Exchange

Rate
Determination
 Learning
Objectives
1. explain how exchange rate movements
are measured,

2. explain how the equilibrium exchange

rate is determined,

3. examine factors that affect the

equilibrium exchange rate,

4. explain the movements in cross

exchange rates, and

5. explain how financial institutions

attempt to capitalize on anticipated
exchange rate movements.
Forex Rate

Spot Rate Forward Rate

Measuring Volatility
Exchange Rate Volatility

FOREIGN EXCHANGE RATE MOVEMENTS A REVIEW OF ANNUAL EXCHANGE MANY MNCS REVIEW EXCHANGE RATES
TEND TO BE LARGER FOR LONGER TIME MOVEMENTS WOULD BE MORE BASED ON BOTH SHORT- AND LONG-TERM
HORIZONS APPROPRIATE FOR AN MNC THAT HORIZONS
CONDUCTS FOREIGN TRADE EVERY YEAR
Demand
for
Currency
Supply
for Currency
Equilibrium
Exchange Rate
Change of
Equilibrium Rate
1. Increase in Demand

2. Decrease in Demand

3. Increase in Supply

4. Decrease in Supply
What was the impact of 2010 Commonwealth Games on
Indian Currency?
What was the impact of 2020 Tokyo Olympics
on USD?
 Exchange Rate
Influencers
Change of
1.Inflation,
2.Interest,
3.Income,
4.Govt. control,
5.Expectations of future rates

This Photo by Unknown author is licensed under CC BY-SA.

This Photo by Unknown author is licensed under CC BY-SA.
 Assume there is a sudden and substantial increase in
What will be the British inflation while U.S. inflation remains low.

impact of (1) How is the demand schedule for pounds affected?

Relative
(2) How is the supply schedule of pounds for sale
affected?

Inflation? (3) Will the new equilibrium value of the pound

increase, decrease, or remain unchanged
What will be the Assume that U.S. and British interest rates are initially
impact of equal but then U.S. interest rates rise while British
rates remain constant.
Relative Interest
Rates?
Real & Nominal Interest
WHAT IS THE RELATIONSHIP AMONG REAL & NOMINAL
INTEREST? – FISHER EQUATION
 Assume that the U.S. income level rises substantially

What will be the while the British income level remains unchanged.
Consider the impact of this scenario on

impact of (1) the demand schedule for pounds,

Income Levels? (2) the supply schedule of pounds for sale, and

(3) the equilibrium exchange rate.

Govt. Control
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
 Impact of Favorable Expectations- Many institutional
investors (such as commercial banks and insurance
Future companies) take currency positions based on anticipated
interest rate movements in various countries

Expectation 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.
Exchange Rate Influencer Summary
Cross Exchange Rate
CAPITALIZING
ON EXPECTED 01 02 03
EXCHANGE Institutional
Speculation
Based on
Institutional
Speculation
Based on
Speculation by
Individuals

RATE Expected
Appreciation
Expected
Depreciation
MOVEMENTS
 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.

Carry Trade ◦ 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.
 Case

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.

1. Determine the profit or loss in USD?

2. Do you foresee any risk?