Download Chapter 16

Chapter 16
Foreign Exchange:
Factors that Influence the Exchange
Rate
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-1
Learning Objectives
• Explain how an equilibrium exchange rate is
determined
• Describe the factors responsible for movements in
the exchange rate
• Identify economic variables affecting an exchange
rate and the mechanisms through which this
occurs
• Understand the relationship between variables
affecting an exchange rate
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-2
Chapter Organisation
16.1 FX Markets and an Equilibrium Exchange Rate
16.2 Factors that Influence Exchange Rate
Movements
16.3 Measuring Exchange Rate Sensitivity to
Changes in Economic Variables
16.4 Summary
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-3
16.1 FX Market and the Equilibrium
Exchange Rate
• Previous chapter
– Focused on the structure and operations of the FX
markets
• This chapter
– Focuses on the factors that influence the value of a
currency (in a floating exchange rate regime) in order to
attempt to forecast future exchange rates with some
reliability and accuracy
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-4
16.1 FX Market and the Equilibrium
Exchange Rate (cont.)
• Floating exchange rate regime
– One in which the value of the currency is determined by
demand and supply conditions
• Pegged exchange rate regime
– Where a domestic currency is locked into a specified
multiple of another currency such as the USD, e.g. Hong
Kong dollar
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-5
16.1 FX Market and the Equilibrium
Exchange Rate (cont.)
• Demand for a currency
– To purchase Australian goods and services foreigners
must buy AUD
– Downward-sloping demand curve occurs as the
devaluation of AUD results in a greater demand by
foreigners
 For foreigners, a fall in the price of the AUD is equivalent to
a reduction in the price of everything in Australia
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-6
16.1 FX Market and the Equilibrium
Exchange Rate (cont.)
• Supply of a currency
– Upward-sloping supply curve occurs as the quantity of
AUDs supplied to the FX market increases as the price of
the AUD increases
– As the AUD appreciates, the price of foreign currency
falls, making foreign goods cheaper for Australian
residents
– The demand for foreign currency increases and,
therefore, so does the supply of AUD
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-7
16.1 FX Market and the Equilibrium
Exchange Rate (cont.)
• Equilibrium exchange rate
– The equilibrium exchange rate is the rate at which the
quantity of AUD supplied to the market is equal to the
demand for AUD
– It shows the unique rate at which both the demanders
and suppliers of AUD will be satisfied
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-8
16.1 FX Market and the Equilibrium
Exchange Rate (cont.)
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-9
Chapter Organisation
16.1 FX Markets and an Equilibrium Exchange Rate
16.2 Factors that Influence Exchange Rate
Movements
16.3 Measuring Exchange Rate Sensitivity to
Changes in Economic Variables
16.4 Summary
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-10
16.2 Factors that Influence Exchange Rate
Movements
• Main factors influencing exchange rate movements
–
–
–
–
–
Relative inflation rates
Relative national income growth rates
Relative interest rates
Exchange rate expectations
Government or central bank intervention
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-11
Relative inflation rates
• Relative inflation rates influence the price and,
therefore, the demand for foreign goods by
residents
• The change in demand for imported goods, in turn,
affects the demand for foreign currency used to
buy these goods
– This view of the determination of the value of a currency
is called purchasing power parity (PPP) and is discussed
in detail later
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-12
Relative inflation rates (cont.)
• Example: increase in US rate of inflation relative to
Australia
– Effect for Australian residents
 US imports more expensive, decreasing demand for these
goods; therefore, reducing the supply of AUD
– Effect for US residents
 Some US demand for goods and services, and assets will
switch to Australian items, increasing demand for AUD to
pay for these items
– Net effect is an appreciation of the AUD
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-13
Relative inflation rates (cont.)
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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
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16-14
Relative national income growth rates
• Example: Australian income growth rates rise
relative to the US
– Australian demand for imports increases, increasing the
supply of AUD, which, in turn, causes the AUD to
depreciate
– A secondary effect could be an increase in foreign
investment in Australia, increasing the demand for AUD,
causing the AUD to recover some value
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-15
Relative national income growth rates
(cont.)
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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
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16-16
Relative interest rates
• Example: if Australian interest rates rise relative to
the US
– Effect for US residents
 US residents and companies may redirect some of their
cash into Australian interest-bearing instruments, increasing
the demand for the AUD
– Effect for Australian residents
 Australian investors and businesses are more likely to keep
their surplus funds invested in Australia, causing a decrease
in the supply of the AUD
– Net effect
 AUD will appreciate
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-17
Relative interest rates (cont.)
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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
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16-18
Relative interest rates (cont.)
