# Chapter 4. Exchange Rate Determination. Lecture Outline. Measuring Exchange Rate Movements

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1 Chapter 4 Exchange Rate Determination Lecture Outline Measuring Exchange Rate Movements Exchange Rate Equilibrium Demand for a Currency Supply of a Currency for Sale Equilibrium Factors that Influence Exchange Rates Relative Inflation Rates Relative Interest Rates Relative Income Levels Government Controls Expectations Interaction of Factors Speculating on Anticipated Exchange Rates 35

7 Chapter 4: Exchange Rate Determination 41 ANSWER: Blue Demon Bank can capitalize on its expectations about pesos (MP) as follows: 1. Borrow MP70 million 2. Convert the MP70 million to dollars: MP70,000,000 \$.15 = \$10,500, Lend the dollars through the interbank market at 8.0% annualized over a 10-day period. The amount accumulated in 10 days is: \$10,500,000 [1 + (8% 10/360)] = \$10,500,000 [ ] = \$10,523, Repay the peso loan. The repayment amount on the peso loan is: MP70,000,000 [1 + (8.7% 10/360)] = 70,000,000 [ ]=MP70,169, Based on the expected spot rate of \$.14, the amount of dollars needed to repay the peso loan is: MP70,169,167 \$.14 = \$9,823, After repaying the loan, Blue Demon Bank will have a speculative profit (if its forecasted exchange rate is accurate) of: \$10,523,333 \$9,823,683 = \$699,650 b. Assume all the preceding information with this exception: Blue Demon Bank expects the peso to appreciate from its present spot rate of \$.15 to \$.17 in 30 days. How could it attempt to capitalize on its expectations without using deposited funds? Estimate the profits that could be generated from this strategy. ANSWER: Blue Demon Bank can capitalize on its expectations as follows: 1. Borrow \$10 million 2. Convert the \$10 million to pesos (MP): \$10,000,000/\$.15 = MP66,666, Lend the pesos through the interbank market at 8.5% annualized over a 30-day period. The amount accumulated in 30 days is: MP66,666,667 [1 + (8.5% 30/360)] = 66,666,667 [ ] = MP67,138, Repay the dollar loan. The repayment amount on the dollar loan is: \$10,000,000 [1 + (8.3% 30/360)] = \$10,000,000 [ ] = \$10,069,170

11 Chapter 4: Exchange Rate Determination 45 ANSWER: Various models are possible. One model would be: Where % Change = a 0 + a 1 (r U.S. r M ) + u in peso r U.S. = real interest rate in the U.S. r M = real interest rate in Mexico a 0 = intercept a 1 = regression coefficient measuring the relationship between the real interest rate differential and the percentage change in the peso s value u = error term Based on the model above, the regression coefficient is expected to have a negative sign. A relatively high real interest rate differential would likely cause a weaker peso value, other things being equal. An appropriate model would also include other independent variables that may influence the percentage change in the peso s value. b. If Tarheel Co. thinks that the existence of a quota in particular historical periods may have affected exchange rates, how might this be accounted for in the regression model? ANSWER: A dummy variable could be included in the model, assigned a value of one for periods when a quota existed and a value of zero when it did not exist. This answer requires some creative thinking, as it is not drawn directly from the text. Solution to Continuing Case Problem: Blades, Inc. 1. How are percentage changes in a currency s value measured? Illustrate your answer numerically by assuming a change in the Thai baht s value from a value of \$0.022 to \$ ANSWER: The percentage change in a currency s value is measured as follows: %Δ = S St S t 1 1 where S denotes the spot rate, and S t 1 denotes the spot rate as of the earlier date. A positive percentage change represents appreciation of the foreign currency, while a negative percentage change represents depreciation. In the example provided, the percentage change in the Thai baht would be:

