International Finances Prepared by Chan Bonnivoit

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INTERNATIONAL FINANCES

Prepared by:MSc. Chan Bonnivoit

For Human Resource University

2010-2011



International Finance

The International Financial System

historical overview

Foreign Exchange Markets market structure,

Spot, Forward Contracts, Futures, Options and Swaps

Determinants and Government intervention Balance of Payments

Current account, capital account and financial account

BP

&

XR Exchange Rates and the Open Economy

Fixed Exchange Rate Systems

Floating Exchange Rate Systems

Purchasing Power Parity



International Parity Conditions

The International Fisher Effect

Covered Interest

Parity

Uncovered Interest Parity

Real Interest Rate Parity

Portfolio management

Forecasting Exchange Rates

Efficient Markets Approach

Fundamental Approach

Technical Approach

Performance of the Forecasters

8Recent developments of international finance




1. Overview and History of




International Monetary Arrangements in Theory and

Practice

The Bimetallism, 1791‐1879

The International Gold Standard, 1879‐1913

The Spirit of the Bretton Woods Agreement, 1945

The Fixed‐Rate Dollar Standard, 1950‐1970

The Floating‐Rate Dollar Standard, 1973‐1984

The Plaza‐Louvre Intervention Accords and the

Floating‐

Rate

Dollar

Standard,

1985‐

1999



For example, if the dollar is pegged to silver at

U.S.$1.293 = 1 ounce of silver, and if the dollar is pegged to gold at U.S.$19.395 = 1 ounce of gold (28.35g gold).

The “mint ratio” was 15 to 1. In other word, the mint price of gold was 15 times that of silver.

Reestablishment in 1834, the dollar is pegged to gold at U.S.$20.67 = 1 ounce of gold.

Then, the “mint ratio was 16 to 1 in USA, while in Abroad 15½ to 1.

The Bimetallism, 1791-1879



For example, if the dollar is pegged to gold at U.S.$30 = 1 ounce of gold, and the British pound is pegged to gold at £6 = 1 ounce of gold, it must be the case that the exchange rate is determined by the relative gold contents:

The International Gold Standard,

1879-1913

$30 = £6

$5 = £1



There are shortcomings: The supply of newly minted gold is so restricted that the

growth of world trade and investment can be hampered for the lack of sufficient monetary reserves.

Even if the

world

returned

to a gold

standard,

any

national government could abandon the standard.

And a sizeable share of the world's known gold reserves were located in the Soviet Union, which would later emerge as a Cold War rival to the United States and Western Europe.


1879-1913



The Relationship Between Money and

Growth Money is needed to facilitate economic transactions.

MV=PY →The equation of exchange. Assuming velocity (V) is relatively stable, the quantity of money (M) determines the level of spending (PY) in the economy.

If sufficient money is not available, say because gold supplies are fixed, it may restrain the level of economic transactions.

If income (Y) grows but money (M) is constant, either velocity (V) must increase or prices (P) must fall. If the latter occurs it creates a deflationary trap.

Deflationary episodes were common in the U.S. during the Gold Standard.



The only currency strong enough to meet the rising demands for international liquidity was the U.S. dollar.

The strength of the U.S. economy, the fixed relationship of the dollar to gold ($35 an ounce), and the commitment of

the U.S. government to convert dollars into gold at that price made the dollar as good as gold.

In fact, the dollar was even better than gold: it earned interest

and

it

was

more

flexible

than

gold

Yet, in an era of more activist economic policy,

governments

did

not

seriously

consider

permanently

fixed

rates on the model of the classical gold standard of the nineteenth century.


1879-1913



The Spirit of the Bretton Woods Agreement,1945

Fix an official par value for domestic currency interms of gold or a currency tied to gold as a

numeraire. In the short run, keep the exchangerate pegged within 1% of its par value, but inthe long-run leave open the option to adjust the

par value unilaterally if the IMF agrees.

In essence, the Agreement removed countries from the tyranny of the

gold standard and permitted greater autonomy for national monetary policies.



Bretton Woods System: 1945-1972

Named for a 1944 meeting of 44 nations at Bretton

Woods, New Hampshire. The purpose was to design a postwar international

monetary system.

