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 Exchange Rate
Change in the Equilibrium Exchange Rate
Factors that Influence Exchange Rates
Relative Inflation Rates
Relative Interest Rates
Relative Income Levels
Government Controls
Movements in Cross Exchange Rates
Capitalizing on Expected Exchange Rate Movements
Institutional Speculation Based on Expected Appreciation
Institutional Speculation Based on Expected Depreciation
Speculation by Individuals
Carry Trade
Exchange Rate Determination ❖ 2
Chapter Theme
This chapter provides an overview of the foreign exchange market. It is designed to illustrate (1) why a
market exists, and (2) why exchange rates change over time.
Topics to Stimulate Class Discussion
1. Why did exchange rates change recently?
2. Show the class a current exchange rate table from a periodical—identify spot and forward quotations.
Then show the class an exchange rate table from a date a month ago, or three months ago. The
POINT/COUNTER-POINT:
How Can Persistently Weak Currencies Be Stabilized?
POINT: The currencies of some Latin American countries depreciate against the U.S. dollar on a
consistent basis. The governments of these countries could attract more capital flows by raising interest
rates and making their currencies more attractive. They also could insure bank deposits so that foreign
investors who invest in large bank deposits do not need to worry about default risk. In addition, they
could impose capital restrictions on local investors to prevent capital outflows.
COUNTER-POINT: Some Latin American countries have had high inflation, which encourages local
firms and consumers to purchase products from the U.S. instead. By reducing inflation, these countries
could relieve the downward pressure on their local currencies. To reduce inflation, a country may have to
reduce its economic growth temporarily. These countries should not raise their interest rates in an attempt
to attract foreign investment, because they will still not attract funds if investors fear that large capital
outflows will occur at the first threat of continued depreciation.
WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you support?
Offer your own opinion on this issue.
ANSWER: There is no perfect solution but recognize the tradeoffs. The proposal to raise interest rates is
Exchange Rate Determination ❖ 3
Answers to End of Chapter Questions
1. Percentage Depreciation. Assume the spot rate of the British pound is $1.73. The expected spot rate
one year from now is assumed to be $1.66. What percentage depreciation does this reflect?
2. Inflation Effects on Exchange Rates. Assume that the U.S. inflation rate becomes high relative to
Canadian inflation. Other things being equal, how should this affect the (a) the U.S. demand for
Canadian dollars, (b) the supply of Canadian dollars for sale, and (c) the equilibrium value of the
Canadian dollar?
3. Interest Rate Effects on Exchange Rates. Assume U.S. interest rates fall relative to British interest
rates. Other things being equal, how should this affect the (a) the U.S. demand for British pounds,
(b) the supply of pounds for sale, and (c) the equilibrium value of the pound?
4. Income Effects on Exchange Rates. Assume that the U.S. income level rises at a much higher rate
than does the Canadian income level. Other things being equal, how should this affect the (a) the
U.S. demand for Canadian dollars, (b) the supply of Canadian dollars for sale, and (c) the equilibrium
value of the Canadian dollar?
5. Trade Restriction Effects on Exchange Rates. Assume that the Japanese government relaxes its
controls on imports by Japanese companies. Other things being equal, how should this affect the (a)
the U.S. demand for Japanese yen, (b) the supply of yen for sale, and (c) the equilibrium value of the
yen?
6. Effects of Real Interest Rates. What is the expected relationship between the relative real interest
rates of two countries and the exchange rate of their currencies?
7. Speculative Effects on Exchange Rates. Explain why a public forecast by a respected economist
about future interest rates could affect the value of the dollar today. Why do some forecasts by
well-respected economists have no impact on today’s value of the dollar?
Exchange Rate Determination ❖ 4
ANSWER: Interest rate movements affect exchange rates. Speculators can use anticipated interest
rate movements to forecast exchange rate movements. They may decide to purchase securities in
8. Factors Affecting Exchange Rates. What factors affect the future movements in the value of the
euro against the dollar?
9. Interaction of Exchange Rates. Assume that substantial capital flows occur among Canada, the
U.S., and Japan. If the interest rates in Canada decline to a level below the U.S. interest rate, and
inflationary expectations remain unchanged, how could this affect the value of the Canadian dollar
against the U.S. dollar? How might this decline in Canada’s interest rates possibly affect the value of
the Canadian dollar against the Japanese yen?
10. Trade Deficit Effects on Exchange Rates. Every month, the U.S. trade deficit figures are
announced. Foreign exchange traders often react to this announcement and even attempt to forecast
the figures before they are announced.
a. Why do you think the trade deficit announcement sometimes has such an impact on foreign
exchange trading?
