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Chapter 16 Foreign exchange: factors that influence the exchange rate Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-1 Learning objectives • Explain how supply and demand issues determine an equilibrium exchange rate • Consider 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 intervention • Explore regression analysis on variables impacting on an exchange rate Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-2 Chapter organisation 16.1 FX markets and an equilibrium exchange rate 16.2 Factors that influence exchange rate movements 16.3 Measuring exchange rate sensitivity to changes in economic variables 16.4 Summary Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-3 16.1 FX markets and an equilibrium exchange rate • Previous chapter: – focused on the structure and operations of the FX markets • This 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.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-4 16.1 FX markets and an equilibrium exchange rate (cont.) • Floating exchange rate regime – One in which the value of the currency is determined by demand and supply conditions with no central bank intervention • Pegged exchange rate regime – Where a domestic currency is locked into a specified multiple of another currency such as the USD (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-5 16.1 FX markets and an equilibrium exchange rate (cont.) • Demand for a currency – To purchase Australian goods and services, foreigners must buy AUD – Downward-sloping demand curve occurs as the devaluation of AUD results in a greater demand by foreigners  For foreigners, a fall in the price of the AUD is equivalent to a reduction in the price of everything in Australia (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-6 16.1 FX markets and an equilibrium exchange rate (cont.) • Supply of a currency – Upward-sloping supply curve occurs as the quantity of AUD supplied to the FX market increases as the price of the AUD increases – As the AUD appreciates, the price of foreign currency falls, making foreign goods cheaper for Australian residents – The demand for foreign currency increases and, therefore, so does the supply of AUD (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-7 16.1 FX markets and an equilibrium exchange rate (cont.) • Equilibrium exchange rate – The equilibrium exchange rate is the rate at which the quantity of AUD supplied to the market is equal to the demand for AUD – It shows the unique rate at which both the demanders and suppliers of AUD will be satisfied (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-8 16.1 FX markets and an equilibrium exchange rate (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-9 Chapter organisation 16.1 FX markets and an equilibrium exchange rate 16.2 Factors that influence exchange rate movements 16.3 Measuring exchange rate sensitivity to changes in economic variables 16.4 Summary Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-10 16.2 Factors that influence exchange rate movements • Main factors influencing exchange rate movements – – – – – Relative inflation rates Relative national income growth rates Relative interest rates Exchange rate expectations Government or central bank intervention Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-11 Relative inflation rates • Relative inflation rates influence the price of and, therefore, the demand for foreign goods by residents • The change in demand for imported goods, in turn, affects the demand for foreign currency used to buy these goods – This view of the determination of the value of a currency is called purchasing power parity (PPP) and is discussed in detail later (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-12 Relative inflation rates (cont.) • Example: increase in US rate of inflation relative to Australia – Effect for Australian residents  US imports more expensive, decreasing demand for these goods; therefore, reducing the supply of AUD – Effect for US residents  Some US demand for goods and services, and assets will switch to Australian items, increasing demand for AUD to pay for these items – Net effect is an appreciation of the AUD (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-13 Relative inflation rates (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-14 Relative national income growth rates • Example: Australian income growth rates rise relative to the US – Australian demand for imports increases, increasing the supply of AUD, which, in turn, causes the AUD to depreciate – A secondary effect could be an increase in foreign investment in Australia, increasing the demand for AUD, causing the AUD to recover some value (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-15 Relative national income growth rates (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-16 Relative interest rates • Example: if Australian interest rates rise relative to the US – Effect for US residents  US residents and companies may redirect some of their cash into Australian interest-bearing instruments, increasing the demand for the AUD – Effect for Australian residents  Australian investors and businesses are more likely to keep their surplus funds invested in Australia, causing a decrease in the supply of the AUD – Net effect  AUD will appreciate (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-17 Relative interest rates (cont.) (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-18 Relative interest rates (cont.) • Expectations about the value of the currency during the investment period – An analysis of the effect of interest rates on the exchange rate cannot ignore expectations about the value of the currency during the investment period – Table 16.1 illustrates the interaction of interest rate differentials and expected changes in the exchange rate over the investment period on currency value (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-19 Relative interest rates (cont.) (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-20 Relative interest rates (cont.) • From Table 16.1 the following impact on the value of the AUD would be evident: – Scenario 1: AUD would depreciate  The 3% benefit obtained from placing funds in the Australian money market would be more than offset by the 5% depreciation of the AUD – Scenario 2: AUD would appreciate  The 3% benefit obtained from placing funds in the Australian money market would be offset only partly by the 2% depreciation of the AUD (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-21 Relative interest rates (cont.) • Reason for change in nominal interest rate – The analysis has ignored whether a change in the nominal interest rate is due to a change in the:  real rate of return; or  inflation expectations premium i nom r  pe (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-22 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 value • Example: 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 world Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-23 Exchange rate expectations • Motivation for turnover in the FX market – Only 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.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-24 Exchange rate expectations (cont.) • Exchange rate expectations are based on expectations about future changes in: – relative inflation – relative income growth – relative interest rates (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-25 Exchange rate expectations (cont.) • Example: AUD expected to depreciate – Effect for Australian residents  Seek to buy foreign currency before AUD falls  Increasing supply of AUD on FX markets – Effect for foreign residents  Defer purchases of AUD  Reduces demand for AUD – Net effect  AUD depreciates as expected (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-26 Exchange rate expectations (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-27 Government or central bank intervention • Policies by foreign and/or domestic governments may affect the relative rate of inflation, income growth or interest rates between countries • Also, the market participants’ expectations that the government will alter its policy affects these variables in the future (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-28 Government or central bank intervention (cont.) • A central bank may also influence the currency by: – intervening in international trade flows – intervening in foreign investment flows – directly intervening in the FX market (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-29 Government or central bank intervention (cont.) • International trade flows – Intervention aimed at increasing exports and/or reducing imports by using the following:  Subsidies to exporters, making exports more competitive • Increases demand for Australian exports and demand for AUD  Intervention on the import side • Tariffs—charge levied on imports increasing their prices • Quotas—restriction on the amount imported • Embargo—prohibition on import of specified goods or services (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-30 Government or central bank intervention (cont.) • Foreign investment flows – Governments alter the exchange rate by altering the flow of investment funds between countries by imposing:  prohibitions on the outflow of funds from a country  penalty taxes on: • residents who earn income offshore • non-residents’ interest income earned in the home country (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-31 Government or central bank intervention (cont.) • Direct FX market intervention – Involves purchases or sales of currency – Two motivations for doing this  Smoothing • RBA tries to remove volatility in the currency caused by speculators  Exchange rate targeting • RBA tries to push the equilibrium exchange rate to some level (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-32 Government or central bank intervention (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-33 Chapter organisation 16.1 FX markets and an equilibrium exchange rate 16.2 Factors that influence exchange rate movements 16.3 Measuring exchange rate sensitivity to changes in economic variables 16.4 Summary Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-34 16.4 Measuring exchange rate sensitivity to changes in economic variables • Regression analysis can be used to assess how changes in economic variables affect the exchange rate – It 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.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-35 Chapter organisation 16.1 FX markets and an equilibrium exchange rate 16.2 Factors that influence exchange rate movements 16.3 Measuring exchange rate sensitivity to changes in economic variables 16.4 Summary Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-36 16.4 Summary • Demand and supply determine the value of a currency in a floating exchange rate regime • Factors influencing the demand and/or supply of a currency – – – – – Relative inflation rates (PPP) Relative national income growth rates Relative interest rates Exchange rate expectations Central bank or government intervention Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 16-37