Determination of Exchange Rates,

Exchange Rate Dynamics and Intervention

Exchange Rate Terminologies

Exchange Rate the price of one nations currency in terms
of another currency, the numerator being the reference
currency.
a. Spot Rate the price at which currencies are traded
for immediate delivery, or in two days in the interbank
market.
b. Forward Rate the price at which foreign exchange
quoted for delivery at a specified future date.

is

Currency Devaluation/Depreciation the decrease in the

stated value of a pegged currency, one whose value is set by
the government.
Currency Revaluation/Appreciation the increase in the par
value of a pegged currency.
Floating Currency one whose value is set by the market
forces.

Determination of Exchange Rates

The Foreign Exchange (Forex) Market
Forex Market network of markets and institutions that
handle foreign currency. The commodity being bought and
sold is the foreign currency.
a. Spot Market deals with currency transactions for
immediate delivery, or in two days. (over the counter)
b. Forward Market deals with currency transactions
for delivery at a specified future date.

Determination of Exchange Rates

The Foreign Exchange (Forex) Market
What would the possible reasons why people would want to
buy foreign currency? (Demand for foreign currency)
a. Travel/Tourism (domestic residents who want to
travel abroad)
b. Trade (purchase of goods and services by domestic
residents from another country)
c. Investment (financial and/or real investments by
domestic residents in another country)
d. Speculation and hedging (expectations by domestic
residents on the foreign currency.

Determination of Exchange Rates

The Foreign Exchange (Forex) Market
What would the possible reasons why foreigners would
want to buy our domestic currency? (Supply for local
currency)
a. Travel/Tourism (foreign residents who want to
travel the domestic country)
b. Trade (purchase of domestic goods and services by
foreign residents)
c. Investment (financial and/or real domestic
investments by foreign
residents)
d. Speculation and hedging (expectations by foreign

Determination of Exchange Rates

The Foreign Exchange (Forex) Market
In summary, the following are factors that affect the
DEMAND and SUPPY in the forex:
a. Exchange rate
b. Real Rate (domestic)
c. Real Rate (foreign)
d. Inflation Rate (domestic)
e. Inflation Rate (foreign)
f. Expectations (speculations)

Determination of Exchange Rates

Factors Affecting Supply and Demand
Relative Inflation Rates (domestic)

Growth in the money supply would cause the price of domestic goods
and services to rise relative to those in other countries
Domestic residents may get to find foreign goods and services
cheaper and may switch consumption from domestic to foreign goods
Higher domestic inflation should lead to a depreciation of the local
currency

Determination of Exchange Rates

Factors Affecting Supply and Demand (Shapiro and
Sarin, 2009)
Relative Interest Rates

Higher interest rates may attract foreign capital inflow (provided a

rise in real interest rates)
Higher real interest rates will cause the domestic currency to
appreciate

Relative Economic Growth

Strong economic growth attracts foreign capital

The production of high quality products lead to higher demand by both
domestic and foreign consumers

Determination of Exchange Rates

Factors Affecting Supply and Demand
Political and Economic Risks
Politically stable nations generate less risky assets
Capital seeks safe havens for investments and the currency of such
havens would appreciate

Determination of Exchange Rates

Participants in the Forex Market

Bank and Non-Bank Forex Dealers

Individuals and Firms conducting International
Commercial and Investment Transactions
Speculators and Arbitrageurs
Central Banks and Treasuries
Forex Brokers

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Calculating Exchange Rate Changes

The amount of currency appreciation or depreciation is

computed as the percentage increase or decrease in value of the
domestic currency in terms of another currency

KenYu: If less of a foreign currency is required to buy a

domestic currency, that means that the domestic currency has
depreciated. If there a + sign, appreciation; - sign, depreciation.
Tip: In computing for the appreciation/depreciation, the DC is
the base currency!
Sample Problem 1:
In 2002, the yen went from $0.0074074 to $0.0084746. By
how much did the yen appreciate against the dollar?
By how much has the dollar depreciated against the yen?
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Calculating Exchange Rate Changes

2nd Sample Problem:

On April 1, 1998, the government of Yugoslavia

devalued the Yugoslav dinar, setting its new
rate at 10.92 dinar to the dollar, from 6 dinar
previously.
By how much has the dinar devalued against the
dollar?
By how much has the dollar appreciated against the
dinar?

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Calculating Exchange Rate Changes

3rd Sample Problem:

On July 2, 1997, the Thai baht fell 17% against the

US$. By how much has the dollar appreciated
against the baht?

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