CHAPTER 6

Exchange Rate Equilibrium

 How Exchange Rates Are
Determined?
o. How exchange rate movements
are measured.
o. How the equilibrium exchange
rate is determined
o. Factors that affect the equilibrium
exchange rates
 Exchange Rate Equilibrium
Definition
“The exchange rate at which the supply for a
currency is equal to the demand of the same
currency”.
 Equilibrium Exchange Rate
• Foreign exchange rates are affected by a number
of factors,
• the equilibrium exchange rate in turn, are also
influenced by its:
• supply and demand.

Hence equilibrium is achieved when a currency's

demand is equal to its supply.
 Exchange Rate and
Appreciation and depreciation of currency
Exchange Rate
Value of one currency in units of another currency
Depreciation
A decline in a value of currency
Appreciation
An increase in currency’s value

• If currency A can buy you more units of foreign currency,

then currency A has appreciated and foreign currency
depreciated

• If currency A can buy you less units of foreign currency,

then currency A has depreciated and foreign currency
appreciated
 Percent change in foreign currency

% change in foreign currency = S – S t-1

S t-1
Where,
S = Current Spot rate
S t-1 = Base Spot rate
If
(+) It is appreciation of foreign currency
(-) It is depreciation of foreign currency
 Equilibrium Exchange Rate
DEMAND of GBP in millions
Price Demand
1 GBP = 1.45 USD 1.45 250m
1.50 200
1.55 150
1.60 100
1.65 50
 Demand for Foreign Currency
Price of Foreign Currency (GBP)

$1.65 Demand line

$1.45
D

50m 250 m
Notice that: Units of Foreign Currency (GBP)

At low price of the currency ($1.45) the demand of the currency is high
At high price of the currency ($1.65) the demand of the currency is low
Equilibrium Exchange Rate
SUPPLY of GBP in millions
Price Supply
1.45 50m
1.50 100
1.55 150
1.60 200
1.65 250
 Supply of Foreign Currency
Price of Foreign Currency (GBP) Supply line
S
$1.65

$1.45
S

50 m 250 m
Units of Foreign Currency (£)
Notice that:
At low price of the currency ($1.45) the supply of a currency is Low
At high price of the currency ($1.65) the supply of a currency is high
 Equilibrium Exchange Rate
Price at which DEMAND of GBP = SUPPLY of GBP
Price D S
1.45 250 50
1.50 200 100
Equilibrium 1.55 150 150
1.60 100 200
1.65 50 250
Equilibrium Exchange Rate

D
S

Exchange Rate

$1.55

S
D

150

Units of Foreign Currency(£)

Factors that influence the Exchange Rate

• Relative Inflation Rates

• Relative Interest Rates
• Relative Income Levels
• Government Restrictions
• Political Events
 Relative Inflation
• High inflation in home relative to foreign country,

• Decline in value of home currency

• Why?

• Low inflation relative to home country,

• increase in value of foreign currency
• Why?
 Relative Inflation
USDemand
US Demandfor
forGBP
GBP
• inflation in US

• Demand for UK goods

• Demand of GBP by US
 Relative Inflation
UK
UKSupply
Supplyof GBP
• US goods will not be demanded by UK

• The supply of GBP for sale will decline

 INFLATION

Price D S D1 S2
1.45 250 50 300 0
1.50 200 100 250 50
Equilibrium price
1.55 150 150 200 100
New Equilibrium 1.60 100 200 150 150
1.65 50 250 100 200
OLD Equilibrium Exchange Rate

D
S

Exchange Rate

$1.55

S
D

150

Units of Foreign Currency(£)

 NEW Equilibrium Exchange Rate
Relative Inflation
D
S

$1.60 o
Exchange Rate
$1.55

S
D

150
Units of Foreign Currency(£)
 Relative Interest Rates
• High interest rates in home country relative to a
foreign country may cause domestic currency to:

• Appreciate
• Why?

• AND

• Foreign currency (GBP) to Depreciate

• Why?
 Relative Interest Rates
USUS
Demand for GBP
Demand
• interest in US

• Reduced demand for UK deposits

• Demand of GBP
 Relative Interest rates
UKUK
Supply of GBP
Supply
• High demand for US Deposits

• Supply of GBP for sale

 INTEREST

Price D S D1 S2
1.45 250 50 200 100
New Equilibrium 1.50 200 100 150 150
Equilibrium 100 200
1.55 150 150
1.60 100 200 50 250
1.65 50 250 0 300
OLD Equilibrium Exchange Rate

D
S

Exchange Rate

$1.55

S
D

150

Units of Foreign Currency(£)

NEW Equilibrium Exchange Rate
Relative Interest Rates
D
S

Exchange Rate

$1.55

$1.50 o
S
D

150
Units of Foreign Currency(£)
 Relative Income Levels
• Increase in domestic income relative to foreign
income may lead to a:

• Decline in the value of domestic currency

• Why?

• Increase in the value of Foreign currency

• Why?
 Relative Income Levels
USUS
Demand for GBP
Demand
• Income in US

• Demand for imported (UK) goods

• Demand of GBP by US
 Relative Income Levels
UKUK Supply
Supply of GBP

• No Effect
 INCOME LEVEL

Price D S D1 S2
1.45 250 50 300 50
1.50 200 100 250 100
Equilibrium 1.55 150 150 200 150
New Equilibrium 1.575 125 175 175 175
1.60 100 200 150 200
1.65 50 250 100 250
 Relative Income Levels

D
S

Exchange Rate $1.575

$1.55

S
D

175
Units of Foreign Currency(£)
Government Restrictions
Changes in Current Exchange Rate may
affect Expected Returns
Depreciation of home currency
It lowers the expected home currency return from
foreign currency deposits.

