The document discusses exchange rate determination and factors that influence exchange rates. It begins by explaining how exchange rate movements are measured and how the equilibrium exchange rate is determined by the interaction of supply and demand. Key factors that can cause fluctuations in exchange rates are then examined, such as relative inflation, interest rates, income levels, and expectations of future economic conditions between countries. Speculators seek to capitalize on anticipated exchange rate movements through currency speculation.

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International Financial Management
11th Edition
by Jeff Madura
1

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4 Exchange Rate Determination
 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.
2
Chapter Objectives

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3
OPEN MARKET FOREX RATES
Updated at: 3/11/2020 8:45 AM (PST)
Currency
Buying Selling
Australian Dollar 111.8 115.8
Bahrain Dinar 405.8 407.8
Canadian Dollar 119.1 121.1
China Yuan 23.75 23.9
Danish Krone 24.35 24.65
Euro 187.1 189.6
Hong Kong Dollar 17.6 17.85
Indian Rupee 2.15 2.22
Japanese Yen 1.55 1.58
Kuwaiti Dinar 498 500.5
Malaysian Ringgit 38.05 38.4
NewZealand $ 98.2 98.9
Norwegians Krone 16.9 17.15
Omani Riyal 409 411
Qatari Riyal 42.9 43.25
Saudi Riyal 42.05 42.65
Singapore Dollar 116.1 119.1
Swedish Korona 17.6 17.85
Swiss Franc 170.5 171.4
Thai Bhat 5 5.1
U.A.E Dirham 43.5 44
UK Pound Sterling 206.6 211.6
US Dollar 159.8 160.5

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4
Currency Symbol Buying Selling
AUD Australian Dollar AUD 140.05 141.3
BHD Bahrain Dinar BHD 587.51 592.01
CAD Canadian Dollar CAD 162.22 163.57
CNY China Yuan CNY 30.62 30.87
DKK Danish Krone DKK 29.18 29.53
EUR Euro EUR 219.4 221.6
HKD Hong Kong Dollar HKD 28.15 28.5
INR Indian Rupee INR 2.67 2.75
JPY Japanese Yen JPY 1.1 1.17
KWD Kuwaiti Dinar KWD 709.39 714.39
MYR Malaysian Ringgit MYR 46.72 47.17
NZD NewZealand $ NZD 127.9 129.1
NOK Norwegians Krone NOK 20.87 21.17
OMR Omani Riyal OMR 575.12 579.62
QAR Qatari Riyal QAR 60.7 61.2
SAR Saudi Riyal SAR 59.1 59.7
SGD Singapore Dollar SGD 156.09 157.9
SEK Swedish Korona SEK 19.72 20.02
CHF Swiss Franc CHF 221.48 223.23
THB Thai Bhat THB 5.8 5.9
AED U.A.E Dirham AED 63.5 64.1
GBP UK Pound Sterling GBP 253.25 258.8
USD US Dollar USD 222.8 225
as per Open Market as on Tue, Oct 25 2022, 06:00 PST
(GMT+5)

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5
Measuring Exchange Rate Movements
 An exchange rate measures the value of one currency in units of
another currency.
 Depreciation: decline in a currency’s value
 Appreciation: increase in a currency’s value
 the spot rate at the more recent date is denoted as S and the spot
rate at the earlier date is denoted as St-1.
 Comparing foreign currency spot rates over two points in time, S
and St-1
 A positive percent change indicates that the currency has
appreciated. A negative percent change indicates that it has
depreciated.
1
1
alue
currency v
foreign
in
Percent





t
t
S
S
S

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6
Exhibit 4.1 How Exchange Rate Movements and Volatility
Are Measured

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7
Exchange Rate Equilibrium
 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 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)
 In liquid spot markets, exchange rates are not highly
sensitive to large currency transactions.

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Exhibit 4.2 Demand Schedule for British
Pounds
8

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9
Exhibit 4.3 Supply Schedule of British Pounds for
Sale
9

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10
Exhibit 4.4 Equilibrium Exchange Rate
Determination
10

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11
Factors That Influence Exchange Rates
rates
exchange
future
of
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expectatio
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change
controls
government
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income
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country'
foreign
the
and
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U.S.
e
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in the
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country'
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the
and
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interest
U.S.
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between th
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inflation
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and
inflation
S.
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percentage
where
)
,
,
,
,
(





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EXP
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EXP
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INF
f
e
The equilibrium exchange rate will change over time as
supply and demand schedules change.

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Factors That Influence Exchange Rates
 Relative Inflation: 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 a increase in demand for dollars
and an increased exchange rate for the dollar. (See Exhibit 4.6)
Fisher Effect:
rate
Inflation
rate
interest
Nominal
rate
interest
Real 


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Exhibit 4.5 Impact of Rising U.S. Inflation on the Equilibrium
Value of the British Pound
13

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Exhibit 4.6 Impact of Rising U.S. Interest Rates on the
Equilibrium Value of the British Pound
14

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15
Factors That Influence Exchange Rates
 Relative Income Levels: Increase in U.S. income leads to
increased in U.S. demand for foreign goods and 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 the
Equilibrium Value of the British Pound
16

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17
Factors That Influence Exchange Rates
 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 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
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.

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Exhibit 4.8 Summary of How Factors Can Affect
Exchange Rates
19

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Movements in Cross Exchange Rates
 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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21
Exhibit 4.9 Trends in the Pound, Euro, and
Pound/Euro
21

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Anticipation of Exchange Rate Movements
 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.
 The “Carry Trade” – Where investors attempt to capitalize on the
differential in interest rates between two countries.

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SUMMARY
 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 point in 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 (Cont.)
 The key economic factors that can influence exchange rate
movements through their effects on demand and supply
conditions are relative inflation rates, interest rates, and income
levels, as well as government controls. As these factors cause a
change in international trade or financial flows, they affect the
demand for a currency or the supply of currency for sale and
therefore affect the equilibrium exchange rate.
 Unique international trade and financial flows between every
pair of countries dictate the unique supply and demand
conditions for the currencies of the two countries, which affect
the equilibrium cross exchange rate. The movement in the
exchange rate between two non-dollar currencies can be
determined by considering the movement in each currency
against the dollar and applying intuition.

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SUMMARY (Cont.)
 Financial institutions can attempt to benefit from expected
appreciation of a currency by purchasing that currency.
Conversely, they can attempt to benefit from expected
depreciation of a currency by borrowing that currency,
exchanging it for their home currency, and then buying that
currency back just before they repay the loan.