International
Financial Management
by
Jeff Madura
Florida Atlantic University
Chapter
4
Exchange Rate Determination
Why this Chapter?
 Financial managers of MNCs that conduct international
business must continuously monitor exchange rates because
their cash flows are' highly dependent on them.
 They need to understand what factors influence exchange
rates so that they can anticipate how exchange rates may
change in response to specific conditions.
 This chapter provides a foundation for understanding how
exchange rates are determined.
Chapter Objectives
 To explain how exchange rate movements are measured;
 To explain how the equilibrium exchange rate is determined;
 To examine the factors that affect the equilibrium exchange
rate;
 To explain the movements in cross exchange rates; and
 To explain how financial institutions attempt to capitalize on
anticipated exchange rate movements.
Some important terminologies
1. Equilibrium Exchange Rate:
The exchange rate at which the demand for a currency and
supply of the same currency are equal. The equilibrium exchange
rate indicates that the price of exchanging two currencies will
remain stable.
2. Cross Rate:
The currency exchange rate between two currencies, both of
which are not the official currencies of the country in which the
exchange rate quote is given in. This phrase is also sometimes
used to refer to currency quotes which do not involve the U.S.
dollar, regardless of which country the quote is provided in.
Continued…
3. Purchasing Power Parity - PPP:
An economic theory that estimates the amount of adjustment
needed on the exchange rate between countries in order for the
exchange to be equivalent to each currency's purchasing power.
The relative version of PPP is calculated as:
Where:
"S" represents exchange rate of currency 1 to currency 2
"P1" represents the cost of good "x" in currency 1
"P2" represents the cost of good "x" in currency 2
In other words, the exchange rate adjusts so that an identical
good in two different countries has the same price when
expressed in the same currency.
Continued…
4. Exchange Rate Movements:
The fluctuations in value between currencies that can result in
losses to investors and businesses that import and export goods.
5. Fisher Effect:
An economic theory proposed by economist Irving Fisher that
describes the relationship between inflation and both real and
nominal interest rates. The Fisher effect states that the real
interest rate equals the nominal interest rate minus the expected
inflation rate. Therefore, real interest rates fall as inflation
increases, unless nominal rates increase at the same rate as
inflation.
Real interest rate  Nominal interest rate  Inflation rate
How can we Measure Exchange
Rate Movements ??
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Measuring
Exchange Rate Movements
 Exchange rate movements affect an MNC's value because they
can affect the amount of cash inflows received from exporting
or from a subsidiary and the amount of cash outflows needed
to pay for imports.
 An exchange rate measures the value of one currency in units of
another currency. As economic conditions change. exchange
rates can change substantially.
 When a currency declines in value, it is said to depreciate. When it
increases in value, it is said to appreciate. Exchange rate can be
measured by comparing a foreign currency's spot rates at two
specific points in time St – St-1.
Continued …
 When a foreign currency's spot rates at two specific points in
time are compared. The spot rate at the more recent date is
denoted as St and the spot rate at the earlier date is denoted as
St-1
 The percentage change in the value of the foreign currency is
computed as follows:
St - St-1
Percent A In foreign currency value =
St-1
 A positive percentage change indicates that the foreign
currency has appreciated. while a negative percentage change
indicates that it has depreciated.
Continued …
 On some days, most foreign currencies appreciate against the
dollar, although by different degrees. On other days, most
currencies depreciate against the dollar, but by different
degrees.
 There are also days when some currencies appreciate while
others depreciate against the dollar; the media describe this
scenario by stating that "the dollar was mixed in trading.
 Foreign exchange rate movements tend to be larger for longer
time horizons. Thus, if yearly exchange rate data were assessed,
the movements would be more volatile. If daily exchange rate
movements were assessed, the movements would be less
volatile.
Continued …
 A review of daily exchange rate movements is important to an
MNC that will need to obtain a foreign currency in a few days
and wants to assess the possible degree of movement over that
period.
 A review of annual exchange movements would be more
appropriate for an MNC that conducts foreign trade every year
and wants to assess the possible degree of movements on a
yearly basis.
 Many MNCs review exchange rate based on short-term and
long-term horizons because they expect to engage in
international transactions in the near future and in the distant
future.
Fluctuation of the British Pound
Over Time
Approximate
Spot Rate of £
$ 1.80
1.75
1.70
1.65
1.60
1.55
1.50
1.45
1.40
1992
1996
Approximate
Annual % D
20 %
15
10
5
0
-5
-10
-15
-20
1992
2000
Approximate £
that could be
Purchased with
$10,000
£ 7000
6800
6600
6400
6200
6000
5800
5600
1996
2000
1992
1996
2000
Equilibrium Exchange rate
Determination
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Equilibrium Exchange Rate
 Although it is easy to measure the percentage change in the
value of a currency, it is more difficult to explain why the value
changed or to forecast how it may change in the future.
