CH 5 Exchange Rates of Ifm

Chapter # 4
Exchange Rate Determination

Comparing foreign currency’s spot rates at
two specific points S and St-1.
Measuring Exchange
Rate Movements
Exchange rate movements Positive percentage change indicates foreign
can affect MNC’s cash inflows currency appreciation, while negative indicates
& outflows. depreciation.
A decline in a currency’s value
is often referred to as
depreciation
The increase in a currency
value is often referred to as
appreciation.
• Demand for a Currency
• Demand means number of currency units that
Exchange Rate would be demanded under various possibilities
Equilibrium for the exchange rate, shown by demand curve
• Exhibit 4.2 Negative sloping downward demand
• Exchange rate represents curve shows the quantity of pounds that would
be demanded by U.S firms at various exchange
price of a currency like any rates at a specific point in time.
other products determined
by the demand & supply of
currency.
• Equilibrium Exchange Rate is

the point at which the
demand for that currency is
equal to supply
Exchange Rate
Equilibrium
Supply of a Currency for sale
• Supply means number of
currency units that would be
supplied under various
possibilities for the exchange
rate, shown by supply curve
• Exhibit 4.3 Positive sloping
upward supply curve shows the
quantity of pounds that would be
supplied to U.S firms at various
exchange rates at a specific point
in time against dollar.
Equilibrium
• According to Exhibit 4.4, the
equilibrium exchange rate is $1.55
because this rate equates the
quantity of pounds demanded with
the supply of pounds for sale
• Impact of Liquidity.
• The liquidity of a currency affects
the sensitivity of the exchange rate
to specific transactions. If the
currency’s spot market is liquid, its
exchange rate will not be highly
sensitive to a single large purchase
or sale of the currency. Conversely,
if the currency’s spot market is
illiquid, its exchange rate may be
highly sensitive to a single large
purchase or sale transaction.
Factors That Influence 1. Relative Inflation Rates
Exchange Rates • Changes in relative inflation rates can affect
international trade activity, which influences
The factors that cause the demand for and supply of currencies and
currency supply and therefore influences exchange rate.
demand schedules to • Example: Increase in U.S. inflation than British
change are: inflation will rise demand for British goods
1. Inflation which leads to increase demand for British
2. Interest rate
pounds in U.S.
3. Income level
4. Government controls
5. Future Expectations
e = % change in spot rate

Example:
2. Relative Interest Rates
Changes in relative interest
rates affect investment in
foreign securities, which
influences the demand for and
supply of currencies and
therefore influences exchange
rates.
Example: Rise in U.S. interest
rates than British interest rates Real Interest Rates.
will reduce the demand for
pounds, while British investors Relatively high interest rate based on
with excess cash, will increase relatively high inflation. So investors consider
supply of pounds to establish real interest rate, which adjusts the nominal
more bank deposits in the United interest rate for inflation:
States. This is graphically Real interest rate = Nominal interest rate - Inflation rate
represented in Exhibit 4.6
This relationship also known as the Fisher effect.
3. Relative Income Levels 4. Government Controls
Income can affect the amount The governments can influence the
of imports demanded, it can equilibrium exchange rate in many ways,
affect exchange rates. including
(1) Imposing foreign exchange barriers,
(2) Imposing foreign trade barriers,
(3) Intervening (buying and selling
currencies) in the foreign exchange
markets, and
(4) Affecting macro variables such as
inflation, interest rates, and income
levels
5. Expectations
Like other financial
markets, 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,
anticipating a future
decline in the dollar’s
value. This response
places immediate
downward pressure
on the dollar.
Speculating on Anticipated Exchange Rates
Example
Example
• If the Asian countries experience a decline in economic growth (and
experience a decline in inflation and interest rates as a result), how will
their currency values (relative to the U.S. dollar) be affected?
• In the 1990s, Russia was attempting to import more goods but had little to
offer other countries in terms of potential exports. In addition, Russia’s
inflation rate was high. Explain the type of pressure that these factors
placed on the Russian currency. ?
Speculating on Anticipated Exchange Rates Speculation.
Blue Demon Bank expects that the Mexican peso will depreciate against the dollar
from its spot rate of $.15 to $.14 in 10 days. The following interbank lending and
borrowing rates exist:
Currency Lending Rate Borrowing Rate
U.S. dollar 8.0% 8.3%
Mexican peso 8.5% 8.7%
Assume that Blue Demon Bank has a borrowing capacity of either $10 million or 70
million pesos in the interbank market, depending on which currency it wants to
borrow. a. How could Blue Demon Bank attempt to capitalize on its expectations
without using deposited funds?
Estimate the profits that could be generated from this strategy.
b. Assume all the preceding information with this exception: Blue Demon Bank
expects the peso to appreciate from its present spot rate of $.15 to $.17 in 30 days.
How could it attempt to capitalize on its expectations without using deposited funds?
Estimate the profits that could be generated from this strategy.

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Chapter # 4

Exchange Rate Determination

• Equilibrium Exchange Rate is

e = % change in spot rate

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