EXCHANGE RATE DETERMINATION

Introduction

Changing money from one currency to another and moving it around to different parts of the world is serious business, both on a personal and a company level. To survive both MNEs and small import and export countries must understand foreign exchange and exchange rates. In a business setting, there is a fundamental difference between making a payment in the domestic market and making a payment abroad. In a domestic transaction, companies use only one currency. In a foreign transaction companies can use two or more currencies.

Foreign exchange is money denominated in the currency of another nation or group of nations. The market in which these transactions take place is the foreign exchange market. Foreign exchange can be in the form of cash, funds available on credit and debit cards, traveler’s checks, bank deposits or other short term claims.

An exchange rate is the price of a currency. It’s the number of units of one currency that buys one unit of another currency, and this number can change daily. Exchange rates make international price and cost comparisons possible.

The Foreign exchange market is made up of many different players. Some players buy and sell foreign exchange because they are exporters and importers of goods and services. Other players buy and sell foreign exchange because of FDI – both investing capital into pulling dividends out of a country. Others are portfolio investors – they buy foreign stocks, bonds and mutual funds, hoping to sell them at a more profitable exchange rate later. These players have different objectives for buying and selling foreign currencies, and in the mean time, they affect supply and demand for those currencies.

The determinants of exchange rate:

1. Floating rate regimes:

Currencies that float freely respond to supply and demand conditions free from government conditions. This concept can be illustrated using a two country model involved the United states and Japan.

The above figure shows the equilibrium exchange rate in the market and then a movement to a new equilibrium level as the market changes. The demand for yen in this example is a function of U.S demand for Japanese goods and services, such as automobiles, and Yen- dominated financial assets, such as securities.

The supply of Yen in this example is a function of Japanese demand for U.S goods and services and Dollar- dominated financial assets. Initially, the supply of and demand for Yen meet at the equilibrium exchange rate e0 and the quantity of Yen is Q1.

Assume demand for Japanese goods and services by Japanese consumers drops because of high U.S inflation. This lessening demand would result in a reduced supply of Yen in the foreign exchange market, causing the supply curve to shift to S’. Simultaneously increasing price to U.S goods might lead to an increase in demand for Japanese goods and services by U.S consumers. This in turn would lead to an increase in demand for Yen in the market, causing the demand curve to shift to D’ and finally leading to an increase in the quantity of Yen and an increase in the exchange rate. The new equilibrium exchange rate would be at e1. From a Dollar standpoint, the increase demand for Japanese goods would lead to an increase in supply of Dollar as more consumers tried to trade theirs Dollars for Yen, and the reduced demand for U.S goods would result in a drop in the demand for Dollars. This would cause a reduction in the Dollar’s value against Yen.

2. Managed fixed rate regime:

In a managed fixed exchange rate regime system, the New York Federal Reserve Bank would hold foreign-exchange reserves, which it would have built up through years for this type of contingency. It could sell enough of its yen reserves at the fixed exchange rate to maintain that rate. Or the Japanese central bank might be willing to accept dollars so that U.S consumers can continue to buy Japanese goods. These dollars would then become part of Japan’s foreign exchange reserves.

The fixed rate could continue as long as the United States had reserves or as long as the Japanese were willing to add dollars to their holdings. Sometimes governments use fiscal or monetary policy, for example, by raising interest rates to create a demand for their currency and to keep the value from falling. Unless something changed the basic imbalance in the currency supply and demand, however, the New York Federal Reserve Bank would run out of yen and the Japanese central bank would stop accepting the dollars because it would fear amassing too many, similar to what happened to South Korea in early 2005. At this point, it would be necessary to change the rate in order to lessen the demand for yen.

If the country determines that intervention will not work, it might adjust its currency’s value. If the country is freely floating, the exchange rate will seek the correct level according to the laws of supply and demand. However, a currency that is pegged to another currency or to a basket of currencies usually is changed on a formal basis in other words, through a devaluation or revaluation, depending on the direction of the change.

Purchasing – Power Parity (ppp):

Purchasing- power parity is well-known theory that seeks to define relationships between currencies. In essence, it claims that a change in relative inflation (meaning a comparison of the countries’ rates of inflation) between two countries must cause a change in exchange rates in order to keep the prices of goods in two countries fairly similar. According to the ppp theory ,if , for example, Japanese inflation were 2% and U.S inflation were 3.5 % , the dollar would be expected to fall by the difference in inflation rates . Then the dollar would be worth fewer yen than before the adjustment.

