9/5/2021

International Corporate Finance 4 Exchange Rate Determination

11th Edition Chapter Objectives

by Jeff Madura
§ Explain how exchange rate movements are measured.
§ Explain how the equilibrium exchange rate is determined.
§ Examine factors that determine the equilibrium exchange
rate.
§ Explain the movement in cross exchange rates.
§ Explain how financial institutions attempt to capitalize on
anticipated exchange rate movements.

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Technical terms in this chapter: Exchange Rate

§ Equilibrium (n):
§ Determine (v):
§ Demand/Supply (n):
§ Appreciate (v)  appreciation (n)
§ Depreciate (v)  depreciation (n)
§ Speculate (v)  speculation (n)

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Exchange Rate Exchange Rate

§ What is an exchange rate? Exchange rate is the price of Direct quotation Indirect quotation
one country’s currency in terms of another country’s
currency.
• Home currency per unit of • Foreign currency per unit
§ Example: Exchange rate $.99/€ Foreign currency of Home currency
§ Domestic currency & Foreign currency • Eg: EUR/USD is 1.6003 – • Eg: AUD/USD quote is
1.6499 0.6061-0.6249

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BID - ASK Bid-Ask

1. If the $/€ bid and ask prices are $1.50/€ and $1.51/€,
respectively, the corresponding €/$ bid and ask prices are

a/ €0.6623 and €0.6667.

b/ $1.51 and $1.50.

c/ €0.6667 and €0.6623.

d/ None of above

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Short abbreviation of Bid/Ask Exchange Rate Equilibrium

n . Consider a $/£ bid-ask quote of $1.3456-$1.3458. The § How is exchange rate set?
currency dealer would likely quote that as 56-58 § The exchange rate is defined by the foreign currency
demand and foreign currency supply.

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Exhibit 4.2 Demand Schedule for British Pounds

Foreign currency demand

§ Foreign currency demand is derived from the demand

+ for foreign country’s goods, services, and financial
assets.
+ E.g: American demand German goods such as Mercedes
autos.
§ Demand for a currency …………..when the value of the
currency decreases, which leads to a……………..sloping
demand schedule.

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Exhibit 4.3 Supply Schedule of British Pounds for Sale

Foreign currency supply

§ Foreign currency supply is derived from the foreign

country’s demand for local goods
§ Foreign buyers must convert their currency in order to
purchase
+ E.g: German demand for US goods such as Dell
computers means Germans must convert euros to US dollar in
order to buy.
§ Supply of a currency …………..when the value of the
currency decreases, which leads to a……………..sloping
demand schedule.

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Exhibit 4.4 Equilibrium Exchange Rate Determination

Exchange Rate Equilibrium

§ Equilibrium equates the quantity of pounds demanded with

the supply of pounds for sale
§ Occurs where the quantity supplied equals the quantity
demanded of a foreign currency at a specific local price.
§ In liquid spot markets, exchange rates are not highly
sensitive to large currency transactions.

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Measuring Exchange Rate Movements Example: Euro Appreciation and US$ Depreciation

§ Depreciation: decline in a currency’s value n Example:

§ Appreciation: increase in a currency’s value
Exchange rate 7/2020 8/2020

§ Comparing foreign currency spot rates over two points in EUR/USD 1.1000 1.200
time, S and St-1

S  S t 1
Percent  in foreign currency v alue  n How many percentage do Euro and USD change?
S t 1

§ A positive percent change indicates that the currency has

appreciated. A negative percent change indicates that it
has depreciated.

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Example: Euro Appreciation and US$ Depreciation Measuring Exchange Rate Movements

n Example:
Exchange rate 7/2020 8/2020
𝑇𝐺 𝑠𝑎𝑢 − 𝑇𝐺 𝑡𝑟ướ𝑐
% 𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝐶𝑢𝑟𝑟𝑒𝑛𝑐𝑦 =   . 100%
𝑇𝐺 𝑡𝑟ướ𝑐
EUR/USD 1.1000 1.200
𝑇𝐺 𝑡𝑟ướ𝑐 − 𝑇𝐺 𝑠𝑎𝑢
n If the dollar value of the Euro goes from $1.10 to $1.20, % 𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝐶𝑢𝑟𝑟𝑒𝑛𝑐𝑦 =   . 100%
𝑇𝐺 𝑠𝑎𝑢
then the Euro has appreciated by

(1.20-1.10)/1.10 = 9.1%

And The US dollar has depreciated by

(1.10-1.20)/1.20 = -8.3%

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Exhibit 4.1 How Exchange Rate Movements and

Volatility Are Measured
Implication.

