# Multinational financial management 7th CH02

Multinational Financial
Management
Alan Shapiro

7
Edition
Power Points by
th

J.Wiley
& Sons
Joseph
F. Greco,
Ph.D.
California State University, Fullerton
1

CHAPTER 2
THE
DETERMINATION OF

EXCHANGE RATES
2

CHAPTER 2 OVERVIEW:
I.

EQUILIBRIUM EXCHANGE
RATES

II. ROLE OF CENTRAL BANKS
III.
EXPECTATIONS AND THE
ASSET MARKET MODEL

3

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.

4

Equilibrium Exchange Rates
B. How Americans Purchase
Goods

German

1. Foreign Currency Demand
-derived from the demand for
foreign country’s goods,
and financial
assets.

services,

e.g. The demand for German
goods by Americans

5

Equilibrium Exchange Rates
2. Foreign Currency Supply:
a. derived from the foreign
country’s demand for
goods.

local

b. They must convert their
currency to purchase.
e.g. German demand for US goods
means Germans

convert Euros to

US\$ in

6

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.

7

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.

8

Equilibrium Exchange Rates
2. Home Currency Depreciation

a.
Foreign currency becomes
more valuable than the home
currency.
b.
The foreign currency’s
value has appreciated against
the home currency.

9

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

10

Equilibrium Exchange Rates
Currency Appreciation

e1 − e0
=
e0

11

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
has appreciated by

e1 − e0
=
e0
= (.68 - .64)/ .64
= 6.25%
12

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.

13

Equilibrium Exchange Rates
D. FACTORS AFFECTING
EXCHANGE RATES:
1.

Inflation rates

2.

Interest rates

3.

GNP growth rates

14

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

15

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

16

THE ROLE OF CENTRAL BANKS
2. Currency Depreciation
- domestic prices fall relative
to foreign prices.
- Exports: more price competitive.
- Imports: less attractive

17

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.

18

THE ROLE OF CENTRAL BANKS
2. Goal of Intervention:
to alter the demand for
one currency by
changing the supply of

another.

19

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

20

Part III. EXPECTATIONS
I.

WHAT AFFECTS A CURRENCY’S VALUE?

A.

Current events

B. Current supply
C. Demand flows
D. Expectation of future
exchange rate

21

EXPECTATIONS
II. Role of Expectations :

A. Currency = financial
asset
B. Exchange rate =
simple relation of two
financial assets
22

EXPECTATIONS
III.Demand for Money and
Currency
Values: Asset
Market Model

Exchange rates reflect the
supply of and demand for
foreign-currency denominated
A.

assets.

23

EXPECTATIONS
B.
Soundness of a Nation’s
Economic Policies
- a nation’s currency tends
strengthen with sound
economic
policies.

to

24

EXPECTATIONS
IV. EXPECTATIONS AND

CENTRAL

BANK BEHAVIOR
- exchange rates also
influenced by

expectations of central
bank behavior.

25

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