The goal was exchange rate stability without the gold standard.

The result was the creation of the IMF and the

World Bank.



Bretton Woods System: 1945-1972

Under the Bretton Woods system, the U.S. dollar was pegged to gold at $35 per ounce and other currencies

were pegged to the U.S. dollar. Each country was responsible for maintaining its

exchange rate within ±1% of the adopted par value by buying or selling foreign reserves as necessary.

The U.S. was only responsible for maintaining the gold parity.

This created strong demand for $ reserves and allowed

the U.S. to run trade deficits. The Bretton Woods system was a dollar‐based gold

exchange standard.



The Spirit of the Bretton Woods

Agreement, 1945

The Role of International Reserves inExchange Rate Determination

Price of Sterling

Quantity of sterling/Time

$2.82

$2.78

D

D

S

S

a$2.80




The Role of International Reserves inExchange Rate Determination

Price of Sterling


$2.82

$2.78

D

D

S

S

a D’

D’

e

f g

The Bank of England uses

its US$reserves tobuy up fg £each period.

S’

S’

h i

j T he Ba n k m u s t b u y

u p i j £

eac h

pe r iod.

D”

D”

b

c d

The Bankmust supply cd £ each

period.



The Fixed-Rate Dollar Standard,1945-1972

In practice, the Bretton Woods system evolved into a fixed‐rate dollar standard.Industrial countries other than the United States :Fix an official par value for domestic currency in terms

of the US$, and keep the exchange rate within 1% of this par value indefinitely.

United States : Remain passive in the foreignexchange market; practice free trade without abalance of payments or exchange rate target.



Bretton Woods System: 1945‐

1972German

mark British pound

Frenchfranc

U.S. dollar

Gold

Pegged at $35/oz.

Par

Value P a r V a l u e P a r

V a l u e



Collapse of Bretton Woods In 1960 Robert Triffin noticed that holding dollars was

more valuable than gold because constant U.S. balance

of payments deficits helped to keep the system liquid and

fuel economic growth.

What would later come to be known as Triffin's

Dilemma was predicted when Triffin noted that if the

U.S. failed to keep running deficits the system would

lose its liquidity, not be able to keep up with the world's

economic growth, and, thus, bring the system to a halt.

Throughout the 1960s countries with large $ reserves

began buying gold from the U.S. in increasing quantities

threatening the gold reserves of the U.S.

http://en.wikipedia.org/wiki/Robert_Triffin

http://en.wikipedia.org/wiki/Balance_of_payments




http://en.wikipedia.org/wiki/Triffin%27s_Dilemma







http://en.wikipedia.org/wiki/Robert_Triffin



Collapse of Bretton Woods

Large U.S. budget deficits and high money growthcreated exchange rate imbalances that could not besustained, i.e. the $ was overvalued and the DMand £ were undervalued.

Several attempts were made at re-alignment buteventually the run on U.S. gold supplies promptedthe suspension of convertibility in September 1971.

Smithsonian Agreement – December 1971



The Floating-Rate Dollar Standard, 1973-

1984

Without an agreement on who would set the common monetary policy and how it would be set, a floating exchange rate system provided the only alternative to the Bretton Woods system.

Essentially, the foreign exchange rate was left to play

the role of a residual variable that did a great deal of the adjusting to offset the macroeconomic policy differences across countries.



The Floating-Rate Dollar Standard, 1973-

1984Industrial countries other than the United States :Smooth short-term variability in the dollar exchange rate,

but do not commit to an official par value or to long-termexchange rate stability.

United States : Remain passive in the foreign exchangemarket; practice free trade without a balance of payments or exchange rate target. No need for sizable

official foreign exchange reserves.



The Plaza-Louvre Intervention Accords andthe Floating-Rate Dollar Standard, 1985-1999

Germany, Japan, and the United States (G-3) : Setbroad target zones for the $/DM and $/¥ exchange

rates. Do not announce the agreed-upon central rates,and allow for flexible zonal boundaries. Allow theimplicit central rates to adjust when economic

fundamentals among the G-3 countries changesubstantially.

