Topic 3. P1 - Ch4 - Exchange Rate Determination

International Financial Management
12th Edition
by Jeff Madura
1 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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.
2 2 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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.
Comparing foreign currency spot rates over two points in time, S
and St-1
A spot rate is the price at which currencies are traded for

immediately delivery
S - St -1
Percent D in foreign currency value =
St -1
Depreciation: decline in a currency’s value
Appreciation: increase in a currency’s value
A positive percent change indicates that the currency has

appreciated. A negative percent change indicates that it has
depreciated. (Exhibit 4.1)
3
Sample Problem
Suppose the U.S. dollar appreciates

against the Russian ruble by 500%. How
much did the ruble depreciate against
the dollar?
4
Demand and supply for foreign currency
1. Which activities create demand for USD in

Vietnam?
2. Which activities create supply for USD in
Vietnam?
The Demand for $ in the Vietnam.

VND/$
D
VND 20000/$
VND 19000/$
VND 18000/$
Qty
At higher exchange rates, Vietnameses demand less dollars
and vice versa resulting in downward-sloping demand curve
for dollars 6
The Supply of dollar in Vietnam
VND/$
S
VND 20000/$
VND 19000/$
VND 18000/$
Qty
At higher exchange rates, the U.S citizens supply
more dollars and vice versa.
7
Equilibrium Exchange Rates
Equilibrium Exchange rates occurs where the quantity

supplied equals the quantity demanded of a foreign
currency at a specific local price.
The dealer is willing to buy foreign exchange at the bid

rate and selling at the ask rate.
Bid rate < ask rate
8
Factors That Influence Exchange Rates
The equilibrium exchange rate will change over time as

supply and demand schedules change.
e = f (DINF , DINT , DINC , DGC , DEXP )
where
e = percentage change in the spot rate
DINF = change in the differential between U.S. inflation
and the foreign country' s inflation
DINT = change in the differential between the U.S. interest rate
and the foreign country' s interest rate
DINC = change in the differential between the U.S. income level
and the foreign country' s income level
DGC = change in government controls
DEXP = change in expectations of future exchange rates
9
1.Inflation
The supply for

American
Higher inflation in dollars decreases
consumers buy less
Vietnam at every exchange
VN goods
rate
Vietnamese
Higher inflation in The demand for
consumers prefer dollars increases –
VN American products rightward shift
10
Inflation combined effect
• A new equilibrium rate e1> eo, a higher inflation rate in VN
will lead to a depreciation of the VND relative to the dollar
or, equivalently, to an appreciation of the dollar relative to
the VND. The relationship is explained by purchasing power
parity (PPP)- chapter 4.
• Relative Inflation Rates: 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.
11
Exhibit 2.2: E(USD/VND)

Higher inflation rate in the U.S.
VND
price
of
one
dollar
Quantity of dollars
12
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 a increase in demand for dollars and an increased
exchange rate for the dollar.
Higher real interest rate will attract more customers. An increase in
Vietnamese interest rate pushes both US and Vietnamese investors
switch from dollar to VND, the net result will be depreciation of the
dollar (in the absence of government intervention)
§ Real Interest Rates
§ Fisher Effect:
Real interest rate @ Nominal interest rate - Inflation rate
13
Exhibit 2.3 E(USD/VND)
Higher interest rate in the U.S.
VND
price
of
e1
one
dollar e0
Quantity of dollars 14
Quantity of dollar
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.
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.
15
Exhibit 4.7 Impact of Rising U.S. Income Levels on Equilibrium Value of

the British Pound
16
16
Expectations:
§ Impact of favorable 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 unfavorable expectations: Speculators can place
downward pressure on a currency when they expect it to
depreciate.
§ Impact of signals on currency speculation. Speculators may
overreact to signals causing currency to be temporarily
overvalued or undervalued.
17
Exhibit 4.8 Summary of How Factors Affect Exchange Rates
18
18
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.
19

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International Financial Management

4 Exchange Rate Determination

§ Explain how exchange rate movements are measured.

The exchange rate represents the price of a currency, or the rate at

A spot rate is the price at which currencies are traded for

A positive percent change indicates that the currency has

Suppose the U.S. dollar appreciates

1. Which activities create demand for USD in

The Demand for $ in the Vietnam.

Equilibrium Exchange Rates

Equilibrium Exchange rates occurs where the quantity

The dealer is willing to buy foreign exchange at the bid

Bid rate < ask rate

The equilibrium exchange rate will change over time as

The supply for

Exhibit 2.2: E(USD/VND)

Relative Interest Rates: Increase in U.S. rates leads to increase in

Exhibit 2.3 E(USD/VND)

Higher interest rate in the U.S.

Relative Income Levels: Increase in U.S. income leads to

Exhibit 4.7 Impact of Rising U.S. Income Levels on Equilibrium Value of

Exhibit 4.8 Summary of How Factors Affect Exchange Rates

Institutional speculation based on expected appreciation -

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