Determinants of FX Rates: Chapter 2. Chapter Objectives & Lecture Notes FINA 5500

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Determinants of FX

Rates:

Chapter 2

Chapter Objectives

& Lecture Notes

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Chapter Objectives: FINA 5500 Chapter 2 / Determinants of Exchange Rates

1. To be able to explain in your own words why there is a negative relationship between

price of a currency and the quantity demanded for that currency

2. To be able to explain in your own words why there is a positive relationship between

price of a currency and the quantity supplied for that currency

3. To be able explain in your own words how price is determined in the currency markets through the interaction of supply and demand schedules for the currency

4. Based on a given supply and demand schedule in the FX market, identify if excess demand or supply exists, and calculate the quantity of excess supply or demand 5. To be able to explain in your own words, and also by using graphs, how the currency

price of a country can change due to supply and/or the demand schedule shifts resulting

from a change in that country’s inflation rate relative to the inflation rate changes in other countries:

6. To be able to explain in your own words, and also by using graphs, how the currency

from a change in that country’s interest rate relative to the interest rate changes in other countries

from a change in that country’s GNP growth rate relative to the GNP growth rate changes in other countries

8. To be able to show the necessary transactions that a currency speculator will make in order to earn profits if s(he) expects that a currency will appreciate or depreciate

9. To be able to show by using graphs, how the supply and demand in the currency market will change due to trading by currency speculators.

10. To be able to calculate the dollar and percentage trading profits that a currency

speculator will earn from a currency appreciation or a currency depreciation.

price of a country can change due to supply and/or the demand schedule shifts in the FX

market resulting from government trade restrictions such as quotas and tarrifs 12. To be able to explain in your own words, and also by using graphs, how the currency

from government transaction in the FX market.

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FINA 5500, Chapter 2 1

Overview: Chapter 2

z How the price of a foreign currency is determined in the FX market:

The demand schedule for FX

The supply schedule for FX

Determination of the equilibrium rate

z Factors that influence (shift) the supply and demand schedules and the equilibrium rate:

Change in relative inflation

Change in relative interest rates

Change in relative national income

Changes in Expectations: Trading strategies in the FX market

Government intervention

Value of a country’s monetary unit

Demand For A Currency

(U.S. viewpoint)

z

Demand for foreign exchange by U.S.

corporations / traders / governments that

need to purchase:

» foreign-produced trade items » foreign assets (real and financial).

z

Demand Curve / Schedule:

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Demand Schedule for British Pounds

Pric e of BP in $ Quantity of BP $1.60 $1.50 10 Bill 20 Bill FINA 5500, Chapter 2 4

Supply For A Currency

(U.S. viewpoint)

z

Supply of foreign exchange by foreign

corporations / traders / governments

that need to purchase:

» U.S.-produced trade items » U.S. assets (real or financial). z

Supply Curve / Schedule:

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Supply Schedule for British Pounds

Pric e of BP in $ Quantity of BP $1.60 $1.50 10 Bill 20 Bill FINA 5500, Chapter 2 6

Exchange Rate Equilibrium

(U.S. viewpoint)

Equilibrium dollar price and quantity of British Pounds are determined such that American and British goods and assets are traded.

Pric e of BP in $ Quantity of BP $1.55 15

Supply Curve for BP

Demand Curve for BP $1.50

20 10

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Changes in Macro-Economic Factors &

Exchange Rates

z

EVENTS:

Increase/decrease in relative domestic inflation

Increase/decrease in relative domestic interest rates

Increase/decrease in relative GNP (national income)

FX trading by Governments

FX trading by speculators due to change in expectations

z

EFFECTS: What happens to:

The supply and demand schedules

The equilibrium exchange rate / price of the foreign currency

The Effects of Relative Domestic Inflation

Increase in the FX Market

z Demand Schedule:

Foreign goods are relatively

cheaper to domestic consumers.

Merchandise imports increase.

Quantity of FX demanded at each exchange rate increases.

z Supply Schedule:

Domestic goods are relatively

expensive for foreign consumers.

Merchandise exports decrease.

Quantity of FX supplied at each exchange rate (ER) falls.

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The Effects of Relative Domestic

Inflation Decrease in the FX Market

Foreign goods are relatively

expensive to domestic consumers.

Merchandise imports decreases.

Quantity of FX demanded at each exchange rate decreases.

Domestic goods are relatively

cheaper for foreign consumers.

Merchandise exports increase.

