Introduction

Exchange rates are important because they enable us

to translate different counties prices into comparable

terms.
Exchange rates are determined in the same way as
other asset prices.
The general goal of this session is to show:

How exchange rates are determined

The role of exchange rates in international trade

Slide 13-1

Exchange Rates and

International Transactions
Domestic and Foreign Prices
If we know the exchange rate between two countries
currencies, we can compute the price of one countrys
exports in terms of the other countrys money.
Example: The dollar price of a 50 sweater with a dollar
exchange rate of $1.50 per pound is (1.50 $/) x (50) =
$75.

Slide 13-2

Exchange Rates and

International Transactions
Two types of changes in exchange rates:
Depreciation of home countrys currency
A rise in the home currency prices of a foreign currency
It makes home goods cheaper for foreigners and foreign goods
more expensive for domestic residents.

Appreciation of home countrys currency

A fall in the home price of a foreign currency
It makes home goods more expensive for foreigners and
foreign goods cheaper for domestic residents.

Slide 13-3

Exchange Rates and

International Transactions
Exchange Rates and Relative Prices
Import and export demands are influenced by relative
prices.
Appreciation of a countrys currency:
Raises the relative price of its exports
Lowers the relative price of its imports

Depreciation of a countrys currency:

Lowers the relative price of its exports
Raises the relative price of its imports

Slide 13-4

The Foreign Exchange Market

Exchange rates are determined in the foreign
exchange market.

The market in which international currency trades take

place

The Actors
The major participants in the foreign exchange market
are:

Commercial banks
International corporations
Nonbank financial institutions
Central banks
Slide 13-5

Exchange Rates and

International Transactions
Interbank trading
Foreign currency trading among banks
It accounts for most of the activity in the foreign
exchange market.

Slide 13-6

Exchange Rates and

International Transactions
Spot Rates and Forward Rates
Spot exchange rates
Apply to exchange currencies on the spot

Forward exchange rates

Apply to exchange currencies on some future date at a
prenegotiated exchange rate

Forward and spot exchange rates, while not

necessarily equal, do move closely together.

Slide 13-7

Exchange Rates and

International Transactions
Foreign Exchange Swaps
Spot sales of a currency combined with a forward
repurchase of the currency.
They make up a significant proportion of all foreign
exchange trading.

Slide 13-8

Exchange Rates and

International Transactions
Futures and Options
Futures contract
The buyer buys a promise that a specified amount of
foreign currency will be delivered on a specified date in
the future.

Foreign exchange option

The owner has the right to buy or sell a specified
amount of foreign currency at a specified price at any
time up to a specified expiration date.

Slide 13-9

Exchange Rate Equilibrium

An exchange rate represents the price of a currency,
which is determined by the demand for that currency
relative to the supply for that currency.

$$

Exchange Rate Equilibrium

Value of
S: Supply of
$1.60
$1.55
$1.50

Equilibrium
exchange rate
D: Demand for
Quantity of

Law of One Price

In competitive markets identical products sold in
different countries must sell for the same price when
their price are expressed in same currency.

Purchasing Power Parity (PPP)Theory

E=P ($) / P (Re)
Big Mac Index
Copyright 2003 Pearson Education, Inc.

Slide 13-12

Factors that Influence

Exchange Rates
e f INF , INT , INC , GC , EXP
e
=percentage change in the spot rate
INF =change in the relative inflation rate
INT =change in the relative interest rate
INC =change in the relative income level
GC =change in government controls
EXP=change in expectations of future exchange rates

Factors that Influence

Exchange Rates
Relative Inflation Rates

$/
r1
r0

S1
S0
D1
D0
Quantity of

U.S. inflation

U.S. demand for British

goods, and hence .

British desire for U.S.

goods, and hence the supply
of .

Relative Inflation Rates

Country in which price inflation is running wild
should expect its currency to depreciate.

Relative PPP: Exchange Rate of one currency against

another will adjust to reflect changes in price level of
two countries.

Copyright 2003 Pearson Education, Inc.

Slide 13-15

Factors that Influence

Exchange Rates
Relative Interest Rates

$/
r0
r1

S0
S1
D0
D1
Quantity of

U.S. interest rates

U.S. demand for British bank

deposits, and hence demand for
.

British desire for U.S.

bank deposits, and hence the
supply of .
Slide 13-16

Relative Interest Rates

In countries where inflation is expected to be high,
interest rates will also be high.

Fisher effect:

Countrys nominal interest rate (i) is

the sum of real interest rate (r) and expected inflation
over the period for which funds are lent (I)
I=r+I

Copyright 2003 Pearson Education, Inc.

Slide 13-17

Factors that Influence

Exchange Rates
Expectations
Foreign exchange markets react to any news that
may have a future effect.

News of a potential surge in U.S. inflation may

cause currency traders to sell dollars.

Many institutional investors take currency

positions based on anticipated interest rate
movements in various countries.

Managerial Implication
Foreign Exchange Risk is of 3 types
Transaction Exposure: The extent to which the income from
individual transactions is affected by fluctuations in foreign
exchange values

Translation Exposure: The extent to which the reported

consolidated results and balance sheets are affected by
fluctuations in foreign exchange values

Economic Exposure: The extent to which a firms future

earning power is affected by changes in exchange rates.

Copyright 2003 Pearson Education, Inc.

Slide 13-19