FIN 6303 International Finance

UNIT III STUDY GUIDEExchange Rate Behavior
Course Learning Outcomes for Unit III
Upon completion of this unit, students should be able to:
2. Examine critical relationships pertaining to foreign currency exchange rates.
2.1 Assess government influence on exchange rate behavior.
2.2 Summarize international arbitrage.
2.3 Explain interest rate and purchasing power parity.
Required Unit Resources
Chapter 6: Government Influence on Exchange Rates
Chapter 7: International Arbitrage and Interest Rate Parity
Chapter 8: Relationships among Inflation, Interest Rates, and Exchange Rates, pp. 259–268
Unit Lesson
Influence From Government
Government policies affect exchange rates directly via specific policies or indirectly due to policies intended to
affect economic conditions. Governments of foreign countries can influence exchange rates through different
types of barriers and by intervening in the foreign exchange markets (Madura, 2021). Trade barriers can
include things like taxes on imports, and these come in the form of quotas, tariffs, and non-tariffs. Tariffs are
often imposed on goods such as technology, oil, and vehicles. Governments also influence the equilibrium
exchange rate through inflation, interest rates, and income levels. It is important for finance managers to
understand how governments influence exchange rates because the exchange rate has a direct impact on
the performance of the multinational corporation (MNC).
Systems of Exchange Rates
Exchange rate systems are classified as fixed, freely floating, managed float, or pegged, depending on the
amount of government control (Madura, 2021). If an exchange rate system is considered fixed, this means the
rate either stays the same or is only allowed to move slightly. A freely floating system is the mirror image of
the fixed system. This system allows for complete flexibility and adjusts continually in response to supply and
demand. Market forces control exchange rates that are freely floating, and they do so without any intervention
from government or other entities. In other words, the invisible hand of the market controls the exchange rate.
Managed float systems do not restrict boundaries of movement, but they are subject to government
intervention. Pegged systems pin or peg the value of a currency to a foreign currency and either move with
that currency or against other currencies.
Direct and Indirect Intervention
Monetary policy controls the growth of the money supply in a country. The policy is carried out by the central
bank of a country and aims to maintain economic growth and keep inflation low. There are several reasons a
country might use direct intervention. If exchange rate movements are too radical, governments might use
direct intervention to try and stabilize the rate. Another reason for direct intervention is to create clear
exchange rate restrictions that set a boundary in which the rate can move. Lastly, governments can use direct
intervention as a response to temporary market disturbances.
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One way that governments can directly intervene in the exchange rate is to purchase
or sell currencies
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GUIDE in the
foreign exchange market. The government purchase of its currency alters supply
and demand, puts upward
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pressure on the currency’s equilibrium value, and ultimately changes the currency’s equilibrium values. If a
government sells a currency, downward pressure is put on the currency’s equilibrium value. Governments use
indirect measures to affect exchange rates by influencing economic factors, such as increasing interest rates
to bring in more international cash flows. This can cause the local currency to appreciate; however, it does not
always work.
International Arbitrage
Arbitrage is a strategy that capitalizes on a discrepancy in quoted prices in search of a riskless profit. In other
words, it is the process of buying a currency when its price is low and selling when the price is high. This
strategy carries no risk and does not restrict investor funds. Hypothetically, an investor could purchase 1
million euros in New York for $1.1 million and sell them immediately in Germany for $1.2 million for a pure
profit of $100,000. This strategy is self-regulating because if everyone tried to capitalize on this opportunity,
the demand for euros in New York would drive up the price of euros there and drive down the dollar price of
euros in Germany. Any difference in exchange rates would disappear very quickly. Opportunities for arbitrage
are few, small, and short-lived. There are three common types of international arbitrage that can be applied to
foreign exchange and international money markets; they are locational, triangular, and covered interest
arbitrage.
Locational Arbitrage
Locational arbitrage takes place when a currency is purchased at one bank and then immediately sold at a
bank at a different location for a profit. Locational arbitrage can occur if foreign exchange quotes are different
between banks. When supply and demand for a currency are different among banks, prices may differ. In
theory, the act of locational arbitrage will force the foreign exchange rate quotes of the banks to realign,
eliminating the possibility of locational arbitrage. Foreign exchange dealers that continuously monitor bank
quotes practice this type of arbitrage. Trades that take advantage of locational arbitrage earn an immediate
risk-free profit. Profit from these types of currency trades is based on the amount of money traded and the
size of the discrepancy.
