1.
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Demand and supply of currency
2.
Sterling is sold on foreign exchange markets when Goods and services are imported (domestic consumers and firms sell sterling to finance their purchase of imports or when they go overseas on holiday) Speculators sell pounds for another currency Investment capital flows out of the UK seeking a better rate of return Central banks go into the market and sell pounds to buy other foreign currencies. When the demand for sterling is high relative to supply, sterling goes up in value (an appreciation). The reverse is true when the market supply of pounds exceeds the demand (a depreciation).
The role of interest rate
International financial investors have an incentive to shift toward dollar-denominated assets, and this increases the demand for dollars in the foreign exchange market. The dollar tends to appreciate immediately. Furthermore, we can determine that the dollar should appreciate to about $0.4975 per SFr, assuming that the interest rates and the expected future exchange rate do not change. Once this new current spot exchange rate is posted in the market , the SFR then is expected to appreciate during the next 90 days at a faster rate, equal to about 6 percent. This re-established uncovered interest parity (5 percent interest plus about 6 percent expected appreciation matches the 11 percent American interest) and eliminates any further desire by international investors to reposition their portfolios.
The role of the expected future spot exchange rate
Example: with the US interest rate at 9 percent, the Swiss interest rate at 5 percent, and the current spot exchange rate at $0.50 per SFr, what happens if the spot exchange rate expected in 90 days increases from about $0.505 to about $0.515 per SFr? Relative to the initial current spot rate, investors now expect the franc to appreciate more in the next 90 days, at about a 12 percent annual rate rather than the previously expected 4 percent. This shifts the return differential in favour of Swiss currency assets and the demand for the franc increases in the foreign exchange market. The current spot exchange rate increases ( the franc appreciates and the dollar depreciates). In fact the spot exchange rate moves to about $0.51 per SFr. At the new spot rate, the franc then is expected to appreciate further by only about 4 percent (annual rate). Uncovered interest parity is re-established, and there is no further incentive for international investors to reposition their portfolios. As with a change in interest rates, the effect of a change in the expected future spot rate on the current spot exchange rate can happen very quickly (instantaneously or within a few minutes)
Demand and supply of currency
Short and long-term movements in the exchange rate, like any price, are caused by changes in market demand and supply conditions. Taking pound for example: The demand for pounds in the FOREX markets comes from four main sources: UK good and services are exported overseascreating an inflow of currency into to the UK which needs to be turned into sterling. Foreign investment flows into the UK economy Market speculators decide they want to purchase pounds in the expectation of making a profit Official buying of the currency by the central bank.
The role of interest rate
Foreign exchange markets seem sensitive to movements in interest rates. Jumps of exchange rates often follow changes in interest rates. If domestic interest rate (i) increases, while the foreign interest rate (if) and the spot exchange rate expected at some appropriate time in the future (eex) remain constant, the return shifts in favour of investments in assets denominated in domestic currency. Example: initially the American interest rate is 9%, the Swiss interest rate is 5% per year, the current spot rate is $0.50 per SFr, and the expected future spot rate in 90 days is $0.505 per SFr, implying that the franc is expected to appreciate at an annual rate of about 4%. What happens if the U.S. interest rate increases to 11%?
International Finance-2010
Chapter 5: What determines exchange rates Tutor: X. Zhang
Topics Covered
Introduction Exchange Rates in the Short Run The Long Run: Purchasing Power Parity (PPP) The Long Run: Monetary Approach How Well Can We Predict Exchange Rates?
The role of the expected future spot exchange rate