Foreign Exchange Determination

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.”
 Exchange Rate Movement:
Measurement
• The percentage change (% D) in the value
of a foreign currency is computed as
St – St – 1
St – 1
where St denotes the spot rate at time t.
• A positive % D represents appreciation of the
foreign currency, while a negative % D represents
depreciation.
 Annual Changes
in the Value of the Euro

Date Exchange Rate Annual % D

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%
Example

Suppose six months ago: $1.3344/€

Suppose today : $1.2403/€

Question: So from $1.3344 to $1.2403. Has the

dollar appreciated or depreciated?
Example
When Nigeria devalued its Naira by 32% against
the dollar. What was the percentage
appreciation in value of the dollar?
Foreign Exchange Quotations
 Foreign Exchange Quotation
• At any given point in time, the exchange rate between two
currencies should be similar across the various banks that provide
foreign exchange services.

• If there is a large discrepancy,

– customers or other banks will purchase large amounts of a

currency from whatever bank quotes a relatively low price and
immediately sell it to whatever bank quotes a relatively low
price.

• Such actions cause adjustments in the exchange rate quotations

that eliminate any discrepancy.
 Spot Quotations
• Banks provide foreign exchange services for a fee

• They buy currencies from customers at a slightly lower price than the
price at which they sell the currencies.

• At any given point in time, a bank’s bid (buy) quote for a foreign
currency will be less than its ask (sell) quote.

• This is the bid/ask spread, which represents the differential between

the bid and ask quotes to cover the costs in accommodating requests
to exchange currencies.

• The bid/ask spread is normally expressed as a percentage of the ask quote

•
bid/ask % spread =
ask rate – bid rate
ask rate
 Example
• To understand how a bid/ask spread could affect you, assume you have
$1,000 and plan to travel from the United States to the United Kingdom.
Assume further that the bank’s bid rate for the British pound is $1.52
and its ask rate is $1.60. Before leaving on your trip, you go to this bank
to exchange dollars for pounds. How much pounds will your $1000 give
you?

• Now suppose that because of an emergency you cannot take the trip,
and you convert the 625 pounds back to US dollars, just after
purchasing the pounds. If the exchange rate has not changed, how
much dollar will you receive?

• Compute the Bid/Ask Spread and interpret.

 Example
• Assume that the prevailing quote for wholesale transactions by a
commercial bank for the euro is $1.0876/78. This means that the
commercial bank is willing to pay $1.0876 per euro. Alternatively, it is
willing to sell euros for $1.0878. Compute the bid/ask spread.
Interpreting Foreign Exchange Quotations
 Interpreting
Foreign Exchange Quotations
• Direct quotations represent the value of a foreign currency in cedis,
while indirect quotations represent the number of units of a foreign
currency per cedi.

Example
The spot rate of the dollar is quoted this morning at Ȼ4.50. This is a direct
quotation, as it represents the value of the foreign currency in cedis. The indirect
quotation of the dollar is the reciprocal of the direct quotation.

Indirect quotation = 1/Direct quotation

= 1/Ȼ4.50
= 0.222, which means $0.222 = Ȼ1
 Interpreting
Foreign Exchange Quotations

• If you initially received the indirect quotation, you can take the
reciprocal of it to obtain the direct quote.

• Since the indirect quotation for the dollar is $0.222, the direct
quotation is:

• Direct quotation = 1/Indirect quotation

= 1/0.222
= Ȼ4.50
Exchange Rate Equilibrium
 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 of that
currency.

$$$
 Exchange Rate Equilibrium

Value of €

S: Supply of €

¢1.60
Equilibrium exchange
¢1.55 rate
¢1.50

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.
 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
 Factors that Influence
Exchange Rates
Relative Inflation Rates (Substitute goods)

¢/£ Ghanaian inflation 

S1
Þ  Ghanaian demand for
S0
r1 British goods, and hence £.
r0
D1
D0
Þ  British desire for
Ghanaian goods, and
Quantity of £
hence the supply of £.
 Factors that Influence
Exchange Rates
Relative Interest Rates (initially the rates are equal)
¢/£ Ghanaian interest rates 
S0
Þ  Ghanaian demand for
S1
r0 British bank deposits, and
r1 hence £.
D0
Þ  British desire for
D1
Ghanaian bank deposits,
Quantity of £
and hence the supply of £.
 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.
 Factors that Influence
Exchange Rates

Relative Income Levels (income initially the same)

¢/£ Ghanaian income level 
Þ  Ghanaian demand for
S0 ,S1
r1
British goods, and hence £.
r0
D1
D0
Þ No expected change for
the supply of £.
Quantity of £
 Factors that Influence
Exchange Rates
Government Controls
• Governments may influence the equilibrium
exchange rate by:
– imposing foreign exchange barriers,
– imposing foreign trade barriers,
– intervening in the foreign exchange market, (buying
and selling currencies) and
– affecting macro variables such as inflation, interest
rates, and income levels.
 Factors that Influence
Exchange Rates
Expectations
• Foreign exchange markets react to any news that
may have a future effect.