Purchasing-power parity from the standpoint of exchange rates seeks to define the relationships between currencies based on relative inflation. If the domestic inflation rate is lower than that in the foreign country , the domestic currency should be stronger than that of the foreign country.

Some studies have shown , there are short –run problems that affects ppp:

· The theory of ppp falsely assumes that there are no barriers to trade and that transportation costs are zero.

· Prices of the big Mac in different countries are distorted by taxes. European countries with high value –added taxes are more likely to have higher prices than countries with low taxes.

· The big Mac is not just a basket of commodities ; its price also includes nontraded costs , such as rent, insurance, and so on.

· Profit margins vary by the strength of competition .the higher the competition , the lower the profit margin and ,therefore , the price .

Despite the ppp theory flaws, most economists agree that ppp measures provide more realistic pictures of the relative size of economies than market exchange rates.

Interest Rates:

Although inflation is the most important long – run influence on exchange rates, interest rates are also important. For example, a couple of articles on the foreign-exchange market in the wall street journal note the impact of interest rates on exchange rates. The nominal interest rate is the real interest rate plus inflation. Because the real interest rate should be the same in every country, the country with the higher interest rate should have higher inflation.

To understand this inter-relationship between interest rates and exchange rates, we need to understand two key finance theories: The fisher effect and the international fisher effect. The first theory links inflation and interest rates, and the second links interest rates and exchange rates. The fisher effect is the theory that the nominal interest rate r in a country (the actual monetary interest earned on an investment) is determined by the real interest rate R (the nominal rate less inflation) and the inflation rate is as follows:

(1+r) = (1+R)(1+i)

The IFE implies that the currency of the country with the lower interest rate will strengthen in the future. Thus, the country with the higher interest rate (and the higher inflation) should have the weaker currency.

Other factors in Exchange- Rate Determination:

Various others factors can cause exchange rate changes. One factor not to be dismissed lightly is confidence. In times of turmoil, people prefer to hold currencies considered safe. For example, during the Kosovo crisis, money flowed into the US. Because of concern over the safety of Western Europe if a true crisis were to occur in Yugoslavia and involve the Russians.

Forecasting Exchange Rate Movements:

Since various factors influence Exchange Rate Movements, managers must be able to analyze those factors to formulate a general idea of the timing, magnitude, and direction of an Exchange Rate Movements.

Fundamental & Technical Forecasting:

Managers can forecast exchange rates by using either of two approaches: fundamental forecasting or technical forecasting. Fundamental forecasting uses trends in economic variables to predict future rates. The data can be plugged into an econometric model or evaluated on a more subjective basis. Technical forecasting uses past trends in exchange rates themselves to spot future trends in rates. Technical forecasters, or chartists, assume that if current exchange rates reflect all facts in the market, then under similar circumstances, future rates will follow the same pattern. However, all forecasting is imprecise. A corporate treasurer who wants to forecast an exchange rate- say, the relationship between the British pound and the US dollar- might use a variety of sources, both internal and external to the company. Many treasurers and bankers use outside forecasters to obtain input for their own forecasts. Forecasters need to provide ranges or point estimates with subjective probabilities based on available data and subjective interpretation. Biases that can skew forecasts include:

Ø Overreaction to unexpected and dramatic news event.

Ø Illusory correlation, that is, the tendency to see correlations or associations in data that are not statistically present but that are expected to occur on the basis of prior beliefs.

Ø Focusing on a particular subset of information at the expense of the overall set of information.

Ø Insufficient adjustment for subjective matters, such as market volatility

Ø The inability to learn from one’s past mistakes, such as poor trading decisions

Ø Overconfidence in one’s ability to forecast currencies accurately

Forecasting includes predicting the timing, direction, and magnitude of an exchange rate change or movement. For countries whose currencies are not freely floating, the timing is often a political decision, and it is not so easy to predict. Although the direction of a change probably can be predicted, the magnitude is difficult to forecast.

It is hard to predict what will happen to currencies & to use those predictions to forecast profits and establish operating strategies.

Factors to monitor:

For freely fluctuating currencies, the law pf supply and demand determines market value. However, very few currencies in the world float freely without any government intervention. Most are managed to some extent, which implies that governments need to make political decisions about the value of their currencies. Assuming governments use a rational basis for managing these values, managers can monitor the same factors the governments follow in order to try to predict values. These factors are:

Ø The institutional setting

· Does the currency float, or is it managed- and if so, is it pegged to another currency, to a basket or to some other standard?

