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

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

2 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 price of a country can change due to supply and/or the demand schedule shifts resulting from a change in that country s interest rate relative to the interest rate changes in other countries 7. 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 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. 11. 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 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 price of a country can change due to supply and/or the demand schedule shifts resulting from government transaction in the FX market. 13. To be able to explain in your words, how the value of a country s monetary unit will affect the price of its currency

3 Overview: Chapter 2 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 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 FINA 5500, Chapter 2 1 Demand For A Currency (U.S. viewpoint) Demand for foreign exchange by U.S. corporations / traders / governments that need to purchase:» foreign-produced trade items» foreign assets (real and financial). Demand Curve / Schedule:» Relationship between the quantity of FX demanded & the price of FX (exchange rate)» Negatively sloping FINA 5500, Chapter 2 2

4 Demand Schedule for British Pounds $1.60 $ Bill 20 Bill Quantity of BP FINA 5500, Chapter 2 3 Supply For A Currency (U.S. viewpoint) Supply of foreign exchange by foreign corporations / traders / governments that need to purchase:» U.S.-produced trade items» U.S. assets (real or financial). Supply Curve / Schedule:» Relationship between the quantity of FX demanded & the price of FX (exchange rate)» Positively sloping FINA 5500, Chapter 2 4

5 Supply Schedule for British Pounds $1.60 $ Bill 20 Bill Quantity of BP FINA 5500, Chapter 2 5 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. $1.60 $1.55 $1.50 Supply Curve for BP Demand Curve for BP Quantity of BP FINA 5500, Chapter 2 6

6 Changes in Macro-Economic Factors & Exchange Rates 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 EFFECTS: What happens to: The supply and demand schedules The equilibrium exchange rate / price of the foreign currency FINA 5500, Chapter 2 7 The Effects of Relative Domestic Inflation Increase in the FX Market Demand Schedule: Foreign goods are relatively cheaper to domestic consumers. Merchandise imports increase. Quantity of FX demanded at each exchange rate increases. Supply Schedule: Domestic goods are relatively expensive for foreign consumers. Merchandise exports decrease. Quantity of FX supplied at each exchange rate (ER) falls. Equilibrium: ER (price of BP) increases D2 S2 Quantity of BP Exchanged FINA 5500, Chapter 2 8

7 The Effects of Relative Domestic Inflation Decrease in the FX Market Demand Schedule: Foreign goods are relatively expensive to domestic consumers. Merchandise imports decreases. Quantity of FX demanded at each exchange rate decreases. Supply Schedule: Domestic goods are relatively cheaper for foreign consumers. Merchandise exports increase. Quantity of FX supplied at each ER increases. Equilibrium: ER (price of BP) decreases D2 S2 Quantity of BP Exchanged FINA 5500, Chapter 2 9 The Effects of Relative Domestic Interest Rate Increase in the FX Market Demand Schedule: Domestic capital attracted to domestic country & domestic capital movement overseas falls. Quantity of FX demanded at each exchange rate decreases. Supply Schedule: Foreign capital attracted to domestic country & foreign capital movement into the domestic country increases. Quantity of FX supplied at each ER rate increases. Equilibrium: ER (price of BP) decreases D2 S2 Quantity of BP Exchanged FINA 5500, Chapter 2 10

8 The Effects of Relative Domestic Interest Rate Decrease in the FX Market Demand Schedule: Domestic capital attracted to foreign country & domestic capital movement overseas increases. Quantity of FX demanded at each exchange rate increases. Supply Schedule: Domestic capital attracted to domestic country & domestic capital movement overseas falls. Quantity of FX supplied at each ER falls. Equilibrium: ER (price of BP) increases D2 S2 Quantity of BP Exchanged FINA 5500, Chapter 2 11 The Effects of Relative Domestic National Income Increase in the FX Market Demand Schedule: With higher income, domestic consumers purchase more foreign goods. Merchandise imports increase. Quantity of FX demanded at each exchange rate increases. Supply Schedule: Either foreign demand for domestic goods does not change or increases with increased foreign dollar purchasing power Quantity of FX supplied at each ER does not change or increases. Equilibrium: ER (price of BP) increases D2 S2 Quantity of BP Exchanged FINA 5500, Chapter 2 12

9 The Effects of Relative Domestic National Income Decrease in the FX Market Demand Schedule: With lower income, domestic consumers purchase less foreign goods. Merchandise imports decrease. Quantity of FX demanded at each exchange rate decreases. Supply Schedule: Either foreign demand for domestic goods does not change or decreases with decreased foreign dollar purchasing power Quantity of FX supplied at each ER does not change or decreases. Equilibrium: ER (price of BP) decreases FINA 5500, Chapter 2 13 D2 Quantity of BP Exchanged S2 Expectations About Currency Prices and Trading Strategy in FX Market: Theory 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 This changes the supply/demand and the price for foreign currency in the FX market FINA 5500, Chapter 2 14

10 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 FINA 5500, Chapter 2 15 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 D2 UK Bank 90 Days Later: - Withdraw BP10,150,000 from UK Bank (10,000,000 [ (90/360)] - Convert pounds to (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 - Annualized percentage profit = (1,597,500 / 15,000,000) *(360/90)*100 = 42.60%. Quantity of BP Exchanged FINA 5500, Chapter 2 16

11 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 [ (60/360)] $15,100,000 from US bank - Convert dollars to $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%. FINA 5500, Chapter 2 17 Price of MP in $ S2 Quantity of MP Exchanged 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 perceived to be abnormally low or high with respect to the US dollar, both the US Central bank and the central bank of other countries may agree to buy or sell the foreign currency (against the dollar) to reverse this trend. FINA 5500, Chapter 2 18

