Exchange Rate Changes

Question 1

Mixed trading

Answer 1

When some currencies appreciate while others depreciate against a specific currency.

Question 2

2 possible supply curves for domestic assets in SHORT RUN SHORT RUN SHORT RUN

Answer 2

Vertical - if fixed amount domestic assets

Upward sloping - Variable amount of domestic assets

Question 3

Demand curve for domestic assets: main determinant?

Answer 3

Relative expected return of domestic assets

Question 4

Factors that influence exchange rates (5)

Answer 4

Inflation
Interest
Income
Government controls
Expectations of future exchange rates

e= f (ΔINF, ΔINT, ΔINC, ΔGC, ΔEXP)

Question 5

Effect of an increase in US relative inflation (from a UK perspective)

Answer 5

Demand more British goods since US more expensive. So demand for pounds increase

British lower their desire for US goods, so reduce supply of pounds.

Overall appreciation of pound, depreciation of dollar.

Question 6

Effect of an increase in US relative interest rates (from UK perspective)

Answer 6

We supply more pounds since more US attractive.

Demand for pounds fall since Americans prefer their own rates.

Depreciation of pound, appreciation of dollar

Question 7

Evaluation of interest rates - is high interest really that attractive? (International fisher effect later builds upon this)

Answer 7

A high interest rate (attractive to investors) may reflect expectations of relatively high inflation (unattractive to investors), which may discourage foreign investment

Question 8

So what should we consider

Answer 8

The REAL interest rate to account for inflation

Question 9

Therefore higher interest rates are not attractive as e.g. the increased attraction of higher £ interest rates offset by the fall in £ value due to higher inflation.

So high interest rates are only attractive if do not come with high inflation

Question 10

Effect of an increase in US income level (from UK perspective)

Answer 10

US demand more british goods, increased demand for pounds.

No change in supply of pound. Just a straight appreciation from the rise in demand

Question 11

4th function of exchange rates: Government controls (3)

Answer 11

Foreign exchange barriers
Foreign trade barriers
Intervening in FEM (thorugh influencing macro variables e.g income, inflation, interest)

Question 12

So how do the 5 determinants of the exchange rate interact? Give example

Answer 12

An increase in income levels sometimes causes expectations of higher interest rates (since economy must be doing well so may need contractionary monetary policy), and higher interest suggests higher inflation.

Thus opposing pressures on foreign currency values.

Question 13

What is the sensititivity of an exchange rate to the 5 factors dependent on?

Answer 13

Volume of international transactions between the 2 countries

Question 14

for a large volume of trade

for a large volume of capital flows

what will be more influential factors?

Answer 14

large volume of trade>inflation rates may be more influential

large colume of capital flows, interest rates more influential

Question 15

pg 20

Question 16

What shifts demand for domestic assets (3)

(Pretty much domestic currency)

Answer 16

As mentioned: expected relative return! So…

domestic interest rate (pos rel)
foreign interest rate (negative rel)
expected future exchange rate (positive rel)

Question 17

Increase in domestic interest rate in diagram

Answer 17

Increse in demand, leading to an appreciation

Question 18

Increase in foreign interest rate (from domestic pov) diagram

Answer 18

fall in demand, depreciation

Question 19

Increase in expected future exchange rate

Answer 19

increase in demand, causing appreciation in CURRENT exchange rate, and so forward rates are higher, which are a guide to current spot rate, so current one will rise too)

Question 20

So when domestic real interest rates raise, the domestic currency appreciates. (Standard)

What if domestic interest rates rise due to an expected increase in inflation? What does this look like in the diagram? Pg 28

Answer 20

currency depreciates.

In a diagram, demand would fall causing depreciation (as opposed to rise following higher interest rates)

Question 21

Effect of increase in money supply

Answer 21

Domestic currency depreciates - higher money supply is main cause of inflation>so supply currency>depreciation

Or higher money supply lowers interest rates, reducing demand, depreciation

Question 22

Speculation strategy that banks use

Answer 22

Sell currency about to depreciate and into the currency it will appreciate against. Then reverse once event finished

Speculation example - borrow their own currency (the one about to depreciate) for 30 days. switch to the currency they expect to appreciate. Lend that currency for the same length (30 days). receive money back plus interest, and also exchange rate has improved so more profit.

Question 23

Risk of speculation

Answer 23

Exchange rates are volatile, so incorrect forecast can result in a large loss

(E.g selling the currency they expect to depreciate - it might not actually depreciate!)

Question 24

Expected that Singapore dollar will depreciate against the euro from 0.48 euros to 0.45 euros in 60 days.

The following interbank lending and borrowing rates exist:
Euro lending rate: 7.0% borrowing rate: 7.2%
Singapore dollar lending rate: 22.0% borrowing rate: 24.0%

Diamond Bank considers borrowing 10 million Singapore dollars in the interbank market and investing the funds in euros for 60 days. Estimate the profits (or losses) that could be earned from this strategy. Should Diamond Bank pursue this strategy?

Answer 24

Get hold of 10M Singapore dollars, the depreciating currency.

Then convert to Euros. 10M x 0.48 = 4.8M euros

Then lend out the euros for 60 days. At 7%.
7% x 60/360 = 1.17% is the interest after 60 days

So 4.8M x 1.0117 = 4,856,160 euros

Convert back to Singapore at 0.45
4856160 / 0.45 = 10791467 Singapore dollars

Then we need to repay back interest for borrowing the initial Singapore dollars. At 24%.

24% x 60/360 = 4% for 60 days so

10M x 1.04 = 10.4M

So profit is 10791467 - 10.4M