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5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox

For use with International Financial Management,
5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
 Chapter 4

Exchange Rate Changes

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5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Chapter Objectives
• Explain how exchange rate movements are measured.
• Explain the effect of demand and supply on exchange rates.
• Examine a range of economic and market factors which may explain
changes in the exchange rate.

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Measuring Exchange Rate Movements (1)
• 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 days when some currencies appreciate while others depreciate against

a specific currency, that currency is said to experience ‘mixed trading’.

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Measuring Exchange Rate Movements (2)
• When a foreign currency’s spot rates are compared at two specific points in
time, the spot rate at the more recent date is denoted as S t and the spot
rate at the earlier date is denoted as S t-1.

• The percentage change in the value of the foreign currency is computed as

follows:

 A positive % change represents appreciation of the foreign

currency, while a negative % change represents depreciation.

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Changes in the Value of C$ and € relative to
US$

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Exchange Rate Equilibrium (1)
• An exchange rate represents the price of a currency or a rate at which
one currency can be exchanged for another.

• The price of any economic good, including money, is determined by

the demand for that currency relative to the supply for that currency.

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Exchange Rate Equilibrium (2)
The quantity of a currency demanded increases when the value of currency
decreases which leads to the downward sloping demand schedule (curve).

Value of £

$1.60
$1.55
$1.50

D: Demand for £

Quantity of £
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Exchange Rate Equilibrium (2)
The quantity of a currency supplied increases when the value of currency
increases which leads to the upward sloping supply schedule (curve).

Value of £

S: Supply of £

$1.60
$1.55
$1.50

Quantity of £
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 Exchange Rate Equilibrium (2)
An equilibrium exchange rate is reached when the quantity of currency
demanded equals to the quantity of currency supplied.

Value of £

S: Supply of £

$1.60
$1.55 Equilibrium
exchange rate
$1.50

D: Demand for £

Quantity of £
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Change is Equilibrium Exchange Rate (1)
• Increase in demand: depicted as a rightward shift of the demand
curve.

• Decrease in demand: depicted as a leftward shift of the demand

curve.

• Increase in supply: depicted as a rightward shift of the supply curve.

• Decrease in suppy: depicted as a leftward shift of the supply curve.

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Factors that Influence Exchange Rates
e  f INF , INT , INC , GC , EXP 
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

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Factors that Influence Exchange Rates (1)
1. Relative Inflation Rates

US relative inflation 
$/£ Þ  US demand for British goods, and
S1
S0 hence the demand of £.
r1
r0
Þ  British desire for US goods, and hence
D1 the supply of £.
D0 Þ Value of $  and £  r0 to r1
Quantity of £

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Factors that Influence Exchange Rates (2)
2. Relative Interest Rates
US relative interest rates 
Þ  British desire for US bank
deposits, and hence the supply
$/£
S0 of £ (British residents supply £).
S1
r0
Þ  US demand for British bank
r1
D0 deposits, and hence the demand
D1 of £ (US residents hold their $).
Quantity of £
Þ Value of £  and $  r0 to r1

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Factors that Influence Exchange Rates (2)
2. Relative Interest Rates (Cont..)

• A relatively high interest rate may 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.

• real interest rate  nominal interest rate – inflation rate

• This relationship is sometimes called the Fisher effect.

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Why do Interest Rates Differ?
• To say it is due to supply and demand which leaves us to understand a little
about the issue.

• Let us see what Irving Fisher has to say about interest rates.

• He wrote about three elements:

o Time Preference (reward for lending and not consuming the money now)
o Risk (reward for the chance that your investment loses value)
o Inflation (recompense for the decline in the purchasing of money)

• If TP = 1% R = 2% and Infl = 3% then interest = 1% + 2% + 3% = 6%.

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So, what does the Fisher analysis mean at an
international level?
Country A Country B comment

Time preference 1½% 1½% No reason for there to be a

difference

+ Risk 1% 1% We choose investments in

each country that have low risk

= Real rate 2½% 2½% Real rates should be the same

+ inflation 4½% 2½% Different economic policies are

inevitable

= interest rate 7% 5% The difference in inflation rates

explains the difference in
interest rates!