Other industrial countries : Support or do not opposeinterventions by the G-3 to keep the dollar within itstarget zone limits.



The Plaza-Louvre Intervention Accords and

the Floating-Rate Dollar Standard, 1985-1999 An episode started by an expansive U.S. fiscal

policy introduced in 1981 combined with tight

monetary control convinced policymakers

that …

exchange rates were too important to be leftto market forces

intervention was deemed appropriate

exchange rates were too important to be theresidual from uncoordinated economic

policies

better policy coordination was required.

h



Current Exchange Rate

Arrangements Free Float

The largest number of countries, about 48, allow market forces to determine their currency’s value.

Managed Float

About 25 countries combine government intervention with market forces to set exchange rates.

Pegged

to

another

currency Such as the U.S. dollar or euro.

No national currency

Some countries do not bother printing their own, they just use the U.S. dollar. For example, Ecuador, Panama, and El Salvador have dollarized .







2. The Foreign Exchange

Market



Origins of the Market

International trade ‐ No single currency is particularly

efficient as a medium of exchange.

International investment ‐ Foreign assets are an alternative store of value. They may also serve to offset

certain financial risks. Some of their features may not be available domestically too.

Speculation ‐ The aim is purely to earn higher returns.



In a typical foreign exchange transaction a party

purchases a quantity of one currency by paying aquantity of another currency.

The modern foreign exchange market started formingduring the 1970s when countries gradually switched tofloating exchange rates from the previous exchange rateregime, which remained fixed as per the Bretton Woods

system.

The foreign exchange market, as we usually think of it,

refers to large commercial banks in financial centerssuch as New York or London trading foreign-currency-dominated deposits with each other.



The purpose of the foreign exchange market is to assist international trade and

investment. The foreign exchange market allows

businesses to convert one currency to another.

For example, it permits a U.S. business to

import European

goods

and

pay

Euros,

even

though the business's income is in U.S. dollars.

The purpose of FX



Measures of Money StockMeasures of Money Stock

Reserve Bank of the Country (RBC) employs FOUR measures of money stock, namely M1, M2, M3, M4

M1 : The measure of money stock designed by M1 is usuallydescribed as the money supply. The components of money supply arecurrency with the public (i.e., notes in circulation, circulation of coins

and circulation of small coins) and deposits (demand deposits withbanks and other deposits with the RBC).

M2 : M2 is M1 + Post Office Savings Bank Deposits.

M3 : M3 is M1 + Time Deposits with the banks. In other words, M3 ismoney supply plus fixed deposits with the banks. M3 is usuallyreferred to as aggregate monetary resources.

M4 : M4 is M3 plus the total Post Office Deposits.



Market participants

Banks: The interbank market caters for both the majority of commercial turnover and large amounts of speculative trading every day. A large bank may trade billions of dollars daily.

Commercial companies: An important part of this market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. Commercial companies often trade fairly small amounts compared to those of banks or speculators

Central Bank: National central banks play an important role in the foreign exchange markets. They try to control the money supply, inflation, and/or interest rates and often have official or unofficial target rates for their currencies. They can use their

often substantial foreign exchange reserves to stabilize the market.

H d f d l t Ab t % t % f th



Hedge funds as speculators: About 70% to 90% of the foreign exchange transactions are speculative. In

other words, the person or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end; rather, they were solely

speculating on the movement of that particular currency.

Investment management firms: Investment management firms (who typically manage large

accounts

on

behalf

of

customers

such

as

pension

funds and mutual funds) use the foreign exchange market to facilitate transactions in foreign securities.







Distinction Between Interest

Rates and Returns

Rate of ReturnC + P t+1 – P t

RET = = ic + g

P t C where: ic = = current yield

P t

P t +1 – P t g = = capital gain

P t



Retail foreign exchange brokers: There are two types of



Retail foreign exchange brokers: There are two types of retail brokers offering the opportunity for speculative

trading: retail foreign exchange brokers and market makers. Retail traders (individuals) are a small fraction of this market and may only participate

indirectly through brokers or banks.

