APC313 FINANCIAL MARKET

ASSIGNMENT COVER SHEET

UNIVERSITY OF SUNDERLAND
BA (HONS) BANKING AND FINANCE
Student ID: 179061246/1
Student Name: Nguyen Thuy Linh
Module Code: APC313

Module Name / Title: Financial Markets
Centre / College: Banking Academy of Viet Nam
Due Date: 12 Jan 2018

Hand in Date: 12 Jan 2018

Assignment Title: Individual assignment

Students Signature:

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Financial Market
APC313

Prepared by: Nguyen Thuy Linh
Student ID: 179061246/1
Submission Date: Jan 12 th, 2018

Word count: 3,833
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Table of Contents
Question 1 ............................................................................................................................ 4
Question 2 .......................................................................................................................... 15
Question 3 .......................................................................................................................... 16
Question 4 .......................................................................................................................... 20
Reference ........................................................................................................................... 23
APPENDIX ........................................................................................................................ 27

3


Question 1
1. Overview
According to Bloomberg, China is belongs to top 20 Emerging Markets (2013). Shanghai Securities
Exchanges (SSE) started formal operations on November 26, 1990 (SSE, 2016). Also according to
the SSE overview, SSE has developed a comprehensive portfolio of bonds, stocks, funds and
derivatives products and world-class exchange systems and one of the largest exchanges in the world
in the global rankings has SSE (2016). SSE has three major operations is issuing, listing and trading.
1.1 Issuing
Issuing shares is inviting the public to buy shares (Jain, 2015). Here are the conditions of SSE for
issuing:
- A limited liability company converted into a company limited by legal shares and obtained consent
and approval from the State Council, that company may issue shares to the public by offering shares.
- All business activities of the issuing organization must be implemented in accordance with the
provisions of law and the industrial policies of the State.
- The issuer should not have any change in key performance, director or senior management and has
not changed the actual supervisor in the past three years.
(SSE, 2016)
1.2 Listing

Listing is the admission of a company's securities for trading on the stock exchange (James, 2014).
To listing IPO shares the issuer applies to SSE must meet the conditions below:
- The total share capital of the issuer must be more than 50 million Yuan (RMB).
- China Securities Regulatory Commission (CSRC) approval is required for stocks that have been
issued to the public.
- Issuers must ensure that their accounting records are free of false records and that there has been no
record of major law violations within the past three years.

4


(SSE, 2016)
1.3 Trading
Trading securities are special assets such as bonds or stocks of the company to generate profits by
buying and selling in the short term. Here are the basic rules for the trading:
- The transaction must comply with the Securities Law of the People's Republic of China. In order to
protect the legitimate interests of investors as well as to protect the order of the stock market, it must
abide by the laws of state agencies and the Constitution of the Shanghai Stock Exchange.
- Trading in securities will be subject to the principles of fairness, publicity and justice.
- All securities trading activities are conducted on the principle of voluntariness, honesty, indemnity
and good faith according to regulations of the Ministry of Foreign Affairs and the Exchange.
(SSE, 2006)
The trading process of SSE is as follows: Stock trading on the SSE is conducted through the
Shanghai Stock Exchange. It is done through auctions focused on automated computer systems, then
all orders are placed by open auctions through the main computer will automatically incorporate
orders based on the principle give priority to time and price. Orders are sent to the main computer
through the seats of SSE members on the stock exchange.
(Javvin, 2008)

2. Evaluate the effectiveness of the activity

2.1 Basic form of Efficient Market Hypothesis (EMH)
A market where stock prices reflect the basic information of companies is called efficient stock
market (Degutis and Novickytė 2014). According to Allen, Myers and Brealey, an effective market
occurs when it is impossible to earn higher returns than the market returns (2011). Degutis and
Novickytė also said that market efficiency has three basic forms: Weak forms, semi-strong form and
strong forms (2014).

