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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.
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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.)
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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.
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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.
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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