Quantity of FX supplied at each ER

increases. z Equilibrium: ER (price of BP) decreases Pric e of BP in $ Quantity of BP Exchanged D1 D2 S2 S1 FINA 5500, Chapter 2 10

The Effects of Relative Domestic

Interest Rate Increase in the FX Market

Domestic capital attracted to domestic country & domestic capital movement overseas falls.

Foreign capital attracted to domestic country & foreign capital movement into the domestic country increases.

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The Effects of Relative Domestic Interest

Rate Decrease in the FX Market

Domestic capital attracted to foreign country & domestic capital movement overseas increases.

Domestic capital attracted to domestic country & domestic capital movement overseas falls.

falls. z Equilibrium: ER (price of BP) increases Pric e of BP in $ Quantity of BP Exchanged D2 D1 S1 S2 FINA 5500, Chapter 2 12

The Effects of Relative Domestic National

Income Increase in the FX Market

With higher income, domestic consumers purchase more foreign goods. Merchandise imports increase.

Either foreign demand for domestic goods does not change or increases with increased foreign dollar purchasing power

does not change or increases.

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The Effects of Relative Domestic National

Income Decrease in the FX Market

With lower income, domestic consumers purchase less foreign goods. Merchandise imports decrease.

Either foreign demand for domestic goods does not change or decreases with decreased foreign dollar purchasing power

does not change or decreases.

z Equilibrium: ER (price of BP) decreases Pric e of BP in $ Quantity of BP Exchanged D1 D2 S1 S2 FINA 5500, Chapter 2 14

Expectations About Currency Prices and

Trading Strategy in FX Market: Theory

z

Based on expectations about future behavior of

macro economic variables, currency traders:

Make predictions about expected changes in foreign currency prices

Based on these expectations:

– Borrow in currency that is expected to depreciate – Lend in currency that is expected to appreciate

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Expectations About Currency Prices and

Trading Strategy in FX Market: Example

Eurobank can borrow/lend Dollars at 4%. It can also borrow/lend Pounds and MP at 6%. It has access to

15,000,000 dollars (or equivalent amounts of BP and MP) for currency speculation

How can Eurobank make trading profits:

1. If it expects BP to appreciate from $1.50 to $1.65 in 90 days. 2. If it expects MP to depreciate from $0.20 to $0.18 in 60 days. Remember:

Borrow in the depreciating currency Lend in the appreciating currency

Eurobank’s Trading Strategy if BP is Expected to

Appreciate: How it Effects the FX Market

Today:

- Borrow $15 million for 90 days (@ 4% / yr) from US Bank

- Buy pounds, $15 million / 1.50 = BP10 mil - Lend BP10 million for 90 days (@ 6% / yr) to

UK Bank 90 Days Later:

- Withdraw BP10,150,000 from UK Bank (10,000,000 [1 + .06 (90/360)] - Convert pounds to dollars @$1.65/BP:

(10,150,000*1.65) = $16,747,500 - Pay off loan to US Bank: (15,000,000

[1+.04*(90/360)] = $15,150,000

- Total profit = $16,747,500 - $15,150,000 = $1,597,500

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Eurobank’s Trading Strategy if MP is Expected to

Depreciate : How it Effects the FX Market

Today:

- Borrow FF75 million for 60 days (@ 6% / yr) from a Mexican (MX) Bank

- Sell FF (for $): MP75 mil / 0.20 = $15 mil - Lend $15 million for 60 days (@ 4% / yr) to

US Bank 90 Days Later: - Withdraw (15,000,000 [1 + .04 (60/360)] $15,100,000 from US bank - Convert dollars to MP @ $0.18/FF: (15,100,000 /0.18) = MP 83,888,889 - Pay off loan to MX Bank: (75,000,000

[1+.06*(60/360)] = MP 75,750,000 - Total profit = 83,888,889 - 75,750,000 =

MP8,138,889

- Annualized percentage profit = (8,138,889 / 75,000,000) *(360/60)*100 = 65.11%. Price of MP in $ Quantity of MP Exchanged D1 S1 S2 FINA 5500, Chapter 2 18

How Governments Impact FX

Market?

