fin 444 chp 4 slides

8/13/2019 Fin 444 Chp 4 Slides

1/24

Exchange Rate Determination

4

Chapter

South-Western/Thomson Learning 2003


2/24

B4 - 2

Chapter Objectives

To explain how exchange rate movements

are measured;

To explain how the equilibrium exchange

rate is determined; and

To examine the factors that affect the

equilibrium exchange rate.


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B4 - 3

Measuring

Exchange Rate Movements An exchange ratemeasures the value of

one currency in units of another currency.

When a currency declines in value, it issaid to depreciate. When it increases in

value, it is said to appreciate.

On the days when some currenciesappreciate while others depreciate against

the dollar, the dollar is said to be mixed

in trading.


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B4 - 4

Measuring

Exchange Rate Movements The percentage change (% in the value

of a foreign currency is computed as

StSt-1St-1

where Stdenotes the spot rate at time t.

A positive % represents appreciation ofthe foreign currency, while a negative %

represents depreciation.


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B4 - 5

Value of

Quantity of

D: Demand for

$1.55

$1.50

$1.60

S: Supply of

equilibriumexchange rate

Exchange Rate Equilibrium

An exchange rate represents the price of a

currency, which is determined by the

demand for that currency relative to the

supply for that currency.


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B4 - 6

$/

Quantity of

S0

D0

r0

U.S. inflation

U.S. demand for

British goods, and

hence .

D1

r1

S1

Factors that Influence

Exchange RatesRelat ive In f lat ion Rates

British desire for U.S.goods, and hence the

supply of .


7/24B4 - 7

$/

Quantity of

r0

S0

D0

S1

D1

r1

U.S. interest rates

U.S. demand for

British bank deposits,

and hence .


Exchange RatesRelat ive In terest Rates

British desire for U.S.bank deposits, and

hence the supply of .


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Relat ive In terest Rates


Exchange Rates

It is thus useful to consider real in terestrates, which adjust the nominal interest

rates for inflation.

A relatively high interest rate may actually

reflect expectations of relatively highinflation, which discourages foreign

investment.


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Relat ive In terest Rates


Exchange Rates

This relationship is sometimes called the

Fisher effect.

real nominal

interest interest inflation raterate rate


10/24B4 - 10

$/

Quantity of

S0

D0

r0

U.S. income level

U.S. demand for

British goods, and

hence .D

1

r1


Exchange RatesRelat ive Inc om e Levels

No expected change forthe supply of .

,S1


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Expectat ions

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.


Exchange Rates


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Expectat ions


Exchange Rates

Fed chairman suggests Fed is Strengthenedunlikely to cut U.S. interest rates

A possible decline in German Strengthenedinterest rates

Central banks expected to Weakenedintervene to boost the euro

Signal Impact on $

Poor U.S. economic indicators Weakened


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Interact ion of Facto rs

Trade-related factors and financial factors

sometimes interact. Exchange ratemovements may be simultaneously

affected by these factors.

For example, an increase in the level ofincome sometimes causes expectations of

higher interest rates.


Exchange Rates


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Interact ion of Facto rs


Exchange Rates

The sensitivity of the exchange rate to

these factors is dependent on the volumeof international transactions between the

two countries.

Over a particular period, different factors

may place opposing pressures on thevalue of a foreign currency.


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Trade-Related

Factors1. Inflation

Differential2. Income

Differential3. Govt TradeRestrictions

Financial

Factors1. Interest Rate

Differential

2. Capital Flow

Restrictions

How Factors Can Affect Exchange Rates

U.S. demand for foreigngoods, i.e. demand for

foreign currency

Foreign demand for U.S.goods, i.e. supply offoreign currency

U.S. demand for foreign

securities, i.e. demandfor foreign currency

Foreign demand for U.S.securities, i.e. supply of

foreign currency

Exchangerate

betweenforeign

currency

and thedollar


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How Facto rs Have Inf luenced Exchange Rates

Because the dollars value changes by

different magnitudes relative to eachforeign currency, analysts often measure

the dollars strength with an index.

The weight assigned to each currency isdetermined by its relative importance in

international trade and/or finance.


Exchange Rates


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With Respect to the Dol lar

Value of Foreign Currency Index Over Time

0

50

100

150

200

250

1972 1976 1980 1984 1988 1992 1996 2000

streng

thens$we

akens

Note: The index reflects equal weights of , , French franc, German mark, and Swiss franc.

$due torelatively highU.S. inflation

& growth

high U.S.interest rates, a

somewhat depressedU.S. economy, & low

inflation

largebalanceof tradedeficit

relatively high U.S.interest rates, &lower balance of

trade deficit

PersianGulf War

U.S. interest rates

HigherU.S.interestrates


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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.

Exchange at

$0.48/NZ$

4. HoldsNZ$41,900,000

2. Holds$20 million

Exchange at

$0.50/NZ$

1. BorrowsNZ$40 million

Borrows at 6.96%

for 30 days

Lends at 6.72%for 30 days 3. Receives

$20,112,000

Returns NZ$40,232,000Profit of NZ$1,668,000

or $800,640


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Impact of Exchange Rates on an MNCs Value

) ) )

n

tt

m

j

tjtj

k1=

1

,,

1

ERECFE

=Value

E (CFj,t ) = expected cash flows in currencyjto be receivedby the U.S. parent at the end of period t

E (ERj,t ) = expected exchange rate at which currencyjcanbe converted to dollars at the end of period t

k = weighted average cost of capital of the parent

Inflation Rates, Interest Rates,Income Levels, Government Controls,

Expectations


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B4 - 22

Measuring Exchange Rate Movements

Exchange Rate Equilibrium Demand for a Currency

Supply of a Currency for Sale

Equilibrium

Chapter Review


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24/24

B4 24

Chapter Review

Speculating on Anticipated Exchange

Rates

How Exchange Rates Affect an MNCsValue

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