Exchange Rate Determination

1
Exchange Rate Determination

• at any point in time there is an equilibrium
  exchange rate
• 0.7143U.S. per Cdn
• demand for Canadian dollars
• comes from U.S. imports of Canadian goods
• lower exchange rate means Canadian goods are
  relatively cheaper and more demand for Cdn
• comes from U.S. investment in Canadian assets
• lower exchange rate means Canadian assets have
  relatively higher returns and more demand for Cdn

2
Exchange Rate Determination

• supply of Canadian dollars
• Canadians wishing to transact in U.S. supply
  Canadian dollars
• comes from Canadian imports of U.S. goods
• lower exchange rate means U.S. goods are
  relatively more expensive and less supply of Cdn
• comes from Canadian investment in U.S. assets
• lower exchange rate means U.S. assets have
  relatively lower returns and less supply of Cdn
• when supply equals demand we have the equilibrium
  exchange rate

3
Exchange Rate Determination
price
S
0.7143
D
quantity
4
Exchange Rate Determination

• equilibrium changes from one instant to the next
• several factors influence the supply and demand
  curves
• inflation rates
• interest rates
• wealth
• government
• expectations

5
Inflation Rates

• suppose Canadian inflation relative to the U.S.
  increases
• Canadian goods are more expensive and less is
  exported
• demand for Cdn decreases
• U.S. goods are less expensive and more is
  imported to Canada
• supply of Cdn increases
• Canadian dollar depreciates to 0.6958

6
Inflation Rates
price
S
S
0.7143
0.6958
D
D
quantity
7
Interest Rates

• suppose Canadian interest rates relative to the
  U.S. increased
• this will cause rates of return on all assets in
  Canada to increase
• Canadian assets become more favorable
• demand for Cdn increases
• U.S. assets become less favorable
• supply of Cdn decreases
• Canadian dollar appreciates to 0.7345

8
Interest Rates
price
S
S
0.7345
0.7143
D
D
quantity
9
Wealth

• suppose Canadian wealth relative to the U.S.
  increased
• supply of Cdn will increase
• Canadians will demand more U.S. goods
• imports to Canada will rise
• Canadian dollar will depreciate

10
Expectations

• all exchange rates are based on future
  expectations
• if inflation expectations increased would get
  same result
• if interest rate expectations increased would get
  same results
• if wealth expectations increased would get same
  results
• discounting produces supply and demand conditions

11
Interaction of Factors

• need to be able to tell a good story
• example
• government of Canada launches a productivity
  campaign
• exports should rise as we become more competitive
• demand for Cdn increases
• Canadian inflation rises relative to U.S.
• demand for Cdn decreases
• supply of Cdn increases

12
Interaction of Factors

• Canadian wealth increases
• supply of Cdn will increase
• Canadian interest rates will rise relative to
  U.S.
• demand for Cdn will increase
• supply of Cdn will decrease
• net effect is difficult to determine
• exchange rate may increase or decrease
• in this situation the most likely effect is an
  appreciation of the Cdn
• comparative statics are easy, interactions
  require a great deal of analysis

13
Interaction of Factors

• you could build models to analyze effects
• as news announcements come in you adjust your
  price
• a regression model would disentangle effects
• domestic GNP, foreign GNP, world GNP
• current account
• domestic interest rates, foreign interest rates,
  world interest rates
• domestic inflation, foreign inflation, world
  inflation

14
Interaction of Factors

• regression coefficients indicate exchange rate
  changes
• example
• CGNP Canadian GNP (billions)
• USGNP U.S. GNP (billions)
• CR Canadian T-Bill rate
• USR U.S. T-Bill rate
• CI Canadian CPI
• USI U.S. CPI

15
Interaction of Factors

• the regression results were as follows
• suppose the current spot rate is 0.7143U.S./Cdn
• what is the effect of the Canadian inflation rate
  increasing from 0.012 to 0.016 on the exchange
  rate?

