Tài chính doanh nghiệp - Chapter two: The determination of exchange rates

1CHAPTER TWO THE DETERMINATION OF EXCHANGE RATES 10/5/2015 1CHAPTER 2 CHAPTER TWO OVERVIEW • Exchange rate equilibrium • The fundamental of Central bank intervention 10/5/2015 2CHAPTER 2 DEMAND FOR A CURRENCY (U.S. VIEWPOINT) • Demand for foreign exchange by U.S. corporations / traders / governments that need to purchase: – foreign-produced trade items – foreign assets (real and financial). • Demand Curve: – Relationship between the quantity of FX demanded & the price of FX (exchange rate) – Negatively sloping 10/5/2015 3CHAPTER 2 DEMAND CURVE FOR BRITISH POUNDS 4 Quantity of BP 10 Bill 20 Bill $1.80 $1.90 P ri ce o f B P in $ 10/5/2015 CHAPTER 2 2SUPPLY FOR A CURRENCY (U.S. VIEWPOINT) • Supply of foreign exchange by foreign corporations / traders / governments that need to purchase: – U.S. -produced trade items – U.S. assets (real and financial). • Supply Curve: – Relationship between the quantity of FX demanded & the price of FX (exchange rate) – Positively sloping 10/5/2015 5CHAPTER 2 SUPPLY CURVE FOR BRITISH POUNDS 6 Quantity of BP 10 Bill 20 Bill $1.80 $1.90 P ri ce o f B P in $ 10/5/2015 CHAPTER 2 EXCHANGE RATE EQUILIBRIUM (U.S. VIEW POINT) 7 Quantity of BP 10 Bill 20 Bill $1.60 $1.90 P ri ce o f B P in $ $1.70 15 Bill Supply Curve for BP Demand Curve for BP 10/5/2015 CHAPTER 2 Equilibrium dollar price and quantity of British Pounds are determined such that American and British goods and assets are traded. CHANGE IN MACROECONOMIC FACTORS & EXCHANGE RATE • EVENTS – Increase/decrease in relative domestic inflation – Increase/decrease in relative domestic interest rates – Increase/decrease in relative GDP – FX trading by Governments – FX trading by speculators due to change in expectations • EFFECTS: What happen to: – The supply and demand schedules – The equilibrium exchange rate/price of the foreign currency 10/5/2015 8CHAPTER 2 3THE EFFECTS OF RELATIVE DOMESTIC INFLATION INCREASE IN THE FX MARKET • Demand Schedule: – Foreign goods are relatively cheaper to domestic consumers. – Merchandise imports increase. – Quantity of FX demanded at each exchange rate increases. • Supply Schedule: – Domestic goods are relatively expensive for foreign consumers. – Merchandise exports decrease. – Quantity of FX supplied at each exchange rate (ER) falls. • Equilibrium: – ER (price of BP) increases 9 Quantity of BP Exchanged S2 P ri ce o f B P in $ S1 D2 D1 10/5/2015 CHAPTER 2 THE EFFECTS OF RELATIVE DOMESTIC INFLATION DECREASE IN THE FX MARKET • Demand Schedule: – Foreign goods are relatively expensive to domestic consumers. – Merchandise imports decrease. – Quantity of FX demanded at each exchange rate decreases. • Supply Schedule: – Domestic goods are relatively cheaper for foreign consumers. – Merchandise exports increase. – Quantity of FX supplied at each exchange rate (ER) increase. • Equilibrium: – ER (price of BP) decreases 10 Quantity of BP Exchanged P ri ce o f B P in $ D1 D2 S1 S2 10/5/2015 CHAPTER 2 THE EFFECTS OF RELATIVE DOMESTIC INTEREST RATE INCREASE IN THE FX MARKET • Demand Schedule: – Domestic capital attracted to domestic country & domestic capital movement overseas falls – Quantity of FX demanded at each exchange rate decreases • Supply Schedule: – Foreign capital attracted to domestic country & foreign capital movement into the domestic country increases – Quantity of FX supplied at each exchange rate increases. • Equilibrium: – ER (price of BP) decreases 11 Quantity of BP Exchanged S1 P ri ce o f B P in $ S2 D1 D2 10/5/2015 CHAPTER 2 THE EFFECTS OF RELATIVE DOMESTIC INTEREST RATE DECREASE IN THE FX MARKET • Demand Schedule: – Domestic capital attracted to domestic country & domestic capital movement overseas increases – Quantity of FX demanded at each exchange rate increases • Supply Schedule: – Foreign capital attracted to domestic country & foreign capital movement into the domestic country falls – Quantity of FX supplied at each exchange rate falls. • Equilibrium: – ER (price of BP) increases 12 Quantity of BP Exchanged S2 P ri ce o f B P in $ S1 D2 D1 10/5/2015 CHAPTER 2 4THE EFFECTS OF RELATIVE DOMESTIC NATIONAL INCOME INCREASE IN THE FX MARKET • Demand Schedule: – With higher income, domestic consumers purchase more foreign goods. Merchandise imports increases – Quantity of FX demanded at each exchange rate increases • Supply Schedule: – Either Foreign demand for domestic goods does not change or increases with increased foreign dollar purchasing power. – Quantity of FX supplied at each exchange rate does not change or increase. • Equilibrium: – ER (price of BP) increases 13 Quantity of BP Exchanged S1 P ri ce o f B P in $ S2 D2 D1 10/5/2015 CHAPTER 2 THE EFFECTS OF RELATIVE DOMESTIC NATIONAL INCOME DECREASE IN THE FX MARKET • Demand Schedule: – With lower income, domestic consumers purchase less foreign goods. Merchandise imports decreases – Quantity of FX demanded at each exchange rate decreases • Supply Schedule: – Either Foreign demand for domestic goods does not change or decreases with decreased foreign dollar purchasing power. – Quantity of FX supplied at each exchange rate does not change or decrease. • Equilibrium: – ER (price of BP) decreases 14 Quantity of BP Exchanged S2 P ri ce o f B P in $ S1 D1 D2 10/5/2015 