Governments may increase or decrease trade

restrictions (tariffs & quotas)

Governments may directly intervene in the FX

markets. If a foreign currency price is

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The US Government Increases Trade

Restrictions

z Trade Restriction Increase in US:

Import duties on UK goods (tarrifs) are increased

Quotas on goods imported from UK

into US are reduced

Fewer UK goods will be imported

Quantity of FX demanded at each ER decreases

z Supply Schedule

Will not change

z Equilibrium: ER (price of BP) decreases Pric e of BP in $ Quantity of BP Exchanged D1 D2 S1 FINA 5500, Chapter 2 20

The US Government Decreases

Trade Restrictions

z Trade Restriction Decrease in US:

Import duties on UK goods (tarrifs) are decreased

Quotas on goods imported from UK

into US are increased

More UK goods will be imported

Quantity of FX demanded at each ER increases

Will not change

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The Foreign Government Increases

Trade Restrictions

Import duties on US goods (tarrifs) are increased in the UK

Quotas on goods imported from US

into UK are decreased

Will not change

Fewer US goods will be sold in UK

decreases z Equilibrium: ER (price of BP) increases Pric e of BP in $ Quantity of BP Exchanged D1 S1 S2 FINA 5500, Chapter 2 22

The Foreign Government Decreases

Trade Restrictions

Import duties on US goods (tarrifs) are decreased in the UK

Quotas on goods imported from US

into UK are increased

Will not change

More US goods will be sold in UK

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Government Intervention in the FX

Market: Non-Sterilized (1)

z

If BP is undervalued (dollar is overvalued ):

Both Central banks buy BP (sell US dollars):

– US money supply rises and the British money supply falls

– US inflation increases and British inflation decreases

Appreciation of BP (depreciation of dollar) is

more due to increased US inflation (decreased

British inflation) rather than central bank

transactions in the FX market

Government Intervention in the FX

Market: Non-Sterilized (2)

z

If BP is overvalued (dollar is undervalued ):

Both central banks sell BP (buy US dollars):

– US money supply falls and the British money supply rises

– US inflation decreases and British inflation increases

Depreciation of BP (appreciation of dollar ) is

more due to decreased US inflation (increased

British inflation) rather than central bank

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Government Intervention in the FX

Market: Sterilized (1)

z

If BP is undervalued (dollar is overvalued ):

Both Central banks buy BP (sell US dollars):

– US money supply rises and the British money supply falls

To neutralized the changes in money supply:

Federal Reserve sells US Treasury securities

and the Central Bank of England buys British

Treasury securities

– US money supply is reduced and the British money supply is increased

The BP appreciation (dollar depreciation ) due to

central bank intervention is usually short lived

Government Intervention in the FX

Market: Sterilized (2)

z

If BP is overvalued (dollar is undervalued ):

Both central banks sell BP (buy US dollars):

– US money supply falls and the British money supply rises

To neutralized the changes in money supply:

Federal Reserve buys US Treasury securities

and the Central Bank of England sells British

Treasury securities

– US money supply is increased and the British money supply is reduced

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Changes in the Value of a Country’s

Monetary Unit and the Exchange Rate

z

A monetary unit is valued as a:

store of value: this is determined by:

– Stability of the nation’s monetary policy

– Reputation and independence of its Central bank

medium of exchange (liquidity): this is

determined by :

– GNP Growth

– Demand for the nation’s assets

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List of Graphs: Supply / Demand Curve Shifts in the Foreign Exchange (FX) Market

In each graph, the vertical axis represents the price of FX in US dollars and the horizontal axis represents the quantity of FX demanded / supplied. D0 and S0 refer to the initial supply and demand schedules while

D1 and S1 refer to the initial supply and demand schedules after they shift. The arrows indicate the direction

of the shift. Please choose the graph (A through H) which provides the best answer to the question.

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In-Class Exercise # 1: Supply / Demand Schedules in the FX Market

The table below presents the supply and demand schedules for BP (from the US view

point).

Price of BP

Schedule A

(# of BP supplied

or demanded)

Schedule B

(# of BP supplied or

demanded)

$1.40

1,000,000

10,000,000

$1.45

2,000,000

8,000,000

$1.50

3,000,000

6,000,000

$1.55

4,000,000

$1.60

5,000,000

2,000,000

$1.65

6,000,000

1,000,000

a) Identify the:

Supply schedule: Schedule A / Schedule B

Demand schedule: Schedule A / Schedule B

b) What would be the clearing price for BP in the foreign exchange market? Why?

c) What would happen if both the US and the British governments fixed the price of

BP at $1.45? Excess supply of BP / Excess demand for BP

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In-Class Exercise # 2: The effects of economic factors in FX Market

Please used the list of graphs to answer questions 1, 3, and 5.