ANSWER: The trade deficit announcement may provide a reasonable forecast of future trade deficits
and therefore has implications about supply and demand conditions in the foreign exchange market.
b. In some periods, foreign exchange traders do not respond to a trade deficit announcement, even
when the announced deficit is very large. Offer an explanation for such a lack of response.
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11. Comovements of Exchange Rates. Explain why the value of the British pound against the dollar will
not always move in tandem with the value of the euro against the dollar.
12. Factors Affecting Exchange Rates. In some historical periods, Brazil’s inflation rate has been very
high. Explain why this places pressure on the Brazilian currency (called the Brazilian real).
13. National Income Effects. Analysts commonly attribute the appreciation of a currency to expectations
that economic conditions will strengthen. Yet, this chapter suggests that when other factors are held
constant, increased national income could increase imports and cause the local currency to weaken.
In reality, other factors are not constant. What other factor is likely to be affected by increased
economic growth and could place upward pressure on the value of the local currency?
14. Factors Affecting Exchange Rates. If Asian countries experience a decline in economic growth (and
experience a decline in inflation and interest rates as a result), how will their currency values (relative
to the U.S. dollar) be affected?
15. Impact of Crises. Why do you think most crises in countries (such as the Asian crisis) cause the local
currency to weaken abruptly? Is it because of trade flows or capital flows?
Exchange Rate Determination ❖ 7
a. Identify the most obvious economic reason for the persistent depreciation of the peso.
b. High interest rates are commonly expected to strengthen a country’s currency because they can
encourage foreign investment in securities in that country, which results in the exchange of other
currencies for that currency. Yet, the peso’s value has declined against the dollar over most years
even though Mexican interest rates are typically much higher than U.S. interest rates. Thus, it
appears that the high Mexican interest rates do not attract substantial U.S. investment in Mexico’s
securities. Why do you think U.S. investors do not try to capitalize on the high interest rates in
Mexico?
ANSWER: The high interest rates in Mexico result from expectations of high inflation. That is, the
c. Why do you think the bid/ask spread is higher for pesos than for currencies of industrialized
countries? How does this affect a U.S. firm that does substantial business in Mexico?
ANSWER: The bid/ask spread is wider because the banks that provide foreign exchange services are
19. Aggregate Effects on Exchange Rates. Assume that the United States invests heavily in government
and corporate securities of Country K. In addition, residents of Country K invest heavily in the
United States. Approximately $10 billion worth of investment transactions occur between these two
countries each year. The total dollar value of trade transactions per year is nearly $8 million. These
patterns are expected to continue in the future.
Because your firm exports goods to Country K, your job as international cash manager requires you
to forecast the value of Country K’s currency (the “krank”) with respect to the dollar. Explain how
each of the following conditions will affect the value of the krank, holding other things equal. Then,
aggregate all of these impacts to develop an overall forecast of the krank’s movement against the
dollar.
a. U.S. inflation has suddenly increased substantially, while Country K’s inflation remains low.
b. U.S. interest rates have increased substantially, while Country K’s interest rates remain low.
Investors of both countries are attracted to high interest rates.
Exchange Rate Determination ❖ 8
c. The U.S. income level increased substantially, while Country K’s income level has remained
unchanged.
d. The U.S. is expected to impose a small tariff on goods imported from Country K.
e. Combine all of the expected impacts to develop an overall forecast.
ANSWER: Two of the scenarios described above place upward pressure on the value of the krank.
20. Speculation. Blue Demon Bank expects that the Mexican peso will depreciate against the dollar from
its spot rate of $.15 to $.14 in 10 days. The following interbank lending and borrowing rates exist:
Lending Rate Borrowing Rate
U.S. dollar 8.0% 8.3%
Mexican peso 8.5% 8.7%
Assume that Blue Demon Bank has a borrowing capacity of either $10 million or 70 million peos in
the interbank market, depending on which currency it wants to borrow.
