Chapter 4

Exchange Rate Determination

International Financial Management

13th Edition – by Jeff Madura
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.

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Measuring Exchange Rate Movements
Depreciation: decline in a currency’s value
Appreciation: increase in a currency’s value
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 has depreciated. (Exhibit 4.1)

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copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Exhibit 4.1 How Exchange Rate Movements and
Volatility Are Measured
Value of Canadian Monthly % Change Monthly %
Dollar (C$) in C$ Value of Euro Change in Euro
Jan. 1 $0.70 — $1.18 —
Feb. 1 $0.71 +1.43% $1.16 −1.69%
March 1 $0.70 −0.99% $1.15 −0.86%
April 1 $0.70 −0.85% $1.12 −2.61%
May 1 $0.69 −0.72% $1.11 −0.89%
June 1 $0.70 +043% $1.14 +2.70%
July 1 $0.69 −1.29% $1.17 +2.63%
Standard deviation 1.04% 2.31%
of monthly changes

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Exchange Rate Equilibrium (1 of 2)
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 for sale 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)

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Exhibit 4.2 Demand Schedule for British Pounds

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Exhibit 4.3 Supply Schedule of British Pounds for Sale

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Exhibit 4.4 Equilibrium Exchange Rate Determination

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Exchange Rate Equilibrium (2 of 2)
Change in the Equilibrium Exchange Rate
• Increase in demand schedule: Banks will increase the exchange to the
level at which the amount demanded is equal to the amount supplied in the
foreign exchange market.
• Decrease in demand schedule: Banks will reduce the exchange to the level
at which the amount demanded is equal to the amount supplied in the foreign
exchange market.
• Increase in supply schedule: Banks will reduce the exchange to the level
at which the amount demanded is equal to the amount supplied in the foreign
exchange market.
• Decrease in supply schedule: Banks will increase the exchange to the
level at which the amount demanded is equal to the amount supplied in the
foreign exchange market.
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Factors That Influence Exchange Rates (1 of 5)
The equilibrium exchange rate will change over time as supply and demand
schedules change.
e = f (ΔINF , ΔINT, ΔINC, ΔGC , ΔEXP)
where
e = percentage change in the spot rate
ΔINF = change in the differential between U. S . inflation and the foreign
country's inflation
ΔINT = change in the differential between the U.S. interest rate and the
foreign country's interest rate
ΔINC = change in the differential between the U.S. income level and the
foreign country's income level
ΔGC = change in government controls
ΔEXP = change in expectations of future exchange rates

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Factors That Influence Exchange Rates (2 of 5)
Relative Inflation Rates: 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 an
increase in demand for dollars and an increased exchange rate for the dollar.
(See Exhibit 4.6)
• Real Interest Rates
o Fisher Effect:

Real interest rate  Nominal interest rate − Inflation rate

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Exhibit 4.5 Impact of Rising U.S. Inflation on the
Equilibrium Value of the British Pound

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Exhibit 4.6 Impact of Rising U.S. Interest Rates on
the Equilibrium Value of the British Pound

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Factors That Influence Exchange Rates (3 of 5)
Relative Income Levels: Increase in U.S. income leads to an increase in U.S.
demand for foreign goods, an increased demand for foreign currency relative to
the dollar, and an increase in the exchange rate for the foreign currency. (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

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Exhibit 4.7 Impact of Rising U.S. Income Levels on
Equilibrium Value of the British Pound

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Factors That Influence Exchange Rates (4 of 5)
Expectations:
• Impact of favorable expectations: 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.
• Impact of unfavorable expectations: Speculators can place downward
pressure on a currency when they expect it to depreciate.
• Impact of signals on currency speculation: Speculators may overreact to
signals, causing currency to be temporarily overvalued or undervalued.

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Factors That Influence Exchange Rates (5 of 5)
Interaction of Factors: Some factors place upward pressure while other
factors place downward pressure. (See Exhibit 4.8)
Influence of Factors across Multiple Currency Markets: common for
European currencies to move in the same direction against the dollar.
Influence of Liquidity on Exchange Rate adjustment: If a currency’s spot
market is liquid then its exchange rate will not be highly sensitive to a single
large purchase or sale.

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Exhibit 4.8 Summary of How Factors Affect
Exchange Rates

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Movements in Cross Exchange Rates (1 of 2)
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.

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Movements in Cross Exchange Rates (2 of 2)
Explaining Movements in Cross Exchange Rate.
• Changes are affected in the same way as types of forces explained earlier
for those that affect demand and supply conditions between two currencies.

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Exhibit 4.9 Example of How Forces Affect the
Cross Exchange Rate (1 of 2)

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Exhibit 4.9 Example of How Forces Affect the
Cross Exchange Rate (2 of 2)

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Capitalizing on Expected Exchange Rate Movements (1 of 2)

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.

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Capitalizing on Expected Exchange Rate Movements (2 of 2)

The “Carry Trade” — Where investors attempt to capitalize on the differential

in interest rates between two countries.
• Impact of appreciation in the investment currency: Increased trade
volume can have a major influence on exchange rate movements over a
short period.
• Risk of the Carry Trade: Exchange rates may move opposite to what the
investors expected.

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Summary (1 of 3)
• 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 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.

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Summary (2 of 3)
• The key economic factors that can influence exchange rate movements
through their effects on demand and supply conditions are relative inflation
rates, interest rates, income levels, and government controls. When these
factors lead to a change in international trade or financial flows, they affect
the demand for a currency or the supply of currency for sale and thus the
equilibrium exchange rate. If a foreign country experiences an increase in
interest rates (relative to U.S. interest rates), then the inflow of U.S. funds to
purchase its securities should increase (U.S. demand for its currency
increases), the outflow of its funds to purchase U.S. securities should
decrease (supply of its currency to be exchanged for U.S. dollars
decreases), and there should be upward pressure on its currency’s
equilibrium value. All relevant factors must be considered simultaneously
when attempting to predict the most likely movement in a currency’s value.

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Summary (3 of 3)
• There are distinct international trade and financial flows between every pair
of countries. These flows dictate the unique supply and demand conditions
for the currencies of the two countries, which affect the equilibrium cross
exchange rate between their currencies. Movement in the exchange rate
between two non-dollar currencies can be inferred from the movement in
each currency against the dollar.
• Financial institutions can attempt to benefit from the expected appreciation of
a currency by purchasing that currency. Analogously, they can benefit from
expected depreciation of a currency by borrowing that currency and
exchanging it for their home currency.

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