Exchange rate movements

When exchange rates change, you will often hear terms used to describe that change like
depreciation, devaluation, appreciation or revaluation. What do these different terms mean?
Well they split into two parts. Two of the terms refer to an upward movement of the
exchange rate. They are:

 Appreciation - this describes an upward movement in a freely floating exchange rate.

This may occur day by day or perhaps even minute by minute.
 Revaluation - this also describes an upward movement in an exchange rate, but in a
fixed exchange rate system. This will be a very infrequent event (if ever) and means
the government has deliberately changed the fixed value of the exchange rate
upwards.

The other two terms are similar, but describe a downward movement in an exchange rate.
They are:

 Depreciation - this describes a downward movement in a floating exchange rate.

 Devaluation - this means that the government has changed the fixed rate of a fixed
exchange rate downwards.

An appreciation or depreciation in the exchange rate will lead to changes in the relative prices
of imports and exports. Depreciation will make exports appear relatively cheaper overseas
while imports will be more expensive.

Changes in exports

As we have seen, depreciation will reduce the overseas price of exports. This should lead to
an increase in demand for exports. The higher the price elasticity of demand for exports, the
bigger the increase in demand for exports will be.

Changes in imports

Depreciation will increase the price of imports. This will lead to a decrease in the demand for
imports, but the scale of the decrease will depend on the price elasticity of demand for
imports. If demand is very inelastic, then imports will change very little. If, on the other hand,
demand is very elastic, then imports will change a lot.
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Factors that influence exchange rates

1. Inflation Rates: Changes in market inflation cause changes in currency exchange rates. A
country with a lower inflation rate than another does will see an appreciation in the value of
its currency. The prices of goods and services increase at a slower rate where the inflation is
low. A country with a consistently lower inflation rate exhibits a rising currency value while
a country with higher inflation typically sees depreciation in its currency and is usually
accompanied by higher interest rates.

2. Interest Rates: Changes in interest rate affect currency value and dollar exchange rate.
Forex rates, interest rates, and inflation are all correlated. Increases in interest rates cause a
country's currency to appreciate because higher interest rates provide higher rates to lenders,
thereby attracting more foreign capital, which causes a rise in exchange rates

3. Country’s Current Account / Balance of Payments: A country’s current account

reflects balance of trade and earnings on foreign investment. It consists of total number of
transactions including its exports, imports, debt, etc. A deficit in current account due to
spending more of its currency on importing products than it is earning through sale of exports
causes depreciation. Balance of payments fluctuates exchange rate of its domestic currency.

4. Government Debt: Government debt is public debt or national debt owned by the central
government. A country with government debt is less likely to acquire foreign capital, leading
to inflation. Foreign investors will sell their bonds in the open market if the market predicts
government debt within a certain country. As a result, a decrease in the value of its exchange
rate will follow.

5. Terms of Trade: Related to current accounts and balance of payments, the terms of trade
is the ratio of export prices to import prices. A country's terms of trade improves if its exports
prices raise at a greater rate than its imports prices. This results in higher revenue, which
causes a higher demand for the country's currency and an increase in its currency's value.
This results in an appreciation of exchange rate.

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6. Political Stability & Performance: A country's political state and economic performance
can affect its currency strength. A country with less risk for political turmoil is more
attractive to foreign investors, as a result, drawing investment away from other countries with
more political and economic stability. Increase in foreign capital, in turn, leads to an
appreciation in the value of its domestic currency. A country with sound financial and trade
policy does not give any room for uncertainty in value of its currency. But, a country prone to
political confusions may see depreciation in exchange rates.

7. Recession: When a country experiences a recession, its interest rates are likely to fall,
decreasing its chances to acquire foreign capital. As a result, its currency weakens in
comparison to that of other countries, therefore lowering the exchange rate.

8. Speculation: If a country's currency value is expected to rise, investors will demand more
of that currency in order to make a profit in the near future. As a result, the value of the
currency will rise due to the increase in demand. With this increase in currency value comes a
rise in the exchange rate as well.

Government influence on exchange rates

Exchange Rate Systems
• Exchange rate systems can be classified according to the degree to which the rates are
controlled by the government.
• Exchange rate systems normally fall into one of the following categories:
– fixed
– freely floating
–managed float
– pegged
1. Fixed Exchange Rate System
 In a fixed exchange rate system, exchange rates are either held constant or allowed to
fluctuate only within very narrow bands.
 The Bretton Woods era (1944-1971) fixed each currency’s value in terms of gold.
 The 1971 Smithsonian Agreement which followed merely adjusted the exchange rates
and expanded the fluctuation boundaries. The system was still fixed.