Appreciation of home currency

It increases the home currency return expected from
foreign currency deposits.
PROBLEM 1 Speculation
• Blue demon bank expects that the MXP will
depreciate against USD from its spot rate of $0.15
to $0.14 in 10 days
• The following interbank rates exist:

Currency Lending rate Borrowing rate

USD 8.0% 8.3%

MXP 8.5% 8.7%

 INSTRUCTIONS
• Assume the blue demon bank has a borrowing
capacity of either $10 million or 70 million pesos
in the interbank market, depending on which
currency it wants to borrow.

a. How could blue demon bank attempt to

capitalize on its expectations without using
deposited funds? –
- Estimate the profits that could be generated from
this strategy.
HINT Rates

Currency Lending rate Borrowing rate

USD 8.0% 8.3%

MXP 8.5% 8.7%

Bank can capitalize on expectations about MXP as follows

1. Borrow MXP 70 million

2. Convert the MXP 70 million to dollars

@current rate
MXP 70,000,000 * $0.15
= $ 10,500,000
3. Lend the USD through the interbank
market at 8.0% annualized over a 10 day
period.

The amount accumulated in 10 days is:

$ 10,500,000 * [ 1+ ( 8% * 10/ 360) ]
= $ 10,500,000 * [ 1.002222]
= $ 10,523,333
4. Repay the peso loan.
The repayment on the peso loan is:
MXP 70,000,000 * [ 1 +(8.7% * 10 / 360)]
= 70,000,000 * [ 1.002417]
= MXP 70,169,167

5. Based on the expected spot rate of $0.14, the

amount of dollars needed to repay the peso loan is:
MXP 70,169,167 * $ 0.14
= USD 9,823,683
6. After repaying the loan. Blue Demon bank will
have a speculative profit
(if its forecasted exchange rates are accurate).

$ 10,523,333 - $ 9,823,683

= USD 699,650
 Calculation of Profit in MXP

MXP 75,166,664
MXP 70,169,167
Profit: MXP 4,997,497

• ($10,523,333 / 0.14 = MXP 75,166,664)

 (b)
• Assume all the preceding information with this
expectation:

• Blue demon bank expects the peso to appreciate

from its present rate of $0.15 to $0.17 in 30 days.

• How could it attempt to capitalize on its

expectations without using deposited funds?

• Estimate the profits that could be generated from

this strategy.
 Rates
Currency Lending rate Borrowing rate

USD 8.0% 8.3%

MXP 8.5% 8.7%

 HINT Rates
Currency Lending rate Borrowing rate

USD 8.0% 8.3%

MXP 8.5% 8.7%

Bank can capitalize on expectations about MXP as follows

1. Borrow 10 million USD

2. Convert the 10 million USD to MXP

@Current Rate
USD 10,000,000 / $0.15
= MXP 66,666,667
3. Lend the MXP through the interbank market at
8.5% annualized over a 30 day period.
The amount accumulated in 30 days is:

MXP 66,666,667 * [ 1+ ( 8.5% * 30/ 360) ]

= 66,666,667 * [ 1.007083 ]
= MXP 67,138,889
4. Repay the USD loan.
The repayment on the USD loan is:
USD 10,000,000 * [ 1 +(8.3% * 30 / 360)]
= 10,000,000 * [ 1.006917]
= USD 10,069,170

5. Convert the peso to USD to repay the loan.

The amount of USD to be received in 30 days
(based on the expected spot rate of $ 0.17)
MXP 67,138,889 * $ 0.17
= USD 11,413,611
6. The profits are determined by estimating
the USD available after repaying the loan:

• USD received in 30 days: 11,413,611

• Repayment on USD loan: 10,069,170

$ 11,413,611 - $ 10,069,170
= USD 1,344,441
PROBLEM Speculation
• Diamond bank expects that the Singapore Dollar
will depreciate against USD from its spot rate of
$0.43 to $0.42 in 60 days
• The following interbank rates exist:

Currency Lending rate Borrowing rate

USD 7.0% 7.2%

SPD 22% 24%

 Instructions
• Diamond bank considers borrowing $10
million Singapore Dollars in the interbank
market and investing the funds in dollars for
60 days.

• Estimate the profits (or loss) that could be

from this strategy.

• Should Diamond bank pursue this strategy?

HINT Speculation
• Diamond bank considers borrowing $10 million
Singapore Dollars

Currency Lending rate Borrowing rate

USD 7.0% 7.2%

SPD 22% 24%

Answer
• Borrow S $ 10 million & Convert to USD @ Spot
S $ 10,000,000 * $0.43 = $ 4,300,000

• Invest the funds for 60 days in USD

The rate earned in the USD for 60 days is:
7% * (60/360) = 1.17%

• The amount accumulated in 60 days is:

$ 4,300,000 * (1+ 0.0117)
= $ 4,350,310
• Convert USD back to S $ in 60 days
@ Expected Rate:

USD 4,350,310/ $ 0.42

= S $ 10,357,881

• The rate to be paid on loan is 24%

Therefore,
0.24 * (60/360)
= 0.04
• Amount owed on S $ loan is:
S $ 10,000,000 * (1 + 0.04)
= S $ 10,400,000

• This strategy results in a loss:

Ended with S $ 10,357,881
To be paid S $ - 10,400,000
loss =S$ - 42,119

Therefore,
Diamond Bank should not pursue this strategy