Financial Markets and Institutions Week 7: Lecture 1 - Exchange Rate Changes Flashcards
Explain how exchange rate movements are measured. Explain the effect of demand and supply on exchange rates. Examine a range of economic and market factors which may explain changes in the exchange rate. (23 cards)
How are exchange rate movements measured and what do they indicate?
Exchange Rates in the Short Run: Supply and Demand Analysis
The exchange rate is the price of domestic assets in terms of foreign assets.
Supply of domestic assets:
Can be fixed (vertical supply curve) or variable (upward sloping).
Demand for domestic assets:
Driven by relative expected return.
At lower values of the domestic currency, demand for domestic assets increases.
Equilibrium exchange rate is determined where supply and demand curves intersect.
What are the main economic and market factors that influence exchange rates and how?
Exchange rate changes are influenced by:
Relative Inflation Rates (ΔINF):
Higher inflation → currency depreciation.
Lower inflation → currency appreciation.
Relative Interest Rates (ΔINT):
Higher interest rates → attract foreign capital → appreciation.
But if high interest is due to inflation expectations → depreciation.
Relative Income Levels (ΔINC):
Higher income → more imports → increased demand for foreign currency → depreciation.
Government Controls (ΔGC):
Includes trade barriers, capital controls, and central bank interventions.
Expectations (ΔEXP):
Anticipated changes in inflation, interest rates, or political stability affect currency demand.
Formula:
Impact of Relative Inflation on Exchange Rates
Impact of Relative Interest Rates on Exchange Rates
If US interest rates rise relative to the UK:
US assets become more attractive → demand for $ increases.
£ depreciates, $ appreciates.
However, if the rise in interest rates is due to expected inflation, the currency may depreciate instead.
This is explained by the Fisher Effect:
Real Interest Rate = Nominal Rate − Inflation Rate
Note (Slide 27):
If interest rates rise in a foreign country, demand for the local currency falls as investors move their money abroad.
Impact of Relative Income Levels on Exchange Rates
How do government controls influence exchange rates?
Foreign exchange barriers (e.g., capital controls).
Trade barriers (e.g., tariffs, quotas).
Direct intervention in forex markets (buying/selling currency).
Macroeconomic policies affecting inflation, interest rates, and income levels.
These tools can be used to stabilize or manipulate the exchange rate.
How do expectations influence exchange rates?
Expectations about future economic conditions (e.g., inflation, interest rates) influence currency demand.
Example: News of potential US inflation → traders sell dollars → dollar depreciates.
Speculators often act on anticipated interest rate changes.
Overreaction is common: markets may initially overshoot and later correct.
Emerging markets are especially sensitive to speculative flows.
Interaction of Factors Affecting Exchange Rates
Exchange rate movements are often the result of interacting factors:
E.g., rising income levels may lead to expectations of higher interest rates.
The dominant factor depends on the nature of international transactions:
High trade volume → inflation differences more influential.
High capital flows → interest rate differences more influential.
The sensitivity of a currency to each factor depends on the country’s economic structure.
How did markets react to Liz Truss’s budget announcement in the UK?
When Liz Truss released her budget during her short tenure as UK Prime Minister, markets reacted negatively.
On the following Monday, the pound (£) fell sharply, nearly reaching parity with the US dollar ($).
Later that day, the pound recovered as markets stabilized.
This illustrates how expectations and political events can cause rapid currency fluctuations.
Equilibrium in the Foreign Exchange Market
Equilibrium exchange rate is where the demand for domestic assets equals the supply.
Influenced by:
Domestic interest rate: ↑ → appreciation.
Foreign interest rate: ↑ → depreciation.
Expected future exchange rate: ↑ → appreciation.
Illustrated by shifts in demand curves for domestic assets.
Impact of Domestic Real Interest Rates on Exchange Rates
Impact of Foreign Real Interest Rates on Exchange Rates
- Demand for local currency falls because interest rate in foreign country has risen so investors move there money to foreign market
Impact of Expected Future Exchange Rates
How do inflation expectations affect the impact of interest rate changes on exchange rates?
What is the Fisher Effect and how does it relate to exchange rates?
The Fisher Effect explains the relationship between nominal interest rates, real interest rates, and inflation.
Formula:
Real Interest Rate=Nominal Interest Rate−Inflation Rate
A high nominal rate may not attract investment if it reflects high inflation expectations.
Investors focus on real returns, not just nominal rates.
How can banks speculate on anticipated exchange rate movements?
Key Insight:
Borrow the weaker currency, invest in the stronger one.
Ensure interest rate differential doesn’t offset gains.
REMEMBER: ‘Borrowing Rate’ means rate for YOU to borrow from interbank
Why Country Risk Analysis Matters
Country risk refers to the potential adverse impact of a country’s environment on foreign exchange returns and investment outcomes.
Unlike typical financial risks, country risk is often binary:
E.g., a government may suddenly block fund transfers or ban currency conversion.
Used to:
Develop risk management strategies.
Screen out high-risk countries.
Revise investment/financing decisions based on new developments.
Political Risk Factors in Country Risk Analysis
Consumer attitudes: Preference for local vs. foreign goods.
Government actions:
Special taxes or restrictions on foreign firms.
Subsidies for local competitors.
Weak enforcement of laws (e.g., IP rights).
Fund transfer restrictions: Prevents repatriation of profits.
Currency inconvertibility: Forces firms to use earnings locally.
War and conflict: Internal or external instability.
Bureaucracy: Slows down business operations.
Corruption: Increases costs and reduces transparency.
Financial Risk Factors in Country Risk Analysis
Economic growth: Recessions reduce demand and profitability.
Interest rates: High rates may deter investment or signal instability.
Exchange rate volatility: Affects returns and cost structures.
Inflation: Erodes real returns and purchasing power.
Example:
Rolls Royce (2016): £4.4bn non-cash loss due to FX volatility post-Brexit.
Types of Country Risk Assessment
Macroassessment: Overall risk of a country, regardless of business type.
Microassessment: Risk specific to the firm’s industry or operations.
Combined assessment includes:
Macropolitical risk
Macrofinancial risk
Micropolitical risk
Microfinancial risk
Note (Slide 46):
You must conduct both macro & micro financial and macro & micro political assessments.
Techniques for Assessing Country Risk
Checklist Approach:
Rate and weight political and financial factors.
Delphi Technique:
Gather expert opinions, average them, and assess dispersion.
Quantitative Analysis:
Use regression and historical data to assess sensitivity to risk factors.
Inspection Visits:
On-the-ground assessments with officials, firms, and consumers.
Combined Approach:
Use multiple methods for a comprehensive view.
a. Because of economics conditions in Mexico and risk of currency depreciation
b. To explicitly incorporate the risk of peso-to-dollar conversion restrictions into capital budgeting, JC Penney can apply expected value analysis or scenario-based adjustments to its projected cash flows.
Alternative: Risk-Adjusted Discount Rate
Increase the discount rate to reflect political risk.
This reduces the present value of future cash flows, making the project less attractive if risk is high.
Supporting Concepts from Lecture:
Country risk is binary: e.g., government either allows or blocks conversion.
Political risk factors include fund transfer restrictions and currency inconvertibility.
Checklist and Delphi techniques can be used to assign weights to such risks.
Microassessment: Tailor risk analysis to JC Penney’s retail operations in Mexico.
