Currencys exchange rate affects the activities of both domestic and international

companies. A country with a currency that is weak (valued low relative to other
currencies) will see a decline in the price of its exports and an increase in the price
of its imports.
Lower prices for the countrys export on world markets can give companies the
opportunity to take market share away from companies whose product prices high
in comparison.
A companies will improve profits if it sells its products in a country with strong
currency while sourcing from a country with a weak currency
Exchanges rate also affect the amount of profit a company earn from its
international subsidiaries. The earnings of international subsidiaries are typically
integrated into the parent companys financial statement in the home currency.
Translating subsidiaries earnings from a weak host country currency into a strong
home currency reduces the amount of these earnings when stated into home
currency.
The international lowering of the value of a currency by the nations government is
called devaluation
The international raising of its value by the nations government, is called
revaluation
Devaluation lowers the price of countrys exports on world market and increase the
price of its imports because the value of the countrys currency is now lower on
world markets.
A government might devalue its currency to give its domestic companies an edge
over competition from other countries.
Devaluation reduces the buying power of consumer in the nation
It can also allow inefficiencies to persist in domestic companies because there is
now less pressure to be concerned with production costs.
Revaluation has the opposite effects.

DESIRE OF STABILITY AND PREDICTABILITY

Although methods do exist for insuring against potentially adverse movements in
exchange rates, most of these are too expensive for small and medium-sized
businesses. , as unpredictability of exchange rate increases, so too does the cost of
insuring against the accompanying risk.
Stable exchange rate improve the accuracy of financial planning and make cash
flow forecasts more precise.
Predictable exchange rate reduce the likelihood that the companies will be caught-
off guard by sudden and unexpected rate changes
They also reduces the need for costly insurance
Rather than purchasing insurance, companies would be better-off spending their
money on more productive activities, such as developing new products or designing
more efficient production methods.

What factors determine exchanges rate

Law of one price
Stripulates that an identical products must have an identical price in all countries
when the price is expressed in a common currency.
For example, suppose coal mined within the united states and germany is of similar
quality in each country. Suppose further that a kilogram of coal cost 1.5 in
germany and $1 in the United states. Therefor the law of one price calculates the
expected exchange rate between the euro and dollar to be 1.5/$. However
suppose the actual euro/dollar exchange rate as witnessed on currency market is
1.2/$. A kilogram of coal still costs $1 in the United States and 1.5 in germany.
But to pay german coal with dollar denominated after the change in exchange rate,
one must convert not just $1 into euros, but $1.25 (the expected exchange rate
divided by the actual exchange rate, or 1.5/$1.2). thus price of coal is higher in
germany than in the United States

Moreover because the law of one price is being violated in our example, an
arbitrage opportunity arisesthat is, an opportunity to buy a product in one country
and sell it in a country where it has greater value.
Mccurrency
Its employ Big Mac as single product to test the law of one price . why big mac
because each one is fairly identical in quality and content across national markets
and almost entirely produced within the nation in which it is sold

According to the most recent Big Mac index, the average price of a Mc Donalds Big
Mac sandwich was $3,73 in the united states. Meanwhile, a Big Mac In China cost a
dollar-equivalent price of $1.95. according to the big mac index, this mean that
chinas yuan is undervalued by 48% (((3.73-1.95)/3.73) x -100) = -48 %). For one
thing the selling price of food is affected by subsidies for agricultural products in
most countries.also, Big Mac is not a traded product in the sense that one can buy
Big Mac in low-priced countries and Sell it in the High-priced countries. Price can
also be affected because Big Mac are subject to different marketing strategies in
different countries.
The drawbacks of the Big Mac index reflect the fact that applying the law of one
price to a single product is to simplistic. A method for estimating exchange rate.
Purchasing power parity
Is the relative ability of two countriescurrencies to buy the same basket of goods
in those two countries.
Suppose 650 baht in thailand will buy a bag of groceries that costs $30 in the United
States. The question is : are thai consumer better off or worse off than their
counterparts in the united states?
Suppose the GNP per capita of each country as follows:

Country Price of a bag GNP/ Capita Exchange GNP in

of groceries rates in 1 dollars
dollar
Thailand 650 baht 122,277 baht 41.45 baht 2.950 dollars
U.S. 30 dollars 26.980 dollars