5


2.1.1 Weak forms EMH
All information contained in the past behavior of the price belong to asset is determined to be weak
form (Howells and Bain, 2005, p.543). In order to determine the weak form, can run the distribution
model to examine the randomness of volatility of stock prices and use serial correlation technique's
data analysis to test the independence of the next price movement (Ajao and Osayuwu, 2012). After
testing, if subsequent price changes of equity-traded stocks are random and independent so this
capital market is belong to weak form.
2.1.2 Semi-strong form EMH
Semi-strong form is reflected by all current and past public information, not just through stock prices
(Mishkin and Eakins, 2011, p.121). The appropriate direct to test of strong-form efficiency is the
study of events (Derdas, 2009). This research aim to determine the market response to events and
information published. In more detail for the purpose of this test is publicly information and events
such as stock splits, acquisitions and mergers may affect the price of the stock.
2.1.3 Strong form EMH
According to Keane, a strong market is effective when stock prices are fully reflected through not
only published information but also all unpublished information and data (1983). It means that, even
for those who have access to insider information such as major shareholders or general director cannot exploit the information to find benefits for them. In practice, there are strict rules and regulations
that prohibit the use of internal information to trade in financial markets (Mishkin and Eakins, 2011).

3. Literature Review

According to Chung's assessment of the Chinese stock market from 1992 to 2005, he said that the
Chinese stock market like the emerging stock markets also was not as effective in terms of
information (2006). The research of Chung use the random walk hypothesis and examined the
effectiveness of two major stock markets in China using the daily data three Shenzhen index chains
and three Shanghai index chains from 1992 to 2005. The author uses this method to determine the

6


time series predictions in Chinese stocks that violate the random walk hypothesis, it represents past
stock changes that cannot be used to predict stock prices in the future. The results of the statistical
test indicate that China's two main stock markets are Shanghai and Shenzhen are not a weak-form
market.
According to Niblock and Sloan, two authors examined the efficiency of weak-form market models
in four Chinese stock markets “Shenzhen A”, “Shenzhen B”, “Shanghai A” and “Shanghai B” in the
2002-2005 period and the authors also use the theory of the random walk to show the predictability
of China's stock indices and together with some evidence of predictability in recent (2007). The
results of the study show that the stock market in China is not weak-form efficient (Niblock and
Sloan, 2007).
In contrary, Xinping also studied the effectiveness of the Chinese stock market through two major
stock markets, Shenzhen and Shanghai. To determine the effectiveness of the Chinese stock market,
Xinping used random walk theory and divide the data sample then applied the GLS, DF, PP KPSS
and ADF tests on stock market returns to be able to test the original unit in the data series in each
Shanghai and Shenzhen stock markets (2010). The results of this study show that the data series is
unstable so the Chinese stock market is belong to weak-form efficient market.

4. Testing
4.1 Data
To test the effectiveness of the activity on market, firstly, Shanghai Composite Index is the market

selected for research within 90 days from 17th July to 24th November 2017. Secondly, the five
companies listed on the Shanghai Composite Index are Aeolus Tyre Co. Ltd, Jinneng Science and
Technology Co. Ltd, SINOPEC Shanghai Petrochemical Co. Ltd, Datang International Power
Generation Co. Ltd and Greenland Holdings Corp Ltd are also used to testing. All information about
the closing price of Shanghai Composite Index and 5 companies are taken from Investing.com source
(For more detail please refers to Appendix 1).
4.2

Methodology

4.2.1 Daily Return

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R i = P t – Pt-1

Formula:

Pt-1
Ri: Daily Return of Stock.
Pt: Daily close price of stock at time.
Pt-1: Daily close price of stock at time (t-1).
(For more detail about daily return of SSE and five companies from 17th July to 24th July please
refers to Appendix 2)

