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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:
The other two terms are similar, but describe a downward movement in an exchange rate.
They are:
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
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.
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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.
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.
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Interest Rate Parity
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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.
(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
F0=S01+ic/1+ib
where:
F0=Forward rate
S0=Spot rate
ic=Interest rate in country c
ib=Interest rate in country b
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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.
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.
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.
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.
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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