Multinational Financial Management Alan Shapiro Edition Power Points by th J.Wiley & Sons Joseph F Greco, Ph.D California State University, Fullerton CHAPTER THE DETERMINATION OF EXCHANGE RATES CHAPTER OVERVIEW: I EQUILIBRIUM EXCHANGE RATES II ROLE OF CENTRAL BANKS III EXPECTATIONS AND THE ASSET MARKET MODEL Part I Exchange Rates I Equilibrium SETTING THE EQUILIBRIUM A Exchange Rates market-clearing prices that equilibrate the quantities supplied and demanded of foreign currency Equilibrium Exchange Rates B How Americans Purchase Goods German Foreign Currency Demand -derived from the demand for foreign country’s goods, and financial assets services, e.g The demand for German goods by Americans Equilibrium Exchange Rates Foreign Currency Supply: a derived from the foreign country’s demand for goods local 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 Equilibrium Exchange Rates Equilibrium Exchange Rate: occurs when the quantity supplied equals the quantity demanded of a foreign currency at a specific local price Equilibrium Exchange Rates C How Exchange Rates Change Increased demand as more foreign goods are demanded, the price of the foreign currency in local currency increases and vice versa Equilibrium Exchange Rates 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 Equilibrium Exchange Rates Calculating a Depreciation: Currency Depreciation = e0 − e1 = e1 where e0 = old currency value e1 = new currency value Note: Resulting sign is always negative 10 Equilibrium Exchange Rates EXAMPLE: euro appreciation If the dollar value of the euro goes from $0.64 (e0) to $0.68 (e1), then the euro has appreciated by e1 − e0 = e0 = (.68 - 64)/ 64 = 6.25% 12 Equilibrium Exchange Rates EXAMPLE: US$ Depreciation We use the first formula, (e0 - e1)/ e1 substituting (.64 - 68)/ 68 = - 5.88% which is the value of the US$ depreciation 13 Equilibrium Exchange Rates D FACTORS AFFECTING EXCHANGE RATES: Inflation rates Interest rates GNP growth rates 14 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 15 THE ROLE OF CENTRAL BANKS B THE IMPACT OF EXCHANGE RATE CHANGES Currency Appreciation: -domestic prices increase relative to foreign prices - Exports: less price competitive - Imports: more attractive 16 THE ROLE OF CENTRAL BANKS Currency Depreciation - domestic prices fall relative to foreign prices - Exports: more price competitive - Imports: less attractive 17 THE ROLE OF CENTRAL BANKS C Foreign Exchange Market Intervention Definition: the official purchases and sales of currencies through the central bank to influence the home exchange rate 18 THE ROLE OF CENTRAL BANKS Goal of Intervention: to alter the demand for one currency by changing the supply of another 19 THE ROLE OF CENTRAL BANKS D The Effects of Foreign Exchange Intervention Effects of Intervention: - either ineffective or irresponsible Lasting Effect: - If permanent, change results 20 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 21 EXPECTATIONS II Role of Expectations : A Currency = financial asset B Exchange rate = simple relation of two financial assets 22 EXPECTATIONS III.Demand for Money and Currency Values: Asset Market Model Exchange rates reflect the supply of and demand for foreign-currency denominated A assets 23 EXPECTATIONS B Soundness of a Nation’s Economic Policies - a nation’s currency tends strengthen with sound economic policies to 24 EXPECTATIONS IV EXPECTATIONS AND CENTRAL BANK BEHAVIOR - exchange rates also influenced by expectations of central bank behavior 25 EXPECTATIONS A Central Bank Reputations B Central Bank Independence C Currency Boards 26 ... exchange rate 21 EXPECTATIONS II Role of Expectations : A Currency = financial asset B Exchange rate = simple relation of two financial assets 22 EXPECTATIONS III.Demand for Money and Currency... Goods German Foreign Currency Demand -derived from the demand for foreign country’s goods, and financial assets services, e.g The demand for German goods by Americans Equilibrium Exchange Rates