 To achieve either of these objectives, the concept of an
equilibrium exchange rate must be understood, as well as the
factors that affect the equilibrium rate.
 Before considering why an exchange rate changes, realize that
an exchange rate at a given point in time represents the price of
a currency, or the rate at which one currency can be exchanged
for another. The exchange rate always involves two currencies.
But our focus is from the U.S. perspective.
Continued …
 The exchange rate of any currency refers to the rate at which it
can be exchanged for U.S. dollars, unless specified otherwise.
 Like any other product sold in markets, the price of a currency is
determined by the demand for that currency relative to supply.
 At any point in time, a currency should exhibit the price at
which the demand for that currency is equal to supply, and this
represents the equilibrium exchange rate.
 Off course, conditions can change over time, causing the supply
or demand for a given currency to adjust, and thereby causing
movement in the currency's price.
Continued …
 The exchange rate represents the price of a currency, or the
rate at which one currency can be exchanged for another.
 Demand for a currency increases when the value of the
currency decreases, leading to a downward sloping demand
schedule. (See Exhibit 4.2)
 Supply of a currency increases when the value of the currency
increases, leading to an upward sloping supply schedule. (See
Exhibit 4.3)
 Equilibrium equates the quantity of pounds demanded with the
supply of pounds for sale. (See Exhibit 4.4)
 In liquid spot markets, exchange rates are not highly sensitive
to large currency transactions.
Exhibit 4.2 Demand
Schedule for British
Pounds
Exhibit 4.3 Supply
Schedule of British
Pounds
Exhibit 4.4 Equilibrium Exchange Rate
Determination
19
Exchange Rate Equilibrium
 An exchange rate that represents the price of a currency, which
is determined by the demand for that currency relative to the
supply for that currency.
Value of £
$1.60
$1.55
$1.50
S: Supply of £
equilibrium
exchange rate
D: Demand for £
Quantity of £
Factors that Influence Exchange
Rates
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Factors Influencing Exchange rates
1.
2.
3.
4.
5.
Continued …
The equilibrium exchange rate will change over
time as supply and demand schedules change.
e  f ( DINF , DINT , DINC, DGC, DEXP)
where
e  percent agechangein t hespot rat e
DINF  changein t hedifferental
i bet ween U.S. inflat ion
and t heforeign count ry's inflat ion
DINT  changein t hedifferental
i bet ween t he U.S. int erestrat e
and t heforeign count ry's int erestrat e
DINC  changein t hedifferental
i bet ween t he U.S. incomelevel
and t heforeign count ry's incomelevel
DGC  changein governmentcont rols
DEXP  changein expect at io
ns of fut ure exchangerat es
Factors that Influence
Exchange Rates
1. Relative Inflation Rates
$/£
r1
r0
S1
S0
D1
D0
Quantity of £
U.S. inflation 
  U.S. demand for
British goods, and
hence £.
  British desire for U.S.
goods, and hence the
supply of £.
Continued …
2. Relative Interest Rates
$/£
r0
r1
S0
S1
D0
D1
Quantity of £
U.S. interest rates 
  U.S. demand for
British bank deposits,
and hence £.
  British desire for U.S.
bank deposits, and
hence the supply of £.
Continued …
3. Relative Income Levels
$/£
r1
r0
U.S. income level 
  U.S. demand for
S0 ,S1
British goods, and
hence £.
D1
 No expected change for
D0
the supply of £.
Quantity of £
Continued …
4. Government Controls
 Governments may influence the equilibrium exchange rate by:
 imposing foreign exchange barriers,
 imposing foreign trade barriers,
 intervening in the foreign exchange market, and
 affecting macro variables such as inflation, interest rates, and
income levels.
Continued …
5. Expectations
 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.
 If investors expect interest rates in one country to rise, they
may invest in that country leading to a rise in the demand for
foreign currency and an increase in the exchange rate for
foreign currency.
Chapter Review
 Measuring Exchange Rate Movements
 Exchange Rate Equilibrium
 Demand for a Currency
 Supply of a Currency for Sale
 Equilibrium
 Factors that Influence Exchange Rates





Relative Inflation Rates
Relative Interest Rates
Relative Income Levels
Government Controls
Expectations