pounds are
combined for a given moment in time.
• At an exchange rate of $1.50, the quantity of pounds
demanded would exceed the supply of pounds for sale.
Consequently, the banks that provide foreign exchange
services would experience a shortage of pounds at that
exchange rate.
• At an exchange rate of $1.60, the quantity of pounds
demanded would be less than the supply of pounds for sale;
in this case, banks providing foreign exchange services would
experience a surplus of pounds at that exchange rate.
• The equilibrium exchange rate is $1.55 because this rate
equates the quantity of pounds demanded with the supply
of pounds for sale.
Change in the Equilibrium Exchange Rate
Increase in Demand Schedule
Decrease in Demand Schedule
Increase in Supply Schedule
Decrease in Supply Schedule
 Factors That Influence Exchange Rates

e = percentage change in the spot rate

∆ INF = change in the differential between U.S. inflation and the foreign country’s inflation
∆ INT = change in the differential between the U.S. interest rate and the foreign country’s interest rate
∆ INC = change in the differential between the U.S. income level and the foreign country’s income level
∆ GC = change in government controls
∆ EXP = change in expectations of future exchange rates
 Relative Inflation Rates
• The sudden jump in U.S. inflation should cause some
U.S. consumers to buy more British products instead of
U.S. products. At any given exchange rate, there would
be an increase in the U.S. demand for British goods,
which represents an increase in the U.S. demand for
British pounds
• In addition, the jump in U.S. inflation should reduce the
British desire for U.S. goods and thereby reduce the
supply of pounds for sale at any given exchange rate.
 Relative Interest Rates
• Assume that U.S. and British interest rates are
initially equal but then U.S. interest rates rise while
British rates remain constant. U.S. investors will likely
reduce their demand for pounds, because U.S. rates
are now more attractive than British rates.
• Because U.S. rates now look more attractive to
British investors with excess cash, the supply of
pounds for sale by British investors should increase
as they establish more bank deposits in the United
States. In response to this inward shift in the demand
for pounds and outward shift in the supply of pounds
for sale, the equilibrium exchange rate should
decrease.
 Relative Income Levels
• Assume that the U.S. income level rises substantially
while the British income level remains unchanged.
• Consider the impact of this scenario on (1) the demand
schedule for pounds, (2) the supply schedule of pounds
for sale, and (3) the equilibrium exchange rate.
• First, the demand schedule for pounds will shift outward,
reflecting the increase in U.S. income and attendant
increased demand for British goods.
• Second, the supply schedule of pounds for sale is not
expected to change. Hence the equilibrium exchange rate
of the pound should rise,
Government Controls
The governments of foreign countries can influence the equilibrium exchange rate in the following ways:

(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.
Expectations
• Impact of Favorable Expectations: Many institutional investors (such as commercial banks and
insurance companies) take currency positions based on anticipated interest rate movements in
various countries.
• Impact of Unfavorable Expectations: Just as speculators can place upward pressure on a
currency’s value when they expect it to appreciate, they can place downward pressure on a
currency when they expect it to depreciate.
• Impact of a Currency Crisis: Sometimes a currency depreciates to such an extent that a currency
crisis ensues. Many emerging markets have experienced a currency crisis. Some emerging
markets seem to have a currency crisis every few years.
Movements in Cross Exchange Rates
The movement in a cross exchange rate over a particular period can be measured as its percentage
change in that period, just as demonstrated previously for any currency’s movement against the
dollar. You can measure the percentage change in a cross exchange rate over some time period even
when you lack cross exchange rate quotations; as shown here:
• One year ago, you observed that the British pound was valued at $ 1.482 while the Swiss franc
(SF) was valued at $.78. Today, the pound is valued at $ 1.50 and the Swiss franc is worth $. 75.
This information allows you to determine how the British pound changed against the Swiss franc
over the last year:
Cross rate of British pound one year ago = 1.482/.78 = 1.9 (£1=SF1.9)
Cross rate of British pound today = 1.50/.75 = 2.0 (£1 = SF2.0)
Percentage change in cross rate of British pound = (2.0 – 1.9)/1.9 = .05263
Thus the British pound depreciated against the Swiss franc by about 5.26 percent over the last year.
