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4.

Determination of Exchange
Rate

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Why this
Chapter?
 Financial managers of MNCs that conduct
international business must continuously
monitor exchange rates because their cash
flows are' highly dependent on them.
 They need to understand what factors
influence exchange rates so that they can
anticipate how exchange rates may change
in response to specific conditions.
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Some
Terminologies
1. Equilibrium Exchange Rate:
The exchange rate at which the
demand for a currency and supply of the
same currency are equal. The equilibrium
exchange rate indicates that the price
of exchanging two currencies will remain
stable.

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Terminologies

2. Cross Rate
The exchange rate between two
currencies, based on their relation with a
particular currency. If the cross rates
show
that the currencies are not priced
correctly, then profit
arbitrage
opportunities are
there.

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Terminologies …
3. Purchasing Power Parity - PPP
An economic theory that estimates the
amount of adjustment needed on the
exchange rate between countries in
order for the exchange to be equivalent
to each currency's purchasing power.

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Terminologies …
4. Exchange Rate Movements:
changes in value of currency.
The fluctuations in value between
currencies that can result in losses to
investors and businesses that import and
export goods.

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Terminologies
5.…
Fisher Effect:
 An economic theory proposed by economist Irving
Fisher that describes the relationship between
inflation and both real and nominal interest rates.
 The Fisher effect states that the real interest rate
equals the nominal interest rate minus the expected
inflation rate.
 Therefore, real interest rates fall as inflation
increases, unless nominal rates increase at the same
rate as inflation.
Real interestrate  Nominal interestrate  Inflation rate
This concept is very important in understanding
international Fisher effect (IFE).

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How can we Measure Exchange
Rate Movements ??

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Measuring Exchange Rate
Movements
 When a currency declines in value, it is said
to depreciate. When it increases in value, it is
said to appreciate. Exchange rate can be
measured by comparing a foreign currency's
spot rates at two specific points in time St– St-
1.

• Exchange rate movements affect an MNC's


value because they can affect the amount of
cash inflows received from exporting or from a
subsidiary and the amount of cash outflows
needed to pay for imports.
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Continued
…An exchange
 rate measures the value of
one currency in units of another currency.
As economic conditions change, exchange
rates can change substantially.
 When a foreign currency's spot rates at two
specific points in time are compared, the
spot rate at the more recent date is denoted
as St and the spot rate at the earlier date is
denoted as St-1

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Continued …
 The percentage change in the value of the foreign
currency is computed as follows:
St - St-1
Percentage change In foreign currency value = St-1
 A positive percentage change indicates that the
foreign currency has appreciated. while a negative
percentage change indicates that it has depreciated.
 Example: If a year ago the value of 1USD=ETB 28 and
today 1USD trades at ETB 32, then we say dollar has
appreciated by 14.3%:
32  28
 28 *100  14.3%

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Continued
 On some ……
days, most foreign currencies
appreciate against the dollar, although
by different degrees. On other days,
most currencies depreciate against the
dollar, but by different degrees.
 There are also days when some
currencies appreciate while others
depreciate against the dollar; the
media describe this scenario by stating
that "the dollar was mixed in trading.

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Continued
…Foreign exchange rate movements tend
to be larger for longer time horizons.
 Thus,
 if yearly exchange rate data were
assessed, the movements would be more
volatile.
 If daily exchange rate movements were
assessed, the movements would be less
volatile.

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Continued … …
 A review of daily exchange rate
movements is important to an MNC
that will need to obtain a foreign
currency in a few days and wants to
assess the possible degree of
movement over that period.

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Continued …
 A review of annual exchange
movements would be more
appropriate for an MNC that conducts
foreign trade every year and wants to
assess the possible degree of
movements on a yearly basis.

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Continued …
 Many MNCs review rate
exchange
based on short- and long-
term
horizons because they term
expect to
engage in international transactions in
the near future and in the distant
future.

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Equilibrium Exchange
rate Determination

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Equilibrium Exchange
Rate it is easy to measure
 Although the
percentage change in the value of a
currency, it is more difficult to explain
why the value changed or to forecast
how it may change in the future.
 To achieve either of these objectives,
the concept of an equilibrium
exchange rate must be understood, as
well as the factors that affect the
equilibrium rate.
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Equilibrium Exchange
Rate considering why an exchange
 Before
rate changes, realize that an
exchange rate at a given point in
time represents the price of a
currency, or the rate at which one
currency can be exchanged for
another.
 The exchange rate always involves
two currencies.

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Continued …
 The exchange rate of any currency refers
to the rate at which it can be exchanged
for one unit of foreign currency.
 Like any other product sold in markets, the
price of a currency is determined by the
demand for that currency relative to
supply.
 At any point in time, a currency should
exhibit the price at which the demand for
that currency is equal to supply, and this
represents the equilibrium exchange rate.
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Continued …
 Off course, conditions can change
over time, causing the supply or
ademand
given for
currency to change, and
thereby causing movement the
in
currency's price.
 So, any factor that affects the DD
and/or supply for currencies affect the
equilibrium exchange rate.

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Continued …
 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.

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Continued …
 Supply of a currency increases when
the value of the currency increases,
leading to an upward sloping supply
schedule.
 Equilibrium equates the quantity of
pounds demanded with the supply of
pounds for sale.

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Continued …

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Continued …

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Exchange Rate
Equilibrium
 An exchange rate that represents the price of a
currency, which is determined by the demand for
that currency relative to the supply for that
currency.

Value of
£ S: Supply of
£
$1.6
0 equilibrium
exchange rate
$1.5
5 D: Demand for £

$1.5
Quantity of
0 £
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Factors that
Influence
Exchange Rates

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Factors Influencing Exchange
rates

1.
2.
3.

4.
5.
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The equilibrium exchange rate will change
over time as supply and demand schedules
change.
e  f (INF , INT , INC, GC, EXP)

where
e  p ercen tag e c h a n g e in the spot rate
 I N F  c h a n g e in the differential b e t w e e n U.S.
inflation a n d the foreign country's inflation
 I N T  c h a n g e in the differential b e t w e e n the U . S . interest
rate a n d the foreign country's interest rate
 I N C  c h a n g e in the differential b e t w e e n the U . S . i n c o m e
level a n d the foreign country's i n c o m e level
 G C  c h a n g e in g o v e r n m e n t controls
 E X P  c h a n g e in expectations of future e x c h a n g e rates

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Factors that
Influence
Exchange Rates
1. Relative Inflation
Rates
$/£
U.S. inflation 
S1
U.S. demand for
S
r1 0
British goods,
r0 and hence £.
D1
D0  British desire for U.S.
goods, and hence
Quantity of
£ the supply of £.
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Continued

2. Relative Interest
Rates
$/ U.S. interest rates 
S0
£   U.S. demand for British
S1
r0 bank deposits, and
r1 hence
D0
£.
D1
  British desire for U.S.
Quantity of
£
bank deposits, and
hence the supply of £.
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Continued

3. Relative Income
Levels
$/ U.S. income level 
£   U.S. demand for
S0 ,S1
British goods, and
r1
r0 hence £.
D1
 No expected change
D0
for the supply of £.
Quantity of
£

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Continued …
4. Government
Controls
 Governments influence
may
equilibrium the
exchange rate
by:
– imposing foreign exchange barriers,

– imposing
– foreign
intervening in thetrade barriers,
foreign exchange market, and
– affecting macro variables such as inflation, interest
rates, and income levels.

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Continued …
5. Expectations
 Expectations have strong impact on
a exchange rates.
 If firms expect U.S. dollar to appreciate,
then in the future dollar will appreciate for
speculative reasons.
 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.
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