– News of a potential surge in Ghanaian inflation may

cause currency traders to sell cedis.

• Many institutional investors take currency

positions based on anticipated interest rate
movements in various countries.
 Factors that Influence
Exchange Rates
Expectations
• Economic signals that affect exchange rates can
change quickly, such that speculators may
overreact initially and then find that they have to
make a correction.

• Speculation on the currencies of emerging

markets can have a substantial impact on their
exchange rates.
 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.
 How Factors Can Affect Exchange Rates
Trade-Related
Factors Ghanaian demand for foreign
1. Inflation goods, i.e. demand for foreign
Differential currency
2. Income
Differential Foreign demand for Ghanaian
3. Gov’t Trade goods, i.e. supply of foreign
Restrictions currency
Exchange rate
between foreign
currency and the
cedi
Ghanaian demand for foreign
Financial securities, i.e. demand for foreign
Factors currency
1. Interest Rate
Differential Foreign demand for Ghanaian
2. Capital Flow securities, i.e. supply of foreign
Restrictions currency
 Exchange Rate Systems
• Exchange rate systems can be classified
according to the degree to which the rates
are controlled by the government:
– freely floating
– fixed
– managed float
– pegged
 Freely Floating
Exchange Rate System
System: Rates are determined by market forces
without governmental intervention.

Each country is more insulated from the economic

problems of other countries.
Central bank interventions just to control exchange
rates are not needed.
Governments are not constrained by the need to
maintain exchange rates when setting new policies.
 Freely Floating
Exchange Rate System
• A country’s exchange rate is determined solely by the demand for
and supply of its currency in the foreign exchange market.

• When a currency’s exchange value rises as a result of market forces,

the exchange rate is said to appreciate.

• When its value falls under this system, it is said to depreciate.

 Freely Floating
Exchange Rate System
 Fixed Exchange Rate System
System: Rates are held constant or allowed to fluctuate
within very narrow boundaries.

Examples: Bretton Woods era (1944-1971), Smithsonian

Agreement (1971)

MNCs know the future exchange rates.

 Governments can revalue their currencies.
 Each country is also vulnerable to the economic
conditions in other countries.
 Fixed Exchange Rate System
• Intervention is carried out using official foreign reserves to balance
the demand for and the supply of the currency in order to maintain
the particular exchange rate at a given level.
 Managed Float
Exchange Rate System

• System: Exchange rates are allowed to move freely

on a daily basis and no official boundaries exist.

• However, governments may intervene to prevent

the rates from moving too much in a certain
direction.

 A government may manipulate its exchange rates

such that its own country benefits at the expense of
other countries.
 Pegged
Exchange Rate System
System: The currency’s value is pegged to a foreign
currency or to some unit of account, and thus
moves in line with that currency or unit against
other currencies.

Examples: European Economic Community’s snake

arrangement (1972), European Monetary System’s
exchange rate mechanism (1979), Mexican peso’s
peg to the U.S. dollar (1994)
 Exchange Rate Arrangements
Floating Rate System:
Afghanistan Hungary Paraguay Sweden
Argentina India Peru Switzerland
Australia Indonesia Poland Taiwan
Bolivia Israel Romania Thailand
Brazil Jamaica Russia United Kingdom
Canada Japan Singapore Venezuela
Chile Mexico South Africa
Euro countries Norway South Korea

Pegged Rate System:

Bahamas Bermuda Hong Kong Pegged to U.S.
Barbados China Saudi Arabia dollar
Government Intervention
 Government Intervention
• Each country has a central bank that may
intervene in the foreign exchange market to
control its currency’s value.

• A central bank may also attempt to control

the money supply growth in its country.
 Government Intervention
• Central banks manage exchange rates
– to smooth exchange rate movements,
– to establish implicit exchange rate boundaries, and
– to respond to temporary disturbances.

• Often, intervention is overwhelmed by market

forces. However, currency movements may be even
more volatile in the absence of intervention.
 Government Intervention
• Direct intervention refers to the exchange of
currencies that the central bank holds as reserves
for other currencies in the foreign exchange market.