1. If the US inflation rate increased by 2% while the British inflation rate

increased by 1%, identify which graph best describes what happens in the

foreign exchange market for BP:

2. If the US inflation rate increased by 2%, while the British inflation rate

increased by 3%, complete each one of the statements below:

a. The demand for BP in the FX market will: increase/decrease/not change

d. The supply of BP in the FX market will: increase/decrease/not change

c. The price of BP in the FX market will: increase/decrease/not change

3. If the US real interest rate increased by 2% while the British real interest

rate did not change, identify which graph best describes what happens in the

foreign exchange market for BP:

4. If the US real interest rate increased by 2% while the British real interest

rate increased by 4%, complete each one of the statements below:

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In-Class Excercise # 3: Currency Price Expectations and Trading Strategy

Citibank can borrow/lend dollars at 6%. It can also borrow/lend euros (E) and pounds (BP) at 8%. It has

access to $15,000,000, E20,00,000, or BP10,000,000 for currency speculation

How can Citibank make trading profits:

Scenario 1: If it expects BP to depreciate from $1.50 to $1.40 in 180 days.

Scenario 2: If it expects E to appreciate from $0.75 to $0.80 in 90 days.

Scenario 1

Scenario 2

Which currency should you

borrow in, and how much ?

Which currency should you invest

in, and how much ?

What will be your profit in $ or

FC

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Non-Sterilized Government Intervention

Situation BP Undervalued / Dollar Overvalued BP Overvalued / Dollar Undervalued

Actions Both US & British Central Banks: Buy BP + Sell $ Both US & British Central Banks: Sell BP + Buy $ Results:

Short term

Demand schedule for BP increases Supply schedule for BP does not change Price of BP increases Price S₁ D₂ D₁ Quantity

Demand schedule for BP does not change Supply schedule for BP increases

Price of BP decreases Price S₁ S2 D₁ Quantity Results: Long term

Sell $ US money supply

increases

US inflation

increases BP appreciates $ depreciates

Buy $ US money supply

decreases

US inflation

decreases BP depreciates $ appreciates Buy BP British money

supply decreases

British inflation

decreases

Sell BP British money supply increases

British inflation

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Sterilized Government Intervention

Situation BP Undervalued / Dollar Overvalued BP Overvalued / Dollar Undervalued Actions Both US & British Central Banks: Buy BP + Sell $

US Central Bank: Sells US government securities

British Central Bank: Buys British government securities

Both US & British Central Banks: Sell BP + Buy $ US Central Bank: Buys US government securities

British Central Bank: Sells British government securities Results:

Short Term

- Demand schedule for BP increases - Supply schedule for BP does not change - Price of BP increases Price S1 D₂ D₁ Quantity

- Demand schedule for BP does not change - Supply schedule for BP increases

- Price of BP decreases Price S₁ S2 D₁ Quantity Results: Long term

Sell $ US money supply

increases US inflation does not change Prices of BP and $ do not change in the long term Buy $ US money supply decreases US inflation does not change Prices of BP and $ do not change in the long term Sell US Govt Securities US money supply decreases Buy US Govt Securities US money supply increases

Buy BP British money supply

decreases British inflation

does not change

Sell BP British money

supply increases British inflation does not change Buy British Govt Securities

British money supply

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The Effects of Macroeconomic Factors in the FX Markets: A Study Guide

Not for use during exam !

Macro Factors

US compared to Foreign Country: Using UK as an example Demand for BP Supply of BP Price of BP Graph

Inflation Inflation in US > Inflation in UK Increase Decrease Increase B

Inflation in US < Inflation in UK Decrease Increase Decrease A

Real interest rate

Real interest rate in US > Real interest rate in UK Decrease Increase Decrease A Real interest rate in US < Real interest rate in UK Increase Decrease Increase B GNP

Growth

GNP growth in US is above normal; GNP growth in UK is normal Increase Increase or no change

Increase G or C

GNP growth in US is below normal; GNP growth in UK is normal Decrease Decrease or no change

Decrease H or D

Government action

BP is undervalued: both governments will buy BP (sell $) Increase No change Increase G BP is overvalued: both governments will sell BP (buy $) No change Increase Decrease E Trade

barriers

UK increases trade barriers for US goods (decrease quotas or increase tariffs) No change Decrease Increase F UK decreases trade barriers for US goods (increase quotas or decrease tariffs) No change Increase Decrease E US increases trade barriers for UK goods (decrease quotas or increase tariffs) Decrease No change Decrease H US decreases trade barriers for UK goods (increase quotas or decrease tariffs) Increase No change Increase G Expectations BP ($) is expected to appreciate (depreciate): traders borrow $, invest in BP Increase No change Increase G BP ($) is expected to depreciate (appreciate): traders borrow BP, invest in $ No change Increase Decrease E Note: