International Financial Management
11th Edition
by Jeff Madura
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4 Exchange Rate Determination
Chapter Objectives
Explain how exchange rate movements are measured.
Explain how the equilibrium exchange rate is determined.
Examine factors that determine the equilibrium exchange
rate.
Explain the movement in cross exchange rates.
Explain how financial institutions attempt to capitalize
on anticipated exchange rate movements.
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Measuring Exchange Rate Movements
The exchange rate represents the price of a currency, or
the rate at which one currency can be exchanged for
another.
Depreciation: decline in a currency’s value
Appreciation: increase in a currency’s value
Comparing foreign currency spot rates over two points in
time, S and St-1
S St 1
Percent in foreign currency value
St 1
A positive percent change indicates that the currency has
appreciated. A negative percent change indicates that it
3 has depreciated.
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Exhibit 4.1 How Exchange Rate Movements and Volatility
Are Measured
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-The liquidity of a currency affects the sensitivity of the exchange
rate to specific transactions.
-With many willing buyers and sellers, even large transactions
can be easily accommodated.
- In liquid spot markets, exchange rates are not highly
sensitive to large currency transactions.
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Exchange Rate Equilibrium
• Before considering why an exchange rate changes,
realize that an exchange rate at a given point in time
represents the price of a currency or the rate at which
one currency can be exchange for another.
• Like any other product sold in markets, the price of a
currency is determined by the demand of that currency
relative to supply.
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Demand Schedule for British Pounds
Demand for a currency increases when the value of the currency
decreases, leading to a downward sloping demand schedule. (See Exhibit
4.2)
Exhibit 4.2
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Supply Schedule of British Pounds for Sale
Supply of a currency increases when the value of the currency
increases, leading to an upward sloping supply schedule. (See Exhibit
4.3)
Exhibit 4.3
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Equilibrium Exchange Rate Determination
Equilibrium equates the quantity of pounds demanded with the
supply of pounds for sale. (See Exhibit 4.4)
Exhibit 4.4
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Factors That Influence Exchange Rates
The equilibrium exchange rate will change over time as
supply and demand schedules change.
e f (INF , INT , INC , GC , EXP)
where
e percentage change in the spot rate
INF change in the relative inflation
INT change in the relative interest rate
INC change in relative income level
GC change in government controls
EXP change in expectations of future exchange rates
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Impact of Rising U.S. Inflation on the Equilibrium Value of the
British Pound
Relative Inflation: Increase in U.S. inflation leads to increase in
U.S. demand for foreign goods, an increase in U.S. demand for
foreign currency, and an increase in the exchange rate for the
foreign currency. (See Exhibit 4.5)
Exhibit 4.5
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Example
Example:
Assume that U.S. inflation suddenly increased while British
inflation remained the same (British and U.S. firms sell goods
serve as substitutes) The increase in U.S. inflation should
cause an increase in the U.S. demand for British goods and
therefore cause an increase in the U.S. demand for British
pounds and a reduction in the supply of pounds for sale as the
British desire for U.S. goods is decreased.
Solve:
If U.S. inflation suddenly increased while European inflation stayed
the same, there would be:
a) An increased U.S. demand for euros and an increased supply
of euros for sale.
b) A decrease U.S. demand for euros and an increased supply of
euros for sale.
c) A decreased U.S. demand for euros and a decreased supply of
euros for sale.
d) An increased U.S. demand for euros and a decreased
supply of euros for sale.
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Impact of Rising U.S. Interest Rates on the Equilibrium Value
of the British Pound
Relative Interest Rates: Increase in U.S. rates leads to increase
in demand for U.S. deposits and a decrease in demand for
foreign deposits, leading to an increase in demand for dollars and
an increased exchange rate for the dollar. (See Exhibit 4.6)
Exhibit 4.6
13
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Solve:
An increase in U.S. interest rates relative to German interest rates
would likely------------- the U.S. demand for euros and
------------- the supply of euros for sale.
a) reduce, increase
b) Increase, reduce
c) Reduce, reduce
d) Increase, increase
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Impact of Rising U.S. Income Levels on the Equilibrium
Value of the British Pound
Relative Income Levels: Increase in U.S. income leads to
increased in U.S. demand for foreign goods and increased demand
for foreign currency relative to the dollar and an increase in the
exchange rate for the foreign currency. (See Exhibit 4.7)
Exhibit 4.7
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Example:
Assume that U.S. income level rises while British income level
remains unchanged so the demand for pounds increases due to
the increase demand for British goods. The supply of pounds for
sale is not expected to change.
Solve:
A large increase in the income level in Mexico along with no growth
in the U.S income is normally expected to cause a(n)
--------------in Mexican demand for U.S goods, and the Mexican peso
should----------------
a) increase, appreciate
b) increase, depreciate
c) decrease, appreciate
d) decrease, depreciate
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Factors That Influence Exchange Rates
Government Controls via:
Imposing foreign exchange barriers
Imposing foreign trade barriers
Intervening in foreign exchange markets
Affecting macro variables such as inflation, interest
rates, and income levels.
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Factors That Influence Exchange Rates
Expectations: If investors expect interest rates
in one country to rise, they may invest in that
country leading to a rise in the demand for
foreign currency and an increase in the
exchange rate for foreign currency.
Impact of signals on currency speculation.
Speculators may overreact to signals causing
currency to be temporarily overvalued or
undervalued.
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Solve:
- Assume that Japan places a strict quota on goods imported from the
U.S. and the U.S. places a strict quota on goods imported from
Japan. This event should immediately cause the U.S. demand for
Japanese yen to _______, and the supply of Japanese yen to be
exchanged for U.S. dollars to _______.
A) increase; increase
B) increase; decline
C) decline; decline
D) decline; increase
- Any event that increases the supply of British pounds to be exchanged
for U.S. dollars should result in a(an) _______ in the value of the
British pound with respect to _______, other things being equal.
A) increase; U.S. dollar
B) increase; nondollar currencies
C) decrease; nondollar currencies
D) decrease; U.S. dollar
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Factors that Influence Exchange Rates
Interaction of Factors: some factors place upward
pressure while other factors place downward
pressure. (See Exhibit 4.8)
Influence of Factors across Multiple Currency
Markets: common for European currencies to move
in the same direction against the dollar.
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Exhibit 4.8 Summary of How Factors Can Affect
Exchange Rates
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Anticipation of 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.
The “Carry Trade” – Where investors attempt to capitalize on the
differential in interest rates between two countries.
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Speculating on Anticipated Exchange Rates
Chicago Bank expects the exchange rate of the New Zealand dollar to
appreciate from its present level of $0.50 to $0.52 in 30 days. The bank can
borrow $20 million or NZ$ 40 million.
Lending rate (at NZ$)= 6.48% Borrowing rate ( for US$)= 7.20%
Borrows at 7.20% for 30
days
1. Borrows $20 4. Holds
million $20,912,320
Returns $20,120,000
Profit of $792,320
Exchange at Exchange at
$0.50/NZ$ $0.52/NZ$
Lends at 6.48% for 30
days
2. Holds NZ$40 3. Receives
million NZ$40,216,000
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SUMMARY
Exchange rate movements are commonly measured by the
percentage change in their values over a specified period, such
as a month or a year. MNCs closely monitor exchange rate
movements over the period in which they have cash flows
denominated in the foreign currencies of concern.
The equilibrium exchange rate between two currencies at any
point in time is based on the demand and supply conditions.
Changes in the demand for a currency or the supply of a
currency for sale will affect the equilibrium exchange rate.
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SUMMARY (Cont.)
The key economic factors that can influence exchange rate
movements through their effects on demand and supply
conditions are relative inflation rates, interest rates, and income
levels, as well as government controls. As these factors cause a
change in international trade or financial flows, they affect the
demand for a currency or the supply of currency for sale and
therefore affect the equilibrium exchange rate.
Unique international trade and financial flows between every
pair of countries dictate the unique supply and demand
conditions for the currencies of the two countries, which affect
the equilibrium cross exchange rate. The movement in the
exchange rate between two non-dollar currencies can be
determined by considering the movement in each currency
against the dollar and applying intuition.
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SUMMARY (Cont.)
Financial institutions can attempt to benefit from expected
appreciation of a currency by purchasing that currency.
Conversely, they can attempt to benefit from expected
depreciation of a currency by borrowing that currency,
exchanging it for their home currency, and then buying that
currency back just before they repay the loan.
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