• Direct intervention is usually most effective when

there is a coordinated effort among central banks
and when the central banks have high levels of
reserves that they can use.
 Effects of Direct Central Bank Intervention
in the Foreign Exchange Market
BoG exchanges ¢ for £ BoG exchanges £ for ¢
to strengthen the £ to weaken the £

Value Value S1
of £ S1 of £ S2

V2
V1
V1
D2 V2
D1 D1

Quantity of £ Quantity of £
 Government Intervention
• Some speculators attempt to determine when the central bank
is intervening directly, and the extent of the intervention, in
order to capitalize on the anticipated results of the intervention
effort.

• Central banks can also engage in indirect intervention by

influencing the factors* that determine the value of a currency.

* Inflation, interest rates, income level, government controls,

expectations
 Government Intervention
• For example, the BoG may attempt to increase interest
rates (and hence boost the cedi’s value) by reducing the
Ghanaian money supply.

• Some governments have also used foreign exchange

controls (such as restrictions on currency exchange) as a
form of indirect intervention.

• Intervention warnings can also be used as an indirect

intervention.
 Intervention as a Policy Tool
• Like tax laws and the money supply, the exchange rate is a tool that a
government can use to achieve its desired economic objectives.

• A weak home currency can stimulate foreign demand for products,

and hence reduce unemployment at home.

• However, it can also lead to higher inflation. A weak home currency

makes imports more expensive.
 Intervention as a Policy Tool
• A strong currency can encourage consumers and firms of the home
country to buy goods from other currencies

• This intensifies foreign competition and forces domestic producers to

refrain from increasing prices.

• Thus, the country’s overall inflation rate should be lower if its

currency is stronger, other things being equal.

• However, it may also lead to higher unemployment.

Purchasing Power Parity Theory
 Purchasing Power Parity Theory
• Exchange rate should reflect the relative price of goods in different
international markets.

• This leads to a theory of exchange rate determination known as

purchasing power parity theory.

• This theory predicts that, under a floating exchange-rate system, the

exchange rate of one currency against another currency will adjust to
ensure that prices for identical goods in the two countries are the
same.
 Purchasing Power Parity Theory
• For example, if a book is priced at 41.6 cedis in Ghana and 10 dollars
in the US, then the nominal exchange rate must be 4.16 cedis per
dollar (GHS41.6/US$10 = 4.16 cedis per dollar).

• Think of the US as the home or domestic country.

– Suppose that P is the price of a book in the US (measured in dollars)

– P* is the price of the same book in Ghana (measured in cedis)

– and e is the nominal exchange rate (the number of cedis needed to buy dollar)
Exchange Rate and Business
 Exchange Rate and Business
• Erratic changes in exchange rates can increase the uncertainty facing
management in its decision making.

• Given the likelihood of a lengthy time period between

– winning an export order or placing an import order and

– the final delivery of the goods

– and the settling of accounts,

– exchange rate fluctuations can make all the difference between a profit or a
loss on the transaction.
 Exchange Rate and Business
• In this way, floating exchange rates may discourage trade and
investment decisions.

• However, short-term risks can be overcome by the use of forward

exchange markets, where firms can agree to buy and sell currency at
a given future date at a contracted price.

• Forward contracts cannot usually be negotiated for more than a year

in advance, so they cannot be used to cover longer-term risks in
international trade and investment.
 Exchange Rate and Business
• Other methods to reduce exchange rate risk include:

– use of forecasts of exchange rate movements;

– risk-spreading through having a range of overseas suppliers and export markets

trading in different currencies, in the hope that this will provide some security;

– hedging, which is useful where there is no forward market: a corporate treasurer can
deal in foreign currencies and deposit sums in different currencies as a hedge against
currency fluctuations;

– investing in foreign subsidiaries: multinational companies can reduce exchange rate

risk by sourcing and supplying in various countries. Exchange rate movements may
also lead them to reallocate work between national plants to retain competitiveness
and to protect profits.
 Exchange Rate and Business
Question
• Suppose a German firm is exporting a luxury car selling at
€40,000 in Germany and, at an exchange rate of $1.75 = €1,
at a price of $70,000 in the USA (ignoring freight and
insurance charges, etc.).

• If the company currently sells 1,000 vehicles per annum in

the USA, what will be its total earnings in the US$?

• If the euro exchange rate appreciates to US$2 = €1, what

advice will you give to the German manufacturer?
 Exchange Rate and Business
Options
• To continue to sell in the USA at the existing price of $70,000 but
receive only €35,000 ($70,000 ÷ $2) as against €40,000 per vehicle –
in which case total receipts fall by €5m (€35m as against €40m).

• To raise the US price to compensate for the euro appreciation – in

which case the price of vehicles in the USA would rise to $80,000. But
at the higher price fewer cars are likely to be sold.

NOTE: Which of the two options is chosen may well depend upon the
price elasticity of demand for the vehicles in the USA.
End of Lecture