Determinants of Exchange Rates

1
Determinants of Exchange Rates

• Chapter Three
• Eiteman, Stonehill, and Moffett

2
Balance of Payments
Balance of Trade
Capital account
Reserve account
Financial account
3
Exchange rate equilibirum

• Demand for the dollar
• all foreigners buying Canadian
• all Canadians selling foreign assets
• Supply of the dollar
• Canadians buying foreign goods and services
• foreigners selling Canadian assets

4
Demand for the dollar(Credits)

• foreigners buying Canadian goods
• foreigners buying Canadian services
• foreigners buying Canadian assets/securities
  (Capital flows)
• increase in Canadian receivables by foreign firms
• US residents buying on Alberta exchange
• Germans buying NF CD denominated bonds

5
Supply of the dollar (Debits)

• Canadians buying foreign goods
• Canadians buying foreign services
• Canadians spending a week at Disneyworld
• Canadians spending six months of the year in
  Texas
• Canadians buying foreign assets/securities
• Canadians buying Condos in Miami

6
Current account

• balance of trade
• value of exports of goods - imports of goods
• services (communications, information,
  financial)
• value of exports of svcs - imports of svcs
• net income transfers
• interest dividends pd on foreign investments
• pensions pd to Canadians living overseas
• transfers (sending checks to E. Europe)

7
Capital account

• foreign direct investment
• investment in real assets
• portfolio investment
• equities
• debt
• intangibles
• patents, leases, goodwill
• errors and omissions

8
Official reserves account

• Central Bank interventions in exchange markets
• changes in official reserves
• gold, silver
• foreign currencies, debt, etc.
• SDRs (Special Drawing Rights at IMF)

9
Effects of BOP

• Fixed exchange rates
• CB uses FXB to bring BOP 0
• Floating exchange rates
• CB ignores BOP
• The exchange rate will adjust to accommodate
  imbalance
• CB may intrude into the exchange market to reduce
  volatility

10
Free Float

• Shift in demand
• US consumers buying more Canadian
• free float allows a new equilibrium
• cd appreciates
• US goods lower in price to Canadians
• usd depreciates
• Canadian goods higher in price to the U.S.

11
Free Float
Foreigners increase their demand for Canadian
goods
S1
usd/cd
en, 0, cd
eo, 0, cd
D2
D1
Qo, cd
Qn, cd
Qcd
12
Intervention
Foreigners increase their demand for Canadian
goods
S1
usd/cd
S2
en, 0, cd
B of C buys usd
eo, 0, cd
D2
D1
Qo, cd
Qn, cd
Qcd
13
Unsterilized Intervention Bank of Canada
balance sheet

• gold
• silver
• cd denominated t-bills
• foreign currency denominated t-bills

• cash
• currency
• chartered bank reserves held at the Bank of
  Canada

Bof C buys US dollars as an asset
Canadian dollar liability increases
14
Domestic Affects of an Unsterilzed Intervention

• Base money increases by amount of purchase
• pressure exerted on prices to increase
• inflation in the economy
• Canadian goods cost more in cd

15
Foreign Affects of anUnsterlized Intervention

• short run
• exchange rate is not allowed to adjust
• long run
• higher Canadian inflation
• US goods cost relatively less to Canadians
• Canadian goods cost relatively more to US
  consumers
• exchange rate remains relatively constant

16
Sterilized Intervention Bank of Canada
balance sheet

• gold
• silver
• cd denominated t-bills
• foreign currency denominated t-bills

• cash
• currency
• chartered bank reserves held at the Bank of
  Canada

Bof C buys US dollars as an asset
No increase in B of C liabilities
B of C sells equal value in other assets
17
Domestic Affects of an Sterilzed Intervention

• Base money remains constant
• prices remain constant

18
Foreign Affects of anSterlized Intervention

• short run
• exchange rate is not allowed to adjust
• long run
• pressure remains on exchange rate to depreciate
• BOT deficit remains
• eventually the cd price of the usd will increase

19
Big Mac index

• The Big Mac, in real terms, should cost the same
  everywhere
• Prices increase with inflation
• prices of Big Macs in Canada increase by 1.9
• prices of Big Macs in US increase by 2.3
• If nothing real changes, exchange rates should
  adjust for the difference
• CD appreciates