CHAPTER 2 EXPECTATIONS ABOUT CURRENCY PRICES AND TRADING STRATEGY IN FX MARKET: THEORY • Based on expectations about future behavior of macro economic variables, currency trades: – Make predictions about expected changes in foreign currency prices – Based on these expectations: • Borrow in currency that is expected to depreciate • Lend in currency that is expected to appreciate – This changes the supply/demand and the price for foreign currency in the FX market 10/5/2015 15CHAPTER 2 HOW GOVERNMENTS IMPACT FX MARKET? Governments may increase or decrease trade restrictions (tariffs & quotas) Governments may directly intervene in the FX markets# If a foreign currency price is perceived to be abnormally low or high with respect to the US dollar, both the US Central bank and the central bank of other countries may agree to buy or sell the foreign currency (against the dollar) to reverse this trend. October 5, 2015 16CHAPTER 2 5WHAT IS A STERILIZED INTERVENTION? • There are basically two types of intervention, sterilized and unsterilized. • Sterilized intervention requires offsetting intervention with the buying or selling of government bonds, • Non-sterilized intervention involves no changes to the monetary base to offset intervention #. October 5, 2015 17CHAPTER 2 GOVERNMENTS INTERVENTION IN THE FX MARKET: STERILIZED (1)  If BP is undervalued (dollar is overvalued ): # – Both Central banks buy BP (sell US dollars): – US money supply rises and the British money supply falls – To neutralized the changes in money supply: Federal Reserve sells US Treasury securities and the Central Bank of England buys British Treasury securities – US money supply is reduced and the British money supply is increased – The BP appreciation (dollar depreciation ) due to central bank intervention is usually short lived October 5, 2015 18CHAPTER 2 GOVERNMENTS INTERVENTION IN THE FX MARKET: NON – STERILIZED (2)  If BP is overvalued (dollar is undervalued ):  Both Central banks sell BP (buy US dollars):  US money supply falls and the British money supply rises  US inflation decreases and British inflation increases  Depreciation of BP (appreciation of dollar) is more due to decreased US inflation (increased British inflation) rather than central bank transactions in the FX market October 5, 2015 19CHAPTER 2 EXHIBIT 2.1 THE DETERMINANTS OF FOREIGN EXCHANGE RATES International Parity Conditions 1. Relative inflation rates (PPP) 2. Relative interest rates (international Fisher effect) 3. Forward exchange rates 4. Interest rate parity (IRP) Balance of Payments 1. Current account balances 2. Portfolio investment 3. Foreign direct investment 4. Official monetary reserves 5. Exchange rate regimes 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 Spot Exchange Rate Monetary ApproachTechnical Analysis  Most determinants of the exchange rate, e.g., the balance of BOP, the inflation rates, the nominal and real interest rates, and the economic prospects, are also in turn affected by changes in the exchange rate  In other words, they are not only linked but mutually determined 6FOREIGN EXCHANGE RATE DETERMINATION • In addition to gaining an understanding of the basic theories or determining factors for the exchange rate, it is equally important to gain the following knowledge which could affect the exchange rate markets 1. The complexities of international political economy • Foreign political risks have been much reduced in recent years because more countries adopted democratic form of government, so capital markets became less segmented from each other and more liquid 2. Societal and economic infrastructures • Infrastructure weakness were the major reasons of the exchange rate collapses in emerging markets in the late 1990s 3. Random political, economic, or social events • For example, recent occurrences of terrorism may increase the political risks and affect the exchange rate market EXCHANGE RATE DETERMINATION • This section will provide a brief overview of the many different theories to determine exchange rate and their relative usefulness in forecasting • The theories discussed in this section include – Purchasing power parity approach – Balance of payments (flows) approach – Monetary approach – Asset market approach – Technical analysis EXCHANGE RATE DETERMINATION • The theory of Purchasing Power Parity states that the exchange rate is determined as the relative prices of goods – PPP is the oldest and most widely followed exchange rate theory • Paul Krugman, Nobel Prize laureate in Economics in 2008, said that “Under the skin an international economist lies a deep-seated belief in some variant of the PPP theory of the exchange rate” – Most exchange rate determination theories have PPP elements embedded within their frameworks – However, PPP calculations and forecasts are plagued with structural differences across countries (e.g., different tax rules or many non-tradable production factors) and significant challenges of data collecting in estimation 10-23 EXCHANGE RATE DETERMINATION • The Balance of Payments (Flows) approach argues that the equilibrium exchange rate is determined through the demand and supply of currency flows from current and financial account activities – The BOP method is the second most utilized theoretical approach in exchange