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2. Freely Floating Exchange Rate System
 In a freely floating exchange rate system, exchange rates are determined solely by
market forces.
 Pros: Each country may become more insulated against the economic problems in
other countries.
 Pros: Central bank interventions that may affect the economy unfavorably are no
longer needed.
 Cons: MNCs may need to devote substantial resources to managing their exposure to
exchange rate fluctuations.
 Cons: The country that initially experienced economic problems (such as high
inflation, increasing unemployment rate) may have its problems compounded.
3. Managed Float Exchange Rate System
 In a managed (or “dirty”) float exchange rate system, exchange rates are allowed to
move freely on a daily basis and no official boundaries exist. However, governments
may intervene to prevent the rates from moving too much in a certain direction.
 Cons: A government may manipulate its exchange rates such that its own country
benefits at the expense of others.
4. Pegged Exchange Rate System
 In a pegged exchange rate system, the home currency’s value is pegged to a foreign
currency or to some unit of account, and moves in line with that currency or unit
against other currencies.
 The European Economic Community’s snake arrangement (1972-1979) pegged the
currencies of member countries within established limits of each other.
 The European Monetary System which followed in 1979 held the exchange rates of
member countries together within specified limits and also pegged them to a
European Currency Unit (ECU) through the exchange rate mechanism (ERM). – The
ERM experienced severe problems in 1992, as economic conditions and goals varied
among member countries.

Government Intervention
 Each country has a government agency (called the central bank) that may intervene in
the foreign exchange market to control the value of the country’s currency.
 In the United States, the Federal Reserve System (Fed) is the central bank.

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  Central banks manage exchange rates – to smooth exchange rate movements, – to
establish implicit exchange rate boundaries, and/or – to respond to temporary
disturbances.
 Often, intervention is overwhelmed by market forces. However, currency movements
may be even more volatile in the absence of intervention.
 Direct intervention refers to the exchange of currencies that the central bank holds as
reserves for other currencies in the foreign exchange market.
 Direct intervention is usually most effective when there is a coordinated effort among
central banks.
 When a central bank intervenes in the foreign exchange market without adjusting for
the change in money supply, it is said to engage in no sterilized intervention.
 In a sterilized intervention, Treasury securities are purchased or sold at the same time
to maintain the money supply.

Concepts of International Arbitrage

Arbitrage can be defined as capitalizing on a discrepancy in quoted prices to make a risk-free
Profit. The effect of arbitrage on demand and supply is to cause prices to realign, such that
risk-free profit is no longer feasible.
• International Arbitragers play a critical role in facilitating exchange rate equilibrium. They
try to earn a risk-free profit whenever there is exchange rate disequilibrium.
• As applied to foreign exchange and international money markets, international arbitrage
(i.e., taking risk-free positions by buying and selling currencies simultaneously) takes three
major forms:
• locational arbitrage
• Triangular arbitrage
• covered interest arbitrage

1. Locational Arbitrage
 Locational arbitragers try to offset spot bid-ask exchange rate disequilibrium
 Locational arbitrage is possible when a bank’s buying price (bid price) is higher than
another bank’s selling price (ask price) for the same currency.

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Example
Bank C Bid Ask Bank D Bid Ask
NZ$ $.635 $.640 NZ$ $.650 $.645

Buy NZ$ from Bank C @ $.640, and sell it to Bank D @ $.645. Profit = $.005/NZ$.

2. Triangular Arbitrage
 Assume that, a bank has quoted the British pound (£) at $ 1.60, the Malaysian Ringgit
(MYR) at $ .20, and the cross exchange rate at £ 1 = MYR 8.1.
 Your first tats would be determine the cross exchange rate that is Pound should be
worth MYR8.0
 When quoting an exchange rate of £ 1 = .81, the bank is exchanging too many Ringgit
for a pound and is asking for too many Ringgit in exchange for a pound. Based on this
information, you can engage in triangular arbitrage by purchasing pounds with dollar,
converting the Pounds to Ringgit and then exchanging the Ringgit for dollars.

3. Covered interest arbitrage

 Covered interest arbitrage is the process of capitalizing on the interest rate differential
between two countries, while covering for exchange rate risk.
 The logic of the term Covered interest arbitrage become clear when it is broken into
two parts; “interest arbitrage” and “covered”.
 Interest arbitrage refers to the process of capitalizing on the difference between
interest rates between two countries. On the other hand, Covered refers to hedging
your position against exchange rate risk.
 Covered interest arbitrage involving investment dominated in different currencies
using forward covered to reduce or eliminate currency risk

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Interest Rate Parity

What Is Interest Rate Parity (IRP)?

Interest rate parity (IRP) is a theory in which the interest rate differential between two
countries is equal to the differential between the forward exchange rate and the spot exchange
rate. Interest rate parity plays an essential role in foreign exchange markets, connecting
interest rates, spot exchange rates and foreign exchange rates.

