Multinational Financial

Management
Alan Shapiro
7 Edition
th

J.Wiley & Sons

Power Points by
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. EQUILIBRIUM EXCHANGE
RATES
II. ROLE OF CENTRAL BANKS
III. EXPECTATIONS AND THE
ASSET MARKET MODEL

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 Part I.
Equilibrium Exchange Rates
I. 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 country’s 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
country’s 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.

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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.
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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.

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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 $0.68 (e1), then the euro
has appreciated by
e1  e0

e0
= (.68 - .64)/ .64
= 6.25%
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Equilibrium Exchange Rates
EXAMPLE: US$ 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 CURRENCY’S
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 Nation’s
Economic Policies
- a nation’s 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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