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FINC3240 International Finance. Exchange Rate and Determination (Chapter 4,6,7,8). Objectives. A. Explain how the equilibrium exchange rate is determined B. Examine factors that determine the equilibrium exchange rate. Exchange Rate Movements.

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Finc3240 international finance

FINC3240International Finance

Exchange Rate and Determination

(Chapter 4,6,7,8)


A. Explain how the equilibrium exchange rate is determined

B. Examine factors that determine the equilibrium exchange rate

Exchange rate movements
Exchange Rate Movements

when one currency depreciates against another, the other must appreciate.

Appreciation vs. Depreciation

Exchange rate equilibrium
Exchange Rate Equilibrium

How exchange rates reach equilibrium?

1. Demand for a Foreign Currency

derived from the local buyers who are willing and able to purchase foreign goods but who must convert their local currencies.

Exchange rate equilibrium1
Exchange Rate Equilibrium

2. Supply of a Foreign Currency

derived from the foreigners who are willing and able to supply foreign currency and convert to local currency

Exchange rates determinants
Exchange Rates Determinants

1. Relative Purchasing Power

2. Relative Inflation Rates

2. Relative Interest Rates

3. Relative Income Levels

4. Government Influence

Purchasing power parity ppp
Purchasing Power Parity (PPP)

implication 1: Consumers shift their demand to wherever prices are lower for the same or similar goods, considering the transportation costs.

Ppp example 1
PPP Example 1

USD/CHY: 6.2000

Country Price per pound


China 5 CHY

Assuming the transportation cost is zero, firms will import chicken from China and need to exchange USD for CHY, until the prices in U.S. and China are close. As a result, demand in CHY will lead to appreciation in CHY and depreciation in USD.

Purchasing power parity
Purchasing Power Parity

implication 2: Inflation affects currency’s purchasing power. The exchange rate should adjust to offset the difference in the inflation rates of the two countries.

Ppp example 2
PPP Example 2

U.S. and U.K. initially had zero inflation. Now assume that the U.S. experiences a 9% inflation rate, while U.K. experiences a 5% inflation rate. What happens to the exchange rate between GBP and USD, considering zero transportation cost?

PPP theory suggests that the British pound should appreciate by approximately 4%, the differential in inflation rates. The reason is that, lower inflation in U.K. means the price of the same goods produced in U.K. is relatively lower. US consumers will buy more UK goods. The increasing consumption of British goods by US consumers would persist until the pound appreciates by about 4% so that the prices of UK good are increased by the same percentage.

Ppp derivation 1
PPP Derivation (1)

  • Home country price indexes:

  • Foreign country price indexes:

  • Assume : =

    Over time

  • Home country inflation rate:

  • Foreign country inflation rate:

  • If > and the exchange rate between the currencies does not change, then the consumer’s purchasing power is greater on foreign goods than on home goods.

  • If < and the exchange rate between the currencies does not change, then the consumer’s purchasing power is greater on home goods than on foreign goods.

Ppp derivation 2
PPP Derivation (2)

  • Foreign price index from the home consumer’s perspective:

    Where is the percentage change in the value of the foreign currency.

  • Home price index from the home consumer’s perspective:

  • PPP suggests the percentage change in the foreign currency should change to maintain parity in the new price indexes of the two countries. Therefore,

Ppp derivation 3
PPP Derivation (3)

  • Since = (because price indexes were initially assumed equal in both countries)

Ppp derivation 4
PPP Derivation (4)

  • If > , then >0. So foreign currency will appreciate.

  • If < , then <0. So foreign currency will depreciate.

Ppp application
PPP Application

Assume an initial equilibrium where GBP’s spot rate is $1.60, US inflation and British inflation are both 3%. If US inflation suddenly increase to 5 %, the GBP will appreciate against the dollar by approximately 2 % according to PPP. The rational is, after US prices rises, US demand for British goods will increase, placing upward pressure on the GBP’s value.

Interest rate parity
Interest Rate Parity

  • Interest Rate Parity Theorem (IRP)

    The exchange rate will adjust by a sufficient amount to offset the interest rate differential between two currencies.

Irp example 1
IRP Example (1)

  • Euro spot rate: EUR/USD: 0.60

  • Euro 6-months interest rate: 8% p.a.

  • USD 6-month interest rate: 4% p.a.

    What is the theoretical price of Euro 6 months from today (Forward Rate)?

    Intuition: returns from investing in USD-denominated fixed-income securities should equal returns from such an alternative strategy that exchanging USD for EUR, investing in EUR-denominated fixed-income securities, and then after 6 months exchanging EUR back to USD.

Irp example 2
IRP Example (2)

  • Returns (cash inflow) from investing $100 in $-denominated fixed-income securities

  • Returns from alternative strategy

  • Therefore,

  • The 6-month forward rate (theoretical fair price based on IRP)

Irp derivation 1
IRP Derivation (1)

  • Amount of the home currency to be invested, A

  • Spot rate in home currency, S

  • Interest rate on home deposit,

  • Interest rate on foreign deposit,

  • Forward rate in home currency, F

    Compare the amount of home currency received at the end of the period

    Strategy A

    Strategy B

Irp derivation 2
IRP Derivation (2)

  • If ih>if, then F>S, which means in the future home currency will depreciate while foreign currency will appreciate.


  • If ih<if, then F<S, which means in the future home currency will appreciate while foreign currency will depreciate.


Irp application 1
IRP Application (1)

Strategy 1: invest in USD for 180 days

Strategy 2:

(a) sell USD for EUR at spot rate; buy a forward USD contract

(b) invest EUR for 180 days in Germany

(3) after 180 days sell EUR for USD through the forward contract

Q: Does IRP holds?

Testing irp
Testing IRP

When Assessing Interest Rate Parity, should also consider:

a. Transaction Costs

b. Political Risk

c. Differential Tax Laws

International fisher effect
International Fisher Effect

A currency’s exchange rate will depreciate against another currency when its interest rate (and therefore expected inflation rate) is higher than that of the other currency.

Relative income levels
Relative Income Levels

Because income can affect the amount of imports demanded, it can affect exchange rates.

e.g. Assume US income rises substantially while the British income remains unchanged. The demand for pounds will shift outward, reflecting the increased demand for British goods. The supply of pounds for sale is not expected to change. Therefore, the equilibrium exchange rate of the pound is expected to rise.

Government controls
Government Controls

Governments influence the equilibrium exchange rate in many ways, including

1. imposing foreign exchange barriers,

2. imposing foreign trade barriers,

3. intervening (buying and selling currencies) in the foreign exchange markets,

4. affecting macro variables such as inflation, interest rates, and income levels.

Homework assignment 4:

Chapter 4: Q&A 2,3,4,12,14,19.

Chapter 6: Q&A 6,13,18

Chapter 7: Q&A 8,10,14,15,21,30.

Chapter 8: Q&A 5,18,26,35.