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Determinants of the Foreign Exchange
Many factors influence but overall for a floating exchange rate the price of the currency is determined by demand for local currency relative to its supply
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Determinants of the Foreign Exchange - "Demand curve"
Downward as the cheaper the NZD, the greater the demand for NZD by overseas residents
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Determinants of the Foreign Exchange - "Supply curve"
Upward sloping as when price of NZD declines, supply curve shows that fewer USD will be supplied.
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Factors that influence Exchange Rate Movements
- Relative inflation rates
- Relative national income growth rates
- Relative interest rates
- Exchange rate expectations
- Central bank or govt intervention
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Factors that Influence Exchange Rate Movements - "Relative inflation rates" - Example: Consider situation in an ideal world, if NZ & USA had been experiencing similarly low rates of inflation, & then USA experienced a substantial & prolonged increase in its inflation rate
- Price of US goods increases
- NZ demand for US goods decreases
- reduction in NZ demand for USD
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As well, surge in US inflation...
- US residents search for cheaper goods & some of US demand for goods switch to NZ
- increased demand for NZD, combined with reduced supply results in curve D1 & an increase in price of NZD.
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Relative inflation rates graph
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Purchasing power parity (PPP)
- Where exchange rates adjust to ensure prices of the same goods are equal between countries
- Relationship between prices of physical goods & services and exchange rates
- Asserts that if the product is the same across all countries e.g. Big Mac, then so should be its price
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PPP example - "Suppose annual inflation in NZ is 2% p.a. & inflation rate in Japan is 4.2%, then if yen-dollar rate is $0.01298 per yen, then spot exchange rate at time t+1 is..."
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PPP Summary - "If PPP holds..."
- The currency of a country with high inflation will tend to depreciate relative to countries with low inflation.
- Countries with relatively higher inflation or where inflation levels are perceived to be rising ⇒ depreciating currency.
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Factors that influence exchange rate movements - Relative national income growth rates
- One mechanism- an increase in rate of growth ⇒increased demand for imports, all else constant ⇒currency depreciation.
- On the other hand, an increase in growth rate ⇒ increase in foreign investment inflows ⇒ currency appreciate.
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Features that influence exchange rate movements - Relative interest rates
- One mechanism- an increase in rate of growth ⇒increased demand for imports, all else constant ⇒currency depreciation.
- On the other hand, an increase in growth rate ⇒ increase in foreign investment inflows ⇒ currency appreciate.
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Relative interest rates - Example - "NZ interest rates rise compared with Australia. So Australians would put some money in accounts in NZ to earn higher interest."
- Increase in demand for NZD by Australians & at same time New Zealanders keep investments in NZ
- So reduction of supply of NZD in FX market
- Overall, increase in interest rate⇒ appreciation of NZD
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Exchange rate expectations
- If market participants expect a depreciation of NZD, then all else being constant, depreciation will occur (funds moved offshore ⇒ increase in supply of NZD on FX market as holders seek to buy foreign currencies before value falls)
- At the same time, demand for NZD as purchasers wait reduces
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Government intervention - numerous ways in which Govt may affect exchange rates.
Polices that affect relative incomes, or inflation, interest rates, e.g. monetary policy can have great influence on short term interest rates which can be transmitted to affect FX rates.
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Government intervention - "Central bank may seek to influence currency by..."
- 1. Govt may intervene directly in FX markets to influence value of currency.
- 2. Intervene in international trade
- 3. Intervene in foreign investment flows
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Central bank may seek to influence currency by - "Govt may intervene directly in FX markets to influence value of currency"
To try to increase FX value of NZD, the bank would sell foreign currency & buy NZD; to reduce its value, the bank would buy foreign currency
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Central bank may seek to influence currency by - "Intervene in international trade"
- Aimed at increasing exports or reducing imports flows
- e.g. Subsidies for exporters or on import side – tariffs, quotas or embargoes
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Balance of trade levels & trends - Current-account (CA) balance
Records the money from selling goods & services to rest of world + income earned on overseas investments versus payments
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Balance of trade levels & trends - If total payments > total receipts...
CA in deficit, need to finance by borrowing FX so foreign debt ↑ & interest payments ↑ .
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Current-account (CA) balance - "Countries with accumulated CA deficit"
- Accumulated CA deficit = weak exchange rates
- Weak currency depreciated over L/T
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Current-account (CA) balance - "Countries with accumulated CA surplus"
- ‘strong’ currency
- Strong currency appreciated over L/T
- Rapid economic growth, rising stock & bond prices & successful economic policies to control inflation & unemployment ⇒ usually to a stronger currency
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Govt interventions - Political conditions aka Trump
Political upheaval and instability can have a negative impact on a country’s currency (possibly as a result of a weaker economy
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Govt. intervention - Market Psychology
Traders’ perceptions and market behaviour influence FX market in a number of ways especially in the S/T
- Flight to quality
- “Buy the rumor, sell the fact”
- Economic numbers that are watched
- Technical trading
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Foreign Exchange Risk and Hedging
When company's profits is affected by FX changes- exposed to FX risk
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Foreign Exchange Risk and Hedging - Main types
- Transaction exposure
- Translation exposure
- Operational exposure
- Economic exposure
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Transaction exposure
When the value of a company's cash inflows received in various currencies is affected.
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Translation exposure
When value of assets & liabilities (usually of foreign subsidiary) is affected
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Operational exposure
Extent to which exchange rate volatility may affect a firm’s future operating cash flows - revenue & costs
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Economic exposure
Broad measure that tries to capture impact of unexpected exchange rate volatility on NPV of firm- combines transaction & operating FX exposures
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Transactional Exposure & Net cash flows
- Companies should calculate net amount of inflows & outflows in each foreign currency, especially group all receivables & payables in foreign currency.
- Timing of cash flows matter especially for a natural hedge.
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Four possible responses to dealing with FX risk
- to hedge nothing (argument company not in FX business)
- to hedge everything (too expensive)
- to forecast
- to partially hedge
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Two Categories of Hedging - Change exposure by:
- External (market) measures
- Internal measures
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Two Categories of Hedging - Change exposure by - (a) External or market measures
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Two Categories of Hedging - Change exposure by - (b) Internal measures
- structural techniques
- match exposures
- leading and lagging
- diversification
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Risk Management: Market-Based Hedging-use of forwards - Example
"An NZ company has US$1 million account receivable due in 6 months. To hedge, the company enters into 6-month forward contract today to sell USD (buy (NZD)"
- Today, company enters forward contract to sell USD at 0.5260 in 6 months (i.e. US$1million = NZD1,901,140.68)
- In 6 Months, company receives US$1million from commercial transaction
- It gives US$1 million to FX dealer, receiving NZD1,901,140.68
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Money Market hedge (Also called BSI hedge) - "Money market hedge involves..."
- STEP I: Borrow USD today
- STEP II: Spot convert USD to NZD
- STEP III: Invest the NZD today
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Money Market hedge - Example - "BSI hedge to cover USD future USD receivable"
- Company borrows sufficient USD to repay USD500,000 in one year
- USD500,000/(1+0.04) = USD480,769.23 borrowed now
- Company buys NZ$ with US$480,769.23 = $599,462.88
- Company invests the NZD599,462.88 for 1 year at 6%=> NZD$635,430.65
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Risk Management: Internal Hedging - Within the business
- Invoicing in home currency
- Creating a natural hedge
- Currency diversification
- Leading and lagging FX transactions
- Mark-ups
- Counter trade and offsets
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