Multinational Financial Management

The Determination of Exchange Rates

Experience shows that neither a state nor a bank ever have had the unrestricted power of issuing paper money without abusing that power.

DAVID RICARDO (1817)

LEARNING OBJECTIVES

• To explain the concept of an equilibrium exchange rate
• To identify the basic factors affecting exchange rates in a floating exchange rate system
• To calculate the amount of currency appreciation or depreciation associated with a given exchange rate change
• To describe the motives and different forms and consequences of central bank intervention in the foreign exchange market
• To explain how and why expectations affect exchange rates

Economic activity is globally unified today to an unprecedented degree. Changes in one nation's economy are rapidly transmitted to that nation's trading partners. These fluctuations in economic activity are reflected, almost immediately, in fluctuations in currency values. Consequently, multinational corporations, with their integrated cross-border production and marketing operations, continually face devaluation or revaluation worries somewhere in the world. The purpose of this chapter and the next one is to provide an understanding of what an exchange rate is and why it might change. Such an understanding is basic to dealing with currency risk.

This chapter first describes what an exchange rate is and how it is determined in a freely floating ...