Notice the following relationships:
■ If the British pound and Swiss franc move by the same percentage against the dollar,
then there is no change in the cross exchange rate. (Review the movements from
year 1 to year 2 in Exhibit)
■ If the British pound appreciates against the dollar by a greater percentage than the
Swiss franc appreciates against the dollar, then the British pound appreciates against
the Swiss franc. (Review the movements from year 2 to year 3 in Exhibit)
■ If the British pound appreciates against the dollar by a smaller percentage than the
Swiss franc appreciates against the dollar, then the British pound depreciates against
the Swiss franc. (Review the movements from year 3 to year 4 in Exhibit)
■ If the British pound depreciates against the dollar and the Swiss franc appreciates
against the dollar, then the British pound depreciates against the Swiss franc.
(Review the movements from year 4 to year 5 in Exhibit)
Institutional Speculation Based on Expected Appreciation
When financial institutions believe that a particular currency is presently valued lower than it
should be in the foreign exchange market, they may consider investing in that currency now before
it appreciates. They would hope to liquidate their investment in that currency after it appreciates
and thus benefit from selling it for a higher price than they paid.
• EXAMPLE
■ Chicago Co. expects the exchange rate of the New Zealand dollar (NZ$) to appreciate from its
present level of $.50 to $.52 in 30 days.
■ Chicago Co. is able to borrow $20 million on a short-term basis from other banks.
■ Present short-term interest rates (annualized) in the interbank market are as given in the table.
Given this information, Chicago Co. could proceed as follows.
1. Borrow $20 million.
2. Convert the $20 million to NZ$40 million (computed as $20,000,000/$.50).
3. Invest the New Zealand dollars at 6.48 percent annualized, which represents a .54 percent returnover
the 30-day period [computed as 6.48% (30/360)]. After 30 days, Chicago Co. will receive NZ$40,216,000
[computed as NZ$40,000,000 (1 + .0054)].
4. Use the proceeds from the New Zealand dollar investment (on day 30) to repay the U.S. dollars
borrowed. The annual interest on the U.S. dollars borrowed is 7.2 percent, or .6 percent over the 30-day
period [computed as 7.2% (30/360)]. The total U.S. dollar amount necessary to repay the U.S. dollar loan
is therefore $20,120,000 [computed as $20,000,000 (1 + .006)].
If the exchange rate on day 30 is $.52 per New Zealand dollar, as anticipated, then the number of New
Zealand dollars necessary to repay the U.S. dollar loan is NZ$38,692,308 (computed as $20,120,000/ $.52
per New Zealand dollar).
Given that Chicago Co. accumulated NZ$40,216,000 from lending New Zealand dollars, it would earn a
speculative profit of NZ$1,523,692, which is equivalent to $792,320 (given a spot rate of $.52 per New
Zealand dollar on day 30). The firm could earn this speculative profit without using any funds from
deposit accounts because the funds would be borrowed through the interbank market.
Institutional Speculation Based on Expected Depreciation

If financial institutions believe that a particular currency is presently valued higher than it should be
in the foreign exchange market, they may borrow funds in that currency now and convert it to their
local currency now—that is, before the target currency’s value declines to its “proper” level. The
plan would be to repay the loan in that currency after it depreciates, so that the institutions could
buy that currency for a lower price than the one at which it was initially converted to their own
currency.
EXAMPLE
Assume that Carbondale Co. expects an exchange rate of $.48 for the New Zealand dollar on day 30.
It can borrow New Zealand dollars, convert them to U.S. dollars, and lend the U.S. dollars out. On
day 30, it will close out these positions. Using the rates quoted in the previous example and
assuming that the firm can borrow NZ$40 million.
1. Borrow NZ$40 million.
2. Convert the NZ$40 million to $20 million (computed as NZ$40,000,000*$.50).
3. Lend the U.S. dollars at 6.72 percent, which represents a .56 percent return over the 30-day
period. After 30 days, it will receive $20,112,000 [computed as $20,000,000 (1 + .0056)].
4. Use the proceeds of the U.S. dollar loan repayment (on day 30) to repay the New Zealand dollars
borrowed. The annual interest on the New Zealand dollars borrowed is 6.96 percent, or .58 percent
over the 30-day period [computed as 6.96%*(30/360)]. The total New Zealand dollar amount
necessary to repay the loan is therefore NZ$40,232,000 [computed as NZ$40,000,000 (1 + .0058)].
If the exchange rate on day 30 is $.48 per New Zealand dollar, as anticipated, then the number of
U.S. dollars necessary to repay the NZ$ loan is $19,311,360 (computed as NZ$40,232,000*$.48 per
New Zealand dollar). Given that Carbondale accumulated $20,112,000 from its U.S. dollar loan, it
would earn a speculative profit of $800,640 without using any of its own money (computed as
$20,112,000 –$19,311,360).