4.2.2 Weak-form Test

3.00%
2.00%

1.00%
0.00%

-1.00%
-2.00%
-3.00%

Figure 1: SSE Daily Return
6.00%
4.00%
2.00%
0.00%
-2.00%
-4.00%
-6.00%

10.00%

5.00%
0.00%
-5.00%

-10.00%

Figure 2: Daily Return of Datang International

Figure 3: Daily Return of Aeolus Tyre Co. Ltd

Power Generation Co. Ltd

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10.00%

15.00%
10.00%

5.00%

5.00%
0.00%

0.00%

-5.00%
-5.00%

-10.00%
-15.00%

-10.00%

Figure 4: Daily Return of Greenland Holdings

Figure 5: Daily Return of Jinneng Science &

Technology Co. Ltd

Corp. Ltd

6.00%
4.00%
2.00%

0.00%
-2.00%
-4.00%
-6.00%

Figure 6: SINOPEC Shanghai Petrochemical Co. Ltd

Looking at the line graph of SSE, it can be seen that the daily return index of this Index from 17th
July to 24th November has many fluctuations. There are three fluctuations that are most apparent on
17th July, the daily return index fell sharply to -1.43% and then to 11th August, dropped to -1.63%
and on 23rd November, the sharpest drop in three months to -2.26%.
The daily return index of Datang International Power Generation Co. Ltd and Aeolus Tire Co. Ltd
also has a lot of fluctuations special in 17th July, when share price of two companies dropped sharply
to 3.62% and -7.66% respectively.
It is clear that all three shares of Greenland Holdings Corp Ltd, Jinneng Science and Technology Co.
Ltd and SINOPEC Shanghai Petrochemical Co. Ltd decline on 17th July, 11th August and 23rd
November. In particular on 17th July, two shares of Greenland Holdings Corp Ltd and Jinneng
Science and Technology Co. Ltd had the strongest drop and were -5.43% and -9.29% respectively.

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Datang
International
Power

Generation
Co. Ltd
Aeolus Tire
Co. Ltd
Greenland
Holdings Corp
Ltd
Jinneng
Science and
Technology
Co. Ltd
SINOPEC
Shanghai
Petrochemical
Co. Ltd

Datang
International
Power
Generation
Co. Ltd
1

Aeolus Tire
Co. Ltd

Greenland
Holdings
Corp Ltd

Jinneng
SINOPEC
Science and
Shanghai
Technology Petrochemical
Co. Ltd
Co. Ltd

0.207177

1

0.356462

0.169065

1

0.367561

0.346837

0.252131

1

0.399142

0.001727

0.249996

0.111453

1

Table 1: Correlation Test of 5 companies

This table shows the correlation of daily indexes of 5 companies. The highest correlation was at 39%
between SINOPEC Shanghai Petrochemical Co. Ltd and Datang International Power Generation Co.
Ltd and lowest at 0.1727% between companies Aeolus Tire Co. Ltd and SINOPEC Shanghai
Petrochemical Co. Ltd.

In general, from charts analyzing the daily index of 5 companies, the five companies most have a
strong to decline in 17th July, 11th August and 23rd November. The results show that all indicators of
the Shanghai Composite Index represent correlated regression models; shares of companies are
predictable for each other.

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4.2.3 Semi-strong form Test

Shanghai Securities Exchanges
2.50%
2.00%
1.50%
1.00%
0.50%
24-Nov-17

17-Nov-17

10-Nov-17

3-Nov-17

27-Oct-17

20-Oct-17

13-Oct-17

6-Oct-17

29-Sep-17

22-Sep-17

15-Sep-17

8-Sep-17

1-Sep-17

25-Aug-17

18-Aug-17

11-Aug-17

4-Aug-17

28-Jul-17

-1.00%

21-Jul-17

-0.50%

14-Jul-17

0.00%

-1.50%
-2.00%

-2.50%

Figure 7: SSE Daily Return

It can be clearly seen that the 3 days have the strongest drop of SSE. 17 th July was called "Black
Monday" on the Chinese stock market with the Shanghai Composite Index down 1.4% to 3,176.46
(Cheng, 2017). China's stock market fell sharply in Friday's (11th Aug) to -1.63%. Chinese stocks
plunged on 23rd November with Shanghai Composite Index had fell to -2.26%.

