ICF11e ch04

International Financial Management
12th Edition
by Jeff Madura
1 © 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.
4 Exchange Rate Determination
Chapter Objectives
 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.
2
Measuring Exchange Rate Movements
 Depreciation: decline in a currency’s value

 Appreciation: increase in a currency’s value
 On the days when some currencies appreciate while others
depreciate against a particular currency, that currency is
said to be “mixed in trading.”
 Comparing foreign currency spot rates over two points in

time, S and St-1
S  St 1
Percent  in foreign currency value 
St 1
 A positive percent change indicates that the currency has
appreciated. A negative percent change indicates that it
3 has depreciated.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
Exhibit 4.1 How Exchange Rate Movements and Volatility
Are Measured
Exchange Rate Equilibrium
 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)
Exhibit 4.2 Demand Schedule for British
Pounds
6
Exhibit 4.3 Supply Schedule of British Pounds for
Sale
7
Exhibit 4.4 Equilibrium Exchange Rate
Determination
8
Exchange Rate Equilibrium
 The liquidity of a currency affects the

sensitivity of the exchange rate to specific
transactions.
 In liquid spot markets, exchange rates are not
highly sensitive to large currency transactions.
 With many willing buyers and sellers, even
large transactions can be easily accommodated.
 Conversely, illiquid currencies tend to exhibit
more volatile exchange rate movements.
Factors That Influence Exchange Rates
The equilibrium exchange rate will change over time as

supply and demand schedules change.
e  f (INF , INT , INC , GC, EXP)
where
e  percentage change in the spot rate
INF  change in the differenti al between U.S. inflation
and the foreign country' s inflation
INT  change in the differenti al between the U.S. interest rate
and the foreign country' s interest rate
INC  change in the differenti al between th e U.S. income level
and the foreign country' s income level
GC  change in government controls
EXP  change in expectatio ns of future exchange rates
 Relative Inflation:
Increase in U.S.
inflation leads to
increase in U.S.
demand for foreign
goods, an increase
in U.S. demand for
foreign currency,
and an increase in
the exchange rate
for the foreign
currency. (See
Exhibit 4.5)
 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. (See
Exhibit 4.6)
• A relatively high interest rate may actually reflect expectations

of relatively high inflation, which may discourage foreign
investment.
• It is thus useful to consider the real interest rate, which adjusts
the nominal interest rate for inflation.
Fisher Effect:
Real interest rate  Nominal interest rate  Inflation rate
 Relative Income Levels: Increase in U.S. income

leads to increase 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. No expected change for
the supply of £. (See Exhibit 4.7)
 Government Controls via:
 Imposing foreign exchange barriers
 Imposing foreign trade barriers
 Intervening in foreign exchange markets
 Affecting macro variables such as inflation, interest
rates, and income levels.
Exhibit 4.7 Impact of Rising U.S. Income Levels on the
Equilibrium Value of the British Pound
15
 Expectations: Foreign exchange markets react

to any news that may have a future effect.
 News of a potential surge in U.S. inflation may
cause currency traders to sell dollars.
 Many institutional investors take currency
positions based on anticipated interest rate
movements in various countries.
 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.
Expectations: Impact of signals on currency

speculation.
 Economic signals that affect exchange rates can

change quickly, such that speculators may overreact
initially causing currency to be temporarily
overvalued or undervalued and then find that they
have to make a correction.
 Speculation on the currencies of emerging markets
can have a substantial impact on their exchange
rates.
Factors that Influence Exchange Rates
 Interaction of Factors: some factors place upward

pressure while other factors place downward
pressure. (See Exhibit 4.8). For example, an
increase in income levels sometimes causes
expectations of higher interest rates, thus placing
opposing pressures on foreign currency values.
 Influence of Factors across Multiple Currency

Markets: common for European currencies to move
in the same direction against the dollar.
Exhibit 4.8 Summary of How Factors Can Affect
Exchange Rates
Trade-Related
Factors
U.S. demand for foreign
1. Inflation goods, i.e. demand for
Differential foreign currency
2. Income
Differential Foreign demand for U.S.
3. Gov’t Trade goods, i.e. supply of Exchange
Restrictions foreign currency rate
between
foreign
Financial U.S. demand for foreign currency
Factors securities, i.e. demand and the
1. Interest Rate for foreign currency dollar
Differential Foreign demand for U.S.
2. Capital Flow securities, i.e. supply of
Restrictions foreign currency
19
Factors that Influence Exchange Rates
 Interaction of Factors:
The sensitivity of an exchange rate to the factors is
dependent on the volume of international transactions
between the two countries.
Large volume of international trade 
 relative inflation rates may be more influential
Large volume of capital flows  interest rate

