Multinational Finance

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Multinational Finance

• Exchange Rate Determination
• Dr. George Ogum

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Outline

• How exchange rate movements are measured
• How the equilibrium exchange rate is determined
• Factors that affect the equilibrium exchange rate
• Inflation rates and equilibrium exchange rate
  (PPP theory)
• Interest rates and equilibrium exchange rates
  (IRP theory)

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Introduction

• Exchange rates
• Enable us to translate currencies of different
  countries into comparable terms
• Are determined in the same way as other asset
  prices
• The General goal of this lecture is to show
• How exchange rates are determined
• The role of exchanger rates in international
  trade

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Foreign Exchange Market

• Exchange rates are determined in the foreign
  exchange market
• The foreign exchange market
• Is the market where one buys (or sells) the
  currency of country A with (or for) the currency
  of country B

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Foreign Exchange Market

• A currency exchange rate
• Represents the number of units of one currency
  that exchanges for a unit of another
• There are two ways to express an exchange rate
  between two currencies (e.g. the and
  pound). One can either write / or /.
  These are reciprocals of each other. Thus if e
  is the / exchange rate and v is the /
  exchange rate then e 1/v
• For Example, on Jan 8, 1997 the following
  exchange rates prevailed,
• e/ 1.69 which implies v / 0.59
• v/ 116. which implies e / 0.0086
• Currency Value Currency value is therefore given
  in terms of another currency Thus the value of a
  US dollar in terms of British pounds is the /
  exchange rate.

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The Foreign Exchange Market

• Exchange rates are determined in the foreign
  exchange market
• The market in which international currency trades
  take place
• The Actors
• The major participants in the foreign exchange
  market are
• Commercial banks
• International corporations
• Nonbank financial institutions
• Central banks

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Measuring Exchange Rate Movements

• Fluctuating value
• Exchange rate
• value of one currency in units of another

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Measuring Exchange Rate Movements

• Two types of changes in exchange rates
• Depreciation of home countrys currency
• A rise in the home currency prices of foreign
  currency
• It makes home goods cheaper of r foreigners and
  foreign goods more expansive for domestic
  residents
• Appreciation of home countrys currency
• A fall in the home price of a foreign currency
• It makes home goods more expensive for foreigners
  and foreign goods cheaper for domestic residents

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Exchange Rate Movement

• Types of transactions in the foreign exchange
  market
• Spot exchange rates
• Apply to exchange currencies on the spot
• Forward exchange rates
• Apply to exchange currencies on some future date
  at a prenegotiated exchange rate
• Foreign Exchange Swaps
• Spot sales of a currency combined with a forward
  repurchase of the currency.
• They make up a significant proportion of all
  foreign exchange trading.
• Foreign Exchange option
• The owner has the right to buy or sell a
  specified amount of foreign currency at a
  specified price at any time up to a specified
  expiration date

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Exchange Rate Movement

• Spot ratepercent change in valueIf the home
  country is the United States then the price of a
  foreign currency say British Pound (), is
  expressed as / (Direct Quotation).

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Exchange Rate Movement

• This is the U.S Dollar price of British Pound.
  If this exchange rate rises then we say that the
  pound has risen in value, or that the pound has
  strengthened (relative to the U.S dollar).

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Exchange Rate Movement

• For example, percent change from 1995 to 1996 is
  (1.580 - 1.550)/1.550 x 100 1.9.
• The change is a positive sign which shows an
  appreciation in British pounds value relative to
  US .

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Exchange Rate Movement

• A negative sign would show a depreciation of the
  British Pound relative to the U.S Dollar.

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Exchange Rate and International Transactions

• An exchange rate can be quoted in two ways
• Direct exchange rate of
• The price of the foreign currency (CAD) in terms
  of dollars
• Ex 1CAD 0.8USD 0.8 per Canadian dollar

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Exchange Rate and International Transactions

• Indirect exchange rate of
• The price of dollars in terms of the foreign
  currency (CAD)
• Ex 1USD 1.25 CAD Canadian dollar 1.25 per U.S.
  