1*. Assume the spot rate of the British Pound is $1.73. The
expected spot rate 1 year from now is assumed to be $1.66.
What percentage depreciation does this reflect?

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Implication. Implication.

2*. The value of euro was $1.30 last week. During last week 3***. You know that Euro appreciates by 5%. Can you
the euro depreciated by 5%. What is the value of euro today?. calculate the change in value of US dollar.

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Exhibit 4.4 Equilibrium Exchange Rate Determination Shift of demand and supply curve

What will q If the demand curves shift to the left or to the right, it
happen if there
is an increase or will change the equilibrium and the exchange rate moves.
decrease in
demand or q If the supply curves shift to the left or to the right, it will
supply of
currency? change the equilibrium and the exchange rate moves.
q Changes in the demand for a currency or the supply of a
currency for sale will affect the equilibrium exchange
rate.

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Factors That Influence Exchange Rates Relative inflation

The equilibrium exchange rate will change over time as § Relative Inflation: Increase in U.S. inflation leads to increase
supply and demand schedules change. in U.S. demand for foreign goods, an increase in U.S. demand
e  f (INF , INT , INC , GC , EXP ) for foreign currency, and an increase in the exchange rate for
the foreign currency.
where § Example: If the US has more inflation than other countries, the
e  percentage change in the spot rate US dollars tend to decrease its value.
INF  change in the differential between U.S. inflation
and the foreign country' s inflation
INT  change in the differential between the U.S. interest rate
and the foreign country' s interest rate
INC  change in the differential between the U.S. income level
and the foreign country' s income level
GC  change in government controls
EXP  change in expectations of future exchange rates
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Exhibit 4.5 Impact of Rising U.S. Inflation on the

Equilibrium Value of the British Pound
Relative interest rates

§ Relative Interest Rates: Increase in U.S. rates leads to increase

in demand for U.S. deposits and a decrease in demand for
foreign deposits, leading to a increase in demand for dollars
and an increased exchange rate for the dollar.
§ Example: If there is a rise in US interest rates relative to
those abroad, how will the value of dollars change?
n Fisher Effect:
Real interest rate  Nominal interest rate  Inflation rate

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Exhibit 4.6 Impact of Rising U.S. Interest Rates on the

Equilibrium Value of the British Pound
Relative income levels

§ Relative Income Levels: Increase in U.S.

income leads to increased in U.S. demand for
foreign goods and increased demand for
foreign currency relative to the dollar and an
increase in the exchange rate for the foreign
currency.

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Exhibit 4.7 Impact of Rising U.S. Income Levels on the

Equilibrium Value of the British Pound
Government controls

§ Government Controls via:

n Imposing foreign exchange barriers
n Imposing foreign trade barriers
n Intervening in foreign exchange markets
n Affecting macro variables such as inflation, interest
rates, and income levels.

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Expectations Factors that Influence Exchange Rates

§ Expectations: If investors expect interest rates n Interaction of Factors: some factors place upward
in one country to rise, they may invest in that pressure while other factors place downward
country leading to a rise in the demand for pressure.
fo reign currency and an in creas e i n the
exchange rate for foreign currency.
§ Imp act of s ign als on cu rren cy sp ec ula t io n .
Speculators may overreact to signals causing
c u r r e n c y t o be t e m p o r a r i l y o v e r v a l u e d o r
undervalued.

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Exhibit 4.8 Summary of How Factors Can Affect

Exchange Rates
Cross Exchange Rates

n Example: Suppose you observe the following exchange

rates: EUR/USD and GBP/USD GBP and EUR.
n Suppose €1 = $1.25 and £1 = $2.00. Calculate the
euro-pound exchange rate.

