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Foundations of Foundations of Multinational Financial Multinational Financial ManagementManagement Alan ShapiroAlan Shapiro J.Wiley & SonsJ.Wiley & Sons

Power Points byPower Points by

Joseph F. Greco, Ph.D.Joseph F. Greco, Ph.D.

California State University, FullertonCalifornia State University, Fullerton

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The Determination of The Determination of Exchange RatesExchange Rates

Chapter 2Chapter 2

33

CHAPTER 2CHAPTER 2THE DETERMINATION OF THE DETERMINATION OF EXCHANGE RATESEXCHANGE RATES

CHAPTER OVERVIEW:CHAPTER OVERVIEW:I.I. EQUILIBRIUM EXCHANGE RATESEQUILIBRIUM EXCHANGE RATES

II.II. ROLE OF CENTRAL BANKSROLE OF CENTRAL BANKS

III. III. EXPECTATIONS AND THE ASSET EXPECTATIONS AND THE ASSET MARKET MODELMARKET MODEL

44

55

Commonly Used TermsCommonly Used Terms

Pegged CurrencyPegged Currency– DevaluationDevaluation– RevaluationRevaluation

Floating currencyFloating currency– DepreciationDepreciation– AppreciationAppreciation

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Part I. Part I. Equilibrium Exchange Equilibrium Exchange RatesRates

I. SETTING THE EQUILIBRIUM I. SETTING THE EQUILIBRIUM

A. The exchange rateA. The exchange rate

is the is the local currencylocal currency price of price of one one unit of foreign currency unit of foreign currency

For example $1.30/€ means the For example $1.30/€ means the euro in theU.S. is worth $1.30.euro in theU.S. is worth $1.30.

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The Demand for The Demand for €€ in in the U.S.the U.S.

B. How Americans Purchase German B. How Americans Purchase German GoodsGoods

1. Foreign Currency Demand1. Foreign Currency Demand-derived from the demand for -derived from the demand for

a foreign country’s a foreign country’s goods, goods, services, services, and financial assetsand financial assets..

e.g. The demand for euros comes e.g. The demand for euros comes from the demand for German from the demand for German

goods by Americansgoods by Americans

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The Demand for The Demand for €€ in in the U.S.the U.S.

Qty

$.50

$/€D

99

Equilibrium Exchange Equilibrium Exchange RatesRates

B.2. Foreign Currency Supply:B.2. Foreign Currency Supply:a. a. derived from the foreign derived from the foreign country’s demand country’s demand

for local for local goods. goods.

1010

b. They must convert their currency b. They must convert their currency to purchase the foreign goods.to purchase the foreign goods.

That means the supply of That means the supply of euros comes from the euros comes from the

German German demand for US goods demand for US goods which which means Germans convert means Germans convert euros euros to US $ in order to buy.to US $ in order to buy.

1111

The Supply of The Supply of €€ in the in the U.S.U.S.

$/ €$/ €

Qty

$.50

S

1212

Equilibrium Exchange Equilibrium Exchange RatesRates

B.3. Equilibrium Exchange B.3. Equilibrium Exchange RateRate

occurs where the quantity occurs where the quantity suppliedsupplied equals the equals the

quantity quantity demanded of ademanded of aforeign currency foreign currency at a specific at a specific local price.local price.

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The $/ The $/ €€ Equilibrium Rate Equilibrium Rate

Qty

$.50

S

$/ €D

Equilibrium

1414

Equilibrium Exchange Equilibrium Exchange RatesRates

C. How Exchange Rates ChangeC. How Exchange Rates Change1. Increased demand1. Increased demand

as more foreign goods are as more foreign goods are demanded, more of the foreign demanded, more of the foreign currency is demanded at each currency is demanded at each

possible exchange ratepossible exchange rate

2.2. The price of the foreign The price of the foreign currency in local currency currency in local currency increases.increases.

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Equilibrium Exchange Equilibrium Exchange RatesRates

C.3C.3. . Home Currency DepreciationHome Currency Depreciation a. Foreign currency a. Foreign currency

more more valuable than valuable than the home the home currency.currency.

b. Conversely, then the b. Conversely, then the foreignforeign

currency’s value has currency’s value has appreciated against appreciated against

the the home currency.home currency.

