CHAPTER 4

Determining the
Exchange Rate
 Learning Objectives
◼ To understand how exchange rate
movements are measured;
◼ To determine the equilibrium exchange
rate.
◼ To examine the factors that affect the
equilibrium exchange rate.
◼ To conduct Speculation on
exchange rate movement.
 Exchange Rate Movement:
Measurement

❖ 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”
USD/GBP
https://www.exchangerates.org.uk/GBP-USD-exchange-rate-history.html
Dollar Yuan Exchange Rate
https://finance.yahoo.com
JPY/USD
https://www.xe.com/currencycharts/?from=USD&to=JPY&view=2Y
 Exchange Rate Movement:
Measurement

Measuring a change in the spot rate for

quotations expressed in home currency terms
(direct quotations):

%∆ = Ending rate – Beginning Rate x 100

Beginning Rate
Rule

Find the percentage change in the value

of the foreign currency
Example (Direct)

Today 3-Months

Spot = THB34.2323/USD Spot = THB35.3235/USD

(HC/FC) (HC/FC)

%∆ FC = THB35.3235/USD - THB34.2323/USD x 100

THB34.2323/USD

= 3.19% appreciation
in the value of USD
Example (Direct)

Today 3 Months

Spot = USD 0.0292 THB Spot =USD 0.0283/THB

HC/FC HC/FC

% ∆ FC= USD0.0283/THB - USD0.0292/THB X 100

USD0 .0292/THB
= - 3 .08%
 Exchange Rate Movement:
Measurement

Quotations expressed in foreign currency terms

(indirect quotations):
%∆ = Beginning Rate – Ending Rate x 100
Ending Rate
Indirect Quote

Today 3M

JPY3.4626/THB JPY3.2500/THB
(FC/HC) (FC/HC)

% ∆ FC = JPY 3.4626/THB - JPY 3.2500/THB X 100

JPY 3.2500/THB

=
Exchange Rate Movement
• A positive %  represents appreciation of
the foreign currency, while a negative %
 represents depreciation.

Percentage ∆ in the value of the foreign currency = S − St −1

 Annual Changes
in the Value of the Euro

Date Exchange Rate Annual %

1/1/2000 $1.001/€ –
1/1/2001 $.94/€ – 6.1%
1/1/2002 $.89/€ – 5.3%
1/1/2003 $1.05/€ +18.0%
1/1/2004 $1.26/€ +20.0%
Review (Direct Quote)

Currency Past Recent Appreciate

/Depreciate
THB/USD THB 31.41 THB 30.32
JPY/USD JPY 109.98 JPY112.90
EUR/GBP EUR 1.14 EUR 1.10
Measuring Change in the Currency
Value
• % change in the value of the base
currency
• EUR value changed from $1.2500/Euro
to $1.3000/Euro
• 1.3000/1.2500 - 1 = 4.00%
• How much has the $ value changed?
• (1/1. 3000 / 1/ 1.2500 ) -1
• (1.2500/1.3000) -1 = -3.85%
Exercise

The immediate aftermath of the Brexit

referendum saw sterling change sharply in value
from $1.24 to $1.10. By how much did the British
Pound change in value?
Percentage Change in the Value of the Foreign
Currency
• % ∆ FC (Direct) = Ending - Beginning
Beginning

• Ending St = B ( 1 + % ∆ )

• Beginning St −1 = Ending
(1+%∆)
 Percentage Change in the Value of the
Foreign Currency
Direct Indirect

% ∆ FC (Direct) = % ∆ FC (Indirect) =
Ending – Beginning Beginning - Ending
Beginning Ending

Ending St = B ( 1 + % ∆ ) Beginning St −1 = E ( 1 + % ∆ )

Beginning St −1 = Ending Ending St = Beginning

(1+%∆) (1+%∆)
Change in world currencies
Currency Pair Value Change

EUR-USD 1.0543 +0.08%

USD-JPY 135.11 +0.60%

GBP-USD 1.2276 -0.09%

EUR-CHF 0.9864 -0.09%

of base currency >> EUro
Example
find currency in Euro
1-M Ago Today

USD1.0535/EUR USD1.0543/EUR

Beginning St −1 = Ending
(1+%∆)
= 1.0543
1+ 0.0008
Example
1-M Today

CHF0.9873/ € CHF 0.9864/ €

0.9864/(1-0.09%)
Exercise

Expect average quarterly movement of

New Zealand

chg. indirect to direct 0.8216 USD/NZD

2023 Q2 = NZD 1.2172/USD

4.25% Q3 2023 Ending Q3= 0.8216(1+4.25%)
=0.8565 USD/NZD

-3.80% Q4 2023 Ending Q4= 0.8565*(1-3.8%)

= 0.8240 USD/NZD
 Domestic
Currency
Supply of Demand
Domestic for
Currency Domestic
Foreign
currency
Currency
== ==

MSME BUSINESSSCHOOL
ASSUMPTION UNIVERSITY
Demand and Supply of FC

DD for FC = SS of HC SS of FC = DD for HC
Outbound Tourist Inbound Tourist
Investment Overseas Foreign Investments
Import goods and services Export of goods and services
 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.
 Exchange Rate Equilibrium