Non‐

bank

foreign

exchange

companies: Non‐

bank

foreign exchange companies offer currency exchange and international payments to private individuals and

companies.

These

are

also

known

as

foreign

exchange

brokers but are distinct in that they do not offer speculative trading but currency exchange with

payments.



Money transfer/remittance companies: Money transfer companies/remittance companies perform high‐ volume low‐ value transfers generally by economic

migrants back to their home country. In 2007, the estimated that there were $369 billion of remittances (an increase of 8% on the previous year). The largest

and best known provider is Western Union with 345,000 agents globally.

The Foreign Exchange Market Setting



The Foreign Exchange Market Setting

The foreign exchange market is unique because of its trading volumes,

the extreme liquidity of the market,

its long trading hours: 24 hours a day except on weekends (from 22:00 UTC on Sunday until 22:00 UTC Friday),

the variety of factors that affect exchange rates.

the low

margins

of profit

compared

with

other

markets

of

fixed income (but profits can be high due to very large trading volumes)

The foreign exchange market is a geographical dispersion,

broker‐dealer market, and hence lacks transparency. Dealers can trade in a number of ways:

direct telephone contact with a dealer at another bank (direct dealing)

telephone contact with a voice broker electronic direct trading and broking systems

http://en.wikipedia.org/wiki/Liquidity

http://en.wikipedia.org/wiki/UTC

http://en.wikipedia.org/wiki/Exchange_rate




http://en.wikipedia.org/wiki/UTC

http://en.wikipedia.org/wiki/Liquidity





F i E h M k t P d t d A ti iti



The spread The difference between selling and buying rates

called the spread, e.g. Bank bid to buy foreign exchange rate at lower rates than the exchange rate quoted to sell.

Spot market

Spot market is where currencies are traded for current delivery (actually, deposits traded in the foreign exchange market generally take 2 working days to clear).

Foreign Exchange Market Products and Activities

Settlement and Settlement Risk



Settlement and Settlement Risk



Spot Rate Quotations Direct quotation US$ for Yen

the U.S. dollar equivalent

e.g. “a Japanese Yen is worth about a penny”

Indirect Quotation US$ for Yen the price of a U.S. dollar in the foreign currency

e.g. “you get 100 yen to the dollar”

Spot Rate Quotations



Country USD

equiv Friday

USD equiv

Thursday Currency per

USD Friday Currency per

USD Thursday

Argentina (Peso) 0.3309 0.3292 3.0221 3.0377

Australia (Dollar) 0.5906 0.5934 1.6932 1.6852

Brazil (Real) 0.2939 0.2879 3.4025 3.4734

Britain (Pound) 1.5627 1.5669 0.6399 0.6386

1 Month Forward 1.5596 1.5629 0.6412 0.6398

3 Months Forward

1.5535 1.5568 0.6437 0.6423

6 Months Forward

1.5445 1.5477 0.6475 0.6461

Canada (Dollar) 0.6692 0.6751 1.4943 1.4813

1 Month Forward 0.6681 0.6741 1.4968 1.4835

3 Months Forward

0.6658 0.6717 1.502 1.4888

6 Months Forward

0.662 0.6678 1.5106 1.4975

p Q

The direct quote

for British pound

is: £1 = $1.5627





The indirect

quote for

British pound

is:

£0.6399 = $1

1.49751.51060.66780.6626 Months Forward

1.48881.5020.67170.66583 Months Forward

1.48351.49680.67410.66811 Month Forward

1.48131.49430.67510.6692Canada (Dollar)

0.64610.64751.54771.54456 Months Forward

0.64230.64371.55681.55353 Months Forward

0.63980.64121.56291.55961 Month Forward

0.63860.63991.5661.5627Britain (Pound)

3.47343.40250.28790.2939Brazil (Real)

1.68521.69320.59340.5906Australia (Dollar)

3.03773.02210.32920.3309Argentina (Peso)

Currency per

USD Thursday

Currency per

USD Friday

USD equiv

Thursday

USD equiv

FridayCountry





Note that the

direct quote isthe reciprocal of

the indirect

quote:1

1.56270.6399

=

1.49751.51060.66780.6626 Months Forward

1.48881.5020.67170.66583 Months Forward

1.48351.49680.67410.66811 Month Forward

1.48131.49430.67510.6692Canada (Dollar)

