1,Chapter 2,Exchange Rates and International Financial Markets,2,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.,3,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. 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.),4,Determination of Equilibrium Exchange Rate,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. The equilibrium exchange rate will change over time.,5,Factors that Influence Exchange Rates,Relative Inflation Rates Relative Interest Rates It is useful to consider real interest rates Relative Income Levels Government Controls * foreign exchange barriers; * foreign trade barriers; * intervening in the foreign exchange market; * affecting macro variables.,6,Factors that Influence Exchange Rates,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.,7,Factors that Influence Exchange Rates,Interaction of Factors * Traderelated factors (inflation differential, income differential and governments trade restrictions) and financial factors (interest rate differential, capital flow restriction) sometimes interact. Exchange rate movements may be simultaneously affected by these factors. * Over a particular period, different factors may place opposing pressures on the value of a foreign currency.,8,Factors 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. Summary of how factors can affect exchange rates: Exhibit 2.1.,9,Inflation Differential,Income Differential,Govt Trade Restrictions,U.S. Demand for Foreign Goods Foreign Demand for U.S. Goods,U.S Demand for the Foreign Currency Supply of the Foreign Currency for sale,Interest Rate Differential,Capital Flow Restrictions,U.S. Demand for Foreign Securities Foreign Demand for U.S. Securities,U.S. Demand for the Foreign Currency Supply of the Foreign Currency for Sale,Exchange Rate Between the Foreign Currency and the Dollar,Trade-Related Factors,Financial Factors,Exhibit 2.1 Summary of How Factors Can Affect Exchange Rates,10,Questions and Applications,Assume that the United States Invests heavily in government and corporate securities of Country K. In addition, residents of Country K invest heavily in the United States. Approximately $10 billion worth of investment transactions occur between these two countries each year. The total dollar value of trade transactions per year is about $8 million. This information is expected to also hold in the future.,11,Questions and Applications,Because your firm exports goods to Country K, your job as international cash manager requires you to forecast the value of country Ks currency ( the “krank) with respect to the dollar. Explain how each of the following conditions will affect the value of the krank, holding other things equal. Then, aggregate all of these impacts to develop an overall forecast of the kranks movements against the dollar.,12,Questions and Applications,a. U. S. Inflation has suddenly increased substantially, while Country Ks Inflation remains low. b. U. S. interest rates have increased substantially, while Country Ks interest rates remains low. Investors of both countries are attracted to high interest rates.,13,Questions and Applications,c. The U.S. Income level has increased substantially, while Country Ks income level has remained unchanged. d. The United States is expected to impose a small tariff on goods imported from Country k. e. Combine all expected impact to develop an overall forecast.,14,International Financial Markets,Topics for class discussion: 1. Where is the foreign exchange market? 2. Why does a foreign exchange market exist? 3. Which international financial markets