1. International Banking
and Trade Finance
Chpt 4

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

3. 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

4. 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

5. From GNED 119

6. 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

7. From GNED 119

8. 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

9. From GNED 119

10. 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

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

12. 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

13. 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

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

15. 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

16. 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

17. 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

18. Factors that influence Exchange Rates
Example text page
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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

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

26. 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)

27. 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

28. 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

29. 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

30. 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

31. 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

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

33. 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

34. 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

35. 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

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

37. 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

38. 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