Chapter Five
Exchange Rate
Determination 5
INTERNATIONAL
FINANCIAL
Chapter Objectives: MANAGEMENT
This chapter aims to:
Explain how exchange rate movements are measured;
Explain how the equilibrium exchange rate is determined; and
EUN / RESNICK
Second Edition
Examine the factors that affect the equilibrium exchange
rate.e the factors that affect the equilibrium exchange
Chapter Outline
Measuring Exchange Rates Movements
Exchange Rate Equilibrium
The Factors influencing Exchange Rates
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 the dollar, the dollar 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.
Fluctuation of the GBP over time
Exchange Rate Equilibrium
Factors Influencing Exchange Rates
Factors Influencing Exchange Rates
Factors Influencing Exchange Rates
Relative Interest Rates
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.
Factors Influencing Exchange Rates
Relative Interest Rates
• real nominal
interest interest – inflation rate
rate rate
This relationship is sometimes called the Fisher
effect.
Factors Influencing Exchange Rates
Factors Influencing 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 Influencing 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.
Factors Influencing Exchange Rates
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
intervene to boost the euro
Factors Influencing Exchange Rates
Interaction of Factors
Trade-related factors and financial factors
sometimes interact. Exchange rate movements
may be simultaneously affected by these factors.
For example, an increase in the level of income
sometimes causes expectations of higher interest
rates.
How Factors Can Affect Exchanges
Rates
Factors Influencing Exchange Rates
How Factors Have Influenced Exchange Rates
Because the dollar’s value changes by different
magnitudes relative to each foreign currency,
analysts often measure the dollar’s strength with
an index.
The weight assigned to each currency is
determined by its relative importance in
international trade and/or finance.
Value of Foreign Currency Index
Over Time
Speculating on Anticipated
Exchange Rates
Speculating on Anticipated
Exchange Rates
Impact of Exchange Rates on an
MNC’s Value
Articles for next Class
10. *“Yen Carry Trade Unravelling Faster,”
Forbes Magazine, Aug.16, 2007.
11. “Myths and Realities of the Global Capital
Market: Lessons for Financial Managers, "Journal
of Applied Corporate Finance, Fall 1993, page
81-90.