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Exchange Rates and International Transactions

• Exchange Rates and Relative Prices
• Import and export demands are influenced by
  relative prices.
• Appreciation of a countrys currency
• Raises the relative price of its exports
• Lowers the relative price of its imports

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Exchange Rates and International Transactions

• Depreciation of a country's currency
• Lowers the relative price of its exports
• Raises the relative price of its imports

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Exchange Rates and International Transactions

• Vehicle currency
• A currency that is widely used to denominate
  international contracts made by parties who do
  not reside in the country that issues the vehicle
  currency.
• Vehicle currency is also used to obtain a cross
  rate (particularly in currencies that are not
  convertible with each other)

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Exchange Rates and International Transactions

• Example In 2001, around 90 of transactions
  among banks involved exchanges of foreign
  currencies for U.S. dollars.

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Exchange Rates and International Transactions

• Cross Rate is an exchange rate between two
  currencies when it is obtained from the rates of
  these two currencies in terms of a third
  currency.
• Lets assume the the dollar price of the British
  pound is 0.6250/ per dollar and that the
  Mexican peso price of a the dollar is Mex4 per
  dollar.

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Exchange Rates and International Transactions

• To determine the price of pounds in terms of
  Mexican pesos or the price of Mexican pesos in
  terms of pounds, one must convert both quotations
  to a common denominator, i.e. the US dollar
• 0.6250/ (as initially given)
• Mex4.0000/ (as initially given)
• Because the prices of dollars are now quoted in
  terms of both pounds and pesos, we can obtain the
  price of pounds in terms of pesos
• Mex/ 4.0000 Mex6.4000/
• 0.6250

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Exchange Rate and Intentional Transactions

• Similarly, we can determine the price of pesos in
  terms of pounds
• /Mex 0.6250 Mex/ 0.1563/Mex
• 4.0000
• The exchange rate between two currencies is
  called the cross rate if it is obtained from the
  rates of these tow currencies in terms of a third
  currency.

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Exchange Rate Equilibrium

• Spot exchange rate
• price of a currency at a specific time
• price set by supply and demand for the currency

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Exchange Rate Equilibrium

• Demand for currency
• e.g., US demand for pound sterling

value
D
quantity
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Exchange Rate Equilibrium

• Supply for a currency
• e.g., supply of British pound
• the greater the price offered, the greater the
  supply

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Exchange Rate Equilibrium

• Exchange rate reflects supply and demand
• lower US means cheaper US goods for British
• increased demand for US goods implies greater
  demand for US

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Factors Affecting Exchange Rates

• Relative interest rates
• Relative inflation rates
• Relative income levels
• Government controls
• Expectations
• Interaction of all the above factors

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Factors Affecting Exchange Rates

• Relative real interest rates
• affects investment in foreign securities
• e.g., US interest rates rises relative to British
  interest rates
• British MNCs shift deposits to US banks

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Factors Affecting Exchange Rates

• increase in British supply of pounds for sale for
  US
• decrease in British MNC demand for pounds
• pound falls in value relative to US

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Factors Influencing Exchange Rates
Value of
S
S2
r
r2
D
D2
Quantity of

• Relative Interest Rates
• A relative rise in U.S. interest rates will
  decrease the U.S. demand for British pounds. In
  addition, the supply of pounds by British
  Corporations will increase

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Factors Affecting Exchange Rates

• Relative interest rates determine exchange rates
  in the short-run
• The impact of interest rates on exchange rates is
  captured by the concept Interest Rate Parity
  (IRP).
• IRP holds when the rate of return on deposits of
  all currencies are just equal

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Factors Affecting Exchange Rates

• Interest Parity The basic Equilibrium
  Condition.
• The foreign exchange market is in equilibrium
  when deposits of all currencies offer the same
  expected rate of return.

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Factors Affecting Exchange Rates

• Interest parity condition
• The expected returns on deposits of any two
  currencies are equal when measured in the same
  currency.
• It implies that potential holders of foreign
  currency deposits view them all as equally
  desirable assets.