· What are the intervention practices? Are they credible? Sustainable?

Ø Fundamental analysis

· Does the currency appear undervalued or overvalued in terms of PPP, balance of payments, foreign-exchange reserves, or other factors?

· What is the cyclical situation in terms of employment, growth, savings, \

· Investment and inflation?

· What are the prospects for government monetary, fiscal, and debt policy?

Ø Confidence factors

· What are the market views and expectations with respect to the political environment, as well as to the credibility of the government and central bank?

Ø Events

· Are they national or international incidents in the news; the possibilities of crises or emergencies.

Ø Technical analysis

· What trends do the charts show? Are there signs of trend reversals?

· At what rates do they appear to be important buy and sell orders? Are they balanced? Is the market overbought? Oversold?

· What are the thinking and expectations of other market players and analysts?

Business implications of exchange - rate changes

Marketing decisions:

Marketing managers watch exchange rates because they can affect demand for a company’s products at home & abroad. Strengthening of a country’s currency value could create problems for exporters. E.g.: If Sony were selling its new 42-inch plasma wega TV set for 605,000 yen, it would cost $5,500 in the United States when the exchange rate was 110 yen to the dollar. At a forecast rate of 108 yen, the TV would cost $5,601. Suppose the yen rises even more- to 105- thus increasing the price of the TV to $5,762. At this point, would consumers be willing to pay $5,762 for a new TV set, or would they wait for the cost to come down? Should Sony pass on the new price to consumers or sell at the same price & absorb the difference in its profit margin? If the yen continues to strengthen beyond 105 yen, what can Sony do?

Production decisions:

Exchange-rate changes also can affect production decisions. A manufacturer in a country where wages & operating expenses are high might be tempted to relocate production to a country with a currency that is rapidly losing value. The company’s currency would buy lots of the weak currency, making the company’s initial investment cheap. Further, goods manufactured in that country would be relatively cheap in world markets.

Financial decisions:

Exchange rates can affect financial decisions, primarily in the areas of sourcing of financial resources, the remittance of funds across national borders, & the reporting of financial results. In the first area, a company might be tempted to borrow money in places where interest rates are lowest. However, recall that interest-rate differentials often are compensated for in money markets through exchange-rate changes.

In deciding about cross-border financial flows, a company would want to convert local currency into its own home-country currency when exchange rates are most favorable so that it can maximize its return. However, countries with weak currencies often have currency controls, making it difficult for MNEs to do so. Finally, exchange-rate changes can influence the reporting of financial results.

Regional Integration:

Argument for regional integration:

The case for integration typically not accepted by many groups within a country which explains why most attempt to achieve regional economic integration has been contentious and hasting. Economic theories of international trade predict that unrestricted free trade will allow the countries to specialize in the products of goods and summon that they can produce more efficiently and economically. The result will be greater world production that would be possible with trade restriction. The regional economic integration can be seen as an attempt to achieve additional gains from the free flow of trade and investment between countries. Undoubtedly it is easier to establish a free trade and investment regions among the world community. Problem of coordination and policy harmonization are largely a function of the number of countries. The greater the number of countries involved, the greater the number of different prospective that must be reconciled, and the harder it will be reach an agreement. Thus attempts to regional economic integration are motivated by the desire to exploit the gains from free trade and investment.

Argument against regional integration:

Although tide has been running high and stronger regional free trade agreements in recent years some economy has expressed concern that benefits of regional integration have been oversold with the cost and have often been ignored. They point out the benefits of regional integration to the participants are determined by the extent of trade creation as opposed to trade diversion. Trade creation occurs when high cost domestic products are replaced by cost of production within the free trade area. Trade diversion occurs when low cost supplies are replaced by high cost supplies uniformly within the free trade area. A regional free trade agreement will benefit the world only when the amount of trade it creates exceeds the amount it diverts. In theory GATT and WTO rules should ensure that a FTA does not result in trade diversion. These rules allow FTA’s to be formed only if the members set tariffs that are not higher or more restrictive to outsiders than the once previously in effect. As a result many feel that the regional integration may result in trade satisfaction due to high tariff barriers. The trade diversion effects might well overshadow the trade creation effects. The only way to guard against these possibilities according to those concerns almost these potential is to increase the scope of the WTO. So it covers non tariff barriers to trade such as VERS.