0.64610.64751.54771.54456 Months Forward

0.64230.64371.55681.55353 Months Forward

0.63980.64121.56291.55961 Month Forward

0.63860.63991.5661.5627Britain (Pound)

3.47343.40250.28790.2939Brazil (Real)


3.03773.02210.32920.3309Argentina (Peso)

Currency per

USD Thursday

Currency per

USD Friday

USD equiv

Thursday

USD equiv

FridayCountry

Forward exchange market



g

Forward exchange market is where currencies may be bought and sold for delivery in future period.

Forward premium means that the forward

exchange rate exceeds the current spot rate.

Forward discount means that the forward

exchange rate is less than the current spot rate.



Forward Rate Quotations

Consider the example from above:

for British pound, the spot rate is

$1.5627 = £1.00

While

the

180‐

day

forward

rate

is

$1.5445 = £1.00

What’s up with that?





Clearly the

market

participants

expect that

the pound

will be

worth lessin dollars in

six months.1.49751.51060.66780.6626 Months Forward

1.48881.5020.67170.66583 Months Forward

1.48351.49680.67410.66811 Month Forward

1.48131.49430.67510.6692Canada (Dollar)

0.64610.64751.54771.54456 Months Forward

0.64230.64371.55681.55353 Months Forward

0.63980.64121.56291.55961 Month Forward

0.63860.63991.5661.5627Britain (Pound)

3.47343.40250.28790.2939Brazil (Real)


3.03773.02210.32920.3309Argentina (Peso)

Currency per

USD Thursday

Currency per

USD Friday

USD equiv

Thursday

USD equiv

FridayCountry

F d P i di t



Forward Exchange Market: where currencies may be bought and sold for delivery in a future period.

For 1 month S(£/$) = forward rate F(£/$) for £: if for 1 month S(£/$) < F(£/$)! forward premium

if for 1 month S(£/$) > F(£/$)! forward discount

Used to avoid the risk of exchange rate changes Suppose I need to pay my supplier of US‐cars in dollar

(10,000$) in 1 month:

S(£/$) = 0.69; for 1 month F(£/$) = 0.70 but in one month S(£/$) = 0.71

If I sign the forward contract I would need £7,000 instead of £7,100.

Forward Premium or discount



Payoff

Profiles

S 30(£/$)

If, in 30 days, S 30(£/$) = 0.71, the short will make a profit

by buying £ atS 30(£/$) = 0.71 and delivering £ at F 30(£/$) =

0.70.

profit

loss

0

F 180(£/$) = 0.700.71

0.1£

short

position

Forward Premium



Forward Premium The percentage difference (annualized) between the current forward rate

and spot rate is the forward premium (if positive) or discount (if negative).

For example, suppose the € is appreciating from S ($/€) = 0.5235 to F 180($/€)

= 0.5307 The forward premium or the percentage return (annualized) is given by:

We may approximate this using natural logarithms as:

180180,€/$ ($/ €) ($/ €) 360 .5307 .5235 .01375

($/ €) 180 .5235 F S FP

S − −= × = =

,€ / $ ,

($ / €) 360 360ln ( )

($/€)n

n n t t

F fp f s

S n n

⎡ ⎤= × = − ×⎢ ⎥

⎣ ⎦

2 = .02750

Forward Premium or discount (Exercise)



To calculate the sum of dollar that need to sell in order to purchase the pound for buying the England‐car in

England and to calculate the percentage of return from forward rate in this case base on the following supposed data:

Suppose I need to pay my supplier of England‐car in pound (10,000£ ) in 3 month:

Spot rate S(£/$) = 0.69; for 3 month Forward rate ($/£) =

1.42, but in 3 month Spot rate S($/£/) = 1,36 Is the result found as forward premium for $ or £?

Forward Premium or discount (Exercise)



Long and Short Forward Positions

If

you

have

agreed

to

sell

anything

(spot

or

forward),

you

are

“short”.