The Formula For Interest Rate Parity (IRP)

F0=S0× (1+ic /1+1b)

Where:
F0=Forward Rate
S0=Spot Rate
ic=Interest rate in country c
ib=Interest rate in country b

There are two versions of interest rate parity:

1. Covered Interest Rate Parity

2. Uncovered Interest Rate Parity

1. Covered Interest Rate Parity

With covered interest rate parity, forward exchange rates should incorporate the difference in
interest rates between two countries; otherwise, an arbitrage opportunity would exist. In other
words, there is no interest rate advantage if an investor borrows in a low-interest rate
currency to invest in a currency offering a higher interest rate. Typically, the investor would
take the following steps:

1. Borrow an amount in a currency with a lower interest rate.

2. Convert the borrowed amount into a currency with a higher interest rate.
3. Invest the proceeds in an interest-bearing instrument in this higher-interest-
rate currency.

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 4. Simultaneously hedge exchange risk by buying a forward contract to convert the
investment proceeds into the first (lower interest rate) currency.

The Formula for Covered Interest Rate Parity Is

(1+id)=S/F∗(1+if)
Where:
id=The interest rate in the domestic currency or the base currency
if=The interest rate in the foreign currency or the quoted currency
S=the current spot exchange rate
F=the forward foreign exchange rate

2. Uncovered Interest Rate Parity

Uncovered interest rate parity (UIP) states that the difference in interest rates between two
countries equals the expected change in exchange rates between those two countries.
Theoretically, if the interest rate differential between two countries is 3%, then the currency
of the nation with the higher interest rate would be expected to depreciate 3% against the
other currency.

The Formula for Uncovered Interest Rate Parity Is

F0=S01+ic/1+ib
where:
F0=Forward rate
S0=Spot rate
ic=Interest rate in country c
ib=Interest rate in country b

Purchasing Power Parity and the International Fisher Effect

Purchasing Power Parity
Purchasing power parity (PPP) is a component of some economic theories and is a technique
used to determine the relative value of different currencies. Purchasing powers indicate is the
capacity of the money for the quantity of commodity that money can purchase.

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Prof Bostel Casel
To determine the exchange rate between currency under this theory the exchange rate
indicate the power of 1 currency which is equal to the of other currency. In this theory gold is
replace by a parity commodity which is produce and consume equally between the countries
like 1 kg of rice in BD is tk 50 In India the same quantity of price with same fitness rp 35.

Definition:
The theory aims to determine the adjustments needed to be made in the exchange rates of two
currencies to make them at par with the purchasing power of each other. In other words, the
expenditure on a similar commodity must be same in both currencies when accounted for
exchange rate. The purchasing power of each currency is determined in the process.

Function of Purchasing Power Parity

The purchasing power parity exchange rate serves two main functions:
 PPP exchange rates can be useful for making compare between countries because they
stay fairly constant from day to day or week to week and only change modestly, if at
all, from year to year.
 Second, over a period of years, exchange rates do tend to move in the general
direction of the PPP exchange rate and there is some value to knowing in which
direction the exchange rate is more likely to shift over the long run.

Type of Purchasing Power Parity

1. Absolute Parity: Absolute Parity is the indicate the price of commodity at different
countries will be equal if the measure by same currency.
2. Relative Parity: Relative Parity refers to the adjustment of transaction cost, adjusting cost
and donation cost.

Quotation
Direct Quotation: Direct Quotation represent the value of a foreign currency in terms of the
home currency (e.g. £ or euro)
Indirect Quotation: Indirect Quotation represents the number of units of a foreign currency
per unit of home currency.

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International Fisher effect
What Is the International Fisher Effect?
The International Fisher Effect (IFE) is an economic theory stating that the expected disparity
between the exchange rate of two currencies is approximately equal to their countries'
nominal interest rates.

Understanding the International Fisher Effect (IFE)

The IFE is based on the analysis of interest rates associated with present and future risk-free
investments, such as Treasuries, and is used to help predict currency movements. This is in
contrast to other methods that solely use inflation rates in the prediction of exchange rate
shift, instead functioning as a combined view relating inflation and interest rates to a
currency's appreciation or depreciation.

The Fisher Effect and the International Fisher Effect

The Fisher Effect and the IFE are related models but are not interchangeable. The Fisher
Effect claims that the combination of the anticipated rate of inflation and the real rate of
return are represented in the nominal interest rates. The IFE expands on the theory,

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suggesting that currency changes are proportionate to the difference between the two nations'
nominal interest rates.

The Relevancy of the International Fisher Effect

In times where interest rates were adjusted by more significant magnitudes, the IFE held
more validity. However, the consumer price index (CPI) is more often used in the adjustment
of interest rates within a specified economy.

Limitations of the Fisher Effect

 Elasticity of demand to interest rates. In periods of confidence and rising asset prices,
high real interest rates may be ineffective in reducing demand. Therefore, in some
circumstances, Central Banks may need to increase the real interest rate to have an
effect.
 Liquidity Trap. In a liquidity trap reducing nominal interest rates can have no effect
on boosting spending. Lower interest rates don’t encourage investment because the
economic climate discourages investment and spending.
 Breakdown between base rates and actual bank rates. In some circumstances, there is
a breakdown between base rates set by Central Bank and the actual interest rate set by
banks.

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