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Factors Affecting Exchange Rates

• Interest parity holds when there are no covered
  interest arbitrage opportunities. This
  no-arbitrage condition can be stated as follows
• e1 1 Rh
• e0 1 Rf
• Using Interest Rate Parity to Calculate the /
  Forward Rate
• The interest rate in the United States is 10
  percent in Japan, the comparable rate is
  7percent. The spot rate for eth yen is
  0.003800. If interest rate parity holds, what
  is the 90day forward rate?
• Solution. According to IRP, the 90-day forward
  rate on the yen, f90, should be 0.003828
• F90 1 (0.10/4)
  0.003828
• 0.003800 1 (0.07/4)

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Factors Affecting Exchange Rates

• Relative inflation rates
• affects supply and demand for currency
• impacts international trade

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Factors Affecting Exchange Rates

• For Example, US inflation rises against British
  inflation
• British goods become less expensive relative to
  US
• increase of US demand for pound sterling
• decrease in British demand for expensive US
  goods
• decrease in British demand for US
• decrease in supply of pounds on sale for US
• British pound increases in value against the US
  

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Factors Affecting Exchange Rates
Value of
S2
S
r2
r
D2
D
Quantity of

• Relative Inflation Rates
• A relative increase in U.S. inflation will
  increase the U.S. demand for British goods, and
  hence the U.S. demand for British pounds. In
  addition, the British desire for U.S. goods, and
  hence the supply of pounds, will drop.

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Factors Affecting Exchange Rates

• Relative inflation rates determine exchange rates
  in the long-run
• The impact of inflation rates on exchange rates
  is captured by the concept Purchasing Power
  Parity (PPP).
• PPP holds when identical products sold in
  different countries sell for the same price when
  their price is expressed in the same currency.

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Factors Affecting Exchange Rates

• Purchasing Power Parity The basic Equilibrium
  condition in the long run.
• The foreign exchange market is in equilibrium
  when the law of one price holds for all goods and
  servicesthe PPP exchange rate can be found by
  comparing prices of identical products in
  different countries (e.g. Big Mac Index)

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Factors Affecting Exchange Rates

• Purchasing Power Parity
• PPP suggests that changes in relative prices
  between countries will lead to exchange rate
  changes. Changes in relative prices in two
  countries will change the exchange rate of their
  currencies the country with the highest price
  inflation should see its currency decline in
  value.

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Factors Affecting Exchange Rates

• The PPP is a theory of exchange rate
  determination in the long run and it can be
  stated as follows
• e1 1 Ih
• e0 1 If
• SAMPLE QUESTION
• The inflation rate in the United States is
  expected to be 4 per year and the inflation rate
  in France is expected to be 6 per year. If the
  current spot rate is 1 FF12.50, what is the
  expected spot rate in one year? in two years?

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Summary

• Exchange rates play a role in spending decisions
  because they enable us to translate different
  countries prices into comparable terms.
• A depreciation (appreciation) of a countrys
  currency against foreign currencies makes its
  exports cheaper (more expensive) and its imports
  more expensive (cheaper).
• Exchange rates are determined in the foreign
  exchange market.

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Summary

• An important category of foreign exchange trading
  is forward trading.
• The exchange rate is most appropriately thought
  of as being an asset price itself.
• The returns on deposits traded in the foreign
  exchange market depend on interest rates and
  expected exchange rate changes.

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Summary

• At the most basic level, exchange rates are
  determined by the demand and supply for different
  currencies
• Factors that affect the supply and demand suggest
  Economic Theories of exchange rate determination
  some of which include

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Summary

• Interest Rate Parity-- the rate of return on
  deposits of all currencies in different countries
  are just equal
• Purchasing Power parity-- holds when identical
  products sold in different countries sell for the
  same price when their price is expressed in the
  same currency.

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Conclusion

• Exchange rates are influenced by many factors
  and the major ones include
• Relative interest rates
• Relative inflation rates
• Relative Income levels
• Government Controls
• Expectation
• Interaction of all the above