Tài chính doanh nghiệp - Chapter 16: Foreign exchange: factors that influence the exchange rate

Chapter 16Foreign exchange: factors that influence the exchange rateLearning objectivesExplain how supply and demand issues determine an equilibrium exchange rateConsider mechanisms and relationships of factors influencing the exchange rate, including:Relative rates of inflation, national income growth, interest and exchange rate expectations and central bank or government interventionExplore regression analysis on variables impacting on an exchange rateChapter organisation16.1 FX markets and an equilibrium exchange rate16.2 Factors that influence exchange rate movements16.3 Measuring exchange rate sensitivity to changes in economic variables16.4 Summary16.1 FX markets and an equilibrium exchange ratePrevious chapter:focused on the structure and operations of the FX marketsThis chapter:focuses on the factors that influence the value of a currency (in a floating exchange rate regime) in order to attempt to forecast future exchange rates with some reliability and accuracy(cont.)16.1 FX markets and an equilibrium exchange rate (cont.)Floating exchange rate regimeOne in which the value of the currency is determined by demand and supply conditions with no central bank interventionPegged exchange rate regimeWhere a domestic currency is locked into a specified multiple of another currency such as the USD(cont.)16.1 FX markets and an equilibrium exchange rate (cont.)Demand for a currencyTo purchase Australian goods and services, foreigners must buy AUDDownward-sloping demand curve occurs as the devaluation of AUD results in a greater demand by foreignersFor foreigners, a fall in the price of the AUD is equivalent to a reduction in the price of everything in Australia(cont.)16.1 FX markets and an equilibrium exchange rate (cont.)Supply of a currencyUpward-sloping supply curve occurs as the quantity of AUD supplied to the FX market increases as the price of the AUD increasesAs the AUD appreciates, the price of foreign currency falls, making foreign goods cheaper for Australian residentsThe demand for foreign currency increases and, therefore, so does the supply of AUD(cont.)16.1 FX markets and an equilibrium exchange rate (cont.)Equilibrium exchange rateThe equilibrium exchange rate is the rate at which the quantity of AUD supplied to the market is equal to the demand for AUDIt shows the unique rate at which both the demanders and suppliers of AUD will be satisfied(cont.)16.1 FX markets and an equilibrium exchange rate (cont.)Chapter organisation16.1 FX markets and an equilibrium exchange rate16.2 Factors that influence exchange rate movements16.3 Measuring exchange rate sensitivity to changes in economic variables16.4 Summary16.2 Factors that influence exchange rate movementsMain factors influencing exchange rate movementsRelative inflation ratesRelative national income growth ratesRelative interest ratesExchange rate expectationsGovernment or central bank interventionRelative inflation ratesRelative inflation rates influence the price of and, therefore, the demand for foreign goods by residentsThe change in demand for imported goods, in turn, affects the demand for foreign currency used to buy these goodsThis view of the determination of the value of a currency is called purchasing power parity (PPP) and is discussed in detail later(cont.)Relative inflation rates (cont.)Example: increase in US rate of inflation relative to AustraliaEffect for Australian residentsUS imports more expensive, decreasing demand for these goods; therefore, reducing the supply of AUDEffect for US residentsSome US demand for goods and services, and assets will switch to Australian items, increasing demand for AUD to pay for these itemsNet effect is an appreciation of the AUD(cont.)Relative inflation rates (cont.)Relative national income growth ratesExample: Australian income growth rates rise relative to the USAustralian demand for imports increases, increasing the supply of AUD, which, in turn, causes the AUD to depreciateA secondary effect could be an increase in foreign investment in Australia, increasing the demand for AUD, causing the AUD to recover some value(cont.)Relative national income growth rates (cont.)Relative interest ratesExample: if Australian interest rates rise relative to the US Effect for US residentsUS residents and companies may redirect some of their cash into Australian interest-bearing instruments, increasing the demand for the AUDEffect for Australian residentsAustralian investors and businesses are more likely to keep their surplus funds invested in Australia, causing a decrease in the supply of the AUDNet effectAUD will appreciate(cont.)Relative interest rates (cont.)(cont.)Relative interest rates (cont.)Expectations about the value of the currency during the investment periodAn analysis of the effect of interest rates on the exchange rate cannot ignore expectations about the value of the currency during the investment periodTable 16.1 illustrates the interaction of interest rate differentials and expected changes in the exchange rate over the investment period on currency value(cont.)Relative interest rates (cont.)