12 46 International Financial Management % Δ= S St S t 1 1 = \$ \$ \$ = 1818%. That is, the baht would be expected to appreciate by 18.18%. 2. What are the basic factors that determine the value of a currency? In equilibrium, what is the relationship between these factors? ANSWER: The basic factors that determine the value of a currency are the supply of the currency for sale and the demand for the currency. A high level of supply of a currency generally decreases the currency s value, while a high level of demand for a currency increases its value. In equilibrium, the supply of the currency equals the demand for the currency. 3. How might the relatively high levels of inflation and interest rates affect the baht s value? (Assume a constant level of U.S. inflation and interest rates.) ANSWER: The baht would be affected both by inflation levels and interest rates in Thailand relative to levels of these variables in the U.S. A high level of inflation tends to result in currency depreciation, as it would increase the Thai demand for U.S. goods, causing an increase in the Thai demand for dollars. Furthermore, a relatively high level of Thai inflation would reduce the U.S. demand for Thai goods, causing an increase in the supply of baht for sale. Conversely, the high level of interest rates in Thailand may cause appreciation of the baht relative to the dollar. A relatively high level of interest rates in Thailand would have rendered investments there more attractive for U.S. investors, causing an increase in the demand for baht. Furthermore, U.S. securities would have been less attractive to Thai investors, causing an increase in the supply of dollars for sale. However, investors might be unwilling to invest in baht-denominated securities if they are concerned about the potential depreciation of the baht that could result from Thailand s inflation. 4. How do you think the loss of confidence in the Thai baht, evidenced by the withdrawal of funds from Thailand, will affect the baht s value? Would Blades be affected by the change in value, given the primary Thai customer s commitment? ANSWER: In general, depreciation in the foreign currency results when investors liquidate their investments in the foreign currency, increasing the supply of its currency for sale. Blades would probably be affected by the change in value, as the sales are denominated in baht. Thus, the depreciation in the baht would have caused a conversion of the baht revenue into fewer U.S. dollars. 5. Assume that Thailand s central bank wishes to prevent a withdrawal of funds from its country in order to prevent further changes in the currency s value. How could it accomplish this objective using interest rates? ANSWER: If Thailand s central bank wishes to prevent further depreciation in the baht s value, it would attempt to increase the level of interest rates in Thailand. In turn, this would increase the demand for Thai baht by U.S. investors, as Thai securities would now seem more attractive. This would place upward pressure on the currency s value. However, the high interest rates could reduce local borrowing and spending.

14 48 International Financial Management 6. Speculative profit (THB460,136, THB402,720,000.00). 57,416, Dollar equivalent of speculative profit (THB57,416, \$0.025). 1,435, Solution to Supplemental Case: Bruin Aircraft, Inc. Some of the more commonly cited factors are listed as follows. This exercise forces students to recognize how factors influence the value of each currency. Check () Here if the Factor Check () Here if the Factor Factors that Can Affect Influences the U.S. Demand Influences the Supply of the Value of the Pound for Pounds Pounds for Sale i U.S. i U.K. INF U.S. INF U.S. Income Growth Differential New U.S. Quotas on Imports from U.K. U.S. Tariffs on Imports from U.K. New U.K. Quotas on Imports from U.S. Check () Here if the Factor Check () Here if the Factor Factors that Can Affect Influences the U.S. Demand Influences the Supply of the Value of the Pound for Pounds Pounds for Sale New U.K. Tariffs on Imports from U.S. Government Intervention to Purchase \$ with Pounds Government Intervention to Purchase Pounds with \$ Government Tax to be Imposed on Interest Income Earned by U.K. Investors from Future U.S. Investments Government Tax to be Imposed on Interest Income Earned by U.S. Investors from Future U.K. Investments

15 Chapter 4: Exchange Rate Determination 49 Small Business Dilemma Assessment by the Sports Exports Company of Factors That Affect the British Pound s Value 1. Given Jim s expectations, forecast whether the pound will appreciate or depreciate against the dollar over time. ANSWER: The pound should depreciate because the British inflation is expected to be higher than the U.S. inflation. This could cause a shift in trade flows that would place downward pressure on the pound s value. The interest rate movements of both countries are expected to be similar for both countries. Therefore, there should not be any adjustment in the capital flows between the two countries. 2. Given Jim s expectations, will the Sports Exports Company be favorably or unfavorably affected by the future changes in the value of the pound? ANSWER: The Sports Exports Company will be unfavorably affected, because depreciation in the British pound will cause the pound receivables to convert into fewer dollars.

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