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Cross Exchange Rates Movements in Cross Exchange Rates

1.* The dollar-euro exchange rate is $1.27 = €1.00 n A cross rate is the currency exchange rate between two
currencies when neither are official currencies of the
and the dollar-yen exchange rate is ¥98.2 = $1.00. country in which the exchange rate quote is given.
n Foreign exchange traders use the term to refer to
What is the euro-yen cross rate? currency quotes that do not involve the U.S dollar,
regardless of what country the quote is provided in.
a/ ¥124,714 = €1.00
n If currencies A and B move in same direction, there is
b/ ¥1.00 = €125 no change in the cross exchange rate.

c/ ¥1.00 = €0.80
d/ None of the above

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Exhibit 4.9 Trends in the Pound, Euro, and

Movements in Cross Exchange Rates Pound/Euro

n When currency A appreciates against the dollar by a

greater (smaller) degree than currency B, then currency
A appreciates (depreciates) against B.
n When currency A appreciates (depreciates) against the
dollar, while currency B is unchanged against the
dollar, currency A appreciates (depreciates) against
currency B by the same degree as it appreciates
(depreciates) against the dollar.

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How to capitalize on Expected Exchange Rate How to capitalize on Expected Exchange Rate
Movements Movements

1. Institutional speculation based on expected appreciation - 1. Institutional speculation based on the expected appreciation of NZD.
When financial institutions believe that a currency is valued lower
n Borrow $20 million at the interest rate………………%.
than it should be in the foreign exchange market, they may invest
in that currency before it appreciates. n Convert the $20 million to NZD:………………….(NZD)
Example: Chicago Co. expects the exchange rate of the New n Invest the NZD at the interest rate of………..%/ year.
Zealand dollar (NZ$) to appreciate from $.50 to $.52 in 30 days.
How should Chicago capitalize on this expected exchange rate n After 30 days, Chicago will receive ……………(NZD).
movements? Suppose Chicago can borrow $20 million on a short- n At the end of the period, Chicago will repay the loans of $20 million. The
term basis from other banks and present short-term interest rates amount of dollars necessary is……………….(USD).
(annualized) in the interbank market are given in this table.
n Assume the exchange rate on day 30 is 1NZD =$0.52. Calculate the amount
CURRENCY LENDING RATE BORROWING RATE
of repayment in NZD:……………(USD).
U.S dollars 6.72% 7.20%
$NZ 6.48% 6.96% n The speculative profit is:…………………(NZD) or …………..(USD)
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How to capitalize on Expected Exchange Rate How to capitalize on Expected Exchange Rate Movements
Movements

2. Institutional speculation based on expected depreciation - If

Example: Carbondale Co. expects the exchange rate of the New Zealand
financial institutions believe that a currency is valued higher than it
should be in the foreign exchange market, they may borrow funds dollar (NZ$) to depreciate from $.50 to $.48 in 30 days. How should
in that currency and convert it to their local currency now before Carbondale capitalize on this expected exchange rate movements? Suppose
the currency’s value declines to its proper level. Chicago can borrow NZ$40 million. The interbank market data are given in
3. Speculation by individuals – Individuals can speculate in foreign this table.
currencies.
CURRENCY LENDING RATE BORROWING RATE
U.S dollars 6.72% 7.20%
$NZ 6.48% 6.96%

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How to capitalize on Expected Exchange Rate Movements Carry Trade Exercise

4. The “Carry Trade” – Where investors attempt to capitalize on the n Hampton Investment Co. is a U.S firm that executes a carry trade in
differential in interest rates between two countries. which it borrows euros (where interest rates are presently low) and
invests in British pounds (where interest rates are presently high).
n Hampton uses $100,000 of its own funds and borrows an additional
600,000 euros. It will pay 0.5% on its euros borrowed for the next
month and will earn 1% on funds invested in British pounds.
n Assume that the euro’s spot rate is $1.20 and that the British pound’s
spot rate is $1.80 (so the pound is worth 1.5 euros at this time).
Hampton uses today’s spot rate as its best guess of the expected
profits from its carry trade.
n Calculate the expected profit from carry trade.