a. How could Blue Demon Bank 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 about pesos (MXP) as follows:
1. Borrow MXP70 million
2. Convert the MXP70 million to dollars:
3. Lend the dollars through the interbank market at 8.0% annualized over a 10-day period. The
amount accumulated in 10 days is:
4. Repay the peso loan. The repayment amount on the peso loan is:
5. Based on the expected spot rate of $.14, the amount of dollars needed to repay the peso
loan is:
Exchange Rate Determination ❖ 9
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MXP70,169,167 × $.14 = $9,823,683
6. After repaying the loan, Blue Demon Bank will have a speculative profit (if its forecasted
exchange rate is accurate) of:
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 (MXP):
3. Lend the pesos through the interbank market at 8.5% annualized over a 30-day period. The
4. Repay the dollar loan. The repayment amount on the dollar loan is:
5. Convert the pesos to dollars to repay the loan. The amount of dollars to be received in 30
6. The profits are determined by estimating the dollars available after repaying the loan:
21. Speculation. Diamond Bank expects that the Singapore dollar will depreciate against the dollar from
its spot rate of $.43 to $.42 in 60 days. The following interbank lending and borrowing rates exist:
Lending Rate Borrowing Rate
U.S. dollar 7.0% 7.2%
Singapore dollar 22.0% 24.0%
Diamond Bank considers borrowing 10 million Singapore dollars in the interbank market and
investing the funds in dollars for 60 days. Estimate the profits (or losses) that could be earned from
this strategy. Should Diamond Bank pursue this strategy?
ANSWER:
Borrow S$10,000,000 and convert to U.S. $:
Exchange Rate Determination ❖ 10
S$10,000,000 × $.43 = $4,300,000
Invest funds for 60 days. The rate earned in the U.S. for 60 days is:
22. Relative Importance of Factors Affecting Exchange Rate Risk. Assume that the level of capital
flows between the U.S. and the country of Krendo is negligible (close to zero) and will continue to be
negligible. In contrast, a substantial amount of trade occurs between the U.S. and the country of
Krendo. How will high inflation and high interest rates affect the value of the kren (Krendo’s
currency)? Explain.
23. Assessing the Euro’s Potential Movements. You reside in the U.S. and are planning to make a one-
year investment in Germany during the next year. Since the investment is denominated in euros, you
want to forecast how the euro’s value may change against the dollar over the one-year period. You
expect that Germany will experience an inflation rate of 1% during the next year, whereas all other
European countries will experience an inflation rate of 8% over the next year. You expect that the
U.S. will experience an annual inflation rate of 2% during the next year. You believe that the primary
factor that affects any exchange rate is the inflation rate. Based on the information provided in this
question, will the euro appreciate, depreciate, or stay at about the same level against the dollar over
the next year? Explain.
24. Weighing Factors That Affect Exchange Rates. Assume that the level of capital flows between the
U.S. and the country of Zeus is negligible (close to zero) and will continue to be negligible. A
substantial amount of trade occurs between the U.S. and the country of Zeus. The main import by the
U.S. is basic clothing purchased by U.S. retail stores from Zeus, whereas the main import by Zeus is
special computer chips that are made only in the U.S. and are needed by many manufacturers in Zeus.
Suddenly, the U.S. government decides to impose a 20% tax on the clothing imports. The Zeus
government immediately retaliates by imposing a 20% tax on the computer chip imports. Second, the
Zeus government immediately imposes a 60% tax on any interest income that would be earned by
Exchange Rate Determination ❖ 11
Zeus investors if they buy U.S. securities. Third, the Zeus central bank raises its local interest rates so
that they are now higher than interest rates in the U.S. Do you think the currency of Zeus (the zee)
will appreciate or depreciate against the dollar as a result of all these government actions described
above? Explain.
25. How Factors Affect Exchange Rates. The country of Luta has large capital flows with the U.S. It
has no trade with the U.S and will not have trade with the U.S. in the future. Its interest rate is 6%, the
same as the U.S. interest rate. Its rate of inflation is 5%, the same as the U.S. inflation rate. You
expect that the inflation rate in Luta will rise to 8% this coming year, whereas the U.S. inflation rate
will remain at 5%. You expect that Luta’s interest rate will rise to 9% during the next year, whereas
the U.S. interest rate will remain at 6%. Do you think Luta’s currency will appreciate, depreciate, or
remain unchanged against the dollar? Briefly explain.
26. Speculation on Expected Exchange Rates. Kurnick Co. expects that the pound will depreciate from
$1.70 to $1.68 in one year. It has no money to invest, but it could borrow money to invest. A bank
allows the company to borrow either 1 million dollars or 1 million pounds for one year. It can borrow
dollars at 6% or Bitish pounds at 5% for one year. It can invest in a risk-free dollar deposit at 5% for
one year or a risk-free British deposit at 4% for one year. Determine the expected profit or loss (in
dollars) if Kurnick Co. pursues a strategy to capitalize on the expected depreciation of the pound.
ANSWER: Initial amount borrowed = 1,000,000 pounds
27. Volatility of Exchange Rate Movements. Assume you want to determine whether the monthly
movements in the Polish zloty against the dollar are more volatile than the monthly movements in
some other currencies against the dollar. The zloty was valued at $.4602 on May 1, $.4709 on June 1,
$.4888 on July 1, $.4406 on August 1, and $.4260 on September 1. Using Excel or another electronic
spreadsheet, compute the standard deviation (a measure of volatility) of the zloty’s monthly exchange
rate movements. Show your spreadsheet.