The “Carry Trade”
One of the most common strategies used by institutional and individual investors to speculate in the
foreign exchange market is the carry trade, whereby investors attempt to capitalize on the
difference in interest rates between two countries. Specifically, the strategy involves borrowing a
currency with a low interest rate and investing the funds in a currency with a high interest rate. The
investor may execute a carry trade for only a day or for several months. The term “carry trade” is
derived from the phrase “cost of carry,” which in financial markets represents the cost of holding (or
carrying) a position in some asset.
EXAMPLE
Hampton Investment Co. is a U.S. firm that executes a carry trade in which it borrows euros (where
interest rates are presently low) and invests in British pounds (where interest rates are presently
high). Hampton uses $100,000 of its own funds and borrows an additional 600,000 euros. It will pay
.5 percent on its euros borrowed for the next month and will earn 1.0 percent on funds invested in
British pounds. Assume that the euro’s spot rate is $1.20 and that the British pound’s spot rate is
$1.80 (so the pound is worth 1.5 euros at this time). Hampton uses today’s spot rate as its best
guess of the spot rate one month from now. Hampton’s expected profits from its carry trade can be
derived as follows.
At Beginning of Investment Period
1. Hampton invests $100,000 of its own funds into British pounds: $100,000/$1.80 per pound =
55,555 pounds
2. Hampton borrows 600,000 euros and converts them into British pounds:
600,000 euros/1.5 euros per pound = 400,000 pounds
3. Hampton’s total investment in pounds: 55,555 pounds + 400,000 pounds = 455,555 pounds
At End of Investment Period
4. Hampton receives: 455,555*1.01 = 460,110 pounds
5. Hampton repays loan in euros: 600,000 euros*1.005 = 603,000 euros
6. Amount of pounds Hampton needs to repay loan in euros:
603,000 euros/1.5 euros per pound = 402,000 pounds
7. Amount of pounds Hampton has after repaying loan: 460,110 pounds - 402,000 pounds = 58,110
pounds
8. Hampton converts pounds held into U.S. dollars: 58,110 pounds*$1.80 per pound = $104,598
9. Hampton’s profit: $104,598 - $100,000 = $4,598
The profit of $4,598 to Hampton as a percentage of its own funds used in this carry trade strategy
over a one-month period is therefore $4,598/$100,000 = 4.598%.
Risk of the Carry Trade
The risk of the carry trade is that exchange rates may move opposite to what the investors
expected, which would cause a loss. Just as financial leverage can magnify gains from a carry trade,
it can also magnify losses from a carry trade when the currency that was borrowed appreciates
against the investment currency.
Hampton’s loss is due to the euro’s appreciation against the pound, which increased the number of
pounds that Hampton needed to repay the euro loan. Consequently, Hampton had fewer pounds to
convert into dollars at the end of the month. Because of its high financial leverage (its high level of
borrowed funds relative to its total investment), Hampton’s losses are magnified.
EXAMPLE
Assume the same conditions as in the previous example but with one adjustment. Namely, suppose
the euro appreciated by 3 percent over the month against both the pound and the dollar; this
means that, at the end of the investment period, the euro is worth $1.236 and a pound is worth
1.456 euros. Under these conditions, Hampton’s profit from its carry trade is measured below. The
changes from the previous example are highlighted below.
 EXAMPLE
At Beginning of Investment Period
1. Hampton invests $100,000 of its own funds into British pounds: 100,000/$1.80 per pound = 55,555 pounds
2. Hampton borrows 600,000 euros and converts them into British pounds: 600,000 euros/1.5 euros per pound =
400,000 pounds
3. Hampton’s total investment in pounds: 55,555 pounds + 400,000 pounds = 455,555 pounds
At End of Investment Period
4. Hampton receives: 455,555 * 1.01 = 460,110 pounds
5. Hampton repays loan in euros: 600,000 euros * 1.005 = 603,000 euros
6. Amount of pounds Hampton needs to repay loan in euros: 603,000 euros/1.456 euros per pound = 414,148
pounds
7. Amount of pounds Hampton has after repaying loan: 460,110 pounds - 414,148 pounds = 45,962 pounds
8. Hampton converts pounds held into U.S. dollars: 45,962 pounds * $1.80 per pound = $82,731
9. Hampton’s profit: $82,731 - $100,000 = - $17,268
In this case, Hampton experiences a loss that amounts to nearly 17 percent of its original $100,000
investment.