Introduction to Finance

LEARNING ACTIVITY
1. Go to the CNNMoney website, http://money.cnn.com. Access “markets” and then 
“currencies” and fi nd current currency exchange rates for the U.S. dollar relative to 
the Australian dollar, British pound, and Canadian dollar. Find either the direct or 
indirect exchange rate and calculate the other one.
2.
Go to the Reuters website, http://www.reuters.com, and fi nd current currency 
exchange rates for the U.S. dollar relative to the Japanese yen, European euro, and 
the Swiss franc. Find either the direct or indirect exchange rate and calculate the 
other one.
6.4
Factors that Aff ect Currency 
Exchange Rates
Currency exchange rates are aff ected by changes in supply and demand relationships, relative 
infl ation rates, relative interest rates, and political risk and/or economic risk. Banks and insti-
tutional investors that are engaged in foreign currency transactions bring diff erences in the 
supply and demand for currencies into “balance” through the process of adjusting exchange 
rates up or down. 
Basic Supply and Demand Relationships 
The supply and demand relation-
ship involving two currencies is said to be in “equilibrium” at the current or spot exchange 
rate. Thus, the 
equilibrium exchange rate
 
is the currency exchange rate that exists when 
the supply and demand for a currency are in balance. Demand for a foreign currency de-
rives from the demand for the goods, services, and fi nancial assets of a country (or group 
of countries, such as the eurozone members). For example, U.S. consumers and investors 
demand a variety of eurozone member goods, services, and fi nancial assets, most of which 
must be paid for in euros. The supply of European euros comes from eurozone member 
demand for U.S. goods, services, and fi nancial assets. A change in the relative demand for 
euros versus U.S. dollars will cause the spot exchange rate to change. Currency exchange 
rates also depend on relative infl ation rates, relative interest rates, and political and eco-
nomic risks.
Figure 6.1
illustrates how exchange rates are determined in a currency exchange market 
by banks that provide foreign exchange services. Graph A depicts a supply and demand rela-
tionship between the U.S. dollar and the European euro (€). The demand curve is downward 
sloping, indicating that the U.S. demand for goods and services from eurozone countries 
would increase as the dollar value of the euro declines. The upward sloping supply curve 
refl ects the demand for U.S. dollars, or the supply of euros for sale, and indicates the willingness