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Datang International Power Generation Co. Ltd
6.00%

5.00%
4.00%
3.00%
2.00%
1.00%

24-Nov-17

17-Nov-17

10-Nov-17

3-Nov-17

27-Oct-17

20-Oct-17

13-Oct-17

6-Oct-17

29-Sep-17

22-Sep-17

15-Sep-17

8-Sep-17

1-Sep-17

25-Aug-17

18-Aug-17

-3.00%

11-Aug-17

4-Aug-17

28-Jul-17

-2.00%

21-Jul-17

-1.00%

14-Jul-17

0.00%

-4.00%
-5.00%

Figure 8: Daily Return of Datang International Power Generation Co. Ltd

In early August, Datang International Power Generation Co. Ltd announced that the company was
facing financial hardship as Beijing failed to raise electricity prices last month to cut coal costs (Ng,
2017). As a result, the company's shares were continuously negative in early August. Particularly, the
highest decline in early August was on August 11, it dropped to -3.27%.

Aeolus Tire Co. Ltd
8.00%
6.00%
4.00%
2.00%

-6.00%

-8.00%
-10.00%

12

24-Nov-17

17-Nov-17

10-Nov-17

3-Nov-17

27-Oct-17

20-Oct-17

13-Oct-17

6-Oct-17

29-Sep-17

22-Sep-17

15-Sep-17

8-Sep-17

1-Sep-17

25-Aug-17

18-Aug-17

11-Aug-17

4-Aug-17

28-Jul-17

-4.00%

21-Jul-17

-2.00%

14-Jul-17

0.00%


Figure 9: Daily Return of Aeolus Tire Co. Ltd

On 11th July, there is public information reported that Aeolus Tire Co. Ltd. lost $ 30.4 million in the
first nine months of 2017 (Ho, 2017). Therefore, the stock price of the following days has dropped
sharply. Especially on July 17th, the daily return index fell strongly to -7.66%.

Greenland Holdings Corp Ltd

8.00%

6.00%
4.00%
2.00%
20-Nov-17

13-Nov-17

6-Nov-17

30-Oct-17

23-Oct-17

16-Oct-17

9-Oct-17

2-Oct-17

25-Sep-17

18-Sep-17

11-Sep-17

4-Sep-17

28-Aug-17

21-Aug-17

14-Aug-17

7-Aug-17

31-Jul-17

-4.00%

24-Jul-17

-2.00%

17-Jul-17

0.00%

-6.00%
-8.00%

Figure 10: Daily Return of Greenland Holdings Corp Ltd
According to Bloomberg, on 25th August, Greenland's report revealed that Greenland based units in
Liaoning had short-term liabilities of 247.5 million Yuan and 210 million Yuan in obligations longterm and they stressed the concern about the company's debt (2017). Th is disclosure of the company
in the report is widely publicized on websites and newspapers on 29 th August caused the share price
of 29th August decline to -0.91%.

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Jinneng Science and Technology Co. Ltd

15.00%
10.00%
5.00%

20-Nov-17

13-Nov-17

6-Nov-17

30-Oct-17

23-Oct-17

16-Oct-17

9-Oct-17

2-Oct-17

25-Sep-17

18-Sep-17

11-Sep-17

4-Sep-17

28-Aug-17

21-Aug-17

14-Aug-17

7-Aug-17

31-Jul-17

24-Jul-17

-5.00%

17-Jul-17

0.00%

-10.00%
-15.00%

Figure 11: Daily Return of Jinneng Science and Technology Co. Ltd
According to EnergyWorld, on 11th August, a landslide occurred at a mine pit that left many people
dead by Lu Xin Co Ltd, owned by Jinneng Science and Technology Co. Ltd (2017). And this made
the stock price of Jinneng Science and Technology Co. Ltd decrease. Specifically, it fell to -0.93% at
Friday's session.

