Exchange Rate
Determination
Ing. Tomáš Heryán, Ph.D.
International Business Finance
FIU/NKIFA
• Exchange rate determination is a complex issue
• In theory we distinguish three major schools of thought
– Balance of payments approach
– International parity conditions
– Asset market approach
• More practical point of view differentiates between two categories of
determinants
– Factors that cause the supply and demand schedules of currencies to change
– Factors affecting exchange rates
• These theories and approaches are not competing, but rather are
complementary to each other
What determines exchange rates?
Exchange Rate Determination (International Business Finance – presentation 05)
The determinants of foreign exchange rates (theoretical view)
Exchange Rate Determination (International Business Finance – presentation 05)
Spot
Exchange
Rate
International Parity Conditions
1. Relative inflation rates
2. Relative interest rates (international Fisher effect)
3. Forward exchange rates
4. Interest rate parity
Asset Market Approach
1. Relative real interest rates
2. Prospects for economic growth
3. Supply & demand for financial assets
4. Outlook for political stability
5. Speculation & market liquidity
6. Contagion & corporate governance
Balance of Payments
1. Current account balances
2. Portfolio investment
3. Foreign direct investment
4. Official monetary reserves
5. Exchange rate regimes
• Factors that cause the supply and demand schedules of currencies to change
– Market fundamentals (economic variables)
• Productivity, inflation rates, real interest rates, consumer preferences, and government trade policy
– Market expectations
• News about future market fundamentals
• Traders’ opinions about future exchange rates
• Factors affecting exchange rates
– Short term: transfers of assets
• Differences in real interest rates and to the shifting expectations of future exchange rates
– Interim: cyclical factors
• Fluctuations in economic activity
– Long term: flows of goods, services, and investment capital
• Inflation rates, investment profitability, consumer tastes, productivity, and government trade policy
The determinants of foreign exchange rates (practical view)
Exchange Rate Determination (International Business Finance – presentation 05)
• Second most utilized theoretical approach in exchange rate determination
(after international parity conditions)
• The basic approach argues that the equilibrium exchange rate is found
when currency flows match up vis-à-vis current and financial account
activities
• This framework has wide appeal as balance-of-payments transaction data
is readily available and widely reported
• Critics may argue that this theory does not take into account stocks of
money or financial assets
Balance of payments approach
Exchange Rate Determination (International Business Finance – presentation 05)
• Also known as Relative Price of Bonds or Portfolio Balance Approach
• Exchange rates are determined by the supply and demand for financial
assets of a wide variety, including bonds
• Shifts in the supply and demand for widely varied financial assets alter
exchange rates
• The forecasting inadequacies of fundamental theories has led to the
growth and popularity of technical analysis, the belief that the study of
past price behavior provides insights into future price movements
– The primary assumption is that any market driven price (i.e., exchange rates) follows
trends
Asset market approach
Exchange Rate Determination (International Business Finance – presentation 05)
• The exchange rate is determined by the supply and demand for national
monetary stocks, as well as the expected future levels and rates of growth
of monetary stocks
• Focuses on changes in the supply and demand for money as the primary
determinant of inflation
• Changes in relative inflation rates in turn are expected to alter exchange
rates through a purchasing power parity effect
Monetary approach
Exchange Rate Determination (International Business Finance – presentation 05)
• Set of theories linking together essential economic variables and explaining
changes in exchange rates
• International parity conditions may not always work out to be „true“ when
compared with observation in real world
• Central to any understanding of how multinational business is conducted
– The mistake is sometimes not with the theory itself, but in the way it is interpreted or
applied in practice
International parity conditions
Exchange Rate Determination (International Business Finance – presentation 05)
• (A) Purchasing power parity
– Forecasts the change in the spot rate on the basis of differences in expected rates of inflation
• (B) Fisher effect
– Nominal interest rates in each country are equal to the required real rate of return (r) plus
compensation for expected inflation ()
• (C) International Fisher effect
– The spot exchange rate should change in an amount equal to but in the opposite direction of the
difference in interest rates between countries
• (D) Interest rate parity
– The difference in the national interest rates should be equal to, but opposite in sign to, the forward rate
discount or premium for the foreign currency, except for transaction costs
• (E) Forward rate as an unbiased predictor
– The forward rate is an efficient predictor of the future spot rate, assuming that the foreign exchange
market is reasonably efficient
Prices, interest rates and exchange rates is equilibrium