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The US$ Depreciates The US$ Depreciates WhenWhen

Qty

$.50

S

$/ €

D

D’

$.65

Q1 Q2

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Rules of CalculationRules of Calculation

If Numerator currency depreciates,If Numerator currency depreciates,

ee1 1 > > ee00:: $0.50 (e$0.50 (e00) to $0.65 (e) to $0.65 (e11), ),

then calculate % depreciation by usingthen calculate % depreciation by using

= (e= (e0 0 - e- e11)/ e)/ e11

And Denominator currency appreciates,And Denominator currency appreciates,

then calculate % appreciation by usingthen calculate % appreciation by using

= (e= (e1 1 - e- e00)/ e)/ e00

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Equilibrium Exchange Equilibrium Exchange RatesRates

C.5C.5 Currency Appreciation Currency Appreciation

= (e= (e1 1 - e- e00)/ e)/ e00

where ewhere e0 0 = old currency value= old currency value

ee11 = new currency value = new currency value

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Equilibrium Exchange Equilibrium Exchange Rates Rates

EXAMPLE: EXAMPLE: €€ Appreciation AppreciationIf the dollar value of the If the dollar value of the €€

goes from $0.50 (egoes from $0.50 (e00) to $0.65 (e) to $0.65 (e11), then ), then

the the €€ has appreciated by has appreciated by

(.65 - .50)/ .50 = 30%(.65 - .50)/ .50 = 30%

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Equilibrium Exchange Equilibrium Exchange RatesRates

C.4. Calculating a Depreciation:C.4. Calculating a Depreciation:

= (e= (e0 0 - e- e11)/ e)/ e11

where where ee0 0 = old currency value= old currency value

ee11 = new currency value = new currency value

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Equilibrium Exchange Equilibrium Exchange RatesRates

EXAMPLE: EXAMPLE: US$ DepreciationUS$ Depreciation

Use the formulaUse the formula

(e(e0 0 - e- e11)/ e)/ e11

substitutingsubstituting(.50 - .65)/ .65 = - (.50 - .65)/ .65 = -

23.1%23.1% is the US$ depreciationis the US$ depreciation

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COMPUTATION COMPUTATION GUIDELINESGUIDELINES

If you are given a rate of appreciation or If you are given a rate of appreciation or depreciation and asked to find the depreciation and asked to find the opposite value:opposite value:

Given:Given: Find:Find:

oror

0 1

1

e ex

e

0 1

1

e e

e

1 0

0

e ex

e

1 0

0

e ex

e

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Sample Problem No.1Sample Problem No.1Suppose the U.S. dollar appreciates Suppose the U.S. dollar appreciates

against the Russian ruble by 500%. against the Russian ruble by 500%. How much did the ruble How much did the ruble depreciate against the dollar?depreciate against the dollar?

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U.S. $ APPRECIATIONU.S. $ APPRECIATION

1 0

0

( )5.00

e e

e

2525

Depreciation of the ruble:Depreciation of the ruble:

0 1

1

e ex

e

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SOLUTIONSOLUTION

1 0

0 0

5e e

e e

1 0

0 0

1

0

1 0

5

1 1 5 1

6

e e

e e

e

e

e e

2727

0 1

1

( )e ex

e

0 0

0

6

6

5

683%

e ex

e

x

x

2828

When the dollar When the dollar appreciated by 500% appreciated by 500% against the ruble, the ruble against the ruble, the ruble depreciated 83% against depreciated 83% against the dollar.the dollar.

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Sample Problem No.2Sample Problem No.2

Suppose the Russian ruble Suppose the Russian ruble depreciates against the U.S. depreciates against the U.S. dollar by 83%. How much did the dollar by 83%. How much did the dollar appreciates against the dollar appreciates against the ruble?ruble?

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Depreciation of the ruble:Depreciation of the ruble:

0 1

1

.83e e

e

3131

U.S. $ APPRECIATIONU.S. $ APPRECIATION

1 0

0

( )e ex

e

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SOLUTIONSOLUTION

1 0

0 0

5e e

e e

0 1

1

0 1

1 1

0

1

0 1

.83

.83

1 1 1 .83

.17

e e

e

e e

e e

e

e

e e

3333

1 0

0

( )e ex

e

1 1

1

.17

.17

.83

.174.88 5.00

500%

e ex

e

x

x

Substituting:

Find the appreciation:

Summing the numerator

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Equilibrium Exchange Equilibrium Exchange RatesRates

D. OTHE FACTORS AFFECTING D. OTHE FACTORS AFFECTING EXCHANGE RATES:EXCHANGE RATES:1.1. Relative Inflation ratesRelative Inflation rates2. 2. Relative Interest ratesRelative Interest rates3.3. Relative economic Relative economic

growthgrowth ratesrates4. Political risk4. Political risk5. 5. ExpectationsExpectations