20
Purchasing Power Parity (PPP)

• Absolute PPP - the law of one price
• the price of any good is the same after adjusting
  for exchange rate changes and relative inflation
  rates
• Relative PPP
• exchange rates adjust to take into account
  relative inflation rates

21
Example - the Law of One Price

• Price 3.69 usd in January 1998
• inflation 2.3 in 1998
• price 3.77 usd in January 1999
• Price 5.35 cd in January 1998
• inflation 1.9 in 1998
• price 5.45 cd in January 1999
• implied exchange rate
• 5.35 cd / 3.69 usd 1.4499 cd / 1 usd Jan 98
• 5.45 cd / 3.77 usd 1.4456 cd / 1 usd Jan 99

22
Absolute PPP

• The Law of One Price does not hold - given an
  exchange rate of 1.5074

23
Purchasing Power Parity

• The exchange rate changes to accommodate
  differential rates of inflation
• If this is so, then relative PPP holds

24
Theory behind relative PPP

• international competition in efficient goods
  markets will cause arbitrage of real prices of
  goods
• relative inflation will cause internal prices to
  change
• exchange rates will adjust for relative inflation
  so that real prices remain unchanged

25
PPP for forecasting

• Known forecasts of
• expected cd inflation,
• expected usd inflation
• known the current exchange rate
• calculate the expected future spot

26
Empirical does PPP hold ?

• international goods mkts not efficient short run
• barriers to trade, transactions costs
• measurement problems
• indices measure changes in a market basket of
  goods, not traded goods
• differences exist in tastes, level of
  development, income
• approximately efficient in the long run

27
Exchange Rate pass through

• exchange rate adjusts for relative inflation
• relative inflation means
• some prices increase faster than inflation
• some slower
• some prices decrease
• however relative real prices of a specific good
  may change internationally

28
Differential Price movements

• Calculate the expected price of buying US
• Expected greater than actual price
• if you are selling this product, you may face
  competitive pressures to lower price

29
Price elasticity of demand

• How do the revenues of the firm react to changes
  in price
• revenues decline if elasticity of own demand is
  less than 1

30
Inelastic own demand
P
Decrease in revenue due to price decrease
P0
PT
Increase in revenue due to increased sales
Q0
QT
Q
31
Elastic own demand
P
Decrease in revenue due to price decrease
P0
Increase in revenue due to increased sales
PT
Q0
QT
Q
32
The Fisher Effect

• The nominal interest rate
• relative nominal interest rates are proportional
  to relative inflation rates

33
Empirical evidence

• capital market integration
• real returns are equal across economies
• efficient capital markets will arbitrage
  differences
• capital market segmentation
• investor preferences may lead to real interest
  rate differentials
• each economy is a separate market

34
International Fisher Effect

• expected future spot should accommodate any
  interest rate differentials

35
Interest Rate parity

• interest rate differentials are covered by the
  forward rate

36
Unbiased forward expectations

• forward rate is the best predictor of the
  expected future spot
• market determined
• it is the best predictor
• it is not unbiased predictor

37
Bank of Canada policy changes

• Fed increases discount rate
• shifts US yield curve
• Bank of Canada does not respond
• Canadian yield curve remains the same
• US real interest rates higher
• nothing happened to US inflation
• Canadian investors buy American
• cd depreciates

38
Forecasting

• fundamental analysis
• balance of payments
• monetary fiscal policies
• regulatory policies
• political risk
• technical analysis
• time series analysis
• correlation
• trends

39
Fundamental analysis

• Fiscal policies
• taxes, expenditures
• deficit and debt policies
• Monetary policies
• relative inflation, interest rates
• exchange rate (foreign reserves, intervention
• Regulatory policies
• trade restrictions
• capital controls

40
Fundamental analysis

• Political risk
• probability of change in government
• probability of change in direction
• external threats
• crime
• war
• Differences between markets
• official markets
• unofficial markets (grey black markets)

41
Technical Analysis

• Time series analysis
• trends
• correlation

42
Covered Interest Arbitrage

• Borrow 100,000 cd _at_ 6.75
• Buy 66,339.39 usd spot at 1.5074
• Lend 66,339.39 for one year _at_ 7.75
• Buy 107,585.59 cd forward _at_ 1.5051
• collect loan of 71,480.69 usd
• take delivery of forward contract
• pay off loan of 106,750 cd
• riskless return of 835.59 cd