We already know that 650 baht will buy in thailand what $30 will buy in the United
States. Thus we calculate 650 : 30 = 21.67 baht per dollar. Whereas the exchange
rate on currency market is 41.45 baht/$, the purchasing power parity rate of the
bath is 21.67 baht /$. We can now recalculate thailands GNP per capita at PPP as
follows : 122,277 : 21.67 = 5.643. thai consumers on average are not nearly as
affluent as their counterparts in the United States. But when we consider the goods
and services that they can purchase with their bath-not the amount of U.S. dollars
that they can buy-we see that the GNP per capita at PPP of $5.643 more accurately
portrays the real purchasing power of thai consumers.
In the context of exchange rates the principle of purchasing power parity can be
interpreted as the exchange rate between two nationscurrencies thai is equal to
the ratio of their price levels. In other words PPP tells us that a consumer in thailand
needs 21.67 units (not 41.45) of thai currency to buy same amount of products as a
consumer in the United States can buy with one dollar.
As we can see in this example, the exchange rate at PPP is normally different from
the actual exchange rate in financial market. Economic forces says PPP theory will
push the actual market exchange rate toward that determined by purchasing power
parity. If they do not, arbitrage opportunities will arise.
Role Of Inflation
Inflation is the result of the supply and demand for a currency. If additional money is
injected into an economy that is not producing greater output, people will have
more money to spend on the same amount of products as before. Therefore,
inflation erodes peoples purchasing power.
Impact of money-supply decisions because f the damaging effects of inflation,
governments try to manage the supply of and demand for their currencies. They do
this through the use of two types of policies designed to influence a nations money
supply. For example selling government securities
Fiscal policy involves using taxes and government spending to influence the money
supply indirectly. For example increase taxes.
Impact of unemployment and interest rates
Other key factors in the inflation equation are a countrys unemployment and
interest rates. When unemployment rates are low, there is shortage of labor and
employers pay higher wages to attract employees. To maintain reasonable profit
margin with higher labor costs, they then usually raise the prices of their products,
passing the cost of higher wages on the consumer and causing inflation.
Interest rate affect inflation because they affect the cost borrowing money. Low
interest rates encourage people to take out loan to buy items such as homes and
cars and to run up debt on credit cards. High interest rates prompt people to cut
down the amount of debt they carry because higher interest rates mean larger
monthly payments on debt. One way to cool off inflationary is to raising interest
rate.
How exchange rates adjust to inflation
Adjustment is necessary to maintain purchasing power parity between nations.
1+i 1
The formula : e= Eb )/ (1+i 2)
E

Eb = exchange rate at the beginning at the period

i 1 =the inflation rate in country 1

i 2 =the inflation rate in country 2

High rates inflation will affecting the purchasing power parity.

Role of interest rate
Two types interest rate : real interest rates and nominal interest rate. Nominal
interest rate consist of real interest rate plus an additional charge for inflation. Bank
usually gives nominal interest rate for the loan. The use of this principle is as
compensated for the erosion od its purchasing power during the loan period caused
by inflation.
Fisher effect principle that the nominal interest rate is the sum of the interest rate
and expected rate of inflation over a specific period.
The relation between exchange rate and interest rate
To illustrate this relation we refer to the international Fisher effect- the principle that
a difference in nominal interest rates supported by two countries currencies will
cause an equal but opposite change in their spot exchange rates
Evaluating Purchasing power parity : purchasing power parity is better at predicting
long term exchange rates, but accurate forecasts of short-term rates are most
beneficial to international managers
There are many possible reasons for the failure of PPP to predict exchange rate
accurately

Impact of added costs

For example transportation costs. Because PPP assume no transportation
costs
Impact of trade barriers
PPP also assume no barriers to international trade.
For example imposed tariff and quota
Impact of business confidence Psychology

FORECASTING EXCHANGE RATES

Efficient market view
A market is efficient if prices of financial instrument quickly reflect new public
information made available to traders. As applied to exchange rate, this means that
forward exchange rates are accurate forecasts of future exchange rates. To accept
this view is to accept that companies do waste times and money collecting and
examining information believed to affect future exchange rate.
Inefficient market view
View that the price of financial instruments do not reflect all publicly available
information.
Forecasting techniques
Fundamental analysis
Techniques that uses statistical model based on fundamental economic indicators to
forecast exchange rate. This model include economic variable such as inflation,
interest rates, money supply, tax-rates and government spending
Technical analysis
Techniques that uses charts of pst trends in currency prices and other factors to
forecast exchange rates
DIFFICULTIES of Forecasting
Highly sophisticated statistical technique in the hands of well-trained analyst
People might miscalculating the importance of economic news becoming available
to the market, placing too much emphasis on some elements and ignoring others.