12 The US Government Increases Trade Restrictions Trade Restriction Increase in US: Import duties on UK goods (tarrifs) are increased Quotas on goods imported from UK into US are reduced Demand Schedule: Fewer UK goods will be imported Quantity of FX demanded at each ER decreases Supply Schedule Will not change Equilibrium: ER (price of BP) decreases D2 Quantity of BP Exchanged FINA 5500, Chapter 2 19 The US Government Decreases Trade Restrictions Trade Restriction Decrease in US: Import duties on UK goods (tarrifs) are decreased Quotas on goods imported from UK into US are increased Demand Schedule: More UK goods will be imported Quantity of FX demanded at each ER increases Supply Schedule Will not change Equilibrium: ER (price of BP) increases D2 Quantity of BP Exchanged FINA 5500, Chapter 2 20

13 The Foreign Government Increases Trade Restrictions Trade Restriction Decrease in US: Import duties on US goods (tarrifs) are increased in the UK Quotas on goods imported from US into UK are decreased Demand Schedule: Will not change Supply Schedule Fewer US goods will be sold in UK Quantity of FX supplied at each ER decreases Equilibrium: ER (price of BP) increases S2 Quantity of BP Exchanged FINA 5500, Chapter 2 21 The Foreign Government Decreases Trade Restrictions Trade Restriction Decrease in US: Import duties on US goods (tarrifs) are decreased in the UK Quotas on goods imported from US into UK are increased Demand Schedule: Will not change Supply Schedule More US goods will be sold in UK Quantity of FX supplied at each ER increases Equilibrium: ER (price of BP) decreases S2 Quantity of BP Exchanged FINA 5500, Chapter 2 22

14 Government Intervention in the FX Market: Non-Sterilized (1) 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 FINA 5500, Chapter 2 23 Government Intervention in the FX Market: Non-Sterilized (2) 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 transactions in the FX market FINA 5500, Chapter 2 24

15 Government Intervention in the FX Market: Sterilized (1) 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 FINA 5500, Chapter 2 25 Government Intervention in the FX Market: Sterilized (2) 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 The BP depreciation (dollar appreciation ) due to central bank transaction is usually short lived FINA 5500, Chapter 2 26

16 Changes in the Value of a Country s Monetary Unit and the Exchange Rate 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 Higher monetary value leads to higher demand and higher value for its currency FINA 5500, Chapter 2 27

17 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. D 0 and S 0 refer to the initial supply and demand schedules while D 1 and S 1 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. (A) (B) (C) S 0 S 1 S 0 S 1 S 0 S 1 D 0 D 1 D 1 D 1 D 0 D 0 (D) (E) (F) S 1 S 0 S 1 S 0 S 1 S 0 D 0 D 1 D 0 D 0 (G) (H) S 0 S 0 D 1 D 0 D 0 D 1

18 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). a) Identify the: 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 4,000,000 $1.60 5,000,000 2,000,000 $1.65 6,000,000 1,000,000 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 d) Calculate the excess supply or demand for BP if both the US and the British governments fixed the price of BP at $1.60.

19 In-Class Exercise # 2: The effects of economic factors in FX Market Please used the list of graphs to answer questions 1, 3, and 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: 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 5. If the US economy moved into a recession, while the British economy remained the same, identify which graph best describes what happens in the foreign exchange market for BP:

20 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. Which currency should you borrow in, and how much? Scenario 1 Scenario 2 Which currency should you invest in, and how much? What will be your profit in $ or FC Which graph best describes what happens in the FX market

21 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 S 1 Demand schedule for BP does not change Supply schedule for BP increases Price of BP decreases Price S 1 S 2 D 2 D 1 Quantity D 1 Quantity Results: Long term Sell $ Buy BP US money supply increases British money supply decreases US inflation increases British inflation decreases BP appreciates $ depreciates Buy $ Sell BP US money supply decreases British money supply increases US inflation decreases British inflation increases BP depreciates $ appreciates

22 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 - Demand schedule for BP does not change - Supply schedule for BP increases - Price of BP decreases Price S 1 S 2 S 1 D 2 D 1 Quantity D 1 Quantity Results: Long term Sell $ Sell US Govt Securities Buy BP Buy British Govt Securities US money supply increases US money supply decreases British money supply decreases British money supply increases US inflation does not change British inflation does not change Prices of BP and $ do not change in the long term Buy $ Buy US Govt Securities Sell BP Sell British Govt Securities US money supply decreases US money supply increases British money supply increases British money supply decrease US inflation does not change British inflation does not change Prices of BP and $ do not change in the long term

23 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 Trade barriers BP is undervalued: both governments will buy BP (sell $) Increase No change Increase G BP is overvalued: both governments will sell BP (buy $) No change Increase Decrease E UK increases trade barriers for US goods (decrease quotas or increase tariffs) No change Decrease Increase F UK decreases trade barriers for US goods (increase quotas or decrease tariffs) No change Increase Decrease E US increases trade barriers for UK goods (decrease quotas or increase tariffs) Decrease No change Decrease H US decreases trade barriers for UK goods (increase quotas or decrease tariffs) Increase No change Increase G Expectations BP ($) 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: 1. Demand and supply are for foreign currency only - not for US dollar. For example, when Americans are buying more pounds (with $), they must be supplying $ in the FX market. In our analysis, we say that the demand for pounds has increased. Similarly, when the Britishers are buying more $ (with pounds), although British demand for $ has increased, in our analysis we say that the supply of pounds has increased in the FX market. 2. From the US viewpoint, appreciation of foreign currency is the same as depreciation of the US dollar (and depreciation of FC = appreciation of $). 3. The effect of each macroeconomic factor is considered one at a time. Please note, that in this analysis, all other factors are assumed to be constant. In the real world, all factors are simultaneously, and constantly, changing.

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