Value of £

S: Supply of £
SS and DD
$1.60 for £
$1.55 Equilibrium determines
exchange rate the value
$1.50
of £
D: Demand for £

Quantity of £
Exchange Rate Equilibrium
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.
Foreign Exchange Rate
Determination
• Balance of Payments
» Current Account Balance
» Portfolio Investment
» Direct Foreign Investment
» Foreign Exchange Regime
» Official Monetary Reserve
FX Determination

• Parity Conditions
» Relative interest rate
» Relative Inflation rate
» Forward exchange rate

• Asset Market Approach

» Relative real interest rate
» Prospects for economic growth
» Economic and social infrastructure
» Political stability
» Speculation
 Factors that Influence
Exchange Rates

e = f (I N F, I N T, I N C, G C, E X P)
e = percentage change in the spot rate
INF = change in the relative inflation rate
 INT = change in the relative interest rate
 INC = change in the relative income level
 GC = change in government controls
 EXP = change in expectations of future
exchange rates
 Factors that Influence
Exchange Rates

Relative Inflation Rates

HC decrease

U.S. inflation 
$/£
S1   U.S. demand for
S0 British goods, and
r1 hence £.
r0
D1   British desire for U.S.
D0
goods, and hence the
Quantity of £ supply of £.

DD £ > SS£ = £ appreciate

Inflation and Exchange Rate
 Factors that Influence
Exchange Rates

Relative Interest Rates HC Increase

U.S. interest rates 

$/£
S0   U.S. demand for
S1 British bank deposits,
r0 and hence £.
r1
D0   British desire for U.S.
D1 bank deposits, and
Quantity of £
hence the supply of £.

DD £ < SS £ = £ depreciate
Interest Rate-Exchange Rate
 Factors that Influence
Exchange Rates
Relative Interest Rates
A relatively high interest rate may
actually reflect expectations of relatively
high inflation, which may discourage
foreign investment.
It is thus useful to consider the real
interest rate, which adjusts the nominal
interest rate for inflation.
 Factors that Influence
Exchange Rates

Relative Interest Rates

real nominal
interest  interest – inflation rate
rate rate

This relationship is sometimes called

the Fisher effect. high inflation >> real int. decrease
Argentina
Interest Rate

Inflation

ARS/USD
 Factors that Influence
Exchange Rates
Relative Income Levels foreign currency becomes appreciated

U.S. income level 

  U.S. demand for
$/£ British goods, and
S0 S 1 hence £.
r1
r0 ,  No expected change for
D1 the supply of £.
D0
Quantity of £

DD £ > SS £ = £ appreciate
GDP Growth Rate - Vietnam Dong
https://tradingeconomics.com/united-kingdom/gdp-growthhttps://tradingeconomics.com/vietnam/gdp-
growth-annual
 Factors that Influence
Exchange Rates
Government Controls
Governments may influence the
equilibrium exchange rate by: Capital control >> less investmet less DDFC

⚫ imposing foreign exchange barriers,

Import duty >> less Imports >> less DDFC
⚫ imposing foreign trade barriers,
higher Inflation >> gov increase interest >> more capital inflow >> more SSFC
⚫ affecting macro variables such as inflation,
interest rates, and income levels.
⚫ intervening in the foreign exchange market,
 Factors that Influence
Exchange Rates
Expectations
Foreign exchange markets react to any
news that may have a future effect. thai >> depreciates

News of a potential surge in Thai inflation

⚫
may cause currency traders to sell Baht.
Many institutional investors take
currency positions based on anticipated
interest rate movements in various
countries.
Example

𝑡0 𝑡3 𝑡0 𝑡3

• Expectation • Expect
inflation Foreign INT.
increase Increase
• Expect FC to • Expect Capital
Depreciate Inflow
• Expect FC to
• Sell FC
increase
• Value of FC
decrease • Increase in
FC
• Get the
full benefit
from the
rise in FC
value
buy
 Impact of Expectations
Currency will increase>> buy today

Expectation increase in interest rates

Uncertainty about economic or political
currency will decrease >> sell
conditions today
>>can’t repay >>less credit rating >> currency will depreciate >>sell today
Rising debt problems
Expectation of public elections
Expectation increasing trade barriers
Improvement in Productivity and
>> productiviity> industrial growth higher >> currency will appreciate
Technology >> buy today
BREXIT Referendum and the GBP
U.S. Election Effect
https://www.statista.com/chart/23435/currencies-react-biden-presidential-win/
expect Biden to launch trade policies thats more libreal
A board displays the Brazilian Real-U.S. dollar and other exchange rates,
following the spread of the coronavirus
https://www.cnbc.com/2020/04/14/emerging-market-currencies-have-been-hammered-by-covid-19.html
UK Can’t Shake Pound Negativity
After Weeks of Political Chaos
Soaring inflation,
weakening
economy all
weighing on
outlook,
Morgan Stanley
analysts see UK as
‘structural
underperformer’
 Factors that Influence
Exchange Rates
Factor Interaction
• 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.
Example

