International Financial Management

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

 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  S t 1
Percent  in foreign currency value 
S t 1

 A positive percent change indicates that the currency has

appreciated. A negative percent change indicates that it
has depreciated.
3  On the days when some currencies appreciate while others
 Exhibit 4.1 How Exchange Rate Movements and Volatility
Are Measured

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 Exchange Rate Equilibrium

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

the rate at which one currency can be exchanged for
another.
 Demand for a currency increases when the value of the
currency decreases, leading to a downward sloping
demand schedule. (See Exhibit 4.2)
 Supply of a currency increases when the value of the
currency increases, leading to an upward sloping
supply schedule. (See Exhibit 4.3)
 Equilibrium equates the quantity of pounds demanded
with the supply of pounds for sale. (See Exhibit 4.4)
 In liquid spot markets, exchange rates are not highly
sensitive to large currency transactions.

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 Exhibit 4.2 Demand Schedule for British
Pounds

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 Exhibit 4.3 Supply Schedule of British Pounds for
Sale

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 Exhibit 4.4 Equilibrium Exchange Rate
Determination

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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 differenti al between U.S. inflation
and the foreign country' s inflation
INT  change in the differenti al between th e U.S. interest rate
and the foreign country' s interest rate
INC  change in the differenti al between th e U.S. income level
and the foreign country' s income level
GC  change in government controls
EXP  change in expectatio ns of future exchange rates
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 Factors That Influence Exchange Rates

 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)
 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. (See Exhibit 4.6)
 A relatively high interest rate may actually reflect
expectations of relatively high inflation, which discourages
foreign investment. It is thus useful to consider real interest
rates, which adjust the nominal interest rates for inflation.
Fisher Effect:
10 Real interest rate  Nominal interest rate  Inflation rate
 Exhibit 4.5 Impact of Rising U.S. Inflation on the Equilibrium
Value of the British Pound

U.S. inflation 
Þ  U.S. demand for British
goods, and hence £.
Þ  British desire for U.S.
goods, and hence the supply
of £.

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 Example

 Consider how the demand and supply schedules displayed in Exhibit

would be affected if U.S. inflation suddenly increased substantially
while British inflation remained the same. (Assume that both British
and U.S. firms sell goods that can serve as substitutes for each other.)
 The sudden jump in U.S. inflation should cause an increase in the U.S.
demand for British goods and therefore also cause an increase in the
U.S. demand for British pounds.
 In addition, the jump in U.S. inflation should reduce the British desire
for U.S. goods and therefore reduce the supply of pounds for sale.
These market reactions are illustrated in Exhibit. At the previous
equilibrium exchange rate of $1.55, there would be a shortage of
pounds in the foreign exchange market.
 The increased U.S. demand for pounds and the reduced supply of
pounds for sale place upward pressure on the value of the pound.
According to Exhibit , the new equilibrium value is $1.57.
 If British inflation increased (rather than U.S. inflation), the opposite
12 forces would occur
 Factors that Influence Exchange Rates

$/£ U.S. interest rates 

S0
Þ  U.S. demand for
S1
r0 British bank deposits,
r1 and hence £.
D0
Þ  British desire for U.S.
D1
bank deposits, and
Quantity of £
hence the supply of £.

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 Example

 Assume that U.S. interest rates rise while British interest rates
remain constant.
 In this case, U.S. investors will likely reduce their demand for
pounds, since the U.S. rates are now more attractive relative to
British rates, and there is less desire for British bank deposits.
 Because U.S. rates will now look more attractive to British
investors with excess cash, the supply of pounds for sale by
British investors should increase as they establish more bank
deposits in the United States.
 Due to an inward shift in the demand for pounds and an
outward shift in the supply of pounds for sale,
 The equilibrium exchange rate should decrease. This is
graphically represented in Exhibit.
 If U.S. interest rates decreased relative to British interest rates,
14 the opposite shifts would be expected.
 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

U.S. income level 

Þ  U.S. demand for British
goods, and hence £.
Þ No expected change for
the supply of £.

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 Example

 Assume that the U.S. income level rises substantially while the
British income level remains unchanged. Consider the impact of
this scenario on (1) the demand schedule for pounds, (2) the
supply schedule of pounds for sale, and (3) the equilibrium
exchange rate.

 First, the demand schedule for pounds will shift outward,

reflecting the increase in U.S. income and therefore increased
demand for British goods. Second, the supply schedule of
pounds for sale is not expected to change.

 Therefore, the equilibrium exchange rate of the pound is

expected to rise, as shown in Exhibit.

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 Government Controls

 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.
 Recall the example in which U.S. interest rates rose relative to
British interest rates.
 The expected reaction was an increase in the British supply of
pounds for sale to obtain more U.S. dollars (in order to
capitalize on high U.S. money market yields).
 Yet, if the British government placed a heavy tax on interest
income earned from foreign investments, this could discourage
17 the exchange of pounds for dollars.
 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.
Signal Impact on $
Poor U.S. economic indicators Weakened
Fed chairman suggests Fed is Strengthened
unlikely to cut U.S. interest rates
A possible decline in German Strengthened
interest rates
Central banks expected to Weakened
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intervene to boost the euro
 Factors that Influence Exchange Rates

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.

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 Example

 Investors may temporarily invest funds in Canada if they expect

Canadian interest rates to increase. Such a rise may cause
further capital flows into Canada, which could place upward
pressure on the Canadian dollar’s value.
 By taking a position based on expectations, investors can fully
benefit from the rise in the Canadian dollar’s value because
they will have purchased Canadian dollars before the change
occurred.
 Although the investors face an obvious risk here that their
expectations may be wrong,
 The point is that expectations can influence exchange rates
because they commonly motivate institutional investors to take
foreign currency positions.
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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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  Assume the simultaneous existence of :
i. a sudden increase in U.S. inflation and
ii. a sudden increase in U.S. interest rates.

 If the British economy is relatively unchanged, the

increase in U.S. inflation will place upward
pressure on the pound’s value

 While the increase in U.S. interest rates places

downward pressure on the pound’s value.

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 Summary of How Factors Can Affect Exchange Rates

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 Movements in Cross Exchange Rates

 If currencies A and B move in same direction, there is

no change in the cross exchange rate.
 When currency A appreciates against the dollar by a
greater (smaller) degree than currency B, then currency
A appreciates (depreciates) against B.
 When currency A appreciates (depreciates) against the
dollar, while currency B is unchanged against the
dollar, currency A appreciates (depreciates) against
currency B by the same degree as it appreciates
(depreciates) against the dollar.

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 Trends in the Pound, Euro, and Pound/Euro

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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
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the differential in interest rates between two countries.
 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.
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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 Speculating on Anticipated Exchange Rates

Chicago Bank expects the exchange rate of the New

Zealand dollar to depreciate from its present level of $0.50
to $0.48 in 30 days.
Borrows at 6.96% for 30
days
1. Borrows NZ$40 4. Holds
million NZ$41,900,000
Returns NZ$40,232,000
Profit of NZ$1,668,000
or $800,640
Exchange at Exchange at
$0.50/NZ$ $0.48/NZ$

Lends at 6.72% for 30

days
2. Holds $20 3. Receives
million $20,112,000

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 Impact of Exchange Rates on an MNC’s Value

Inflation Rates, Interest Rates,

Income Levels, Government Controls,
Expectations

m 
n 

E  CFj , t   E ER j , t   
 j 1 
Value =   
t =1  1  k  t

 
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
29 period t
 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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