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BF 464: Internatıonal Finance

BF 464: Internatıonal Finance. Exchange Rates and The Determination of Exchange Rates. THE DETERMINATION OF EXCHANGE RATES. CHAPTER OVERVIEW: I. EXCHANGE RATES II. EQUILIBRIUM EXCHANGE RATES II I . ROLE OF CENTRAL BANKS I V . EXPECTATIONS AND THE ASSET MARKET MODEL.

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BF 464: Internatıonal Finance

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  1. BF 464: Internatıonal Finance Exchange Rates and The Determination of Exchange Rates

  2. THE DETERMINATION OF EXCHANGE RATES • CHAPTER OVERVIEW: • I. EXCHANGE RATES • II. EQUILIBRIUM EXCHANGE RATES • III. ROLE OF CENTRAL BANKS • IV. EXPECTATIONS AND THE ASSET MARKET MODEL

  3. Definion of Exchange Rates • The price of one currency in terms of another currency is called an exchange rate. • For example, the $/Euro exchange rate is just the number of dollars that one Euro will buy. If a Euro would buy 1.2154 dollars, exchange rate would be expressed as $1.2154/Euro. In this example, $ is the reference currency. - Exchange rates has a strong influence on the current account and other macroeconomic prices <-> an important price. - Is also an asset price, and is governed by the same principles governing the behaviour of other asset prices (form of wealth <-> expectations) • Spot Rate: the price at which currencies are traded for immediate delivery, or in two days in the interbank market. • Forward Rate: the price at which foreign exchange is quoted for delivery at a specified future date (e.g. 3 months)

  4. Equilibrium Exchange Rates • Equilibrium ER is the market-clearing price that equilibrate the quantities supplied and demanded of foreign currency. • B. How Americans Purchase German Goods • 1. Foreign Currency Demand • -derived from the demand for a foreign country’s goods, services, and financial assets. • e.g. The demand for German goods by Americans

  5. The Demand for € in the U.S. $/€ D $.50 Qty

  6. Equilibrium Exchange Rates • B.2. Foreign Currency Supply: • a. derived from the foreign country’s demand for local goods. • b. They must convert their currency to purchase. • e.g. German demand for US goods means Germansconvert euros to US $in order to buy.

  7. The Supply of € in the U.S. • $/ € S $.50 Qty

  8. Equilibrium Exchange Rates • B.3. Equilibrium Exchange Rate • occurs where the quantity supplied equals the quantity demanded of a foreign currency at a specific local price.

  9. The $/ € Equilibrium Rate $/ € Equilibrium D S $.50 Qty

  10. Equilibrium Exchange Rates • How Exchange Rates Change • 1. Increased demand for Euro • (D curve shifts up) • More local goods are demanded at the initial equilibrium by foreigners • - Foreign currency loses value in terms of local currency (depreciation)

  11. The US$ Depreciates D’ $/ € D $.65 S $.50 Qty Q1 Q2

  12. Equilibrium Exchange Rates • 1. Increased Supply of Euro • (S curve shifts rıght) - More foreign goods are demanded at the initial equilibrium - Foreign currency value increases in terms of local currency (appreciation)

  13. The US$ Appreciates When $/ € D S $.50 S’ $.35 Qty Q2 Q1

  14. Equilibrium Exchange Rates • C.5 Currency Appreciation • = (e1 - e0)/ e0 • where e0 = old currency value • e1 = new currency value

  15. Equilibrium Exchange Rates • EXAMPLE: € Appreciation • If the dollar value of the € goes from $0.50 (e0) to $0.65 (e1), then the € has appreciated by • (.65 - .50)/ .50 = 30%

  16. Equilibrium Exchange Rates • C.4. Calculating a Depreciation for $: • = (e0 - e1)/e1how? • where e0 = old currency value • e1 = new currency value • => (1/e1)- (1/e0))/ (1/e0)

  17. Equilibrium Exchange Rates • EXAMPLE: US$ Depreciation • Use the formula • (e0 - e1)/ e1 • substituting • (.50 - .65)/ .65 = - 23.1% • is the US$ depreciation.

