Download Factors Affecting Exchange Rates: Interest Rates, Inflation, Growth, & Government Interven and more Slides Management Fundamentals in PDF only on Docsity! Factors That Affect the Equilibrium Exchange Rate: Changes in Demand Relative (short-term) interest rates. Affects the demand for financial assets (increase demand for high interest rate currencies). Relative rates of inflation. Affects the demand for real (goods) and financial assets; hence the demand for currencies Low inflation results in increase global demand for a country’s goods. Low inflation results in high real returns on financial assets. Relative economic growth rates. Affects longer term investment flows in real capital assets (FDI) and financial assets (stocks and bonds). Changes in global and regional risk. Safe Haven Effects: Foreign exchange markets seek out safe haven countries during periods of uncertainty. Docsity.com
Safe Haven Effect: September 11, 2001
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Appreciation against USD since midnight Sep 10, %
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Sep 11 14:46 CET:
Plan crashes into tower one
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06:00 12:00 18:00 += 00:00» 06:00 = 12:00 ~—18:00
September 11 and 12, 2001 (CET)
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Factors That Affect the Equilibrium Exchange Rate: Government Interest Rate Adjustments Some governments may also use interest rate adjustments to influence their currencies. When a currency become “too weak:” Governments might raise short term interest rates to encourage short term foreign capital inflows. Higher interest rates make investments more attractive and increase demand for the currency. When a currency becomes “too strong:” Governments might lower short term interest rates to discourage short term foreign capital inflows. Lower interest rates will make investments less attractive and reduce the demand for the currency. Docsity.com Factors That Affect the Equilibrium Exchange Rate: Carry Trade Strategies Carry trade strategy: A foreign exchange trading strategy in which a trader sells a currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. This strategy offers profit not only from the interest rate difference (overnight interest rate) but additionally from the currency pair’s fluctuation. An example of a "yen carry trade": A trader borrows Japanese yen from a Japanese bank, converts the funds into Australian dollars and buys an Australian bond for the equivalent amount. If we assume that the bond pays 4.5% and the Japanese borrowing rate is 1.0%, the trader stands to make a profit of 3.5% as long as the exchange rate between the countries does not change. In this example, the trader is short on yen and long on Australian dollars. Docsity.com Impact of Carry Trades on Exchange Rates Carry trades can result in a huge amount of capital flows in and out of currencies. High interest rate currency will experience increase demand. Low interest rate currency will experience increase in supply. Combined this will result in a strengthening of the high interest rate currency against the low interest rate currency. However, when traders reverse their positions, the opposite exchange rate effects will occur. When do they reverse: During periods of increasing global uncertainty about interest rates and exchange rates. For a case which combines carry trade and government intervention, please see: Case Study: New Zealand Central Bank Intervention in the Foreign Exchange Market, June 11, 2007 (posted on course web site). Docsity.com