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Factors that Influence Exchange Rates (3)
3. Relative Income Levels

US income level 
$/£
Þ  US demand for British
S,S1 goods, and hence demand
r1 for £.
r0
D1 Þ No expected change for the
D0
supply of £.
Quantity of £

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Factors that Influence Exchange Rates (4)
4. Government Controls
• Governments may influence the equilibrium exchange rate by:

imposing foreign exchange barriers (specific institutions, quantity of FX, unnecessary

documents)

imposing foreign trade barriers,

intervening in the foreign exchange market, and
affecting macro variables such as inflation, interest rates, and income levels.

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Factors that Influence Exchange Rates (5)
5. Future Expectations
• Foreign exchange markets react to any news that may have a future effect.
o News of a potential surge in US inflation may cause currency traders to sell dollars.

• Favorable Expectations: If investor expects interest rates in one country to rise, they
may invest in that country, leading to a rise in demand for foreign currency and an
increase in exchange rate for foreign currency.

• Unfavorable expectations: Speculation can place a downward pressure on a

currency when they expect it to depreciate.

• However, economic signals that affect exchange rates can change quickly, such that
speculators may overreact initially and then find that they must make a correction.
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Factors that Influence Exchange Rates (6)
6. Liquidity of Currency
• The liquidity of a currency affects the sensitivity of the exchange rate to specific
transactions.

• If a currency’s spot market is liquid, then its exchange rate will not be highly
sensitive to large sale and purchase.

• Conversely, illiquid currencies tend to exhibit more volatile exchange rate

movements.

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Factors that Influence Exchange Rates (7)
7. Interaction of Factors
• The various factors sometimes interact and simultaneously affect exchange
rate movements.

• Some factors place upward pressure while other factors place downward
pressure.

• For example: An increase in relative inflation level (outflow of funds)

sometimes causes expectations of higher interest rates (inflow of funds),
therefore placing opposing pressures on foreign currency values.

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 How Factors Can Affect Exchange Rates
(UK)
Unfavorable

Favorable

Unfavorable

Favorable

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Factors that Influence Exchange Rates (7)
7. Interaction of Factors (Cont..)
• 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

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Factors that Influence Exchange Rates (7)
• 7. Interaction of Factors (Cont..)
• Example

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Speculating on Anticipated Exchange Rates
• 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.

• The simple strategy is to get out of the currency about to depreciate and
into the currency that is going to appreciate against it. Then reverse the
positions after the event to end up with more than you started with.

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Speculating on Anticipated Exchange Rates
London Bank expects the exchange rate of the New Zealand dollar to appreciate
against the £ from its present level of £0.35 to £0.38 in 30 days*.

Borrows at 7.20%** for 30

1. Borrows £20 m days 4. Holds £21,831,543

Repays £20,120,000
A profit of 21,831,543 – 20,120,000 =
Exchange at 1,711,543 Exchange at £0.38/NZ$
£0.35/NZ$
Lends at 6.48% for 30
days
2. Holds 3. Receives
NZ$57,142,857 NZ$57,451,428

* An increase of 8.57% **30 days is 1/12th the annual rates here

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Speculating on Anticipated Exchange Rates
London Bank expects the exchange rate of the New Zealand dollar to
depreciate from its present level of 0.50 euros to 0.48 euros in 30 days*.
Borrows at 6.96%**
for 30 days
1. Borrows 4. Holds
NZ$40 million NZ$41,900,000
Returns NZ$40,232,000
Profit of NZ$1,668,000
Exchange at 0.50 or 800,640 euros Exchange at 0.48
euros/NZ$ euros/NZ$
Lends at 6.72% for
30 days 3. Receives
2. Holds 20m
euros 20,112,000 euros
* A euro increase of 4.17% **30 days is 1/12th the annual rates here

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Speculating on Anticipated Exchange Rates
• Between 2 currencies borrow in the weaker currency and invest in the
stronger currency providing that the interest rate difference is not too
adverse.
• Exchange rates are very volatile, and a poor forecast can result in a large
loss.
• Firms can take large risks: ‘Since the EU referendum at the end of June,
the value of sterling relative to the US dollar has fallen significantly. As a
result, we have recognised a £4.4bn in-year non-cash mark-to-market
valuation adjustment for our currency hedge book as part of our reported
financing costs of £(4,677)m (2015: £(1,341)m).’ Annual Report, Rolls
Royce, 2016.
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