• Expectations about the value of the currency
during the investment period
– So far, the role of interest rates on the exchange rate has
ignored expectations about the value of the currency
during the investment period
– Table 16.1 illustrates the interaction of interest rate
differentials and expected changes in the exchange rate
over the investment period on currency value
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-19
Relative interest rates (cont.)
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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
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16-20
Relative interest rates (cont.)
• From Table 16.1 the following impact on the value
of the AUD would be evident
– Scenario 1: AUD would depreciate
 The 3% benefit obtained from placing funds in the
Australian money market would be more than offset by the
5% depreciation of the AUD
– Scenario 2: AUD would appreciate
 The 3% benefit obtained from placing funds in the
Australian money market would only be partly offset by the
2% depreciation of the AUD
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-21
Relative interest rates (cont.)
• Reason for change in nominal interest rate
– The analysis has ignored whether a change in the
nominal interest rate is due to a change in the
 Real rate of return
or
 Inflation expectations premium
i nom  r  pe
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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-22
Relative interest rates (cont.)
• Example: if nominal interest rates rise due to an
increase in the inflation expectations premium
– The currency may not appreciate, and could depreciate
due to
 The effect of inflationary expectations (PPP theory)
 Businesses and individuals seeking to invest cash holdings
in overseas’ securities to avoid a loss of value
• Example: if nominal interest rates rise due to an
increase in the real rate of return
– The currency may appreciate due to an inflow of funds
from the rest of the world
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-23
Exchange rate expectations
• Motivation for turnover in the FX market
– Only part of the turnover in the FX market is accounted
for by transactions associated with exports, imports and
financial assets
– A significant portion of turnover is motivated by changes
in exchange rate expectations
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-24
Exchange rate expectations (cont.)
• Exchange rate expectations are based on
expectations about future changes in
– Relative inflation
– Relative income growth
– Relative interest rates
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-25
Exchange rate expectations (cont.)
• Example: AUD expected to depreciate
– Effect for Australian residents
 Seek to buy foreign currency before AUD falls
 Increasing supply of AUD on FX markets
– Effect for foreign residents
 Defer purchases of the AUD
 Reduces demand for AUD
– Net effect
 AUD depreciates as expected
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-26
Exchange rate expectations (cont.)
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Government or central bank intervention
• Policies by foreign and/or domestic governments
may affect the relative rate of inflation, income
growth or interest rates between countries
• Also, the market participants’ expectations that the
government will alter its policy affecting these
variables in the future
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-28
Government or central bank intervention
(cont.)
• A central bank may also influence the currency by
– Intervening in international trade flows
– Intervening in foreign investment flows
– Directly intervening in the FX market
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-29
Government or central bank intervention
(cont.)
• International trade flows
– Intervention aimed at increasing exports and/or reducing
imports by using
 Subsidies to exporters, making exports more competitive
• Increases demand for Australian exports and demand for AUD
 Intervention on the import side
• Tariffs—charge levied on imports increasing their prices
• Quotas—restriction on the amount imported
• Embargo—prohibition on import of specified goods or services
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-30
Government or central bank intervention
(cont.)
• Foreign investment flows
– Governments alter the exchange rate by altering the flow
of investment funds between countries by
 Prohibitions on the outflow of funds from a country
 Imposing penalty taxes on
• Residents who earn income offshore
• Non-residents’ interest income earned in the home country
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-31
Government or central bank intervention
(cont.)
• Direct FX market intervention
– Involves purchases or sales of currency
– Two motivations for doing this
 Smoothing
• RBA tries to remove volatility in the currency caused by
speculators
 Exchange rate targeting
• RBA tries to push the equilibrium exchange rate to some level
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-32
Government or central bank intervention
(cont.)
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-33
Chapter Organisation
16.1 FX Markets and an Equilibrium Exchange Rate
16.2 Factors that Influence Exchange Rate
Movements
16.3 Measuring Exchange Rate Sensitivity to
Changes in Economic Variables
16.4 Summary
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-34
16.4 Measuring Exchange Rate Sensitivity
to Changes in Economic Variables
• Regression analysis can be used to assess how
changes in economic variables affect the
exchange rate
– It is a statistical technique that determines the
relationship between a dependent variable (the exchange
rate) and independent variables (relative growth, inflation
and interest rates etc.)
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-35
Chapter Organisation
16.1 FX Markets and an Equilibrium Exchange Rate
16.2 Factors that Influence Exchange Rate
Movements
16.3 Measuring Exchange Rate Sensitivity to
Changes in Economic Variables
16.4 Summary
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-36
16.4 Summary
• Demand and supply determine the value of a
currency in a floating exchange rate regime
• Factors influencing the demand and/or supply of a
currency
–
–
–
–
–
Relative inflation rates (PPP)
Relative national income growth rates
Relative interest rates
Exchange rate expectations
Central bank or government intervention
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-37