CH 02

International
Financial
Management
Alan Shapiro & Peter Moles
Adapted by Dr. Jayanta Kumar Seal
“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
Seal
CHAPTER 2
The Determination of
Exchange Rates
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CHAPTER OVERVIEW:
CHAPTER OVERVIEW:
2.1 SETTING THE EQUILIBRIUM SPOT
EXCHANGE RATE
2.2 EXPECTATIONS AND THE ASSET
MARKET MODEL OF EXCHANGE RATES
2.3 THE FUNDAMENTALS OF CENTRAL BANK
INTERVENTION
2.4 THE EQUILIBRIUM APPROACH
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Equilibrium Exchange Rates
2.1 SETTING THE EQUILIBRIUM SPOT

EXCHANGE RATE
A. The exchange rate
is the price of one unit of foreign currency
expressed as a certain price in local
currency.
For example, $1.30/€ means the euro is worth

$1.30.
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B. When Americans purchase German
goods:
1. Foreign currency demand derived from the
demand for foreign country’s goods, services, and
financial assets,
e.g. the demand for German cars by

Americans.
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The Demand for € in the U.S.
$/€
D
$1.20/€
$1.10/€
$1.00/€
Qty
At higher exchange rates, Americans demand fewer euros and
vice versa.
2. Foreign currency supply
a. derived from the foreign country’s demand for
local goods.
b. foreigners must convert their currency to

purchase,
e.g. German demand for U.S. goods means

Germans convert € to US$ in order to buy.
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The Supply of € in the U.S.
$/€
$1.20/€
S
$1.10/€
$1.00/€
Qty
At higher exchange rates, Germans supply more euros

and vice versa.
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3. Equilibrium spot exchange rate
occurs where the quantity supplied equals the
quantity demanded of a foreign currency at a specific
local exchange rate.
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The $/€ Equilibrium Rate
$/€ Equilibrium
D
S
$1.10
Qty
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C. How exchange rates change:
1. Increased demand
as more foreign goods are demanded, more
of the foreign currency is demanded at each
possible exchange rate.
2. The exchange rate of the foreign

currency in local currency increases.
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3. Home currency depreciation
a. foreign currency more valuable than the

home currency.
b. conversely,
the foreign currency’s value has
appreciated against the
home currency.
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The US$ Depreciates when
$/€ D’
D
$1.20/€
S
$1.10/€
Q1 Q2
Qty
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Computing a currency appreciation:
= (e1 - e0)/e0
where e0 = old currency value

e1 = new currency value
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Computing a currency depreciation:
= (e0 - e1)/e1
where e0 = old currency value

e1 = new currency value
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D. Factors affecting exchange rates:
1. Inflation rates.
2. Interest rates.
3. GNP growth rates.
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Expectations and the Asset Market
Model of Exchange Rates
2.2 THE ROLE OF EXPECTATIONS
A. Currency = financial asset.
B. Exchange rate = simple relation of two financial assets.
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Expectations
C. The nature of money and currency values:
1. Asset market model
exchange rates reflect the supply of and

demand for foreign-currency denominated assets.
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Expectations
2. Soundness of a nation’s economic policies
a nation’s currency tends to strengthen with

sound economic policies.
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Expectations
3. Expectations and central bank behavior
exchange rates are also influenced by
expectations of central bank behavior.
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Expectations
D. Central bank reputations and currency
values:
1. Central bank
the nation’s official monetary authority.
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Expectations
2. Price stability and central bank independence
when the bank limits its focus to price
stability, it is more likely to succeed in its
goal.
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Expectations
3. Currency board
‒ exists where there is no central bank
‒ instead the board issues notes
‒ has no discretionary monetary policy.
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The Fundamentals of
Central Bank Interventions
2.3 HOW REAL EXCHANGE RATES AFFECT
RELATIVE COMPETITIVENESS
A. Appreciation:
– Domestic prices increase
relative to foreign prices.
– Exports: less competitive.

Imports: more attractive.
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The Fundamentals of Central Bank
Interventions
B. Currency depreciation:
domestic prices fall relative to foreign prices.
– Exports: more price competitive.

– Imports: less attractive.
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Interventions
C. Foreign exchange market intervention
Mechanics of intervention
Sterilized vs unsterilized intervention
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Interventions
D. The effects of foreign exchange market
intervention:
1. Definition: the official purchases and sales of

currencies through the central bank to
influence the home exchange rate.
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The Equilibrium Approach
2.4 THE EQUILIBRIUM APPROACH TO
EXCHANGE RATES
A. Disequilibrium theory and exchange rate

overshooting:
1. Various economic frictions cause
prices to adjust slowly over time.
2. Leads to “overshooting”.
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The Equilibrium Approach
B. The equilibrium theory of exchange
rates and its implications:
1. Markets clear through price adjustments.

2. Repeated shocks in supply and
demand create a correlation
between changes in nominal and
real exchange rates.
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CH 02

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International

2.1 SETTING THE EQUILIBRIUM SPOT

For example, $1.30/€ means the euro is worth

e.g. the demand for German cars by

b. foreigners must convert their currency to

e.g. German demand for U.S. goods means

At higher exchange rates, Germans supply more euros

2. The exchange rate of the foreign

a. foreign currency more valuable than the

where e0 = old currency value

where e0 = old currency value

2.2 THE ROLE OF EXPECTATIONS

A. Currency = financial asset.

B. Exchange rate = simple relation of two financial assets.

exchange rates reflect the supply of and

a nation’s currency tends to strengthen with

– Exports: less competitive.

domestic prices fall relative to foreign prices.

– Exports: more price competitive.

1. Definition: the official purchases and sales of

A. Disequilibrium theory and exchange rate

1. Markets clear through price adjustments.

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