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8/13/2019 Fin 444 Chp 4 Slides
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Exchange Rate Determination
4
Chapter
South-Western/Thomson Learning 2003
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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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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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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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Value of
Quantity of
D: Demand for
$1.55
$1.50
$1.60
S: Supply of
equilibriumexchange rate
Exchange Rate Equilibrium
An exchange rate represents the price of a
currency, which is determined by the
demand for that currency relative to the
supply for that currency.
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$/
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 .
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$/
Quantity of
r0
S0
D0
S1
D1
r1
U.S. interest rates
U.S. demand for
British bank deposits,
and hence .
Factors that Influence
Exchange RatesRelat ive In terest Rates
British desire for U.S.bank deposits, and
hence the supply of .
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Relat ive In terest Rates
Factors that Influence
Exchange Rates
It is thus useful to consider real in terestrates, which adjust the nominal interest
rates for inflation.
A relatively high interest rate may actually
reflect expectations of relatively highinflation, which discourages foreign
investment.
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Relat ive In terest Rates
Factors that Influence
Exchange Rates
This relationship is sometimes called the
Fisher effect.
real nominal
interest interest inflation raterate rate
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$/
Quantity of
S0
D0
r0
U.S. income level
U.S. demand for
British goods, and
hence .D
1
r1
Factors that Influence
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.
Factors that Influence
Exchange Rates
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Expectat ions
Factors that Influence
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.
Factors that Influence
Exchange Rates
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Interact ion of Facto rs
Factors that Influence
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.
Factors that Influence
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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Measuring Exchange Rate Movements
Exchange Rate Equilibrium Demand for a Currency
Supply of a Currency for Sale
Equilibrium
Chapter Review
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Chapter Review
Speculating on Anticipated Exchange
Rates
How Exchange Rates Affect an MNCsValue
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