43
Central Bank affects on liquidity

• cash currency
• directly supplied by CB
• checking accounts debit cards
• money multiplier determined
• CB directly affects the multiplier
• reserve requirements
• capital requirements
• credit cards
• availability of credit indirectly affected by CB

44
Factors affecting money exchange rates

• 1. economic growth
• economic growth increases demand for base
• 2. inflation
• CB controls the supply of base money
• 3. interest rates
• CB controls the bank rate directly
• CB influences term structure of interest rates
  indirectly
• 4. political risk

45
1. Economic Growth
Change in demand for money with growth in the
economy
S
D2
D1
M
46
1. Economic Growth

• Growth increases the demand for money
• demand for money curve shifts up
• Assume CB keeps money supply constant
• no change in the vertical supply curve
• the value of money increases
• prices and value of money inversely related
• domestically - deflation
• internationally - exchange rate appreciation

47
2. Money Supply
S1
S2
Supply curve after CB increase money supply
D
M
48
2. Money Supply

• Central Bank increases supply of money
• supply curve shifts out
• Assuming no change in demand for money
• the demand for money curve remains stationary
• the value of money decreases
• prices and value of money inversely related
• domestically - inflation
• internationally - exchange rate depreciation

49
3. Term Structure of Interest Rates
iT
New term structure of interest rates after CB
increases bank rate
Term to maturity
50
3. Shift in Term Structure of Interest
Rates

• Central bank changes the bank rate
• only rate directly controlled by CB
• least risky rate in the economy
• no default risk
• little interest rate risk - overnight funds rate
• other rates will ratchet up relative to risk
• default - ability to pay
• interest rate risk - relative to term to
  maturity

51
4. Political Risk

• party in power makes the rules
• distribution of income and wealth
• tax law
• transfers
• regulatory environment
• increase or decrease frims costs of doing
  business
• change of party in power
• change in the rules
• for example PQ in power in Québec

52
4. Jump Shift in Term Structure
iT
Jump in term structure after a large change in
political risk
Term to maturity
53
4. Jump Shift in Term Structure

• Small change in power structure
• new rules
• some increase in uncertainty about future
• small discrete change in market risk premium
• Large change in power structure
• systemic change in the economy
• large increase in uncertainty about future
• large discrete change in market risk premium

54
4. Capital Asset Pricing System
iM the market rate increases as the
market becomes more risky
iM - irf the market risk premium also increases
?I measure of risk increases with
market volatility
55
Free Float
Foreigners increase their demand for Canadian
goods
S1
usd/cd
en, 0, cd
eo, 0, cd
D2
D1
Qo, cd
Qn, cd
Qcd
56
Intervention
Foreigners increase their demand for Canadian
goods
S1
usd/cd
S2
en, 0, cd
B of C buys usd
eo, 0, cd
D2
D1
Qo, cd
Qn, cd
Qcd
57
Unsterilized Intervention Bank of Canada
balance sheet

• gold
• silver
• cd denominated t-bills
• foreign currency denominated t-bills

• cash
• currency
• chartered bank reserves held at the Bank of
  Canada

Bof C buys US dollars as an asset
Canadian dollar liability increases
58
Domestic Affects of an Unsterilzed Intervention

• Base money increases by amount of purchase
• pressure exerted on prices to increase
• inflation in the economy
• Canadian goods cost more in cd

59
Foreign Affects of anUnsterlized Intervention

• short run
• exchange rate is not allowed to adjust
• long run
• higher Canadian inflation
• US goods cost relatively less to Canadians
• Canadian goods cost relatively more to US
  consumers
• exchange rate remains relatively constant

60
Sterilized Intervention Bank of Canada
balance sheet

• gold
• silver
• cd denominated t-bills
• foreign currency denominated t-bills

• cash
• currency
• chartered bank reserves held at the Bank of
  Canada

Bof C buys US dollars as an asset
No increase in B of C liabilities
B of C sells equal value in other assets
61
Domestic Affects of an Sterilzed Intervention

• Base money remains constant
• prices remain constant

62
Foreign Affects of anSterlized Intervention

• short run
• exchange rate is not allowed to adjust
• long run
• pressure remains on exchange rate to depreciate
• BOT deficit remains
• eventually the cd price of the usd will increase

63
BOT (Current Account) Deficit

• currency depreciation
• higher prices for imports
• lower prices for exports
• protectionism
• tariffs, quotas, import restrictions
• capital controls
• restrict foreign ownership
• exchange market intervention