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Lecture multinational financial management chapter 2 ngo thi ngoc huyen

DEMAND FOR A CURRENCY
(U.S. VIEWPOINT)

CHAPTER
TWO

• Demand for foreign exchange by U.S. corporations /
traders / governments that need to purchase:

THE DETERMINATION OF
EXCHANGE RATES

– 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

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CHAPTER 2

1

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CHAPTER 2

3

DEMAND CURVE FOR BRITISH POUNDS

CHAPTER TWO OVERVIEW

Price of BP in $

• Exchange rate equilibrium
• The fundamental of Central bank intervention
$1.90

$1.80

10 Bill

20 Bill

Quantity of BP

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CHAPTER 2

2

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CHAPTER 2

4

1


EXCHANGE RATE EQUILIBRIUM
(U.S. VIEW POINT)

SUPPLY FOR A CURRENCY
(U.S. VIEWPOINT)

Equilibrium dollar price and quantity of British Pounds are determined such that American
and British goods and assets are traded.

• Supply of foreign exchange by foreign corporations /
traders / governments that need to purchase:

Supply Curve for BP

Price of BP in $

– 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

$1.90

$1.70

$1.60

Demand Curve for BP

10 Bill

15 Bill

20 Bill

Quantity of BP

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5

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7

CHANGE IN MACROECONOMIC FACTORS &
EXCHANGE RATE

SUPPLY CURVE FOR BRITISH POUNDS

Price of BP in $

• EVENTS






$1.90

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:

$1.80

– The supply and demand schedules
– The equilibrium exchange rate/price of the foreign currency
10 Bill

20 Bill

Quantity of BP

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6

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8

2


THE EFFECTS OF RELATIVE DOMESTIC
INFLATION INCREASE IN THE FX MARKET

• Demand Schedule:

• Supply Schedule:
– Domestic goods are relatively expensive for
foreign consumers.
– Merchandise exports decrease.
– Quantity of FX supplied at each exchange
rate (ER) falls.

D2

Price of BP in $

– Foreign goods are relatively cheaper to
domestic consumers.
– Merchandise imports increase.
– Quantity of FX demanded at each exchange
rate increases.

D1

S2

S1

– 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.

D1

Price of BP in $

• Demand Schedule:

THE EFFECTS OF RELATIVE DOMESTIC INTEREST
RATE INCREASE IN THE FX MARKET

D2

S1

S2

• Equilibrium:

• Equilibrium:

– ER (price of BP) decreases

Quantity of BP Exchanged

Quantity of BP Exchanged

– ER (price of BP) increases

CHAPTER 2

9

THE EFFECTS OF RELATIVE DOMESTIC
INFLATION DECREASE IN THE FX MARKET
• Demand Schedule:

CHAPTER 2

11

THE EFFECTS OF RELATIVE DOMESTIC INTEREST
RATE DECREASE IN THE FX MARKET
• Demand Schedule:

• Supply Schedule:
– Domestic goods are relatively cheaper for
foreign consumers.
– Merchandise exports increase.
– Quantity of FX supplied at each exchange
rate (ER) increase.

• Equilibrium:

D1

Price of BP in $

– Foreign goods are relatively expensive to
domestic consumers.
– Merchandise imports decrease.
– Quantity of FX demanded at each exchange
rate decreases.

D2

S1

S2

– Foreign capital attracted to domestic
country & foreign capital movement into
the domestic country falls
– Quantity of FX supplied at each exchange
rate falls.

• Equilibrium:

Quantity of BP Exchanged

CHAPTER 2

– Domestic capital attracted to domestic
country & domestic capital movement
overseas increases
– Quantity of FX demanded at each exchange
rate increases

• Supply Schedule:

10

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D2
D1

S2

S1

Quantity of BP Exchanged

– ER (price of BP) increases

– ER (price of BP) decreases

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Price of BP in $

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CHAPTER 2

12

3


THE EFFECTS OF RELATIVE DOMESTIC NATIONAL
INCOME INCREASE IN THE FX MARKET
• Demand Schedule:

• 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.

D2

Price of BP in $

– With higher income, domestic consumers
purchase more foreign goods. Merchandise
imports increases
– Quantity of FX demanded at each exchange
rate increases

• Equilibrium:

• 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:

S2

• 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
Quantity of BP Exchanged

– ER (price of BP) increases

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D1

S1

EXPECTATIONS ABOUT CURRENCY PRICES
AND TRADING STRATEGY IN FX MARKET: THEORY

CHAPTER 2

13

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• 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:

D1

S2
S1

D2

(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.

Quantity of BP Exchanged

– ER (price of BP) decreases

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Governments may increase or decrease trade restrictions

Price of BP in $

– With lower income, domestic consumers
purchase less foreign goods. Merchandise
imports decreases
– Quantity of FX demanded at each exchange
rate decreases

15

HOW GOVERNMENTS IMPACT
FX MARKET?

THE EFFECTS OF RELATIVE DOMESTIC NATIONAL
INCOME DECREASE IN THE FX MARKET
• Demand Schedule:

CHAPTER 2

CHAPTER 2

14

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CHAPTER 2

16

4


GOVERNMENTS INTERVENTION IN THE
FX MARKET: NON – STERILIZED (2)

WHAT 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 #.

 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

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CHAPTER 2

17

GOVERNMENTS INTERVENTION IN THE
FX MARKET: STERILIZED (1)

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CHAPTER 2

19

EXHIBIT 2.1 THE DETERMINANTS OF FOREIGN
EXCHANGE RATES
International Parity Conditions
1.
2.
3.
4.

 If BP is undervalued (dollar is overvalued ): #

Relative inflation rates (PPP)
Relative interest rates (international Fisher effect)
Forward exchange rates
Interest rate parity (IRP)

– Both Central banks buy BP (sell US dollars):
– US money supply rises and the British money supply falls

Technical Analysis

US Treasury securities and the Central Bank of England buys
Asset Market Approach

British Treasury securities

1.
2.
3.
4.
5.
6.

– 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

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CHAPTER 2

Monetary Approach
Spot
Exchange
Rate

– To neutralized the changes in money supply: Federal Reserve sells

18

Relative real interest rates
Prospects for economic growth
Supply & demand for financial assets
Outlook for political stability
Speculation & market liquidity
Contagion & corporate governance

Balance of Payments
1.
2.
3.
4.
5.

Current account balances
Portfolio investment
Foreign direct investment
Official monetary reserves
Exchange rate regimes

 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

5


FOREIGN EXCHANGE RATE DETERMINATION

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

• 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

1. The complexities of international political economy

• 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”

• 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

– 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

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

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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 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

6


EXCHANGE 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)

7


THE ASSET MARKET APPROACH TO FORECASTING
5. 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

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

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

• Relatively high real interest rates and good long-run prospects cause heavy
capital inflow into the U.S.

8


ILLUSTRATIVE 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

9


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

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