Income Purchasing power Import

DD for FC FC Appreciation

Interest Capital Inflow SS of FC

FC Depreciation
How Factors Can Affect Exchange Rates
Trade-Related
Factors
U.S. demand for foreign
1. Inflation goods, i.e. demand for
Differential foreign currency
2. Income
Differential Foreign demand for U.S.
3. Gov’t Trade goods, i.e. supply of Exchange
Restrictions foreign currency rate
between
foreign
Financial U.S. demand for foreign currency
Factors securities, i.e. demand and the
1. Interest Rate for foreign currency dollar
Differential Foreign demand for U.S.
2. Capital Flow securities, i.e. supply of
Restrictions foreign currency
 Factors that Influence
Exchange Rates

Factor Interaction
The sensitivity of an exchange rate to the
factors is dependent on the volume of
international transactions between the two
countries.
Large volume of international trade 
relative inflation rates may be more influential
Large volume of capital flows  interest rate
fluctuations may be more influential
 Example
Factors U.S. Mexico Japan

Change in -1% -2% -4%

int.rate
Change in +2% -3% -6%
inflation
US/Mexico mainly trade >> emphasize on inflation
 Anticipated Exchange Rates
Speculation
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.
Example

• You plan to invest in a foreign currency for

one year.
If the choice is between U.S. Dollar and Brazilian Real , which currency
would you choose?
If interest rate in U.S. is 8% p.a. and 12% p.a. in Brazil, which currency
would you choose? Brazil
If U.S.$ exchange rate is expected to remain stable, and BRL expected to
depreciate by 6% over the year, which currency would you choose? U.S.
Institutional Speculation

Currency Lending Rates Borrowing Rates

U.S.$ 6.72% 7.20%

NZ $ 6.48% 6.96%
Anticipated Exchange Rates Speculation
Chicago Bank expects the exchange rate of the New
Zealand dollar to appreciate from its present level of
$0.50 to $0.52 in 30 days.
Borrows at
7.20%(.6%) for 30 always think in term of buying/selling foreign currency
1. Borrows days 4. Holds
$20 million $20,912,320
20m (1+0.006)
Returns $20,120,000
Exchange at Profit of $792,320 Exchange at
$0.50/NZ$ $0.52/NZ$
Lends at
6.48%(.54%) for
2. Holds 30 days 3. Receives
NZ$40 million NZ$40,216,000
step 1,2 today >> step 3,4 in 30 days 40m (1+0.0054)
expect NZD to increase >> borrow US >> use USD to buy NZD >> invest in NZ
 Investor Position

Transaction Net
FX % E-B/B +4% Gain
Int. Int. Diff Invest Rate – -0.06% Loss
Borrowing Rate

Net Gain 3.94%

Anticipated Exchange Rates Speculation

Chicago Bank expects the exchange rate of the New

Zealand dollar to depreciate from its present level of
$0.50 to $0.48 in 30 days.
expect NZD to depreciate >> borrow NZD >> sell NZD at spot rate >> at bid rate >> invest in US >> buy NZD
Borrows at
6.96%(.58%) for 30
1. Borrows days
4. Holds
NZ$40 million NZ$41,900,000
Returns NZ$40,232,000
Profit of NZ$1,668,000
Exchange at or $800,640 Exchange at
$0.50/NZ$ $0.48/NZ$
Lends at 6.72%
(.56%) for 30
2. Holds days 3. Receives
$20 million $20,112,000
 Borrower Position

Transaction Net
FX % E-B/B (0.52-0.5)/0.5
-4% Gain
Int. Int. Diff Invest Rate –Borrowing -0.02% Loss
Rate 0.58-0.56(monthly)

Net gain 3.98%

Anticipation of Exchange Rate
Movements
• Institutional speculation based on expected appreciation -
When financial institutions believe that a currency is valued
lower than it should be in the foreign exchange market, they
may invest in that currency before it appreciates.

• Institutional speculation based on expected depreciation

– If financial institutions believe that a currency is valued
higher than it should be in the foreign exchange market, they
may borrow funds in that currency and convert it to their
local currency now before the currency’s value declines to
its proper level.
Anticipation of Exchange Rate
Movements
• Speculation by individuals – Individuals can
speculate in foreign currencies. Establish a margin
account whereby they may finance a portion of
their investment with borrowed funds in order to
take positions in a foreign currency.

• The “Carry Trade” – Where investors attempt to

capitalize on the differential in interest rates
between two countries.
Carry Trade
• Commonly used strategy to speculate in the FX
market.
• Capitalize on interest rates between countries
• Borrow in a currency with low interest rate and
invest in currency with high interest rate
• Can be as short as 1 day or as long as several
months
• Profit is the difference between interest earned
from investment in currency with high interest rate
versus interest paid on the currency with low interest
rates
Carry Trade

• Choice of currency to borrow and

invest depends not only on interest
rates but also on exchange rate.
• Investors prefer to borrow currency with a
low interest rate that they expect will
weaken.
• Invest in a currency with a high interest rate
that they expect will strengthen.
 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.
Carry Trade
 Carry Trade
• Hampton’s expected profits from its carry
trade can be derived as follows.