Exchange rate is an important macroeconomic variable in an open economy. It allows for the conversion of one country’s currency into that of another, thereby providing international connectivity by facilitating international trade and transfer of funds between countries. Critical events whether domestic or foreign affect it as do basic factors of the economy. The study of the recent global financial crisis (2007) makes it clear that it originated in the United States but global financial connectivity spread it to the rest of the world. The adverse effects of the financial crisis on the equilibrium path of the exchange rate will be better understood with the aid of those exchange rate models that have a financial orientation. The objective of this study is to investigate the dynamics of exchange rate in a financial crisis situation by using structural exchange rate models available in the literature. This study has modified the portfolio balance model of Branson et al. (1985) and Gylfason and Helliwell (1983) synthesis of Keynesian, monetary and portfolio model by incorporating the financial crisis variable in the domestic and foreign bond functions. It describes the effect of financial crisis on the preferred portfolio composition. The transformed portfolio model and the synthesis model established that in a two country case, the small country having no internal economic crisis experiences an appreciation of its currency during a financial crisis and vice versa. The empirical evidence of these theoretical results are confirmed by considering the exchange rate of Pakistan rupee against the US dollar by considering the time series quarterly data set over the period 1982 to 2010. Johansen’s (1988, 1992) maximum likelihood method of cointegration is used to establish the long-run relationship among the macroeconomic fundamental variables such as interest rate, inflation rate, output level, money supply, investment in domestic and foreign securities and government spending. The dynamics of nominal exchange rate in the short run is analyzed through error-correction Supervised by: Dr. Abdul Qayyum