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

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

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  1. Chapter 4 Exchange Rate Determination
  2. 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. Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 4-2
  3. 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.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 4-3
  4. 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.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 4-4
  5. 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. Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 4-5
  6. The equilibrium exchange rate S(d/f) Sf S0 Df Q f Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 4-6
  7. 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.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 4-7
  8. The effect of a higher domestic inflation rate S(d/f) Sf S1 S0 Df Q f Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 4-8
  9. 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. Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 4-9
  10. The effect of a higher domestic interest rate S(d/f) Sf S0 S1 Df Q f Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 4-10
  11. 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.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 4-11
  12. 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.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 4-12
  13. Factors affecting the supply of and demand for FX (cont.) • The role of expectations: Speculators buy and sell currencies on the basis of expectations. Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 4-13
  14. Speculation • 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.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 4-14
  15. Speculation (cont.) • Destabilising speculation, which drives the exchange rate away from its equilibrium value, occurs when speculators buy a currency when it is high and sell it when it is low. • This kind of behaviour arises, for example, when speculators believe that there is a bubble in the market . (cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 4-15
  16. Speculation (cont.) • Stabilising speculation occurs when speculators buy a depreciating currency and sell an appreciating currency. Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 4-16
  17. 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. Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 4-17
  18. Deriving PPP * P SP 0 1 * P0 SP0 * P1 SP1 (cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 4-18
  19. Deriving PPP (cont.) P1 S1 P1 P0 S0 P0 (1 P ) (1 S )(1 P ) S P P Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 4-19
  20. Deriving PPP from the S-D model S1 P1 / P1 S0 P0 / P0 P1 / P0 S1 S0 P1 / P0 (cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 4-20
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