4 Exchange Rate Determination
CHAPTER OBJECTIVES
The specific objectives of this chapter are to: II explain how exchange rate movements are measured,
a explain how the equilibrium exchange rate is determined,
examine factors that affect the equilibrium exchange rate, it explain the movements in cross exchange rates, and • explain how financial institutions attempt to capitalize on anticipated exchange rate movements.
WEB
WWW.xe.corn/ict Real-time exchange rate quotations.
EXAMPLE
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. This chapter provides a foundation for understanding how exchange rates are determined.
4-1 MEASURING EXCHANGE RATE MOVEMENTS 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 out-flows needed to pay for imports. An exchange rate measures the value of one currency in units of another currency. As economic conditions change, exchange rates can change substantially. A decline in a currency’s value is known as depreciation. When the British pound depreciates against the U.S. dollar, this means that the U.S. dollar is strengthening relative to the pound. An increase in currency value is known as appreciation. When a foreign currency’s spot rate at two different times are compared, the spot rate at the more recent date is denoted S and the spot rate at the earlier date is denoted as StA. The percentage change in the value of the foreign currency is then computed as follows:
Percent in foreign currency value = S — Sr 1
St _1 A positive percentage change indicates that the foreign currency has appreciated, and a negative percentage change indicates that it has depreciated. The values of some cur-rencies have changed as much as 10 percent over a 24-hour period. On some days, most foreign currencies appreciate against the dollar (although by dif-ferent degrees); on other days, most currencies depreciate against the dollar (though again by different degrees). There are also days when some currencies appreciate while others depreciate against the dollar; the financial media describe this scenario by stating that “the dollar was mixed in trading.” Exchange rates for the Canadian dollar and the euro are shown in the second and fourth columns of Exhibit 4.1 for the months from January 1 to July 1. First, observe that the direction of the move-ment may persist for consecutive months in some cases but in other cases may not persist at all. The magnitude of the movement tends to vary every month, although the range of percentage movements over these months is a reasonable indicator of the range of percentage movements in
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