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Premier University[B.B.A]

International Financial Management

Presentation SubjectEXCHANGE RATE DETERMINATION

Submitted toLecturer:Ms.Nilufar Sultana

Department of FinanceFaculty of Business AdministrationPremier University, Chittagong.

 Semester: 8th Section: “A” Batch :22nd

 Group Name: D

Page 3

Presenters Profile

NO ID NAME

1 1022114412 Md. Ariful Islam Saimon Chowdhury

2 1022114372 Md.Shahadat Hossain

3 1021114362 Imteaj Ibna Hossain

41022114406

Md.Towky Uddin

51022114384

Md.Shazzad Hossain

61022114600

Shuvashis Sarkar

EXCHANGE RATE DETERMINATION

Premier University

Foreign exchange Rate • Exchange rate is the price of a currency in terms of other; • Exchange rate determination is the most crucial decision for

international business;• A good forecasting of exchange rate can increase the

company’s value by investing in profitable project;• Exchange rate generally effect the future cash flow of an

organization;• Exchange rate also reflect the condition of market of a

country;

Importance of determination exchange rate in International business

• It is an Important decision for MNCs to predict the exchange rate; whether it is appreciated or depreciated.

• Suppose it costs US citizen $1.99 to buy ₤1 in 2014 and one years later it costs only $1.58 – dollar has appreciated

• Suppose it costs US citizen $1.99 to buy ₤1 GBP in 2014 and one years later it costs only $2.01 – dollar has Depreciated.

Foreign Exchange Rate

• Different countries have different currencies with different values….

Example: India - Rupees America -Dollar China - Yuan• When trade takes place….. the persons of these countries have to convert their

currencies to other countries currencies to make payments

WHY IT NEEDED???.....

• For this purpose the concept of foreign exchange come into operation.

• Under mechanism of international payments, the currency of a country is converted in to the currency of another country through FOREIGN EXCHANGE MARKET.

• The effect of globalization and international trade • Increased import and export

WHY IT NEEDED???.....

• Also called “FOREX” market.• It is the place were foreign moneys were bought and

sold.• It involves the buying of one currency and selling of

another currency simultaneously.• Exchange rates are determined here….• Has no geographical boundaries…..

FOREIGN EXCHANGE MARKET

• It is the rate at which one currency will be exchanged for another in foreign exchange.

• It is also regarded as the value of one country’s currency in terms of another currency.

There are three basic types; Fixed rate Floating rate Managed rate

FOREIGN EXCHANGE RATE

• It is the system of following a fixed rate for converting currencies.

• In this system, the government (or the central bank acting on its behalf) intervenes in the currency market in order to keep the exchange rate close to a fixed target.

• It does not allow major fluctuations from the central rate.

FIXED EXCHANGE RATE

Advantages It provide the stability of exchange rate.Fixed rates provide greater certainty for exporters

and importers.

Disadvantages Too rigid to take care of major upheavals. Need large reserves to defend the fixed

exchange rate. May cause destabilizing speculations; most currency

crisis took place under a fixed exchange system.

Advantages & Disadvantages

• Under the flexible exchange rate system, the rate of exchange is allowed to vary to suit the economic policies of the government.

• Flexible exchange rates are exchange rates, which fluctuate according to market forces.

• The value of the currency is determined solely by the forces of demand and supply in the exchange market.(self correcting mechanism)

FLOATING/FLEXIBLE EXCHANGE RATE

Advantages Automatic adjustment for countries with a large balance

of payments deficit. Flexibility in determining interest rates Allow countries to maintain independent economic

policies. Permit a smooth adjustment to external shocks. Don't need to maintain large international reserves.

Disadvantages Flexible exchange rates are highly unstable so that flows

of foreign trade and investment may be discouraged. They are inherently inflationary.

Advantages & Disadvantages

• Managed exchange rate systems permit the government to place some influence on an exchange rate that would otherwise be freely floating.

• Managed means the exchange rate system has attributes of both systems.

• Through such official interventions it is possible to manage both fixed and floating exchange rates.

MANAGED EXCHANGE RATE

• As stated earlier exchange rate is determined by its the forces of supply and demand.

• Therefore, if for some reason people increase their demand for a specific currency, then the price will rise provided that the supply remains stable.

• On the contrary, if the supply is increased the price will decline and it is provided that the demand remains stable.

Simple Mechanism of Demand & Supply

Simple Mechanism of Demand & Supply

• Most widely accepted theory “According to PPP theory, when exchange rates are of a fluctuating nature,

the rate of exchange between two currencies in the long run will be fixed by their respective purchasing powers in their own nations.”

• i.e the price of a good that is charged in one country should be equal to the one charged for the same good in another country, being exchanged at the current rate.

• This rule is also known as the law of one price.• It is an economic theory that estimates the amount of adjustment

needed on the exchange rate between countries in order for the exchange to be equivalent to each currency's purchasing power.

Purchasing Power Parity Theory (PPP Theory)

• The balance of payments approach is another method that explains what the factors are that determine the supply and demand curves of a country’s currency.

• As it is known from macroeconomics, the balance of payments is a method of recording all the international monetary transactions of a country during a specific period of time.

• The transactions recorded are divided into four categories: the current account transactions, the capital account transactions, financial account and the central bank transaction.

The Balance of Payment Theory

CURRENT ACCOUNT

export and import of goods &services CAPITAL ACCOUNT

Capital transfers FINANCIAL TRANSFERS

Foreign direct investmentPortfolio investment

RESERVEBANK TRANSACTIONS

• According to the theory, a deficit in the balance of payments leads to fall or depreciation in the rate of exchange, while a surplus in the balance of payments strengthens the foreign exchange reserves, causing an appreciation in the price of home currency in terms of foreign currency. A deficit balance of payments of a country implies that demand for foreign exchange is exceeding its supply.

• As a result, the price of foreign money in terms of domestic currency must rise, i.e., the exchange rate of domestic currency must fall. On the other hand, a surplus in the balance of payments of the country implies a greater demand for home currency in a foreign country than the available supply. As a result, the price of home currency in terms of foreign money rises, i.e., the rate of exchange improves.

1. Interest Rate Whenever there is an increase interest rates in domestic

market there will be increase investment funds causing a decrease in demand for foreign currency and an increase in supply of foreign currency.

2. Inflation Rate when inflation increases there will be less demand for

local goods (decreased supply of foreign currency) and more demand for foreign goods (increased demand for foreign currency).

DETERMINANTS OF FOREIGN EXCHANGE RATE

3. Government budget deficit or surplus The market usually react negatively to widening govt.

budget deficits and positively to narrowing budget deficits. This will result in change in the value of countries currency.

4. Political conditions Internal, regional and international political

conditions and events can have a profound effect on currency market

DETERMINANTS OF FOREIGN EXCHANGE RATE

• Advantages of a strong currency– Makes imported raw materials cheaper– Helps to control inflation– Leads to lower interest rates– Makes foreign assets cheaper

• Disadvantages of a strong currency– Exporters lose price competitiveness– Adverse impact on competitiveness may be moderated if leads

to lower wage demands

Impact of exchange rate on firms

MNC

Importance of exchange rate determination for MNC’s