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Ch. 4 Exchange Rate Determination

Topics

� Measuring Exchange Rate Movement

� Factors that Influence Exchange Rates

� Impact of Exchange Rates on an MNC’s Value

Measuring Exchange Rate Movements

� Exchange rate: measures the value of one currency in units of another currency.

� The percentage change (% ∆) in the value of a foreign currency is computed as

St – St-1

St-1

where St denotes the spot rate at time t.

� A positive % ∆ represents appreciation of the foreign currency, while a negative % ∆ represents depreciation.

Exchange Rate Equilibrium

� An exchange rate represents the price of a currency, which is determined by the demand for that currency relative to the supply for that currency.

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Exchange Rate Equilibrium

� Change in the Equilibrium Exchange Rate

� Increase in demand schedule: Banks will increase the exchange to the level at which the amount demanded is equal to the amount supplied in the foreign exchange market.

� Decrease in demand schedule: Banks will reduce the exchange to the level at which the amount demanded is equal to the amount supplied in the foreign exchange market.

� Increase in supply schedule: Banks will reduce the exchange to the level at which the amount demanded is equal to the amount supplied in the foreign exchange market.

� Decrease in supply schedule: Banks will increase the exchange to the level at which the amount demanded is equal to the amount supplied in the foreign exchange market.

Factors That Influence Exchange Rates

� The equilibrium exchange rate will change over time as supply and demand schedules change.

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inflation U.S. between aldifferenti the in change

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1. Relative Inflation Rates

U.S. inflation ↑� U.S. demand ↑ for British goods � £ ↑

� British demand ↓ for U.S. goods � Supply of £ ↓

2. Relative Interest Rates

U.S. interest rates ↑� U.S. demand ↓ for British bank deposits � £ ↓

� British demand ↑ for U.S. bank deposits � Supply of £ ↑

A relatively high interest rate may actually reflect expectations of relatively high inflation, which discourages foreign investment.

Factors that Influence Exchange Rates

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3. Relative Income Levels

U.S. income level ↑

� No expected change for the supply of £.

� U.S. demand ↑ for British goods � £ ↑

4. Governments may influence the equilibrium exchange rate by

� imposing foreign exchange barriers,

� imposing foreign trade barriers,

� intervening in the foreign exchange market, and

� affecting macro variables such as inflation, interest rates, and income levels.

Factors that Influence Exchange Rates

5. Expectations� Foreign exchange markets react to any news that may

have a future effect.

� Institutional investors often take currency positions based on anticipated interest rate movements in various countries.

� Because of speculative transactions, foreign exchange rates can be very volatile.

Signal Impact on $

1. Poor U.S. economic indicators Weakened

2. Fed chairman suggests Fed is

unlikely to cut U.S. interest rates Strengthened

3. A possible decline in German

interest rates Strengthened

4. Central banks expected to

intervene to boost the euro Weakened

Factors that Influence Exchange Rates

Factors that Influence Exchange Rates

� Interaction of Factors

� Trade-related factors and financial factors sometimes interact. Exchange rate movements may be simultaneously affected by these factors.

� Over a particular period, different factors may place opposing pressures on the value of a foreign currency.

� The sensitivity of the exchange rate to these factors is dependent on the volume of international transactions between the two countries.

� Because the dollar’s value changes by different magnitudes relative to each foreign currency, analysts often measure the dollar’s strength with an weighted index.

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Capitalizing on Expected Exchange Rate

Movements

� Institutional speculation based on expected appreciation: When financial institutions believe that a currency is valued lower than it should be in the foreign exchange market, they may invest in that currency before it appreciates.

� Institutional speculation based on expected depreciation: If financial institutions believe that a currency is valued higher than it should be in the foreign exchange market, they may borrow funds in that currency and convert it to their local currency now before the currency’s value declines to its proper level.

� Speculation by individuals: Individuals can speculate in foreign currencies.

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E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t

E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t

k =weighted average cost of capital of the parent

Inflation Rates, Interest Rates,Income Levels, Government Controls,

Expectations

Inflation Rates, Interest Rates,Income Levels, Government Controls,

Expectations

Impact of Exchange Rates on MNC’s Value