International Banking and Trade Finance Chpt 4

Overview Measure exchange rates Determine equilibrium exchange rates Examine factors affecting exchange rates

Measuring Exchange Rate Movements value of one currency in units of another eg. One dollar U.S. = 1.44 CDN Fluctuating value appreciation increase in currency value relative to another depreciation decrease in currency value relative to another

Exchange Rate Movement Price of a currency , or,,,,,,,, how much a currency cost “… an exchange rate at a given point in time represents a price of a currency…” page 106 price, like any product, is a function of demand demand relative to the supply

From GNED 119

Exchange Rate Equilibrium Supply for a currency e.g., supply of British pound the greater the price offered, the greater the supply quantity value S

From GNED 119

Exchange Rate Equilibrium Spot exchange rate price of a currency at a specific time price set by supply and demand for the currency Demand for currency e.g., US demand for pound sterling value D quantity

From GNED 119

Exchange Rate Equilibrium Exchange rate reflects supply and demand lower $US means cheaper US goods for British increased demand for US goods implies greater demand for $US D value S quantity

Factors Influencing Exchange Rates Relative inflation rates Relative interest rates Relative income levels Government controls Expectations

Factors that influence Exchange Rates Relative inflation rates page 109 changes in inflation rates can affect international trade activity, which influences the demand and supply of currencies if inflation is high, price of products is rising fast and the economy will have a lot of money to buy foreign products if they buy foreign products, there is need for currencies other than the currency they have, so demand is high

Factors that influence Exchange Rates Inflation means the price of goods and services rises quickly a consequence is that people are also making more money and relative to goods and services from other countries, they can afford to import more

Factors that influence Exchange Rates In reality, “… the true equilibrium exchange rate will reflect several factors simultaneously…”

Factors that influence Exchange Rates 1. Relative Interest Rates page 110 changes in relative interest rates affect investment in foreign securities, which influence the demand and supply of currencies

Factors Influencing Exchange Rates Relative inflation rates affects supply and demand for currency impacts international trade e.g., British inflation rises against US inflation British goods become more expensive relative to US decrease of US demand for pound sterling increase in British demand for “cheaper” US goods increase in British demand for $US increase in supply of pounds on sale for $US British pound declines in value against the $US

Factors that influence Exchange Rates if interest rates in a country are low, portfolio investments there will also be proportionately low therefore making ROI - return on investments low therefore people will sell the securities and demand will decline

Factors that influence Exchange Rates Example text page 110 - 111 the reunification of East and West Germany, and the resulting rise in German interest rates U.S. investors invested in German securities due to the higher ROI

Factors that influence Exchange Rates 2. Real Interest Rates “while a relatively high interest rate may attract foreign inflows - high interest rate might indicate high inflation - which would scare people off by discouraging them to invest real interest rate = nominal interest rate - inflation rate Page 112

Factors Influencing Exchange Rates Relative interest real rates affects investment in foreign securities e.g., British interest rises relative to US interest British MNCs shift deposits to British banks decline in British supply of pounds for sale for $US increase in British MNC demand for pounds pound rises in value relative to $US

Factors that influence Exchange Rates 3. Relative Income Levels if income in a country increases, globalization will increase demand for foreign products demand for foreign products will increase demand for the currency of the countries where those products come from Page 112

Factors that influence Exchange Rates 3. Relative Income Levels in the late 1980’s and early 1990’s, income levels in North America caused massive imports of Japanese consumer products, making the Japanese yen rise very high Page 112

Factors Influencing Exchange Rates Relative income levels e.g., British income rises relative to US income demand schedule for pound remains the same supply of pounds for sale for $US should rise British buy more US goods British pound falls against the $US

Factors that influence Exchange Rates 4. Government Intervention Page 112 Reasons for intervention smooth exchange rate movements establish implicit exchange rate boundaries react to temporary disturbances

Factors Influencing Exchange Rates Government controls foreign exchange barriers foreign trade barriers central bank intervention intervention may affect inflation, interest rates and income levels

Factors that influence Exchange Rates 4. Government Intervention Page 112 What will the government do ? 1 impose 4X barriers 2 impose foreign trade barriers 3 intervene by buying and selling currencies 4 do things to effect inflation rate and interest rates eg. Alter bank rate, or print money (monetary policy)

Factors that influence Exchange Rates 5. Expectations Page 113 Market expectations of future rates 4X markets react to news that might effect future events eg. News of possible inflation in a country - due to some crisis, may cause currency traders to dump that currency before it declines in value

Factors that influence Exchange Rates 5. Expectations Page 113 Institutional investors take currency positions based on anticipated interest rate movements They do detailed research on many aspects of a country to determine if the currency is going to be in demand, or not, and if it is going to be in demand, they buy large amounts and sell it for a profit days or weeks in the future

Factors Influencing Exchange Rates Expectations e.g., news of potential increase in British inflation market expects decline in value of pound institutional traders sell pound sterling value of pound declines against the $US

Factors Influencing Exchange Rates Factors affecting demand for foreign goods inflation differential income differential government’s trade restrictions Factors affecting demand for foreign securities interest rate differential government’s capital flow restrictions

Speculating on Anticipated Rates Speculating on anticipated changes in rates e.g., a bank’s expectation on the British pound: appreciate from $1.635 to $1.650 in 30 days develops a trading strategy based upon interest rate differentials and expected exchange rate movement

Speculating on Anticipated Rates, an Example Borrow $30 million at 7.00 %

Speculating on Anticipated Rates, an Example Borrow $30 million at 7.00 % Convert $30 million to PS 18,348,624 $30,000,000 / $1.635 = PS 18,348,624

Speculating on Anticipated Rates, an Example Borrow $30 million at 7.00 % Convert $30 million to PS 18,348,624 $30,000,000 / $1.635 = PS 18,348,624 Lend pounds at 6.26 % for 30 days PS 18,348,624 x [1+ (0.0626)(30/360)] bank has PS 18,444,349 in 30 days

Speculating on Anticipated Rates, an Example Borrow $30 million at 7.00 % Convert $30 million to PS 18,348,624 $30,000,000 / $1.635 = PS 18,348,624 Lend pounds at 6.26 % for 30 days PS 18,348,624 x [1+ (0.0626)(30/360)] bank has PS 18,444,349 in 30 days Convert British pounds to $US PS 18,444,349 x $1.650 = $30,433,176

Speculating on Anticipated Rates, an Example Repay $US loan with proceeds from pound $30,000 x [1 + (0.07)(30/360)] = $30,174,990

Speculating on Anticipated Rates, an Example Repay $US loan with proceeds from pound $30,000 x [1 + (0.07)(30/360)] = $30,174,990 Calculate profit from speculation (assumes pound rises to $1.65 in 30 days) $30,433,176 - $30,174,990 = $258,186

Summary Exchange rate movements Equilibrium exchange rate measured by percentage change in value Equilibrium exchange rate determined by supply and demand economic and governmental factors affect exchange rates inflation and interest rates are factors most closely monitored by financial markets all factors interact to affect exchange rates