Multinational Financial Management:

Part 1: The international Financial

Environment
Chapter 4 Exchange Rate Determination

PowerPoint designed by Dr. Sun for Fin365 at KU

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Chapter Objectives
This chapter will:

A. Explain how exchange rate movements are measured

B. Explain how the equilibrium exchange rate is
determined

C. Examine factors that determine the equilibrium

exchange rate
D. Explain the movement in cross exchange rates

E. Speculate on anticipated exchange rates

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Measuring
Exchange Rate Movements
An exchange rate measures the value of one currency
in units of another currency.
When a currency declines in value, it is said to
depreciate. When it increases in value, it is said to
appreciate.
On the days when some currencies appreciate while
others depreciate against a particular currency, that
currency is said to be “mixed in trading.”
Measuring
Exchange Rate Movements
The percentage change (% D) 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 % D represents appreciation of the

foreign currency, while a negative % D
represents depreciation. (Exhibit 4.1)
Exhibit 4.1 How Exchange Rate Movements
and Volatility Are Measured
Exchange Rate Equilibrium
The exchange rate represents the price of a currency,
or the rate at which one currency can be exchanged for
another. (eg. US Dollars vs. British pounds)

Demand for a currency increases when the value of

the currency decreases, leading to a downward sloping
demand schedule.

Supply of a currency for sale increases when the value

of the currency increases, leading to an upward
sloping supply schedule.

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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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8
 Exhibit 4.4 Equilibrium Exchange Rate Determination

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Factors that Influence
Exchange Rates

e  f  INF , INT , INC , GC , EXP 

e = percentage change in the spot rate

 INF = change in the relative inflation rate
 INT = change in the relative interest rate
 INC = change in the relative income level
 GC = change in government controls
 EXP = change in expectations of future
exchange rates
 Factors that Influence
Exchange Rates
Relative Inflation Rates

$/£ U.S. inflation 

S1
Þ  U.S. demand for British
S0
r1 goods, and hence £.
r0
D1
D0
Þ  British desire for U.S.
goods, and hence the
Quantity of £
supply of £.
 Factors that Influence
Exchange Rates
Relative Interest Rates

$/£ U.S. interest rates 

S0
Þ  U.S. demand for British
S1
r0 bank deposits, and hence
r1 £.
D0
Þ  British desire for U.S.
D1
bank deposits, and hence
Quantity of £
the supply of £.
Factors that Influence
Exchange Rates
Relative Interest Rates
• A relatively high interest rate may actually
reflect expectations of relatively high inflation,
which may discourage foreign investment.

• It is thus useful to consider the real interest

rate, which adjusts the nominal interest rate for
inflation.
Factors that Influence
Exchange Rates
Relative Interest Rates
• real nominal
interest  interest – inflation rate
rate rate
• This relationship is sometimes called the Fisher
effect.
Factors that Influence
Exchange Rates
Relative Income Levels

$/£ U.S. income level 

Þ  U.S. demand for British
S0 ,S1
r1
goods, and hence £.
r0
D1
Þ No expected change for
D0
the supply of £.
Quantity of £
Factors that Influence
Exchange Rates
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.
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.

Credit Crisis Example:

In the period from 2000 to 2008. there were substantial capital flows
from the United States to Europe (U.S. demand for Euros), which placed
continuous upward pressure on the euro's value.

However, as the credit crisis intensified in September 2008, there were

signals that Europe's economy would weaken in the near future.
Speculators anticipated that a weaker economy in Europe would cause a
reduction in the capital inflows in Europe. Thus, they began to unwind
their positions by moving their money out of Euros and into dollars. This
caused a large increase in the supply of Euros for sale in exchange for
dollars in the foreign exchange market, which caused the euro to
depreciate by 20 percent within 2 months.
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 Factors that Influence
Exchange Rates
Interaction of Factors: The various factors sometimes interact
and simultaneously affect exchange rate movements. 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.
Influence of Liquidity on Exchange Rate adjustment: If a
currency’s spot market is liquid then its exchange rate will
not be highly sensitive to a single large purchase or sale.
Exhibit 4.8 Summary of How Factors Affect
Exchange Rates
Factors that Influence
Exchange Rates
Interaction of Factors
• The sensitivity of an exchange rate to the
factors is dependent on the volume of
international transactions between the two
countries.
Large volume of international trade 
relative inflation rates may be more influential
Large volume of capital flows  interest rate
fluctuations may be more influential
Factors that Influence
Exchange Rates
Interaction of Factors
 An understanding of exchange rate
equilibrium does not guarantee accurate
forecasts of future exchange rates because that
will depend in part on how the factors that
affect exchange rates will change in the future.
Movements in Cross Exchange Rates

Today, you notice that the euro is valued at $1.33 while the Mexican
peso is valued at $.10. One year ago, the euro was valued at $1.40.
and the Mexican peso was worth $09. This information allows you
to determine how the euro changed against the Mexican peso over
the last year.

Cross rate of euro today = 1.33/.10 ,(One Euro = 13.33 pesos)

Cross rate of euro one year ago = 1.40/.09 (One euro = 15.55 pesos)
Percentage change= (13.33-15.55)/15.55=-14.3%

Thus, the euro depreciated against the peso by 14.3 percent over the
last year.

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Movements in Cross Exchange Rates
If currencies A and B move in same direction by the same
magnitude against the dollar. 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 against the dollar.
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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.
Most common strategy to speculate:
Carry Trade
The “Carry Trade” — Where investors attempt to capitalize
on the differential in interest rates between two countries.
• Impact of appreciation in the investment currency:
Increased trade volume can have a major influence on
exchange rate movements over a short period.
• Risk of the Carry Trade: Exchange rates may move
opposite to what the investors expected.
Speculating on
Anticipated Exchange Rates
Many commercial banks attempt to capitalize on their
forecasts of anticipated exchange rate movements in
the foreign exchange market.
The potential returns from foreign currency
speculation are high for banks that have large
borrowing capacity.
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 $20,912,320

million
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
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 $20,112,000
million
Speculating on
Anticipated Exchange Rates
 Exchange rates are very volatile, and a poor forecast
can result in a large loss.
One well-known bank failure, Franklin National Bank
in 1974, was primarily attributed to massive
speculative losses from foreign currency positions.
SUMMARY (1 of 3)
• 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
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.
SUMMARY (2 of 3)
• The key economic factors that can influence exchange rate
movements through their effects on demand and supply
conditions are relative inflation rates, interest rates, income
levels, and government controls. When these factors lead to a
change in international trade or financial flows, they affect the
demand for a currency or the supply of currency for sale and
thus the equilibrium exchange rate. If a foreign country
experiences an increase in interest rates (relative to U.S. interest
rates), then the inflow of U.S. funds to purchase its securities
should increase (U.S. demand for its currency increases), the
outflow of its funds to purchase U.S. securities should decrease
(supply of its currency to be exchanged for U.S. dollars
decreases), and there should be upward pressure on its
currency’s equilibrium value. All relevant factors must be
considered simultaneously when attempting to predict the most
likely movement in a currency’s value.
SUMMARY (3 of 3)
• There are distinct international trade and financial flows
between every pair of countries. These flows dictate the unique
supply and demand conditions for the currencies of the two
countries, which affect the equilibrium cross exchange rate
between their currencies. Movement in the exchange rate
between two non-dollar currencies can be inferred from the
movement in each currency against the dollar.
• Financial institutions can attempt to benefit from the expected
appreciation of a currency by purchasing that currency.
Analogously, they can benefit from expected depreciation of a
currency by borrowing that currency and exchanging it for their
home currency.