Exchange Rate Determination (International Business Finance – presentation 05)
Diagram of international parity conditions
Exchange Rate Determination (International Business Finance – presentation 05)
Forecast change in
spot exchange rate
Forecast difference
in rates of inflation
Purchasing
power parity
( A )
Forward premium
on foreign currency
Interest
rate parity
( D )
International
Fisher Effect
( C )
Forward rate as
an unbiased
predictor
( E )
Difference in
nominal
interest rates
Fisher effect
( B )
• Law of one price
– All else being equal (no transaction costs) a product’s price should be the same in all
markets
• Even if prices for a particular product are in different currencies, the law of
one price states that
– P * SR = P*
– Where the price in domestic market (P) multiplied by the spot exchange rate (SR, foreign
currency per domestic currency), equals the price of the product in the foreign market
(P*)
• Conversely, if prices stated in local currencies, and markets are efficient, the
exchange rate can be deducted from the relative local product prices
– SR = P* / P
Prices and exchange rates
Exchange Rate Determination (International Business Finance – presentation 05)
• If the law of one price were true for all goods, the purchasing power parity
(PPP) exchange rate could be found from any set of prices
• Absolute theory of PPP
– Through price comparison, prices of individual products can be determined through the
PPP exchange rate
• Absolute PPP states that the spot exchange rate is determined by the relative
prices of an identical basket of goods
– SR = P* / P
Absolute purchasing power parity
Exchange Rate Determination (International Business Finance – presentation 05)
• Invented by The Economist in 1986 as a lighthearted guide to whether
currencies are at their “correct” level
• The Big Mac PPP is the exchange rate that would leave a burger in any
country costing the same as in the USA
• Burgernomics was never intended as a precise gauge of currency
misalignment, merely a tool to make exchange-rate theory more digestible
• There is also an adjusted index which addresses the criticism that you
would expect average burger prices to be cheaper in poor countries than in
rich ones because labour costs are lower
The Big Mac Index
Exchange Rate Determination (International Business Finance – presentation 05)
Selected rates from the Big Mac Index
Exchange Rate Determination (International Business Finance – presentation 05)
The Big Mac Index (July 2017)
Exchange Rate Determination (International Business Finance – presentation 05)
• Not particularly helpful in determining what the spot exchange rate today,
but that the relative change in prices between two countries over a period of
time determines the change in the exchange rate over that period
• More specifically, the spot exchange rate should change in an equal amount
but in the opposite direction to the difference in inflation rates between two
countries
– Thus, the currency with higher (lower) inflation rate will depreciate (appreciate)
Relative purchasing power parity
Exchange Rate Determination (International Business Finance – presentation 05)
Relative purchasing power parity
Exchange Rate Determination (International Business Finance – presentation 05)
• A measure of the response of imported and exported product prices to
changes in exchange rates
– Complete pass-through: 100% of the impact of a change in exchange rates is passed on to
the consumer in prices of imported goods
– Partial pass-through: Less than 100% of the impact of a change in exchange rates is
passed on to the consumer in prices of imported goods
• Although PPP implies that all exchange rate changes are passed through by
equivalent changes in prices to trading partners, empirical researches in the
1980s questioned this long-held assumption
• For example, a car manufacturer may or may not adjust pricing of its cars
sold in a foreign country if exchange rates alter the manufacturer’s cost
structure in comparison to the foreign market
Exchange rate pass-through
Exchange Rate Determination (International Business Finance – presentation 05)
• Nominal interest rates in each country are equal to the required real rate of
return plus compensation for expected inflation
• Because investors concern about the real returns (i.e., the growth of their
purchasing power), we would expect that as inflation increases, investors
will demand higher nominal rates of returns on their investment
– i = r + π + (r × π)
– i = r + π (Approximate form)
• i = nominal interest rate
• r = real interest rate
• π = expected inflation
– Empirical tests (using ex-post) national inflation rates have shown the Fisher effect
usually exists for short-maturity government securities
The Fisher effect
Exchange Rate Determination (International Business Finance – presentation 05)
• Relationship between the percentage change in the spot exchange rate over
time and the differential between comparable interest rates in different
national capital markets
• Fisher found that the spot exchange rate should change in an equal amount
but in the opposite direction to the difference in interest rates between two
countries
– The opposite direction means for a country with lower (higher) interest rates, its currency
will appreciate (depreciate)
• St = Indirect spot exchange rate at the beginning of the period
• St+1 = Indirect spot exchange rate at the end of the period
• i$ = Interest rate in the U.S.