ANSWER:
First day in:
Value
Change
May
0.4602
June
0.4709
2.33%
Exchange Rate Determination ❖ 12
July
0.4888
3.80%
August
0.4406
-9.86%
September
0.426
-3.31%
Std Dev
6.21%
28. Impact of Economy on Exchange Rates. Assume that inflation is zero in the U.S. and in Europe and
will remain at zero. U.S. interest rates are presently the same as in Europe. Assume that the economic
growth in the U.S. is presently similar to that occurring in Europe. Assume that international capital
flows are much larger than international trade flows. Today, there is news reports clearly signal that
economic conditions in Europe will be weaken in the future, whereas economic conditions in the U.S.
will be steady. Explain why and how (which direction) the euro’s value would change today based on
this information.
29. Movements in Cross Exchange Rates. Last year a dollar was equal to 7 Swedish kronor, and a
Polish zloty was equal to $.40. Today, the dollar is equal to 8 Swedish kronor and a Polish zloty is
equal to $.44. By what percentage did the cross exchange rate of the Polish zloty in Swedish kronor
(that is, the number of kronor that can be purchased with one zloty) change over the last year?
ANSWER:
Old rates last year
Spot rate of kronor = (1.00/7) = $.142857
30. Measuring Exchange Rate Volatility. Here are exchange rates for the Japanese yen and British
pound at the beginning of each of the last 5 years. Your firm wants to determine which currency is
more volatile as it assesses its exposure to exchange rate risk. Estimate the volatility of each
currency’s movements.
Beginning of Year
Yen
Pound
1
0.008
1.47
2
0.011
1.46
3
0.008
1.51
4
0.01
1.54
5
0.012
1.52
Exchange Rate Determination ❖ 13
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ANSWER: The standard deviation of the yen’s movements is about 28%, versus about 2% for the
pound’s movements. Thus, the yen is much more volatile than the pound, based on the data provided.
31. Impact of Economy on Exchange Rate. The country of Quinland has large capital flows with the
U.S. It has no trade with the U.S and will not have trade with the U.S. in the future. Its interest rate is
6%, the same as the U.S. interest rate. You expect that the inflation rate in Quinland will be 1% this
coming year, whereas the U.S. inflation rate will be 9%. You expect that Quinland’s interest rate will
be 2% during the next year, whereas the U.S. interest rate will rise to 10% during the next year.
Quinland’s currency adjusts in response to market forces. Will Quinland’s currency appreciate,
depreciate, or remain unchanged against the dollar?
32. Impact of Economy on Exchange Rate. The country of Zars has large capital flows with the U.S. It
has no trade with the U.S and will not have trade with the U.S. in the future. Its interest rate is 6%, the
same as the U.S. interest rate. Its rate of inflation is 5%, the same as the U.S. inflation rate. You
expect that the inflation rate in Zars will rise to 8% this coming year, while the U.S. inflation rate will
remain at 5%. You expect that Zars’ interest rate will rise to 9% during the next year. You expect that
the U.S. interest rate will remain at 6% this year. Zars’ currency adjusts in response to market forces
and is not subject to direct central bank intervention. Will Zars currency appreciate, depreciate, or
remain unchanged against the dollar?
33. Impact of Economy on Exchange Rates. The country of Vezot has massive capital flows with the
U.S. because it has no restrictions on the movement of investment funds into or out of the country.
Its inflation rate just increased substantially, while the U.S. inflation rate remains unchanged. Vezot‘s
interest rate just increased substantially, while the U.S. interest rate remains unchanged. Vezot’s
income level just increased substantially, which will increase consumption of products within its
country; the U.S. income level remains unchanged. Negligible international trade occurs between
Vezot and the U.S. Vezot can easily obtain all of its imported products from border countries instead
of the U.S. The U.S. just imposed very large taxes on U.S. companies that import products from
Vezot from today forward. Vezot does not impose restrictions on imports from the U.S. Vezot’s
currency is freely floating. Based on this information, do you think Vezot’s currency will appreciate,
depreciate, or remain unchanged against the dollar? Briefly explain.
34. Foreign Exchange Transactions. Assume the country of Neeland has stable and predictable
international trade flows with the U.S. Neeland periodically makes the news because its government
might have problems repaying its debt owed to local banks. The value of its currency (the “nee”)
exhibits much volatility. Thus, the value of the nee. Briefly explain what types of transactions are
likely causing the shifts in demand for the nee and supply of the nee for sale in the foreign exchange
market.
