Foundations of Multinational Financial Management Alan Shapiro J.Wiley

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Foundations of Multinational Financial
Management Alan Shapiro J.Wiley Sons

• Power Points by
• Joseph F. Greco, Ph.D.
• California State University, Fullerton

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The Determination of Exchange Rates

• Chapter 2

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CHAPTER 2THE DETERMINATION OF EXCHANGE RATES

• CHAPTER OVERVIEW
• I. EQUILIBRIUM EXCHANGE RATES
• II. ROLE OF CENTRAL BANKS
• III. EXPECTATIONS AND THE ASSET MARKET MODEL

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Commonly Used Terms

• Pegged Currency
• Devaluation
• Revaluation
• Floating currency
• Depreciation
• Appreciation

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Part I. Equilibrium Exchange Rates

• I. SETTING THE EQUILIBRIUM
• A. The exchange rate
• is the local currency price of one unit of
  foreign currency
• For example 1.30/ means the euro in theU.S. is
  worth 1.30.

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The Demand for in the U.S.

• B. How Americans Purchase German Goods
• 1. Foreign Currency Demand
• -derived from the demand for a foreign
  countrys goods, services, and financial
  assets.
• e.g. The demand for euros comes from the
  demand for German goods by Americans

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The Demand for in the U.S.

/
D
.50
Qty
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Equilibrium Exchange Rates

• B.2. Foreign Currency Supply
• a. derived from the foreign countrys
  demand for local goods.

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• b. They must convert their currency to purchase
  the foreign goods.
• That means the supply of euros comes from
  the German demand for US goods which means
  Germans convert euros to US in order to buy.

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The Supply of in the U.S.

• /

S
.50
Qty
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Equilibrium Exchange Rates

• B.3. Equilibrium Exchange Rate
• occurs where the quantity supplied equals
  the quantity demanded of a foreign currency
  at a specific local price.

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The / Equilibrium Rate

• /

Equilibrium
D
S
.50
Qty
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Equilibrium Exchange Rates

• C. How Exchange Rates Change
• 1. Increased demand
• as more foreign goods are demanded, more
  of the foreign currency is demanded at each
  possible exchange rate
• 2. The price of the foreign currency in
  local currency increases.

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Equilibrium Exchange Rates

• C.3. Home Currency Depreciation a. Foreign
  currency more valuable than the home
  currency.
• b. Conversely, then the foreign
• currencys value has appreciated
  against the home currency.

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The US Depreciates When

• /

D

D
.65
S
.50
Qty
Q1
Q2
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Rules of Calculation

• If Numerator currency depreciates,
• e1 gt e0 0.50 (e0) to 0.65 (e1),
• then calculate depreciation by using
• (e0 - e1)/ e1
• And Denominator currency appreciates,
• then calculate appreciation by using
• (e1 - e0)/ e0

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Equilibrium Exchange Rates

• C.5 Currency Appreciation
• (e1 - e0)/ e0
• where e0 old currency value
• e1 new currency value

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Equilibrium Exchange Rates

• EXAMPLE Appreciation
• If the dollar value of the goes from 0.50
  (e0) to 0.65 (e1), then the has appreciated by
• (.65 - .50)/ .50 30

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Equilibrium Exchange Rates

• C.4. Calculating a Depreciation
• (e0 - e1)/ e1
• where e0 old currency value
• e1 new currency value

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Equilibrium Exchange Rates

• EXAMPLE US Depreciation
• Use the formula
• (e0 - e1)/ e1
• substituting
• (.50 - .65)/ .65 - 23.1
• is the US depreciation

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COMPUTATION GUIDELINES

• If you are given a rate of appreciation or
  depreciation and asked to find the opposite
  value
• Given Find
• or

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Sample Problem No.1

• Suppose the U.S. dollar appreciates against the
  Russian ruble by 500. How much did the ruble
  depreciate against the dollar?

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U.S. APPRECIATION
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• Depreciation of the ruble

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SOLUTION
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• When the dollar appreciated by 500 against the
  ruble, the ruble depreciated 83 against the
  dollar.

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Sample Problem No.2

• Suppose the Russian ruble depreciates against
  the U.S. dollar by 83. How much did the dollar
  appreciates against the ruble?

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• Depreciation of the ruble

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U.S. APPRECIATION
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SOLUTION
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Find the appreciation
Substituting
Summing the numerator
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Equilibrium Exchange Rates

• D. OTHE FACTORS AFFECTING EXCHANGE RATES
• 1. Relative Inflation rates
• 2. Relative Interest rates
• 3. Relative economic growth rates
• 4. Political risk
• 5. Expectations