Exchange Rate Determination

Subject :- Multinational financial management Unit :- 4th

Presented by:Seema Gupta (100792) Sonu Kumari(100798) MBA (3rd sem.)

Outline
Defining Exchange Rate
Measuring Exchange Rate Movements
Appreciation/Depreciation of a currency

Exchange Rate Equilibrium Three main approaches for determination

Factors that influence Exchange Rate

Movements

Meaning of Exchange Rate and Measuring Changes in Exchange Rates

Value of one currency in units of another currency A decline in a currencys value is referred to as depreciation and an increase in currencys value is called appreciation. If currency A can buy you more units of foreign currency, currency A has appreciated and foreign currency depreciated If currency A can buy you less units of foreign currency, currency A has depreciated and foreign currency appreciated

Appreciation/Depreciation
Percentage change in value US $
New Value of Foreign Currency per unit of $ Old value of foreign currency per $

-------------------------------------------------- X 100
Old value of Foreign Currency per $

Percentage change in value of Foreign Currency

New Value of $ per units of Foreign Currency
Old value of $ per unit of foreign currency

-------------------------------------------------- X 100
Old value of $ per unit of Foreign Currency

Exchange Rate Equilibrium

Forces of Demand and Supply
Demand for foreign currency negatively

related to the price of foreign currency Supply of foreign currency positively related to the price of foreign currency Forces of demand and supply together determine the exchange rate

Demand for Foreign Currency

Price for Foreign Currency

D $2.00 $1.50 D
50m 75 m Units of Foreign Currency ()

Supply of Foreign Currency

Supply for Foreign Currency

$2.00

$1.50 S
50 m 75 m Units of Foreign Currency ()

Equilibrium Exchange Rate

Exchange Rate

$1.6775

D
Units of Foreign Currency()

Determination of Exchange Rates

Exchange rate determination is complex. The following exhibit provides an overview of the many determinants of exchange rates. This road map is first organized by the three major schools of thought (parity conditions, balance of payments approach, asset market approach), and secondly by the individual drivers within those approaches. These are not competing theories but rather complementary theories.
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Determination of Exchange Rates

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Parity Conditions Approach

The theory of purchasing power parity is the most widely accepted theory of all exchange rate determination theories:
PPP is the oldest and most widely followed of the exchange rate theories. Most exchange rate determination theories have PPP elements embedded within their frameworks. PPP calculations and forecasts are however plagued with structural differences across countries and significant data challenges in estimation.
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Balance of Payments Approach

The balance of payments approach is the second most utilized theoretical approach in exchange rate determination:
The basic approach argues that the equilibrium exchange rate is found when currency flows match up current and financial account activities. This framework has wide appeal as BOP transaction data is readily available and widely reported. Critics may argue that this theory does not take into account stocks of money or financial assets.
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Asset Market Approach

The asset market approach argues

that exchange rates are determined by the supply and demand for a wide variety of financial assets:
Shifts in the supply and demand for financial assets alter exchange rates. Changes in monetary and fiscal policy alter expected returns and perceived relative risks of financial assets, which in turn alter exchange rates.
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Asset Market Approach

The asset market approach assumes that whether foreigners

are willing to hold claims in monetary form depends on an extensive set of investment considerations or drivers (among others): Relative real interest rates Prospects for economic growth Capital market liquidity A countrys economic and social infrastructure

Political safety
Corporate governance practices Contagion (spread of a crisis within a region)

Speculation

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What Changes the Equilibrium Rate?

Inflation rates:
Higher domestic inflation means less demand for local goods (decreased supply of foreign currency) and more demand for foreign goods (increased demand for foreign currency).

Interest rates:
Higher domestic (real) interest rates attract investment funds causing a decrease in demand for foreign currency and an increase in supply of foreign currency.

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What Changes the Equilibrium Rate?

Economic growth:
Stronger economic growth attracts investment funds causing a decrease in demand for foreign currency and an increase in supply of foreign currency.

Political & economic risk:

Higher political or economic risk in the domestic country results in increased demand and reduced supply of foreign currency.

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What changes the Equilibrium Rate?

Changes in future expectations:
Any improvement in future expectations regarding the domestic currency or economy will decrease the demand for foreign currency and increase the supply of foreign currency.

Government intervention:
Maintain weak currency to improve export competitiveness.

Exchange Rate Determination

An interaction of factors
Is it possible for a country with high real

returns to have a low currency value? Is it possible for a country with low real returns to have a high currency value?

Any query!!!