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# Multinational Financial Management

Alan Shapiro

7th Edition
J.Wiley & Sons
Power Points by Joseph F. Greco, Ph.D. California State University, Fullerton
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CHAPTER 2
THE DETERMINATION OF EXCHANGE RATES

CHAPTER 2 OVERVIEW:
I. EQUILIBRIUM EXCHANGE RATES II. ROLE OF CENTRAL BANKS III. EXPECTATIONS AND THE ASSET MARKET MODEL

## Part I. Equilibrium Exchange Rates

I. SETTING THE EQUILIBRIUM A. Exchange Rates market-clearing prices that equilibrate the quantities supplied and demanded of foreign currency.
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## Equilibrium Exchange Rates

B. How Americans Purchase German Goods
1. Foreign Currency Demand -derived from the demand for foreign countrys goods, services, and financial assets. e.g. The demand for German goods by Americans

## Equilibrium Exchange Rates

2. Foreign Currency Supply: a. derived from the foreign countrys demand for local goods. b. They must convert their currency to purchase. e.g. German demand for US goods means Germans convert DM to US \$ in order to buy.
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## Equilibrium Exchange Rates

3. 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 1. Increased demand
as more foreign goods are demanded, the price of the foreign currency in local currency increases and vice versa.
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## Equilibrium Exchange Rates

2. Home Currency Depreciation
a. b. Foreign currency becomes more valuable than the home currency. The foreign currencys value has appreciated against the home currency.

## Equilibrium Exchange Rates

3. Calculating a Depreciation:
Currency Depreciation

e0 e1 e1
where e0 = old currency value e1 = new currency value
Note: Resulting sign is always negative
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## Equilibrium Exchange Rates

Currency Appreciation

e1 e0 e0

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## Equilibrium Exchange Rates

EXAMPLE: dm Appreciation
If the dollar value of the dm goes from \$0.64 (e0) to \$0.68 (e1), then the dm has appreciated by

e1 e0 e0
= (.68 - .64)/ .64 = 6.25%
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## 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.

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## Equilibrium Exchange Rates

D. FACTORS AFFECTING EXCHANGE RATES: 1. Inflation rates 2. Interest rates 3. GNP growth rates

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PART II.

## I. FUNDAMENTALS OF CENTRAL BANK INTERVENTION A. Role of Exchange Rates:

LINKS BETWEEN THE DOMESTIC AND THE WORLD ECONOMY

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## THE ROLE OF CENTRAL BANKS

B. THE IMPACT OF EXCHANGE RATE CHANGES 1. Currency Appreciation: -domestic prices increase relative to foreign prices. - Exports: less price competitive - Imports: more attractive

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## THE ROLE OF CENTRAL BANKS

2. Currency Depreciation
- domestic prices fall relative to foreign prices. - Exports: more price competitive. - Imports: less attractive

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## THE ROLE OF CENTRAL BANKS

C. Foreign Exchange Market Intervention 1. Definition: the official purchases and sales of currencies through the central bank to influence the home exchange rate.
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## THE ROLE OF CENTRAL BANKS

2. Goal of Intervention: - to alter the demand for one currency by changing the supply of another.

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## THE ROLE OF CENTRAL BANKS

D. The Effects of Foreign Exchange Intervention 1. Effects of Intervention: - either ineffective or irresponsible 2. Lasting Effect: - If permanent, change results
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## Part III. EXPECTATIONS

I. WHAT AFFECTS A CURRENCYS VALUE?

A. Current events
B. C. D. Current supply Demand flows Expectation of future exchange rate
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EXPECTATIONS
II. Role of Expectations : A. Currency = financial asset B. Exchange rate = simple relation of two financial assets
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EXPECTATIONS
III. Demand for Money and Currency Values: Asset Market Model A. Exchange rates reflect the

## supply of and demand for foreign-currency denominated assets.

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EXPECTATIONS
B. Soundness of a Nations Economic Policies
- a nations currency tends to strengthen with sound economic policies.

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EXPECTATIONS
IV. EXPECTATIONS AND
CENTRAL BANK BEHAVIOR

## - exchange rates also influenced by

expectations of central bank behavior.

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EXPECTATIONS
A. Central Bank Reputations B. Central Bank Independence
C. Currency Boards

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