SINOPEC Shanghai Petrochemical Co. Ltd

5.00%
4.00%

3.00%
2.00%

1.00%

-3.00%

-4.00%
-5.00%

14

20-Nov-17

13-Nov-17

6-Nov-17

30-Oct-17

23-Oct-17

16-Oct-17

9-Oct-17

2-Oct-17

25-Sep-17

18-Sep-17

11-Sep-17

4-Sep-17

28-Aug-17

21-Aug-17

14-Aug-17

7-Aug-17

31-Jul-17

-2.00%

24-Jul-17

-1.00%

17-Jul-17

0.00%


Figure 11: Daily Return of SINOPEC Shanghai Petrochemical Co. Ltd
According to Sahara Reporters, on Wednesday, 23rd August, Sinopec was investigated by the US
government for allegedly bribing Nigerian government officials for a $ 100 million bribe to settle
business disputes (2017). This makes the price of stock of SINOPEC Shanghai Petrochemical Co.
fell sharply to -4.75% in 24th August and this is the sharpest decline from 17th July to 23rd November.

4.3

Result

Based on the Weak-form Test and Semi-strong Form Test with Literature Review, it shows that
emerging market in China are not only showing signs of Weak-form but also showing signs of Semistrong Form.

Question 2
Follow to Mishkin and Eakins, Eurocurrency is foreign currency that is deposited at banks abroad

(2012). For example, Eurocurrency can know that the Japanese yen kept by the banks in London are
Euro yen, the pound is held in the banks in Germany is Eurosterling. The Eurocurrency market
emerged after the Second World War when considerable amounts of US dollars were kept in Europe
especially in London in the 1950s and 1960 (Arnold, 2012). The main reason for the development of
this market is the same as the other finances market innovation, it reduces the cost of international
trade by providing traders a viable means of saving on trade balances in a world where trade is
denominated and traded in dollars (Balbach and Resler, 1980).
This market has the following main functions. Firstly, the Eurocurrency market allows countries and
corporations to lend and borrow funds world- wide, picking the financial institution which is the most
suitable regardless of geographic position (Arnold, 2012). Secondly, the Eurocurrency market is
known as a parallel money market serving as a financing source for short-term financing of foreign
trade, so that banks can adjust liquidity at certain times in year and as a major source of funding for
some borrowers (Howell and Bain, 2007).
Recently, the bank has regulations and restrictions on capital flows that have stimulated the robust
development of Euromarkets. Some of the regulations that affect US banking operations by

15


Regulation Q (which specifies the deposit ceiling interest rate over 30 days and prohibits payment of
any deposit less than 30 days) (Terrell, 1979).
Follow to Markusen, Melvin, Kaempfer and Maskus, international trade is the exchange of national
goods and services and the elements and effects of trade on the domestic and international economies
(1995). In addition, the factors that affect trade of the domestic and international economy are
transactions related to Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI).
Foreign direct investment is defined as the investment by which the investor establishes a subsidiary
abroad or has significant control over the foreign company (Abotsi, 2016). FPI means a fund entry
into a country where foreign residents can buy securities from the bond market or stock of this
country (Surbhi, 2016). Since all international trade deals are related to foreign currency so
Eurocurrency market plays an important and useful role in international transactions.

Eurocurrency market is useful for conducting international transactions because according to Howell
and Bain, it helps increase the range of opportunities for both borrowers and lenders to narrow the
gap between interest rates and lending rates, and it also provides critical risk insurance for episodes
transnational corporations. Thus, the movement of international short-term capital has increased
significantly and it has become a major force in international capital market integration (2007).
In addition, the growth of Eurocurrency market has produced far reaching effects on the monetary
scene and the international financial system. Firstly, these floating funds have augmented the official
international liquidity and helped the financing of deficits in the balance of payments of countries
(Clark, 1993). Secondly, these Eurocurrency funds are found useful for private corporate investments
and for working capital purposes (Pilbeam, 2010). Thirdly, this market provided the quick and
efficient source of funds.