rate determination • Today, this method is largely dismissed by academics , but practitioners still rely on different variations of the theory for decision making – This framework is appealing since the BOP transaction data is readily available and widely reported – Critics may argue that this theory emphasizes on flows of currency, but stocks of currency or financial assets of residents play no role in exchange rate determination • The monetary approach considers the currency stocks of residents • The asset market approach argues that exchange rates are altered by shifts in the supply and demand of financial assets 7EXCHANGE RATE DETERMINATION • The Monetary Approach states that the supply and demand for currency stocks, as well as the expected growth rates of currency stocks, will determine the price level or the inflation rate and thus explain changes of the exchange rate according to PPP – The arguments are all about currency stocks of residents – The inference is to link the demand or the supply of currencies with residents’ behavior to adjust the stock of currencies • Main results of the monetary approach are as follows: – Currency supply ↑ domestic currency depreciation 1. Currency supply ↑ supply of currency > demand of currency  residents’ current currency holding > residents’ desired currency holding  residents spend the currency  price level ↑ according to PPP, domestic currency depreciates 2. Domestic currency supply growth rate > foreign currency supply growth rate  domestic currency depreciates vs. foreign currency EXCHANGE RATE DETERMINATION – Interest rate ↑ domestic currency depreciation 1. Interest rate ↑ opportunity cost for residents to hold the currency increases  demand of currency ↓ residents’ current currency holding > residents’ desired currency holding  residents spend the currency price level ↑ according to PPP, domestic currency depreciates 2. Increase of domestic interest rate > increase of foreign interest rate  domestic currency depreciates against foreign currency – Real income ↑ domestic currency appreciation 1. Real income ↑ (= real GDP ↑ = outputs of products and services ↑)  number of transactions ↑ demand of currency ↑ residents’ current currency holding < residents’ desired currency holding  residents decrease the spending of the currency price level ↓ (or because the supply of products and services ↑, price level ↓ and less currency is spent to achieve the same utility)  according to PPP, domestic currency appreciates 2. Domestic real income growth rate > foreign real income growth rate (domestic economic growth > foreign economic growth)  domestic currency appreciates against foreign currency EXCHANGE RATE DETERMINATION • The monetary approach omits a number of factors: – The failure of PPP to hold in the short to medium term – The change of the interest rate and the real income will affect the economic activities and thus affect the currency supply • In the above inference, however, the change of the interest rate and the real income affect only the currency demand – Currency demand appearing to be relatively unstable over time • There are many factors other than the interest rate and the real income to affect the money demand, e.g., the economic boom or recession, so the money demand is difficult to be predicted THE ASSET MARKET APPROACH TO FORECASTING • The asset market approach assumes that the motives of foreigners to hold claims in one currency depends on an extensive set of investment considerations or drivers: 1. Relative real interest rates (an important concern for investing in foreign bonds and money market instruments) 2. Prospects for economic growth (the major reason for cross-border equity investment and foreign direct investment) 3. Capital market liquidity (Cross-border investors are not only interested in investing assets to earn higher returns, but also in being able to sell assets quickly for fair market value) 4. A country’s economic and social infrastructure (which is an indicator of that country’s ability to survive in unexpected external stocks) 85. Political safety (which is usually reflected in political risk premiums for a country’s securities) 6. Corporate governance practices (poor corporate governance practices can reduce the investing will of foreign investors) 7. Contagion (which is the spread of a crisis in one country to its neighboring countries, and can cause an innocent country to experience capital flight and a resulting depreciation of its currency) 8. Speculation (can cause a foreign exchange crisis or make an existing crisis worse) In summary, the asset market approach believes that the above factors affect the motives of investments from both domestic and foreign investors and thus affect the exchange rate THE ASSET MARKET APPROACH TO FORECASTING • Foreign investors are willing to hold securities and undertake foreign direct or portfolio investment in highly developed countries based primarily on relative real interest rates and the outlook for economic growth and profitability • The experience of the U.S. illustrates why some forecasters believe that exchange rates are more heavily influenced by economic prospects than by the current account – For 1981-1985, the US$ strengthened despite growing current account deficits • Relatively