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Carry Trade Answer Self- Test 1

1. Hampton’s total investment in pounds: ………………..(pounds) A large increase in the income level in Mexico along
with no growth in the US income level is normally
2. Hampton receives back the amount of pounds after the investment
expected to cause (assuming no change in interest
period: …………..(pounds) rates or other factors a(n)… in Mexican demand for
3. Hampton repays loan in euros: …………… euros. US goods, and the Mexican peso would…
4. Amount of pounds Hampton needs to repay loan in euros
……………………(pounds).
a. increase; appreciate
b. increase; depreciate
5. Amount of pounds Hampton has after repayment loan:
c. decrease; depreciate
…………………………(pounds)
d. decrease; appreciate
6. Hampton converts pounds held into US dollars:………………(dollars)

7. Hampton’s profit:……………………(dollars)
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Self- Test 2 Self- Test 3

An increase in US interest rates relative to German Investors from Germany, the United States, and the
interest rates would likely… to the US demand for UK frequently invest in each other based on prevailing
euros and…. the supply of euro for sale.. interest rates. If British interest rates increase,
Ge r ma n i nv e s to r s a r e l i k e l y t o b u y… d o l l a r-
a. reduce; increase denominated securities, and the euro is likely to…
relative to the dollar.
b. increase; reduce
c. reduce; reduce
a. fewer; depreciate
d. increase; increase
b. fewer; appreciate
c. more; depreciate
d. more; appreciate

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Application 1 Application 2

n On August 8,2009, Zimbabwe changed the value of the Zim n In 1995, one dollar bought ¥90. In 2009, it bought about ¥110.
dollar from Z$40$US to Z$60/$US a/ What was the dollar value of the Yen in 1995? What was the
a/ What was the original US dollar value of the Zim dollar? Yen’s dollar value in 2009?
b/ By what percent has the Zim dollar devalued (revalued) relative b/ By what percent has the Yen fallen in value between 1995 and
to the US dollar? 2009?
c/ By what percentage has the US dollar appreciated (depreciated) c/ By what percent has the dollar risen in value between 1995 and
relative to the Zim dollar? 2009?
n Suppose the US dollar appreciated against the Russian Ruble
by 500%. How much did the Ruble depreciate against the
dollar?

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Application 3 SUMMARY

ABC Bank expects that Singapore will depreciate against the
dollar from its spot rate of $.43 to $42 in 60 days. The following
interbank lending and borrowing rate exist:
Lending Rate
US dollar 7%
Singapore dollar 22%
ABC Bank considers borrowing 10 millions Singapore dollars in
the interbank market and investing the funds in dollars for 60
days. Estimate the profits (or losses) that could be earned from
this strategy. Should ABC Bank pursue this strategy?
n Exchange rate movements are commonly measured by the
percentage change in their values over a specified period, such
as a month or a year. MNCs closely monitor exchange rate
movements over the period in which they have cash flows
denominated in the foreign currencies of concern.
Borrowing Rate
n The equilibrium exchange rate between two currencies at any
7.2%
point in time is based on the demand and supply conditions.
24% n Changes in the demand for a currency or the supply of a
currency for sale will affect the equilibrium exchange rate.

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SUMMARY (Cont.) SUMMARY (Cont.)

§ The key economic factors that can influence exchange rate § Financial institutions can attempt to benefit from expected
movements through their effects on demand and supply appreciation of a currency by purchasing that currency.
conditions are relative inflation rates, interest rates, and income Conversely, they can attempt to benefit from expected
levels, as well as government controls. As these factors cause a depreciation of a currency by borrowing that currency,
change in international trade or financial flows, they affect the exchanging it for their home currency, and then buying that
demand for a currency or the supply of currency for sale and currency back just before they repay the loan.
therefore affect the equilibrium exchange rate.
§ Unique international trade and financial flows between every
pair of countries dictate the unique supply and demand
conditions for the currencies of the two countries, which affect
the equilibrium cross exchange rate. The movement in the
exchange rate between two non-dollar currencies can be
determined by considering the movement in each currency
against the dollar and applying intuition.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

59 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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