(cont.)Relative interest rates (cont.)From Table 16.1 the following impact on the value of the AUD would be evident:Scenario 1: AUD would depreciateThe 3% benefit obtained from placing funds in the Australian money market would be more than offset by the 5% depreciation of the AUDScenario 2: AUD would appreciateThe 3% benefit obtained from placing funds in the Australian money market would be offset only partly by the 2% depreciation of the AUD(cont.)Relative interest rates (cont.)Reason for change in nominal interest rateThe analysis has ignored whether a change in the nominal interest rate is due to a change in the:real rate of return; orinflation expectations premium(cont.)Relative interest rates (cont.)Example: if nominal interest rates rise owing to an increase in the inflation expectations premium:the currency may not appreciate, and could depreciate because of:the effect of inflationary expectations (PPP theory)businesses and individuals seeking to invest cash holdings in overseas’ securities to avoid a loss of valueExample: if nominal interest rates rise owing to an increase in the real rate of return:the currency may appreciate because of an inflow of funds from the rest of the worldExchange rate expectationsMotivation for turnover in the FX marketOnly part of the turnover in the FX market is accounted for by transactions associated with exports, imports and financial assets A significant portion of turnover is motivated by changes in exchange rate expectations(cont.)Exchange rate expectations (cont.)Exchange rate expectations are based on expectations about future changes in:relative inflationrelative income growthrelative interest rates(cont.)Exchange rate expectations (cont.)Example: AUD expected to depreciateEffect for Australian residentsSeek to buy foreign currency before AUD fallsIncreasing supply of AUD on FX marketsEffect for foreign residentsDefer purchases of AUDReduces demand for AUDNet effectAUD depreciates as expected(cont.)Exchange rate expectations (cont.)Government or central bank interventionPolicies by foreign and/or domestic governments may affect the relative rate of inflation, income growth or interest rates between countriesAlso, the market participants’ expectations that the government will alter its policy affects these variables in the future(cont.)Government or central bank intervention (cont.)A central bank may also influence the currency by:intervening in international trade flowsintervening in foreign investment flowsdirectly intervening in the FX market(cont.)Government or central bank intervention (cont.)International trade flowsIntervention aimed at increasing exports and/or reducing imports by using the following:Subsidies to exporters, making exports more competitiveIncreases demand for Australian exports and demand for AUDIntervention on the import sideTariffs—charge levied on imports increasing their pricesQuotas—restriction on the amount importedEmbargo—prohibition on import of specified goods or services(cont.)Government or central bank intervention (cont.)Foreign investment flowsGovernments alter the exchange rate by altering the flow of investment funds between countries by imposing:prohibitions on the outflow of funds from a countrypenalty taxes on:residents who earn income offshorenon-residents’ interest income earned in the home country(cont.)Government or central bank intervention (cont.)Direct FX market interventionInvolves purchases or sales of currencyTwo motivations for doing thisSmoothingRBA tries to remove volatility in the currency caused by speculatorsExchange rate targetingRBA tries to push the equilibrium exchange rate to some level(cont.)Government or central bank intervention (cont.)Chapter organisation16.1 FX markets and an equilibrium exchange rate16.2 Factors that influence exchange rate movements16.3 Measuring exchange rate sensitivity to changes in economic variables16.4 Summary16.4 Measuring exchange rate sensitivity to changes in economic variablesRegression analysis can be used to assess how changes in economic variables affect the exchange rateIt is a statistical technique that determines the relationship between a dependent variable (the exchange rate) and independent variables (relative growth, inflation and interest rates, etc.)Chapter organisation16.1 FX markets and an equilibrium exchange rate16.2 Factors that influence exchange rate movements16.3 Measuring exchange rate sensitivity to changes in economic variables16.4 Summary16.4 SummaryDemand and supply determine the value of a currency in a floating exchange rate regimeFactors influencing the demand and/or supply of a currencyRelative inflation rates (PPP)Relative national income growth ratesRelative interest ratesExchange rate expectationsCentral bank or government intervention