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Multinational Financial

Management
Alan Shapiro
th
7
Edition
Power Points by

J.Wiley
& Sons
Joseph
F. Greco,
Ph.D.
California State University, Fullerton
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CHAPTER 2
THE
DETERMINATION OF
EXCHANGE RATES
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CHAPTER 2 OVERVIEW:
I.
II.
III.

EQUILIBRIUM EXCHANGE
RATES
ROLE OF CENTRAL BANKS
EXPECTATIONS AND THE
ASSET MARKET MODEL

Part I.
Exchange
Rates
I.Equilibrium
SETTING THE
EQUILIBRIUM
A. Exchange Rates
market-clearing prices that
equilibrate the quantities
supplied and demanded of
foreign currency.
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Equilibrium Exchange Rates


B. How Americans Purchase
German Goods
1. Foreign Currency Demand
-derived from the demand for
foreign countrys goods,
services, and financial
assets.
e.g. The demand for German
goods by Americans
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Equilibrium Exchange Rates


2. Foreign Currency Supply:
a. derived from the foreign
countrys demand for
local goods.
b. They must convert their
currency to purchase.
e.g. German demand for US goods
means Germans convert Euros to
US$ in order to buy.

Equilibrium Exchange Rates


3. Equilibrium Exchange Rate:
occurs when the quantity
supplied equals the
quantity
demanded of
a foreign
currency
at a specific local
price.
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Equilibrium Exchange Rates


C. How Exchange Rates Change
1. Increased demand
as more foreign goods are
demanded, the price of the foreign
currency in local
currency
increases and vice versa.

Equilibrium Exchange Rates


2. Home Currency Depreciation
a.

Foreign currency becomes


more valuable than the home
currency.
b. The foreign currencys
value
has appreciated against the home
currency.

Equilibrium Exchange Rates


3. Calculating a Depreciation:
Currency Depreciation

e0 e1

e1

where e0 = old currency value


e1 = new currency value
Note: Resulting sign is always negative
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Equilibrium Exchange Rates


Currency Appreciation

e1 e0

e0

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Equilibrium Exchange Rates

EXAMPLE: euro appreciation


If the dollar value of the euro goes
from $0.64 (e0) to $0.68 (e1), then
the euro
e1 by
e0
has appreciated

e0

= (.68 - .64)/ .64


= 6.25%
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Equilibrium Exchange Rates


EXAMPLE: US$ Depreciation
We use the first formula,
(e0 - e1)/ e1
substituting
(.64 - .68)/ .68 = - 5.88%
which is the value of the US$
depreciation.
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Equilibrium Exchange Rates


D. FACTORS AFFECTING
EXCHANGE RATES:
1. Inflation rates
2. Interest rates
3. GNP growth rates

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PART II.

THE ROLE OF CENTRAL


BANKS

I. FUNDAMENTALS OF CENTRAL
BANK INTERVENTION
A. Role of Exchange Rates:
LINKS BETWEEN THE DOMESTIC
AND THE WORLD
ECONOMY
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THE ROLE OF CENTRAL BANKS


B.
THE IMPACT OF EXCHANGE RATE CHANGES
1. Currency Appreciation:
-domestic prices increase relative to foreign
prices.
- Exports: less price competitive
- Imports: more attractive

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THE ROLE OF CENTRAL BANKS


2. Currency Depreciation
- domestic prices fall relative
to foreign prices.
- Exports: more price competitive.
- Imports: less attractive

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THE ROLE OF CENTRAL BANKS


C. Foreign Exchange Market
Intervention
1. Definition: the official
purchases and sales of
currencies through the
central bank to influence the
home exchange rate.
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THE ROLE OF CENTRAL BANKS


2. Goal of Intervention:
-to alter the demand for
one currency by
changing the
supply of
another.

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THE ROLE OF CENTRAL BANKS


D.

The Effects of Foreign Exchange


Intervention
1. Effects of Intervention:
- either ineffective or
irresponsible
2. Lasting Effect:
- If permanent, change
results
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Part III. EXPECTATIONS


I.

WHAT AFFECTS A
CURRENCYS VALUE?

A. Current events
B. Current supply
C. Demand flows
D. Expectation of future
exchange rate
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EXPECTATIONS
II. Role of Expectations :
A. Currency = financial
asset
B. Exchange rate =
simple relation of two
financial assets
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EXPECTATIONS
III. Demand for Money and
Currency Values: Asset
Market Model
A. Exchange rates reflect the
supply of and demand
for
foreign-currency
denominated
assets.
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EXPECTATIONS
B. Soundness of a Nations
Economic Policies
- a nations currency tends
to strengthen with sound
economic policies.

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EXPECTATIONS
IV. EXPECTATIONS AND

CENTRAL BANK BEHAVIOR

- exchange rates also


influenced by
expectations of central
bank behavior.

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EXPECTATIONS
A. Central Bank Reputations
B. Central Bank Independence
C. Currency Boards
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