Question 3
1. Differences between Money markets and Capital markets
Money and Capital markets are the two groups that make up the financial market and the most
noticeable difference between these markets is the length of time that loans are borrowed (Howells
and Bain, 2007).

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Instruments Market

Money Market

Capital Market

Treasury Bills, Certificate of

Bonds, stocks or shares

Deposits, Commercial Paper

Maturity

Short-term

Long-term

Level of risk involved

Low risk

High risk

Risk Return trade off

Low

High

Market transactions

Telephone and Electronically

Take place in organized

in operation

exchanges at the building where

the securities is located
Participants Market

Government, Commercial banks

Companies and Governments

and Brokerage firms
Table 2: Differences between Money and Capital Markets

1.1 Market Instruments
Market participants will be meeting the diverse needs of a wide range of money market instruments
available such as Treasury Bills, Certificate of Deposits, Commercial Paper (Mishkin and Eakins,
2011). Major instruments traded in the capital market include bonds and stocks or shares of the
company (Howells and Bain, 2007). (For more detail about example please refers to Appendix 3).
1.2 Maturity
Money market is the stock market with short-term debt period of about one year or less (Bodie, Kane
and Macus, 2015). Capital markets provide capital for long-term use with an initial maturity of more
than one year (Mishkin and Eakins, 2011).
1.3 Level of risk involved in operation
Because trading securities have short-term, highly liquid so the money market is low risky and due to
long-term maturity, capital market face the volatility of prices, creating more risk than the money
market (Mishkin and Eakins, 2011).

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1.4 Risk return trade-off
According to Bodie, Kane and Macus, money market has low maturities and low credit risks ensure
minimal capital gains and investing in capital markets has higher return (2015).

1.5 Market transactions
Follow to Mishkin and Eakins, money market trading by arranging purchases and sell between
telephone participants and completing them electronically while most capital market transactions take
place in organized exchanges at the building where the securities is located (2011).
1.6 Participants Market
Money market participants include: The government sells securities to finance the debt to the State;
Commercial banks buying Treasury securities, short-term loans and selling certificates of deposits,
Brokerage firms usually act as agents for financial services buyers and Capital markets are used by
companies and governments to raise capital for long-term use (Mishkin and Eakins, 2011).
2. Need for both Types of Financial Markets
Financial markets are categorized by two types: money market and capital market. In these two
markets, what is offer for sale are claims or debts in exchange for money and it is borrowed money in
both markets (Howells and Bain, 2007).

These two markets are closely related to each other. The interest rate in the monetary market is the
parameter that represents the minimum yield when comparing different returns on investments on
capital market and money market (Chovancová, 2001). If the interest rates of banks are high, this will
make savers prefer depositing money into banks to enjoy interest rates and lower risk than investing
in securities. Between the market interest rate and the price of bonds are inversely proportional. Also
according to Chovancová, the rise in interest rates in the money market is accompanied by fall in the
market price of sock and vice versa (2001).

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Price of
Bonds

Supply of bonds (by

borrowers)

Supply of Loanable
Funds (by saverlenders)

Demand for Loanable Funds
(by borrowers)

Demand for bonds
(by saver-lenders)
Quantity of Bonds

Quantity
of
Loanable Funds

Figure 12: The opposite of stock price and market interest

Monetary market instruments are tools known as cash equivalents to their liquidity and safety (Bodie,
Kane and Macus, 2015). Therefore, lenders will prefer to invest in money market because it is still
profitable but safe and highly liquid. As well as according to the authors Bodie, Kane and Macus,
Capital markets are much more diversified than money market, it has a long-term maturity but with
high interest rates (2015). Borrowers like governments and companies will prefer capital markets.
Because the State Government can issue bonds and long-term debt to fund the construction of prisons
and schools and companies issue both securities and bonds to finance their long-term projects
(Mishkin and Eakins, 2011).

Final, an economy that is indispensable the money markets and capital markets, they performs a
function of providing capital to the economy. Operations in two markets are complementary and
interdependent. Therefore, need to have both money market and capital market to making financial

markets more effective active.