high real interest rates and good long-run prospects cause heavy capital inflow into the U.S. THE ASSET MARKET APPROACH TO FORECASTING – For 1990-2000, the US$ strengthened despite continued worsening balances on current account • The US$ remained to be strong due to foreign capital inflow motivated by rising stock and real estate prices, a low rate of inflation, high real interest rates, and an irrational expectation about future economic prospects • Actually, from 1995 to 2001, the Nasdaq index increased by a factor of more than 6 – After the terrorists attacked the U.S. on September 11, 2001 • A negative reassessment of long-term prospects due to the newly formed political risk in the U.S. • The drop of the stock markets and a series of failures in corporate governance of large corporations further led to a large withdrawal of foreign capital from the U.S. • According to both the BOP approach and the asset market approach, the US$ depreciated since then THE ASSET MARKET APPROACH TO FORECASTING DISEQUILIBRIUM: EXCHANGE RATES IN EMERGING MARKETS • The asset market approach is also applicable to emerging markets, however, not only the relative real interest rates and the prospects for economic growth but also additional factors contribute to exchange rate determination – The Asian and Argentine crises are examined as illustrative cases in this section 9ILLUSTRATIVE CASE: THE ASIAN CRISIS OF 1997 • The roots of the Asian currency crisis extended from a fundamental change in the economics of the region: the transition of many Asian nations from being net exporters to net importers due to the following two reasons – Rapidly economic expansion – Many Asian countries pegged its currency at a fixed exchange rate with the US$, so their currencies appreciated with the US$ being strong after 1995 • The deficit of BOP generates the depreciation pressure – To support their pegged exchange rates, Asian nations require to attract net capital inflow – The most visible roots of the crisis were the excess capital inflows into Thailand in 1996 and early 1997 ILLUSTRATIVE CASE: THE ASIAN CRISIS OF 1997 • Thai banks continued to raise capital internationally, and extended credit to a variety of domestic investments and enterprises beyond what the Thai economy could support • As the investment “bubble” expanded, market participants questioned the ability of the economy to repay the rising amount of debt, so the Thai baht was attacked by international speculation CFs (factor 8) • The Thai government intervened directly (using up precious currency reserves) and indirectly by raising interest rates in support of the currency (to stop the continual outflow) • On July 2, 1997, the Thai central bank allowed the baht to float, and the Thai baht against US$ fell 17% in several hours and 38% in 4 months ILLUSTRATIVE CASE: THE ASIAN CRISIS OF 1997 • The international speculators attacked a number of neighboring Asian nations, some with and some without characteristics similar to Thailand (factor 7) – It is the Asia’s own version of the tequila effect – “Tequila effect” is the term used to describe how the Mexican peso crisis of December 1994 quickly spread to other Latin American currency and equity markets – The spread of the financial panic is termed “contagion” • The Philippine peso, the Malaysian ringgit, and Indonesian rupiah all fell in the months following the July baht devaluation ILLUSTRATIVE CASE: THE ASIAN CRISIS OF 1997 • The Asian economic crisis (which was much more than just a currency collapse) had other reasons besides traditional balance of payments difficulties: – Corporate socialism • In Asia, because the influence of governments, even in the event of failure, it was believed that governments would not allow firms to fail, banks to close, and workers to lose their jobs • This kind of policy provided the stability of the economy, but when business liabilities exceeded the capacities of governments to bail businesses out, the crisis happened – Overinvestment in Asian countries (factor 2) • Due to the low interest rate in both Japan and the U.S., too much capital for portfolio investments flowed into Asian countries, which supports the bubble in Asian countries – Banking liquidity and management (factors 3, 4, and 6) • The lack of transparency and monitoring mechanisms encouraged banks to underestimate the credit risk of firms and expand the lending business too much 10 ILLUSTRATIVE CASE: THE ASIAN CRISIS OF 1997 • Banks did not hedge exchange rate risk while raising international capital, so when the domestic currency depreciated in the financial crisis, they suffered further loss • During the financial crisis, banks themselves suffer the liquidity problem, so banks cannot provide liquidity to firms for conducing their businesses – Political risk (factor 5) • Investors did not have confidence in the political stability of southeast Asian countries. So, if there is any sign for political problems, the capital out flowed from those countries immediately • After the crisis, the slowed economies of this region quickly caused major reductions in world demands for many commodities and thus the decline of the commodity prices, e.g., oil, metal, agricultural products, etc., which is part of the reasons for the Russian crisis in 1998