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Foreign Exchange Rate Determination:

Expectations and the Asset Market
Model
International Financial
Management
Dr. A. DeMaskey
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Learning Objectives
What are the determinants of exchange rates?
Are changes in exchange rates predictable?
What factors affect the equilibrium exchange
rate?
What is the role of expectations?
How do central banks intervene in the foreign
exchange market?
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Potential Foreign Exchange Rate
Determinants
Parity Conditions
1. Relative inflation rates
2. Relative interest rates
3. Forward exchange rates
4. Exchange rate regimes
5. Official monetary reserves
Infrastructure
1. Strength of banking system
2. Strength of securities markets
3. Outlook for growth and profitability
Speculation
1. Currencies
2. Securities
3. Uncovered interest arbitrage
4. Real estate
5. Commodities
Cross-Border Investment
1. Foreign direct investment
2. Portfolio investment
Political Risk
1. Capital controls
2. Black market in currencies
3. Exchange rate spreads
4. Risk premium on securities
and FDI
Spot Exchange Rate
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Measuring Exchange Rate
Movements
Appreciation
Depreciation
Percent Change in the Foreign
Currency Value
Percent Change in the Home
Currency Value
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Exchange Rate Equilibrium
Demand
Supply
Equilibrium Exchange Rate
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Equilibrium Exchange Rate
S

D

$1.50
Dollar Value of
Quantity of
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Macro-Economic Factors
Influencing Exchange Rates
Relative Inflation Rates
Relative Interest Rates
Relative Income Levels
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Impact of Rising U.S. Inflation on the
Equilibrium Value of the British Pound
S

D

$1.50
Dollar Value of
Quantity of
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Impact of Rising U.S. Interest Rates on
the Equilibrium Value of the British Pound
S

D

$1.50
Dollar Value of
Quantity of
10
Impact of Rising U.S. Income on the
Equilibrium Value of the British Pound
S

D

$1.50
Dollar Value of
Quantity of
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Government Controls
Foreign Exchange Barriers
Foreign Trade Barriers
Government Intervention in Foreign
Exchange Market
Affecting macro variables, such as
inflation, interest rates, and income
levels
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Expectations
Foreign exchange markets react to any news
that may have a future effect.
Institutional investors often take currency
positions based on anticipated interest rate
movements in various countries.
Because of speculative transactions, foreign
exchange rates can be very volatile.
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Role of Expectations
Signal Impact on $
Poor U.S. economic indicators
Fed chairman suggests Fed is
unlikely to cut U.S. interest rates
A possible decline in German
interest rates
Central banks expected to
intervene to boost the euro
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Interaction of Factors
Trade-Related Factors
Financial Factors
Trade-related factors and financial
factors sometimes interact.
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Factors Affecting Exchange
Rates
Inflation Differential
Income Differential
Govt Trade Restrictions
Interest Rate Differential
Capital Flow Restrictions
U.S. Demand
For Foreign Goods



Foreign Demand
For U.S. Goods
U.S. Demand
For FC



Supply of FC
For Sale
U.S. Demand
For Foreign
Securities

Foreign Demand
For U.S. Securities
U.S. Demand
For FC


Supply of FC
For Sale
Exchange Rate
Between the
Foreign Currency
And the Dollar
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Government Intervention
Reasons
Direct
Sterilized
Non-Sterilized
Indirect
Government Policy
Government Barriers
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Central Bank Intervention
Nonsterilized Intervention
To Strengthen the C$
Federal Reserve
Banks Participating
In the Foreign
Exchange Market
C$ $
Sterilized Intervention
To Strengthen the C$
Federal Reserve
Banks Participating
In the Foreign
Exchange Market
Financial
Institutions
That Invest
In Treasury
Securities
$ C$
Treasury Securities
$
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Impact of Currency Value
Government Deficit
Government Policy Tool
Weak Home Currency
Strong Home Currency
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Effect of Expectations
Currency values are determined by:
Inflation
Interest rates
Economic and political stability
GDP growth
Reputation of central bank
In reality, however, exchange rates are
affected by expectations of these
variables.

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Central Bank Behavior
Reputable central banks:
Are trusted by markets to maintain a
currencys purchasing power through sound
monetary policy.
Tend to be independent.
Have currencies that are more highly valued
than those issued by less reputable banks.