If you have agreed to buy anything (forward or spot), you are “long”.

If you have agreed to sell forex forward, you are short. If you have agreed to buy forex forward, you are long.

Payoff Profiles



Payoff Profiles

S 180($/¥)0

F 180($/¥) = 0.009524

Short position

loss

profitIf you agree to sell anything in the

future at a set price and the spot

price later falls then you gain.

If you agree to sell anything in the future at a set price

and the spot price later rises

then you lose.



Payoff Profiles

loss

profit

Whether the payoff profile slopes up or down

depends upon whether

you use the direct or

indirect quote:

F 180(¥/$) = 105 or

F 180($/¥) = .009524.

0 S 180(¥/$)

F 180(¥/$) = 105

short

position



Payoff

Profiles

S 180(¥/$)

When the short entered into this forward contract,

he agreed to sell ¥ in 180 days at F 180(¥/$) = 105

profit

loss

0

F 180(¥/$) = 105

short position



Payoff

Profiles

S 180(¥/$)

If, in 180 days, S 180(¥/$) = 120, the short will make a profit

by buying ¥ atS 180(¥/$) = 120 and delivering ¥ at F 180(¥/$)

= 105.

profit

loss

0

F 180(¥/$) = 105120

15¥

short

position



Payoff

Profiles

S 180(¥/$)

loss

0 F 180(¥/$) = 105

Long position

-F 180(¥/$)

F 180(¥/$)

short

position

Since this is a zero-sum game, the

long position payoff is the opposite

of the short.

profit

Payoff Profiles



Payoff ProfilesThe long in this forward contract agreed to BUY ¥ in 180

days at F 180(¥/$) = 105

If, in 180 days, S 180(¥/$) = 120, the long will lose by having to

buy ¥ at S 180(¥/$) = 120 and delivering ¥ at F 180(¥/$) = 105.

loss

0 S 180(¥/$)

Long

position

profit

120

–15¥

F 180(¥/$) = 105

Foreign Exchange Market Products and

Activities



Foreign Exchange Swap an agreement to trade currencies at one date and

reverse the trade at a later trade. Citibanks wants pounds now and arranges a swap

with Barclays.

Citibanks trades dollars for pounds now and pounds for dollars in one month.

Swap is like borrowing on one currency while lending another currency for the duration of the swap period

Activities



S(£/$) = 0.69; for 1 month F(£/$) = 0.70

Annual % return of pound : 0.014 x 12 = 0.17

Foreign e change option (commonl



Foreign exchange option (commonly shortened to just FX option or currency option) FX option is a derivative financial instrument where the owner has the right but not the

obligation to exchange money denominated in one currency into another currency at a pre‐agreed exchange rate on a specified date

For example a GBPUSD FX option might be



For example a GBPUSD FX option might be

specified by a contract giving the owner the right but not the obligation to sell £1,000,000 and buy $2,000,000 on December 31.

In this case the pre‐agreed exchange rate, or strike price, is 2.0000 USD per GBP (or 0.5000 GBP per

USD) and the notional are £1,000,000 and $2,000,000.

If the rate is lower than 2.0000 come December 31 (say at 1 9000) meaning that the dollar is stronger



(say at 1.9000), meaning that the dollar is stronger and the pound is weaker,

then the option will be exercised, allowing the owner to sell GBP at 2.0000 and immediately buy it back in the spot market at 1.9000,

making a profit of (2.0000 GBPUSD ‐ 1.9000 GBPUSD)*1,000,000 GBP = 100,000 USD in the

process. If they immediately exchange their profit into GBP this amounts to 100,000/1.9000 = 52,631.58 GBP.





Speculation

entails

more

than

the

assumption

of a

risky position. It implies financial transactions undertaken when an individual’s expectations differ from the market’s expectation.

Simple Hedging Strategies



Activity to Hedge Strategy Payable in domestic currency Nothing, no FX risk.

Payable in foreign currency Accelerate payment if foreign currency

expected to appreciate.Delay payment if foreign currency expected to depreciate.

Receivable in domestic currency

No FX risk.

