tailieunhanh - Lecture International finance: An analytical approach (2/e) – Chapter 4: Exchange rate determination and related issues

The goals of this chapter are: To identify the factors causing changes in the exchange rate, to illustrate the effect of arbitrage and speculation, to explain how the bid-offer spread and the forward spread are determined, to examine the AUD exchange rate determination. | Chapter 4 Exchange Rate Determination and Related Issues Objectives To identify the factors causing changes in the exchange rate. To illustrate the effect of arbitrage and speculation. To explain how the bid-offer spread and the forward spread are determined. To examine the AUD exchange rate determination. Some Stylised Facts The exchange rate follows approximately a random walk with little or no drift. The spot and forward rates tend to move in the same direction and by approximately the same amount. There is no correspondence between exchange rates and prices. Some Stylised Facts (cont.) There is no strong relationship between the exchange rate and the current account. Rapid monetary expansion leads to rapid currency depreciation. The Equilibrium Exchange Rate S(d/f) Sf Df Q f Factors Affecting the Supply of and Demand for FX Relative inflation rates Relative interest rates Relative growth rates The government Expectations The Effect of a Higher Domestic Inflation Rate S(d/f) Sf Df Q f The Effect of a Higher Domestic Interest Rate S(d/f) Sf Df Q f Arbitrage in the FX Market Arbitrage is the simultaneous purchase and sale of currencies to capitalise on anomalies in quoted exchange rates. It is triggered by the violation of an equilibrium condition. Two-Point Arbitrage Also known as spatial or locational arbitrage, it arises when the following condition is violated: Three-Point (Triangular) Arbitrage It is trigged when cross exchange rates are inconsistent, . when the following condition is violated: The Profitable Sequence x z y (a) Unprofitable sequence z x y (b) Profitable sequence Multipoint Arbitrage The condition precluding multipoint arbitrage is: Five-Point Arbitrage AUD (a) Clockwise USD EUR GBP JPY Five-Point Arbitrage (cont.) (b) Anti-clockwise AUD USD EUR GBP JPY Speculation in the FX Market Speculators buy and sell currencies on the basis of certain expectations about the future movements of exchange rates. Destabilising and Stabilising . | Chapter 4 Exchange Rate Determination and Related Issues Objectives To identify the factors causing changes in the exchange rate. To illustrate the effect of arbitrage and speculation. To explain how the bid-offer spread and the forward spread are determined. To examine the AUD exchange rate determination. Some Stylised Facts The exchange rate follows approximately a random walk with little or no drift. The spot and forward rates tend to move in the same direction and by approximately the same amount. There is no correspondence between exchange rates and prices. Some Stylised Facts (cont.) There is no strong relationship between the exchange rate and the current account. Rapid monetary expansion leads to rapid currency depreciation. The Equilibrium Exchange Rate S(d/f) Sf Df Q f Factors Affecting the Supply of and Demand for FX Relative inflation rates Relative interest rates Relative growth rates The government Expectations The Effect of a Higher Domestic Inflation Rate S(d/f) Sf Df