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Question 4
1. Distinguish between spot and forward foreign exchange rates
Forward exchange rate and spot exchange rate are two kinds of exchange rate transactions (Mishkin
and Eakins, 2011). The forward and spot exchange market is a free market, also call over-the-counter
(OTC) market because it does not take place in the central market where buyers and sellers gather
(Eun and Resnick, 2005).
The forward markets include quoted prices today for the transfer and payment on a fixed day in the
future of a specific amount of another currency (Buckley, 2012). The transition price of the forward
rate is equal to the spot price, but usually it will be higher (premium) or lower (discounted) than the
spot price and the forward exchange rate quoted above most currencies for multiple terms such as 1,
3, 6, 9, and 12 months are available (Eun and Resnick, 2005). The forward market allows businesses
to hedge against exchange rate changes by selling and buying currencies first (Howells and Bain,
2007).
In conjunction with forward trading, there is also a spot foreign exchange market. The foreign
exchange spot market is a currency market for immediate delivery and delivery and payment is
usually two business days from the date of transaction (Buckley, 2012).
2. Methods of Determining Exchange Rate

2.2

Purchasing Power Parity

Purchasing power parity (PPP) theory is one of the best theories of determining the exchange rate.
This theory holds that the purchasing power of each currency will be depended on exchange rates
between two currencies in two different countries and to keep the purchasing power of the two

currencies are same, the exchange rate will be correction (Howells and Bain, 2007). For example,
British goods are cheaper than US goods at the current exchange rate, at which time US citizens will
switch to use British goods. They do this by selling dollars and buying UK euro, pushing the value of
the dollar on the pound. According to Mishkin and Eakins, the PPP theory suggests that if a country's
price increased relative to the value of a country's currency, its currency will lose value (another
country's currency should appreciate) (2011).

20


Often, purchasing power parity (PPP) are expressed in relative terms because people do not care
about the absolute exchange rate that people are interested in changing the current prices and this
shows the difference between the Spot prices and inflation rates across countries (Howells and Bain,
2005).
Howells and Bain also argue that, the difference in interest rates has to be balanced with the expected
change in the spot exchange rate in equilibrium and this equality is called the Fisher open hypothesis
(2007). From this it can be seen that the combination of Fisher's efficiency and purchasing power
parity has created a relationship between the exchange rate and the difference in interest rates.
2.3

Demand and Supply

According to research on Howell and Bain (2011), to determine the exchange rate can be based on
supply and demand. The example of Mishkin and Eakins (2011) below will help explain why
exchange rates can be determined by analyzing the supply and demand of the foreign exchange
market.
Assuming the dollar is a domestic asset and the euro is foreign currency belonging to a foreign asset.
The amount of dollar assets supplied is fixed to the exchange rate and it does not change at any
exchange rate, it is the vertical supply curve S so just focus on the demand curve.
2.3.1 Domestic Interest Rate

S
Exchange Rate,
(euros/$)
E2
curr
E1
curren

2

1

D1

21

D2
Quantity of
Dollar Assets


Figure 13: The response of the increase in Domestic interest rates
With rising domestic interest rates, the expected gains for the domestic currency (dollar) will also
increase and demand will change in the right curve. The equilibrium exchange rate will increase from
E1 to E2. In contrast, in case of falling domestic interest rates, relative expected returns will also fall
on the domestic currency (dollar); the demand curve will move to the left and cause the domestic
currency to depreciate.

2.3.2 Foreign Interest Rate

S
Exchange Rate,
(euros/$)
E1
curr
E2
curren

1

2

D2

D1

Quantity of
Dollar Assets

Figure 14: The response of the increase in Foreign interest rates
In the case of rising foreign interest rates (Euro), the interest on foreign assets will increase relative to
domestic assets (Dollars). On the contrary, falling foreign interest rates will increases the expected
relative return on domestic assets (Dollars), which will make demand curve move to the right and
make the domestic currency appreciate.

22


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