16
Interaction of Factors

• macro-analysis can be useful for an integrated
  forecasting tool of cash flows
• projecting cash flows and discounting
• speculation on macro-analysis can be costly
• raises questions of efficiency of FX market

17
Market Efficiency

• can one profit from speculation in FX markets
• strategies based on past information
• very little support of profit
• strategies based on information processing
• ability to analyze markets better
• some support of profit
• however, when transactions costs and risk is
  considered profit disappears

18
Market Efficiency

• strategies based on inside information
• few studies done here
• most likely will be profitable for dramatic
  announcement effects
• this type of information is relatively less
  important in the markets, however

19
Forward Rates

• T-Bill quotes
• for face value of 100
• n days to maturity
• Y cash price
• Z quote
• example 30-day quote is 5.4
• cash price is 99.55

20
Forward Rates

• Canada
• 60-day T-bill quote is 4.8
• 120-day T-bill quote is 5.2
• U.S.
• 60-day T-bill quote is 4.6
• 120-day T-bill quote is 5.3
• spot exchange rate is 0.6925U.S./cdn
• find the 60-day and 120-day forward rates

21
Fixed Exchange Rates

• exchange rate target is fixed
• rate can fluctuate 2.25 each way
• periodically may have to adjust target
• continuously need to intervene to maintain target
• minimal risk of exchange rate changes

22
Freely Floating Rates

• rates adjust freely to market conditions
• more responsive to economic conditions
• domestic monetary policy often influences rates
• maximal risk of exchange rate changes

23
Managed Float

• same as freely floating with periodic
  interventions
• domestic monetary policy and intervention
  influence rates
• risk lies between fixed and float
• basically like a fixed with larger bands

24
Pegged

• proportional to other major currency or unit of
  account
• inherits properties of pegged unit
• loss of intervention and monetary policy effects

25
Modeling

• type of exchange rate system has impact on
  modeling
• example option pricing
• floating ? geometric Brownian motion
• fixed ? geometric Brownian motion with
  reflecting barriers
• managed float ? geometric Brownian motion with
  reflecting barriers and jumps
• pegged ? inherits properties of peg

26
Government Intervention

• domestic intervention
• control inflation
• control interest rates
• control capital flows
• control net exports
• international intervention
• interact in FX market directly

27
Government Intervention

• suppose currency has appreciated and is hurting
  domestic employment
• wish to lower the price of the currency
• remove capital controls
• interest rates drop, demand for currency drops
  and exchange rate depreciates
• increase quotas and tariffs
• imports fall, demand for currency drops and
  exchange rate depreciates
• all other methods involve monetary policy

28
Central Bank

• balance sheet approach
• increase in money supply leads to increase in
  assets

LIABILITIES
ASSETS
Securities
Notes in Circulation
mostly govt bonds
Foreign Currency
29
Central Bank

• domestic objectives
• maintain money supply for domestic transactions
• if money supply increases too slowly you have
  inflation

D
D
S
S
30
Central bank

• domestic objectives
• present objectives are to maintain low inflation
• expand money supply to keep inflation low
• expanding money supply means purchasing bonds
• demand pressures in bond market may push bond
  prices up and interest rates down
• we will assume that low inflation will always be
  maintained
• otherwise, to fight a high currency price we
  could increase inflation

31
Intervention Policies

• suppose the Canadian Dollar is strong
• want to lower the exchange rate
• nonsterilized intervention
• sell Canadian dollars and buy U.S. dollars
• supply of Canadian dollars shifts right and
  exchange rate falls
• on the balance sheet liabilities increase
  because more Canadian dollars are outstanding and
  on the asset side FX reserves increase
• if all goes well the currency should depreciate

32
Intervention Policies

• nonsterilized intervention
• process could be deflationary
• why?
• exports rise an imports fall
• exchange rate inches back up
• bond prices may fall
• why?
• interest rates rise
• exchange rate inches back up
• market is always moving away from your
  intervention policy

33
Intervention Policies

• sterilized intervention
• sell Canadian dollars and buy U.S. dollars
• sell govt bonds and buy Canadian dollars
• net result
• asset side of balance sheet has changed
• if all goes well currency should depreciate
• still have same problem as before in that market
  moves away from your intervention

34
Summary

• completed ch. 4
• appendix is interesting reading
• good questions 2-4,8,13,14,16,19
• completed chapter 6
• good questions 4-7, 14,16,17,20
• next lecture
• parity relations
• ch. 7 interest rate parity
• ch. 8, PPP