Cambridge Syllabus Notes

6.3.3 Exchange Rates – Appreciation and Depreciation

Objective

To understand what causes an exchange rate to appreciate or depreciate, how these movements are measured, and the consequences for businesses that import, export, or manage cash‑flows.

1. What is an exchange rate?

An exchange rate is the price of one currency expressed in terms of another. It tells us how many units of the home currency are required to obtain one unit of the foreign currency (or vice‑versa).

2. Ways of quoting exchange rates

Quotation type	Definition	Example (Home = A, Foreign = B)
Direct quotation	Home‑currency per unit of foreign currency	0.85 A = 1 B
Indirect quotation	Foreign‑currency per unit of home currency	1.18 B = 1 A

3. Exchange‑rate regimes (brief)

Floating (market‑determined) – rates move freely according to supply and demand.
Fixed (pegged) – the government or central bank maintains a set rate against another currency or a basket.
Managed (dirty float) – a floating system with occasional official interventions.

Businesses must know the regime because it influences the predictability of future rates and the need for hedging.

4. Appreciation and depreciation

4.1 Appreciation of the home currency

The home currency becomes stronger relative to the foreign currency. In a direct quotation this is shown by a fall in the number of home‑currency units needed to buy one foreign unit.

Correct example: If the rate moves from 0.85 A = 1 B to 0.80 A = 1 B, Currency A has appreciated against Currency B.

4.2 Depreciation of the home currency

The home currency becomes weaker. In a direct quotation this is shown by a rise in the number of home‑currency units required for one foreign unit.

Example: If the rate changes from 0.85 A = 1 B to 0.90 A = 1 B, Currency A has depreciated against Currency B.

5. Main factors that cause movements (and the direction they produce)

Factor	Effect on home‑currency value	Resulting movement
Higher domestic interest rates	Attracts foreign capital → greater demand for home currency	Appreciation
Higher foreign interest rates (relative to domestic)	Domestic investors seek higher returns abroad → sell home currency	Depreciation
Lower domestic inflation (relative to foreign)	Home goods retain purchasing power → currency perceived as more valuable	Appreciation
Higher foreign inflation	Foreign goods become relatively more expensive → demand for foreign currency falls	Appreciation of home currency
Strong economic performance	Boosts investor confidence → inflow of foreign capital	Appreciation
Political instability	Reduces investor confidence → capital outflow	Depreciation
Speculative expectations	Anticipated future gains cause buying or selling pressure	Can trigger short‑term appreciation or depreciation

6. Limitations of exchange‑rate analysis

Exchange rates can be highly volatile; short‑term movements may not reflect underlying fundamentals.
Data lag – published rates may be outdated by the time businesses act.
Multiple interacting factors make precise prediction difficult.
Government interventions can abruptly alter the trend.

7. Impact on businesses

7.1 Importers

Appreciation – foreign goods become cheaper in home‑currency terms; lower input costs and potentially higher profit margins.
Depreciation – imports become more expensive; costs rise unless the firm can pass the increase onto customers.

7.2 Exporters

Depreciation – home‑produced goods are cheaper for overseas buyers; export volumes and home‑currency revenue tend to increase.
Appreciation – exported goods become relatively expensive abroad; competitiveness and export revenue may fall.

7.3 Competitiveness & profitability

Depreciation generally benefits export‑oriented firms but hurts import‑oriented firms.
Appreciation has the opposite effect.
Firms must monitor exchange‑rate trends to decide on pricing, sourcing, investment, and risk‑management strategies.

8. Implications for cash‑flow forecasting & working capital

Exchange‑rate changes affect the timing and amount of foreign‑currency cash inflows/outflows, altering projected cash balances.
Businesses that rely on imported inputs must adjust working‑capital requirements when a depreciation raises purchase costs.
Accurate forecasts should include a sensitivity analysis (e.g., “What if the A/B rate moves ±5 %?”).

9. Risk‑management (hedging) – a brief box

Hedging tool	How it works	When it is commonly used
Forward contract	Agreement to buy/sell a set amount of foreign currency at a predetermined rate on a future date.	When a firm knows the exact amount and date of a future foreign‑currency transaction.
Currency option	Gives the right, but not the obligation, to exchange at a set rate; premium is paid upfront.	When a firm wants protection against adverse moves but also wants to benefit from favourable moves.
Money market hedge	Uses borrowing/lending in different currencies to lock in an effective rate.	When forward markets are illiquid or when the firm prefers a cash‑flow based hedge.

10. Suggested diagram

Draw a simple line graph:

X‑axis: Time (months/years)
Y‑axis: Exchange rate (A per B)
Show a rising segment (appreciation of A) and a falling segment (depreciation of A).
Annotate each segment with brief notes such as “cheaper imports” (appreciation) and “more competitive exports” (depreciation).

Key points to remember

Appreciation = home currency strengthens; depreciation = home currency weakens.
Appreciation lowers import costs but can reduce export competitiveness.
Depreciation raises import costs but can boost export competitiveness and profit margins.
Exchange‑rate movements are influenced by interest rates, inflation, economic performance, political stability, and speculation.
Limitations (volatility, data lag, multiple factors) mean predictions are never certain.
Businesses use hedging tools (forwards, options, money‑market hedges) and adjust cash‑flow forecasts to manage the risk.

appreciation and depreciation of an exchange rate