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Foundations of Multinational Financial Management Alan Shapiro J.Wiley & Sons

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### Foundations of Multinational Financial ManagementAlan ShapiroJ.Wiley & Sons

### The Determination of Exchange Rates

Power Points by

Joseph F. Greco, Ph.D.

California State University, Fullerton

Chapter 2

CHAPTER 2THE DETERMINATION OF EXCHANGE RATES

CHAPTER OVERVIEW:

I. EQUILIBRIUM EXCHANGE RATES

II. ROLE OF CENTRAL BANKS

III. EXPECTATIONS AND THE ASSET MARKET MODEL

Commonly Used Terms

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

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.

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

Equilibrium Exchange Rates

B.2. Foreign Currency Supply:

a. derived from the foreign country’s demand for local goods.

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.

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.

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.

Equilibrium Exchange Rates

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.

Rules of Calculation

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

Equilibrium Exchange Rates

C.5 Currency Appreciation

= (e1 - e0)/ e0

where e0 = old currency value

e1 = new currency value

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%

Equilibrium Exchange Rates

C.4. Calculating a Depreciation:

= (e0 - e1)/ e1

where e0 = old currency value

e1 = new currency value

Equilibrium Exchange Rates

EXAMPLE: US$ Depreciation

Use the formula

(e0 - e1)/ e1

substituting

(.50 - .65)/ .65 = - 23.1%

is the US$ depreciation

COMPUTATION GUIDELINES

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

Given: Find:

or

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?

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

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?

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

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