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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. The Determination of Exchange Rates. Chapter 2. CHAPTER 2 THE DETERMINATION OF EXCHANGE RATES. CHAPTER OVERVIEW:

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Foundations of multinational financial management alan shapiro j wiley sons l.jpg

Foundations of Multinational Financial ManagementAlan ShapiroJ.Wiley & Sons

Power Points by

Joseph F. Greco, Ph.D.

California State University, Fullerton



Chapter 2 the determination of exchange rates l.jpg
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 country’s 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 country’s 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 goods.€ in the U.S.

$/ €

S

$.50

Qty


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Equilibrium Exchange Rates goods.

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 $/ goods.€ Equilibrium Rate

$/ €

Equilibrium

D

S

$.50

Qty


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Equilibrium Exchange Rates goods.

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 goods.

C.3. Home Currency Depreciation a. Foreign currency more valuable than the home currency.

b. Conversely, then the foreign

currency’s value has appreciated against the home currency.


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The US$ Depreciates When goods.

$/ €

D’

D

$.65

S

$.50

Qty

Q1

Q2


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Rules of Calculation goods.

If Numerator currency depreciates,

e1 > 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 goods.

C.5 Currency Appreciation

= (e1 - e0)/ e0

where e0 = old currency value

e1 = new currency value


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Equilibrium Exchange Rates goods.

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 goods.

C.4. Calculating a Depreciation:

= (e0 - e1)/ e1

where e0 = old currency value

e1 = new currency value


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Equilibrium Exchange Rates goods.

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 goods.

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 goods.

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




Solution l.jpg
SOLUTION goods.


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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 ruble depreciated 83% against the dollar.

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


Slide30 l.jpg


U s appreciation31 l.jpg
U.S. $ APPRECIATION ruble depreciated 83% against the dollar.


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SOLUTION ruble depreciated 83% against the dollar.


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Find the appreciation: ruble depreciated 83% against the dollar.

Substituting:

Summing the numerator


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Equilibrium Exchange Rates ruble depreciated 83% against the dollar.

D. OTHE FACTORS AFFECTING EXCHANGE RATES:

1. Relative Inflation rates

2. Relative Interest rates

3. Relative economic growth rates

4. Political risk

5. Expectations


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