Lecture International finance: An analytical approach (3/e): Chapter 4 - Imad A. Moosa

Chapter 4 - Exchange rate determination. The objectives of this chapter are: to present some stylised facts about the observed behaviour of exchange rates, to identify the factors that lead to changes in the supply of and demand for foreign exchange and, consequently, the exchange rate,...

Chapter 4

Exchange Rate Determination

Objectives

• To identify the factors causing changes in the

exchange rate.

• To describe purchasing power parity and the

monetary model of exchange rates.

• To explain how the bid-offer spread and the forward spread are determined.

• To examine the factors affecting the AUD exchange rate.

Some stylised facts

• The exchange rate follows approximately a random walk with little or no drift.

• The spot and forward rates tend to move in the same direction and by approximately the same amount.

• There is no correspondence between exchange

rates and prices

(cont.)

Some stylised facts (cont.)

• The relation between the exchange rate and the

current account is not strong

• Rapid monetary expansion leads to rapid currency

depreciation.

(cont.)

Some stylised facts (cont.)

• The behaviour of exchange rates is often described

as “bubbles followed by crashes”.

• Volatility clustering Periods of calm are followed by periods of calm, and periods of turbulence are

followed by periods of turbulence.

• Exchange rates move in cycles with significant

random variation.

Factors affecting the supply of and demand for FX

• Relative inflation rates: A country that has a higher

inflation rate than its trading partners will experience

a depreciating currency.

(cont.)

Factors affecting the supply of and demand for FX (cont.)

• Relative interest rates: Higher interest rates lead to currency appreciation.

• Distinction must be made between nominal and real exchange rates

The effect of a higher domestic

Factors affecting the supply of and demand for FX (cont.)

• Relative growth rates: The effect of growth is

ambiguous since it affects the current account and

financial account in different directions

(cont.)

Factors affecting the supply of and demand for FX (cont.)

• The role of the government: The government affects exchange rates by determining the exchange rate

regime, through central bank intervention, by

imposing and removing trade barriers, and by

affecting the variables that determine exchange

rates.

(cont.)

Factors affecting the supply of and demand for FX (cont.)

• The role of expectations: Speculators buy and sell

currencies on the basis of expectations.

• Speculators participate in the foreign exchange

market, buying and selling currencies by anticipating future movements of exchange rates

• By their actions, speculators affect the supply of and demand for currencies and therefore exchange

rates.

(cont.)

• This kind of behaviour arises, for example, when

speculators believe that there is a bubble in the

market

(cont.)

Speculation (cont.)

• Stabilising speculation occurs when speculators buy

a depreciating currency and sell an appreciating

currency.

Purchasing power parity

• The theory of purchasing power parity (PPP)

describes the relation between prices and exchange rates

• PPP is important for international business firms

because the validity of this theory precludes the

possibility of real currency appreciation and

depreciation and hence the presence of exposure to economic risk.

(cont.)

Deriving PPP (cont.)

P P

S

P S

P

P

P S

S P

0

1 0

1 0

1

Deriving PPP from the S-D model

0 1

0

1 0

1

0 0

1 1

0 1

/ /

/ /

P P

P

P S

S

P P

P

P S

S

(cont.)

Deriving PPP from the S-D model

(cont.)

P

P S

S



 1

1 0 1

The PPP exchange rate

P

P S

S

t t t

Derivation from PPP

S

S S

D 100

PPP and the real exchange rate

) /

(

) /

(

1 1

1 1

0 0

0 0

P P

S Q

P P

S Q

(cont.)

PPP and the real exchange rate

(cont.)

) 1

(

) 1

(

) 1

(

0 1

0 1

0 1

P P

P

P P

P

S S

PPP and the real exchange rate

(cont.)

0 1

0

0 0

) 1

(

) 1

( )

1 (

Q Q

P P

P

P S

S







The empirical validity of PPP

• There is little empirical evidence to support the

validity of PPP, particularly in the short run.

• There is some evidence for PPP under hyperinflation and over long periods of time.

Actual and PPP exchange rates

(USD/AUD)

Percentage deviation of the actual rate from the PPP rate (USD/AUD)

Nominal and real exchange rates

(USD/AUD)

PPP as a trading rule

) ,

, ,

F S

P

P f

S



The monetary model of exchange rates

Y kP

M S

kY

M P

kPY

M d

Predictions of the monetary model

• A monetary expansion leads to depreciation of the

Determination of the bid-offer

spread

• Since the bid rate is the rate at which the dealer buys and the customer sells, it is determined by the

intersection of the dealer’s demand curve and the

customer’s supply curve

• Conversely, the offer rate is determined by the

intersection of the customer’s demand curve and the dealer’s supply curve

Determination of the forward

spread

• The nạve model is based on the assumption that

there are independent demand and supply forces in the spot and forward markets

• It also assumes that there is a separate market with independent supply and demand forces for forward contracts with different maturities

(cont.)

Determination of the forward

• The forward spread is the difference between the

forward and spot rates.

Factors affecting the AUD exchange rates

• Interest rates

• Commodity prices and the terms of trade

• Inflation

• The external account

• The role of the RBA

Australian dollar exchange rates

(December 1983 = 100)

Australian and US short-term

interest rates

Commodity prices (December 1983

= 100)

Consumer prices (December 1983 = 100)

The role of the RBA

• The RBA intervenes in the foreign exchange market for three reasons:

(i) to calm the market when it tends to become

disorderly;

(ii) to help reverse exchange rate overshooting;

(iii) to give monetary policy greater room to manoeuvre

(cont.)

The role of the RBA (cont.)

• Direct intervention by the RBA takes the form of

smoothing and testing transactions

• ‘Smoothing’ transactions aims to ease the volatility of the currency’s path in reaction to news to prevent

exchange rate overshooting

• By ‘testing’, the RBA tries to discern market volatility from trends.