CHAPTER 4: Exchange Rate Determination

*Financial managers of MNCs that conduct international business must

continuously monitor exchange rates because their cash flows are
highly dependent on them

British SUPPLY of pounds

I. Managing Exchange Rate Movements

As economic conditions change, exchange rates can change

substantially

Appreciate increase in currency strength/value

Depreciate decrease in currency strength/value

% change in exchange rate

S t - St-1
St

x100%

Where:
St spot rate at more recent period
St-1 spot rate at earlier period
(+) change indicates appreciation
(-) change indicates depreciation

Volatility drasticness of change

Movement change in exchange rate
Movements tend to be more volatile for longer time horizons;
Movements in daily assessments are less volatile than
movements in yearly assessments
Length of time horizons where exchange rate movement
measurements are based depend on whether a firms
transactions will occur in the near (just days from now) or
distant future (a year from now).

What does the phrase British supply of pounds mean? That

phrase means that the supply of pounds in the US came
from the UK. It does NOT refer to supply of pounds in the UK
British supply of pounds increases as price of pounds
increases (price, supply).
That happens because a more expensive currency (pounds
in this case) is stronger or has more buying power. Of
course, British investors will take advantage of this by buying
dollars and investing so much in the US.

Equilibrium Exchange Rate

II. Exchange Rate Equilibrium

Measuring exchange rate movements is easy. What is

difficult is to explain why they move the way they do or to
forecast how it may change in the future. To explain or
forecast exchange rate movements, understanding first
exchange rate equilibrium is necessary

The price of a currency depends on the supply and demand

of that currency (law of supply and demand)
U.S. DEMAND for pounds

What does the phrase US demand for pounds mean? That

phrase means that the demand of pounds came from the
US.
US demand for pounds increases as price of pounds
decreases and vice versa(price, demand)

At an exchange rate of $1.50, the quantity of pounds

demanded would exceed the supply of pounds for sale. And
at an exchange rate of $1.60, the quantity of pounds
demanded would be less than the supply of pounds for sale.
According to the graph, the equilibrium exchange rate is
$1.55 because this rate equates the quantity of pounds
demanded with the supply of pounds for sale.
Impact of spot market liquidity: illiquid currencies are low in
supply. Its exchange rate is highly sensitive to a single
sale/purchase.

III. Factors That Influence Exchange Rates

Factors that influence currency supply and demand will also

influence exchange rates
(1) Relative Inflation Rate

(2)

Changes in inflation rates affect international trade

activities which influence supply and demand of
currencies which, consequently, also influence
exchange rates.
US inflation will:
1. US demand for British goods, US
demand for pounds
2. British demand for US goods, British
supply of pounds in the ForEx market

(4)

Government Control
The government of foreign countries can influence
equilibrium exchange rates in many ways:
1. Imposing foreign exchange barriers
2. Imposing foreign trade barriers
3. Affecting macrovariables such as inflation
rates, interest rates, and income levels
Recall the instance on increase in US interest rates.
British supply for pounds increased right? Yet, if the
British government placed a heavy tax on interest
income earned from foreign investments, this could
discourage the exchange of pounds for dollars

(5)

Market expectations for future exchange rates

Foreign exchange markets react to changes in inflation
rate / interest rate / other factors even before they
occur.
Currency supply and demand (which influence
exchange rates) will be affected

Interaction of factors
Think about this:
Assume the simultaneous existence of (1) a
sudden increase in U.S. inflation and (2) a sudden
increase in U.S. interest rates. If the British
economy is relatively unchanged, the increase in
U.S. inflation will place upward pressure on the
pounds value because of its impact on
international trade. Yet, the increase in U.S.
interest rates places downward pressure on the
pounds value because of its impact on capital
flows.
The sensitivity of an exchange rate to these
factors is dependent on the volume of international
transactions between the two countries. If the two
countries engage in a large volume of international
trade but a very small volume of international
capital flows, the relative inflation rates will likely
be more influential. If the two countries engage in
a large volume of capital flows, however, interest
rate fluctuations may be more influential.

Summary of how factors can affect exchange rates

Relative Interest Rate

Changes in relative interest rates affect investments in

foreign securities which, consequently, also influence
exchange rates.
Increase in U.S. interest rates will attract foreign
investors:
1. US demand for British securities, US
demand for pounds
2. British demand for US securities, British
supply of pounds in the market
Real Interest Rate: In reality, a relatively high interest
rate expected high inflation rate. For this reason, it is
helpful to consider the real interest rate.

Real interest rate = nominal interest rate inflation rate

(3)

Why does a high inflation rate increase interest rates in

banks? Remember, too much money in circulation
causes prices of commodities to rise (inflate). What the
Central Bank / Federal Reserve does to combat
inflation is to increase interest rates of commercial
banks to attract investors. That way money is kept in
banks and to not circulate in the local economy.

Relative Income Levels

Movements in Cross Exchange Rates

Example: Cross rate of euro to Mexican peso

Income can affect imports and foreign investments

which, consequently, also influence exchange rates.
Increase in US income:
1. US demand for British goods, US
demand for pounds
2. No effect on British supply of pounds

Forecasted spot rate in one year (St)

1.00 = $1.33
M = $0.10
Spot rate today (St-1)
1.00 = $1.40
M = $0.09

Cross rate of in one year = 1.33/0.10 = M13.33

Cross rate of today = 1.40/0.09 = M15.55

% change / movement

13.33 -15 ,55

15.55

x100%= -

14.3%
Anticipation of Exchange Rate Movements
(1) Institutional Speculation Based on Expected Appreciation
Example A

(2)

Institutional Speculation Based on Expected Depreciation

Example B