• i¥ = Interest rate in Japan
The international Fisher effect
Exchange Rate Determination (International Business Finance – presentation 05)
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• Exchange rate quoted today for settlement at some future date
• Forward exchange agreement between currencies states the exchange rate at
which a foreign currency will be bought forward or sold forward on a
specific date in the future
• Forward rate for a 90-day forward agreement
– FFC/$ = Forward rate for a foreign currency (FC) and the $
– SFC/$ = Current spot rate for a foreign currency (FC) and the $
– iFC = Foreign interest rate
– i$ = U.S. interest rate
Forward rate
Exchange Rate Determination (International Business Finance – presentation 05)
 
    
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   
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FC FC
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• Provides the link between the foreign exchange markets and the
international money markets
• The theory states that the difference in the national interest rates should be
equal to, but opposite in sign to, the forward rate premium or discount for
the foreign currency, except for transaction costs
• The forward premium or discount is the percentage difference between the
spot and forward exchange rate, stated in annual percentage terms
• Investors must be rewarded or penalized to offset the expected change in
exchange rates
Interest rate parity
Exchange Rate Determination (International Business Finance – presentation 05)
Interest rate parity
Exchange Rate Determination (International Business Finance – presentation 05)
• The spot and forward exchange markets are not constantly in the state of equilibrium
described by interest rate parity
• When the market is not in equilibrium, the potential for arbitrage profit exists
• The arbitrager who recognizes such an imbalance will move to take advantage of the
disequilibrium by investing in whichever currency offers the higher return on a
covered basis
• The key to determining whether to start in dollars or the foreign currency is to
compare the differences in interest rates to the forward premium on the foreign
currency (the cost of cover)
– If the difference in interest rates is greater than the forward premium (or expected change
in the spot rate), invest in the higher interest yielding currency
– If the difference in interest rates is less than the forward premium (or expected change in
the spot rate), invest in the lower interest yielding currency
Covered interest arbitrage
Exchange Rate Determination (International Business Finance – presentation 05)
Covered interest arbitrage
Exchange Rate Determination (International Business Finance – presentation 05)
• Investors borrow in countries and currencies exhibiting relatively low
interest rates and convert the proceeds into currencies that offer much
higher interest rates
• The transaction is “uncovered,” because the investor does not sell the higher
yielding currency proceeds forward, choosing to remain uncovered and
accept the currency risk of exchanging the higher yield currency into the
lower yielding currency at the end of the period
Uncovered interest arbitrage
Exchange Rate Determination (International Business Finance – presentation 05)
Uncovered interest arbitrage (The Yen carry trade)
Exchange Rate Determination (International Business Finance – presentation 05)
Interest rate parity and equilibrium
Exchange Rate Determination (International Business Finance – presentation 05)
• Some forecasters believe that forward exchange rates are unbiased
predictors of future spot exchange rates
• Unbiased prediction simply means that the forward rate will, on average,
overestimate and underestimate the actual future spot rate in equal
frequency and degree
Forward rate as an unbiased predictor of the future spot rate
Exchange Rate Determination (International Business Finance – presentation 05)
Forward rate as an unbiased predictor of the future spot rate
Exchange Rate Determination (International Business Finance – presentation 05)
THANK YOU FOR YOUR
ATTENTION
J