Triangular Arbitrage
There is a connection between triangular arbitrage and cross exchange rates. Cross exchange rates are
determined between two currencies by the values of these currencies with respect to a third currency. Looked
at from the perspective of the United States, cross rates represent the relationship between two currencies
other than the dollar. When actual cross exchange rates differ from the rate that should exist, then triangular
arbitrage becomes possible. When there is a divergence in cross exchange rates between two currencies,
triangular arbitrage can become a profit opportunity. In comparison to locational arbitrage, triangular arbitrage
also carries no risk, nor does it use investor funds because the purchase and sale are immediate. Triangular
arbitrage forces cross exchange rates to realign, rendering triangular arbitrage impossible again.
The impact of triangular arbitrage is that exchange rates are quickly brought back into equilibrium. When
investors use dollars to purchase a foreign currency, the bank will increase the ask or buy price for that
currency with respect to the dollar. The investor then uses the foreign currency to purchase a second foreign
currency. The bank then reduces its bid or sell price for the first foreign currency with respect to the second
foreign currency, which reduces the number of the second foreign currency to be exchanged for the first
foreign currency. As a result, the investor uses the second currency to circle back and purchase U.S. dollars
at which time the bank will reduce its bid price of the second foreign currency with respect to the dollar.
Realignment occurs quickly, eliminating any continued benefit.
Covered Interest Arbitrage
Covered interest arbitrage states that the size of the premium or discount of the forward rate of a currency
should be nearly equal to the differential of the interest rates between countries (Madura, 2021). This type of
arbitrage is founded on the relationship between the premium of the forward rate and the gap in the interest
rate. Generally speaking, the forward rate of the foreign currency will be discounted if the foreign country’s
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interest rate is higher than the U.S. interest rate. To be possible, the forward premium
must beGUIDE
markedly
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different from the interest rate.
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The idea behind covered interest arbitrage is to take advantage of the variance in the interest rates of the
countries of interest. Exchange rate risk is covered with a forward contract. Covered interest arbitrage can be
separated into two parts. First, interest arbitrage denotes profiting from the gap between two countries’
interest rates. Second, covered arbitrage means the position is hedged against any exchange rate risk.
Locational and triangular arbitrage are risk free and do not tie up investor funds. The same cannot be said for
covered interest arbitrage. Funds are tied up for some period, so if an investor can earn the same return on a
domestic deposit, then covered interest arbitrage would not be advantageous. In the case of covered interest
arbitrage, as with the other types of arbitrage, market forces will rather quickly cause the market to readjust.
Interest Rate Parity
Interest rate parity (IRP) is the equilibrium state that occurs when market forces bring interest rates and
exchange rates back into alignment. When this happens, covered interest arbitrage ceases to be a possibility.
In a state of equilibrium, the forward rate will be significantly different than the spot rate—enough so that the
interest rate variances between two currencies will be counterbalanced. When the foreign interest rate is
higher than the domestic interest rate, the forward rate should include a discount equal to roughly the
difference between the two rates. In contrast, if the foreign interest rate is less than the home country’s
interest rate, a premium should be included with the forward rate that is near the difference of the two rates.
According to IRP theory, the amount of the forward premium or discount should equal the interest rate
differential of focus. Therefore, due to interest rate parity covered, interest arbitrage is not feasible. This is
because the interest rate advantage is offset by the discount on the forward rate. As a result, covered interest
arbitrage cannot typically bring better returns than what could be gained through an equal domestic
investment.
Purchasing Power Parity Theory
One factor that has significant influence on exchange rates is inflation. This connection between inflation and
exchange rates is known as purchasing-power parity (PPP) and plays an important role in foreign exchange
risk and exposure. It is an idea made popular by Gustav Cassell (1918) in the early 1900s. The relationship
between exchange rates and commodity prices is known as the law of one price.
This law states that a commodity will have the same price in terms of a common currency in every country.
This means that the dollar price of a commodity in the United States equals the pound price of a commodity in
Britain multiplied by the spot exchange rate of dollars per British pound. It is important to note that costs like
transportation costs and import tariffs can cause deviations from this relationship. There are two main types of
PPP theory, which are absolute and relative.
The absolute form of PPP is supported by the theory that, given no international barriers, consumers will
choose prices that are the lowest. This shift in demand to the lowest price will continue until the lower inflation
in the foreign country is countered by the strengthening of the currency. This indicates that prices of a pile of
goods in two countries will be equivalent when measured using the same general currency. Any discrepancy
in price will result in a shift in demand until prices equalize. The relative form of PPP accounts for
imperfections in the market (e.g., transportation, taxes). In this form, PPP states the rate of change of the
exchange rate is equal to the approximate difference between inflation rates.
References
Cassel, G. (1918, December). Abnormal deviations in international exchanges. The Economic Journal,
28(112), 413–415. https://www-jstor-org.libraryresources.columbiasouthern.edu/stable/2223329
Madura, J. (2021). International financial management (14th ed.). Cengage Learning.
https://bookshelf.vitalsource.com/#/books/9780357130667
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