  18. Equilibrium Exchange Rates • D. THE FACTORS AFFECTING EXCHANGE RATES: • 1. Inflation rates • 2. Interest rates • 3. GNP/GDP growth rates

  19. Equilibrium Exchange Rates • Excess growth ın Money Supply  higher inflation • US goods are more expensive • Demand for US products declines => decline in Euro supply (demand for $ also drops). • Hence, Supply curve for Euro shifts up • At the same time, demand for Euroland products increases => Euro demand ıncreases at the same exchange rate. • Hence, Demand curve shifts right As a result of these interactions, new equilibrium results at e**, where US dollar depreciates. “Higher inflation rate in a country leads to a depreciation in its currency” • 1. Inflation Rate – Higher US inflation rate $/ € D’ D S’ e** S e* Qty Q1 Q2

  20. Equilibrium Exchange Rates • 1. Interest Rate • An increase in US real interest rate relative to Euroland will: • Shift investments to dollar denominated securities – Increased Euro Supply • Hence, Euro will depreciate (dollar will appreciate) 2. Economic Growth Strong economic growth will attract investment capital seeking to acquire domestic assets. This, in turn, will lead to a higher demand for domestic currency. 3. Political and Economic Risk Lower political and economic risk will strengthen a nation’s currrency.

  21. Sample Problem • Suppose the U.S. dollar appreciates against the Russian ruble by 500%. How much did the ruble depreciate against the dollar? • To solve the problem, you can approach it in two steps: • Solve for e1 • Substitute and solve for the depreciation (x)

  22. U.S. $ APPRECIATION

  23. RUBLE DEPRECIATION

  24. SOLUTION – Step 1 Solve for e1

  25. SOLUTION – Step 2 Substitute and solve for x

  26. SOLUTION • When the dollar appreciated by 500% against the ruble, the ruble depreciated 83% against the dollar.

  27. EXPECTATIONS • Currency values are affected by • current events • current supply and demand flows • expectations about future exchange rate movements

  28. EXPECTATIONS • Why expectations? • currencies are financial assets • exchange rate is simply the relative price of two currencies

  29. EXPECTATIONS • The desire to hold a currency today depends critically on expectations of the factors that can affect the currency’s future value. • => Exchange rates are forward looking. Hence, they are strongly influenced by expectations about future economic, social and political factors. • Asset Market Model of Exchange Rate Determination: • The value of a currency today depends on whether or not people still want to hold that currency (or assets denominated in that currency) in the future.

  30. What is Money? • Serves as a medium of exchange. People are willing to accept it in exchange for goods and services • Provides liquidity. • Store of value – transfer purchasing power from the present into the future • Unit of account – prices are expressed in terms of a standardized unit of account (e.g. without money, how would you buy milk if you only had eggs?)

  31. Demand for Money • Hence, demand for money depends on: • İts ability to maintain its value • Level of economic activity • Hence, • lower expected inflation  higher demand for money • higher economic growth  higher demand for money • The demand for money is also affected by: • Expected real return (positively) • Riskiness of country’s assets (negatively)

  32. Demand for Money • Since exchange rates represent the relative demand for two moneys, same factors also impacts the exchange rates.

  33. Central Bank • Exchange rates are also influenced byexpectations of central bank behavior. • A. Central Bank Reputations – money is like a brand-name product whose value is backed by the reputation of the central bank • Fiat money: nonconvertible paper money; no anchor to the price level (no standart of value) • B. Central Bank Independence and accountability  for a good reputation • Currency Boards: issues notes and coins that are convertible on demand and at a fixed rate into a foreign reserve currency. There is no central bank.

  34. Intervention • A rise in the real or inflation-adjusted exchange rate raises the prices of domestic goods relative to the price of foreign goods. •  hurts exports; cheaper foreign products for consumers • Foreign Exchange market intervention refers to official purchases of and sales of foreign currency through central banks. • unsterilized: domestic money supply is not insulated from the foreign exchange transactions • Sterilized: The impact of foreign exchange transaction is sterilized through an open market operation (e.g., sale or purchase of treasury bills by Central Bank)

  35. Intervention • Suppose both Fed and CB ın Euroland wants to keep old equlibrium at e0. •  excess demand for euros equal to (Q3-Q1) •  excess supply of US dollars equal to (Q3-Q1)* e0. • US Money Supply will fall, Euroland Money supply will rise $/ € D’ Sterilized intervention has transitory impact since it impacts expectations and not the fundemantals. Unsterilized can have lasting impact by impacting money supply and hence creating inflation (or deflation) D S’ e** S e* Qty Q1 Q2 Q3

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