app & dep chapter2nd

8/7/2019 APP & DEP chapter2nd

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Foundations of Multinational

Financial ManagementAlan Shapiro

J.Wiley & SonsPower Points by

Joseph F. Greco, Ph.D.

California State University, Fullerton

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The Determination of Exchange

Rates

Chapter 2

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CHAPTER 2THE DETERMINATION OF EXCHANGE

RATES

CHAPTER OVERVIEW:I. EQUILIBRIUM EXCHANGE RATES

II. ROLE OF CENTRAL BANKS

III. EXPECTATIONS AND THE ASSET MARKETMODEL

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4


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Commonly Used Terms

Pegged Currency

Devaluation

Revaluation Floating currency

Depreciation

Appreciation

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Part I.

Equilibrium Exchange Rates

I. SETTING THE EQUILIBRIUM

A. The exchange rate

is the local currency price of one unit

of foreign currency

For example $1.30/ means the euro in

theU.S. is worth $1.30.

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The Demand for in the U.S.

B. How Americans Purchase German Goods

1. Foreign Currency Demand

-derived from the demand for a foreigncountrys goods, services, and financialassets.

e.g. The demand for euros comes from the

demand for German goods by Americans

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The Demand for in the U.S.

8

Qty

$.50

$/D


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B.2. Foreign Currency Supply:a. derived from the foreign

countrys demand for local goods.

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b. They must convert their currency to purchasethe foreign goods.

That means the supply of euros comesfrom the German demand for US goodswhich means Germans convert euros to

US $ in order to buy.

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The Supply of in the U.S.

$/

11

Qty

$.50

S


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B.3. Equilibrium Exchange Rate

occurs where the quantity supplied

equals the quantity demanded of a foreigncurrency at a specific local price.

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The $/ Equilibrium Rate

13

Qty

$.50

S

$/

D

Equilibrium


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C. How Exchange Rates Change1. Increased demand

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

possible exchange rate

2. The price of the foreign currency in localcurrency increases.

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C.3. Home Currency Depreciation a.Foreign currency more valuable thanthe home currency.

b. Conversely, then the foreigncurrencys value hasappreciated against the home

currency.

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The US$ Depreciates When

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Qty

$.50

S

$/

D

D

$.65

Q1 Q2


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Rules of Calculation

If Numerator currency depreciates,

e1 > e0: $0.50 (e0) to $0.65 (e1),

then calculate % depreciation by using

= (e0 - e1)/ e1

And Denominator currency appreciates,

then calculate % appreciation by using

= (e1 - e0)/ e0

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C.5 Currency Appreciation

= (e1 - e0)/ e0

where e0 = old currency value

e1 = new currency value

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EXAMPLE: Appreciation

If the dollar value of the goes from $0.50

(e0) to $0.65 (e1), then the has appreciated by

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

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C.4. Calculating a Depreciation:

= (e0 - e1)/ e1

where e0 = old currency value

e1 = new currency value

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EXAMPLE: US$ Depreciation

Use the formula

(e0 - e1)/ e1substituting

(.50 - .65)/ .65 = - 23.1%

is the US$ depreciation

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COMPUTATION GUIDELINES

If you are given a rate of appreciation or

depreciation and asked to find the opposite

value:Given: Find:

or

0 1

1

e e

x

e

!

1 0

0

e e

x

e

!

22

0 1

1

e e

e

!

1 0

0

e e

x

e

!


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Sample Problem No.1

Suppose the U.S. dollar appreciates against

the Russian ruble by 500%. How much did

the ruble depreciate against the dollar?

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U.S. $ APPRECIATION

1 0

0

( )5.00

e e

e

!

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Depreciation of the ruble:

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0 1

1

e e

x

e

!


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SOLUTION

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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

!

!

!


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0 1

1

( )e ex

e

!

27

0 0

0

6

6

56

8 3 %

e e

x

e

x

x

!

!

!


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When the dollar appreciated by 500%

against the ruble, the ruble

depreciated 83% against the dollar.

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Sample Problem No.2

Suppose the Russian ruble depreciates

against the U.S. dollar by 83%. How much did

the dollar appreciates against the ruble?

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Depreciation of the ruble:

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0 1

1 .8 3

e e

e

!


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U.S. $ APPRECIATION

1 0

0

( )e ex

e

!

31

e e


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SOLUTION

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1 0

0 0

5e e

e e

!

0 1

1

0 1

1 1

0

1

0 1

. 8 3

. 8 3

1 1 1 . 8 3

. 1 7

e e

e

e e

e e

e

e

e e

!

!

!

!


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1 0

0

( )e ex

e

!

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1 1

1

. 1 7

. 1 7

. 8 3

. 1 74 . 8 8 5 . 0 0

5 0 0

e e

xe

x

x

!

!

! }

!

Substituting:

Find the appreciation:

Summing the

numerator


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D. OTHE FACTORS AFFECTING EXCHANGERATES:

1. Relative Inflation rates

2. Relative Interest rates

3. Relative economic growth rates

4. Political risk

5. Expectations

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