Chapter 2
Exchange Rates and International Financial Markets
1
Objectives
This chapter provides a foundation for understanding how exchange rates are determined, also identifies and discusses the various international financial markets used by MNCs. The specific objectives are: * to explain how the equilibrium exchange rate is determined; * to examine factors that affect the equilibrium exchange rate; and * to describe the background and corporate use of the international financial markets.
* foreign exchange barriers; * foreign trade barriers; * intervening in the foreign exchange market; * affecting macro variables.
5
Factors that Influence Exchange Rates
(interest rate differential, capital flow
restriction) sometimes interact. Exchange
rate movements may be simultaneously
affected by these factors.
* Over a particular period, different factors
• Expectations * Foreign exchange markets react to any news that may have a future effect. * Institutional investors often take a currency positions based on anticipated interest rate movements in various countries. * Because of speculative transactions, foreign exchange rates can be very volatile.
• The equilibrium exchange rate will change over time.
4
Factors that Influence Exchange Rates
• Relative Inflation Rates • Relative Interest Rates
It is useful to consider real interest rates • Relative Income Levels • Government Controls
6
Factors that Influence
Exchange Rates
• Interaction of Factors
* Trade–related factors (inflation differential,
income differential and government’s
trade restrictions) and financial factors
• The percentage change in the value
of a foreign currency is computed as (St – St-1)/ St-1 ( where St denotes the
spot rate at time t.) 3
Determination of Equilibrium Exchange Rate
may place opposing pressures on the
value of a foreign cus that Influence Exchange Rates
• The sensitivity of the exchange rate to these factors is dependent on the volume of international transactions between the two countries.
• An exchange rate represents the price of a currency, which is determined by the demand for that currency relative to the supply of that currency.
• The equilibrium exchange rate is the point where the demand for one currency equates the supply of that currency.
• Summary of how factors can affect exchange rates: Exhibit 2.1.
2
Determination of Equilibrium Exchange Rate
• An exchange rate measures the value of one currency in units of another currency.
• When a currency declines in value, it is said to depreciate. When it increases in value, it is said to appreciate.