Foundations of Multinational

Financial Management
Alan Shapiro
J.Wiley & Sons
Power 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 2
THE DETERMINATION OF EXCHANGE
RATES
CHAPTER OVERVIEW:
I. EQUILIBRIUM EXCHANGE RATES
II. ROLE OF CENTRAL BANKS
III. EXPECTATIONS AND THE ASSET MARKET
MODEL

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4
 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 foreign
country’s goods, services, and financial
assets.

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.

$/€
D

$.50

Qty

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 Equilibrium Exchange Rates
B.2. Foreign Currency Supply:
a. derived from the foreign
country’s demand for local goods.

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b. They must convert their currency to purchase
the foreign goods.

That means the supply of euros comes

from the German demand for US goods
which means Germans convert euros to
US $ in order to buy.

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 The Supply of € in the U.S.

$/ €

S
$.50

Qty

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 Equilibrium Exchange Rates

B.3. Equilibrium Exchange Rate

occurs where the quantity supplied
equals the quantity demanded of a foreign
currency at a specific local price.

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 The $/ € Equilibrium Rate

$/ € Equilibrium
D

S
$.50

Qty

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 Equilibrium Exchange Rates
C. How Exchange Rates Change
1. 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 local

currency increases.

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 Equilibrium Exchange Rates

C.3. Home Currency Depreciation a.

Foreign currency more valuable than
the home currency.
b. Conversely, then the foreign
currency’s value has
appreciated against the home
currency.

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 The US$ Depreciates When

$/ € D’
D
$.65
S

$.50
Q1 Q2 Qty
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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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Equilibrium Exchange Rates

C.5 Currency Appreciation

= (e1 - e0)/ e0

where e0 = old currency value

e1 = new currency value

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 Equilibrium Exchange Rates

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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 Equilibrium Exchange Rates

C.4. Calculating a Depreciation:

= (e0 - e1)/ e1

where e0 = old currency value

e1 = new currency value

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 Equilibrium Exchange Rates

EXAMPLE: US$ Depreciation

Use the formula

(e0 - e1)/ e1
substituting
(.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 eopposite
e 
0
x
1

value: e 1

Given: Find:
 e0  e1    e1  e0   x
or e1 e0
 e1  e0  x
e0
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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

(e1  e0 )
 5.00
e0

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• Depreciation of the ruble:

e0  e1
x
e1
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e1 e0
 5
e0 e0

SOLUTION

e1 e0
  5
e0 e0
e1
11  5 1
e0
e1  6e0
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 (e0  e1 )
x
e1
e0  6e0
 x
6e0
5
 x
6
x  83% 27
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:

e0  e1
 .83
e1
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U.S. $ APPRECIATION

(e1  e0 )
x
e0

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e1 e0
 5
e0 e0

SOLUTION

e0  e1
 .83
e1
e0 e1
  .83
e1 e1
e0
 1  1  1  .83
e1
e0  .17 e1
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Find the appreciation:

(e1  e0 )
x
Substituting: e0
e1  .17e1
 x
Summing the .17 e1
numerator
.83
 x
.17
x  4.88  5.00
 500%
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 Equilibrium Exchange Rates

D. OTHE FACTORS AFFECTING EXCHANGE

RATES:
1. Relative Inflation rates
2. Relative Interest rates
3. Relative economic growth rates
4. Political risk
5. Expectations

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