 fluctuations may be more influential
Movements in Cross Exchange Rates
 If currencies A and B move in same direction, there is

no change in the cross exchange rate.
 When currency A appreciates against the dollar by a
greater (smaller) degree than currency B, then currency
A appreciates (depreciates) against B.
 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.
Exhibit 4.9 Trends in the Pound, Euro, and
Pound/Euro
22
Anticipation of Exchange Rate Movements
 Institutional speculation based on expected appreciation - When

financial institutions believe that a currency is valued lower than
it should be in the foreign exchange market, they may invest in
that currency before it appreciates.
 Institutional speculation based on expected depreciation - If
financial institutions believe that a currency is valued higher than
it should be in the foreign exchange market, they may borrow
funds in that currency and convert it to their local currency now
before the currency’s value declines to its proper level.
 Speculation by individuals – Individuals can speculate in foreign
currencies.
 The “Carry Trade” – Where investors attempt to capitalize on the
differential in interest rates between two countries.
Speculating on Anticipated Exchange Rates
Chicago Bank expects the exchange rate of the New

Zealand dollar to appreciate from its present level of
$0.50 to $0.52 in 30 days.
Borrows at 7.20%
for 30 days
1. Borrows 4. Holds
$20 million $20,912,320
Returns $20,120,000
Profit of $792,320
Exchange at Exchange at
$0.50/NZ$ $0.52/NZ$
Lends at 6.48%
2. Holds for 30 days 3. Receives
NZ$40 million NZ$40,216,000
Chicago Bank expects the exchange rate of the New

Zealand dollar to depreciate from its present level of
$0.50 to $0.48 in 30 days.
Borrows at 6.96%
for 30 days
1. Borrows 4. Holds
NZ$40 million NZ$41,900,000
Returns NZ$40,232,000
Profit of NZ$1,668,000
Exchange at or $800,640 Exchange at
$0.50/NZ$ $0.48/NZ$
Lends at 6.72%
2. Holds for 30 days 3. Receives
$20 million $20,112,000
 Many commercial banks attempt to capitalize on their

forecasts of anticipated exchange rate movements in
the foreign exchange market.
 The potential returns from foreign currency
speculation are high for banks that have large
borrowing capacity.
 Exchange rates are very volatile, and a poor forecast
can result in a large loss.
One well-known bank failure, Franklin National Bank
in 1974, was primarily attributed to massive
speculative losses from foreign currency positions.
SUMMARY
 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.
 The equilibrium exchange rate between two currencies at any
point in time is based on the demand and supply conditions.
Changes in the demand for a currency or the supply of a
currency for sale will affect the equilibrium exchange rate.
SUMMARY (Cont.)
 The key economic factors that can influence exchange rate

movements through their effects on demand and supply
conditions are relative inflation rates, interest rates, and income
levels, as well as government controls. As these factors cause a
change in international trade or financial flows, they affect the
demand for a currency or the supply of currency for sale and
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.
SUMMARY (Cont.)
 Financial institutions can attempt to benefit from expected

appreciation of a currency by purchasing that currency.
Conversely, they can attempt to benefit from expected
depreciation of a currency by borrowing that currency,
exchanging it for their home currency, and then buying that
currency back just before they repay the loan.

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International Financial Management

 Explain how exchange rate movements are measured.

 Depreciation: decline in a currency’s value

 Comparing foreign currency spot rates over two points in

 The exchange rate represents the price of a

 The liquidity of a currency affects the

The equilibrium exchange rate will change over time as

• A relatively high interest rate may actually reflect expectations

Real interest rate  Nominal interest rate  Inflation rate

 Relative Income Levels: Increase in U.S. income

 Expectations: Foreign exchange markets react

Expectations: Impact of signals on currency

 Economic signals that affect exchange rates can

 Interaction of Factors: some factors place upward

 Influence of Factors across Multiple Currency

Large volume of capital flows  interest rate

 If currencies A and B move in same direction, there is

 Institutional speculation based on expected appreciation - When

Chicago Bank expects the exchange rate of the New

Chicago Bank expects the exchange rate of the New

 Many commercial banks attempt to capitalize on their

 Exchange rate movements are commonly measured by the

 The key economic factors that can influence exchange rate

 Financial institutions can attempt to benefit from expected

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