Exchange Rate Determination ❖ 14
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ANSWER: In general, this can be explained by speculative flows of funds. Speculators tend to move
out of the nee when there is bad news like this, because such news might discourage foreign
investment by MNCs that are concerned about the country’s political instability. So, speculators sell
the nee upon the news, which places downward pressure on the nee‘s value immediately. However, if
there is favorable news the next day in which fears of debt repayment are reduced, speculative money
can move back in, and the demand for the nee in the foreign exchange market can increase the value
of the nee.
35. Weighing the Influence of Factors on Exchange Rates. The New Zealand dollar‘s spot rate was
equal to $.60 last month. New Zealand conducts much international trade with the U.S. but that the
financial (investment) transactions between the two countries are negligible. Assume the following
conditions have occurred in the last year. First, interest rates in New Zealand increased but decreased
in the U.S. Second, inflation in New Zealand increased but decreased in the U.S. Third, the New
Zealand central bank intervened in the foreign exchange market by exchanging a very small amount
of U.S. dollars to purchase a very small amount of New Zealand dollars. How should the New
Zealand dollar change over the year based on the information provided here?
ANSWER: The key is to weigh the influence of each effect in order to derive a total effect. Two of
the factors described above place upward pressure on the value of the New Zealand dollar. The high
CRITICAL THINKING
Solving a Currency Crisis Review a recent currency crisis in a foreign country in the last year or so,
using an online search term such as “currency crisis.” Summarize the details of the currency crisis, and
write a short essay explaining whether the country should have attempted to impose a fixed exchange rate
system for its currency to prevent the currency crisis.
ANSWER:
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 $0.026.
−
S
t
1
Exchange Rate Determination ❖ 15
where S denotes the spot rate, and
St−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:
%$0.$0.
$0.. = −=−=
−
−
S S
S
t
t
1
1
026 022
022 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?
3. How might the lose in the confidence in the baht, evidenced by the withdrawal of funds from
Thailand, 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
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?
5. Assume that Thailand’s central bank wishes to prevent a withdrawal of funds from its country so as to
prevent further changes in the currency’s value. How could it accomplish this objective by
manipulating interest rates?
Exchange Rate Determination ❖ 16
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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.
6. Construct a spreadsheet illustrating the steps Blades’ treasurer would need to follow to speculate on
expected movements in the baht’s value over the next 30 days. Also show the speculative profit (in
dollars) resulting from each scenario. Use both of Ben Holt’s examples to illustrate the possible
speculation. Assume that Blades can borrow either $10 million or the baht equivalent of this amount.
Furthermore, assume that the following short-term interest rates (annualized) are available to Blades:
Currency
Lending Rate
Borrowing Rate
Dollars
8.10%
8.20%
Thai baht
14.80%
15.40%
Depreciation of the Baht from $0.022 to $0.020
1. Borrow Thai baht ($10,000,000/0.022)
454,545,454.50
2. Convert the Thai baht to dollars ($454,545,454.50 million × $0.022).
10,000,000.00
3. Lend the dollars at 8.10% annualized, which represents a 0.68% return over
the 30-day period [computed as 8.10% × (30/360)]. After 30 days, Blades
would receive ($10,000,000 × (1 + .0068))
10,068,000.00
4. Use the proceeds of the dollar loan repayment (on Day 30) to repay the
baht borrowed. The annual interest on the baht borrowed is 15.40%, or 1.28%
over the 30-day period [computed as 15.40% × (30/360)]. The total baht
amount necessary to repay the loan is therefore (454,545,454.50 × (1 + .0128))
460,363,636.40
5. Number of dollars necessary to repay baht loan ($THB460,363,636.40 × $0.02)
9,207,272.73
6. Speculative profit ($10,068,000 – $9,207,272.73)
860,727.27
Appreciation of the Baht from $0.022 to $0.025
1. Borrow dollars.
10,000,000.00
2. Convert the dollars to Thai baht ($10 million/$0.022).
454,545,454.50
3. Lend the baht at 14.80% annualized, which represents a 1.23% return
over the 30-day period [computed as 14.80% × (30/360)]. After 30 days,
Blades would receive (THB454,545,454.50 × (1 + .0123))
460,136,363.60
4. Use the proceeds of the baht loan repayment (on Day 30) to repay
the dollars borrowed. The annual interest on the dollars borrowed is
8.20%, or 0.68% over the 30-day period [computed as 8.20% × (30/360)].
The total dollar amount necessary to repay the loan is therefore
Exchange Rate Determination ❖ 18
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.
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?