Receivable in foreign currency Accelerate payment if foreign currency

expected to depreciate.Delay payment if foreign currency expected to appreciate.

A Little More Sophisticated Hedging Strategies



Activity to Hedge Strategy Payable in domestic currency Nothing, no FX risk.

Payable in foreign currency Borrow at the domestic interest rate i

and convert the proceeds to foreign currency. Lend at the foreign interest rate i* . When payable comes due, sell foreign asset and make payable. Use

domestic currency reserved for payable to pay off loan. Receivable in domestic currency No FX risk.

Receivable in foreign currency Borrow amount of receivable at the

foreign interest rate i*

and convert the proceeds to domestic currency. When receivable is paid, use foreign currency to pay off loan.

Arbitration



Arbitrage is the simultaneous, or nearly simultaneous, purchase of securities in one market

for

sale

in

another

market

with

the

expectation

of

a

risk‐free profit.

Cross Rates arbitrage condition: $/£ = x$, ¥/£ = y¥ => $/¥ = ($/£)/(¥/£)

Cross rate means that the third exchange rate

implied by any two exchange rates involving three currencies.



Triangular Arbitrage



$

£¥

Credit

Lyonnais

S (£/$)=1.50

Credit Agricole

S (¥/£)=85

Barclays

S (¥/$)=120

First calculate the

implied cross

rates to see if anarbitrage exists.

Suppose we

observe these

banks postingthese exchange

rates.



Triangular Arbitrage



Barclays

S (¥/$)=120

As easy as 1 – 2 – 3:

1. Sell $ for £,

2. Sell £ for ¥,

3. Sell ¥ for $.

$Credit

Lyonnais

S (£/$)=1.50

Credit Agricole

S (¥/£)=85

¥ £

1

2

3

$

The Demand for Currency



Choosing an investment

currency. All things equal, choose the currency

with the highest interest rate. All things equal, choose the currency

with the largest expected appreciation.



A Simple Rule

The $ rate of return on euros deposits is approximately the euros interest rate plus the rate of depreciation of the $ against the euros.

The rate of depreciation of the $ against the euros is the percentage increase in the dollar/euro exchange rate over a year.





What is the return on investing in dollar?

Take $100, convert into euros today.

$100 * S(€/$) = € 70.9 (if exchange rate is 0.709 €/$ or 1.41043 $/€ ) Deposit € 70.9 in a euros‐area bank

€ 70.9 * (1+r) = € 73.6367 (if interest rate is 3.86%)

Convert € 73.6367 into dollars. Which exchange rate to use? Use the exchange rate existing one

year from now.

€ 73.6367

*

$/€F

=

$

103.8594

(if

forward

rate

is

1.41043

$/€) If dollars interest rate is 4.14%, which currency should we

invest in. But then, what does that mean for the exchange rate? US$ is expected to appreciate up 0.71 €/$ (1.408 $/€)



Equilibrium in FX Market Most FX transactions are purchases/sales of bank deposits.

Example: A French resident can “purchase” a euro deposit by depositing euros into a bank account or CD (Certificate of Deposit) and earn R D.

Or, they can convert euros into dollars and “purchase” a Eurodollar deposit and earn R F.

R D is fixed but R F depends on the exchange rate between

euros and

dollars.

So

that

R

D

is known

when

the

investment is made, but R F is not.

R F is an ‘expected’ return.



F



Points on the R Curve

Assume i F

= 10%

Point A: S t =0.95 R F = [0.10 − (1.0 − 0.95)] = 5%

Point B: S t

=1.00 R F = [0.10 − (1.0 − 1.00)] = 10%

Point C: S t =1.05 R F = [0.10 − (1.0 − 1.05)] = 15%

Short‐Run XR Adjustments



Equilibrium:

RD= RF at E *

If St > E *, RF > RD, sell $, St ↓

If St < E *, RF < RD, buy $, St ↑

Factors affecting RD



R D shifts right when:

i D↑, because R D↑at each St

Note: This assumes that

domestic π e is unchanged, so

domestic real rate ↑

Factors affecting RF



R F curve shifts right when:

i F ↑ because R F ↑ at each St

E(S t+1 )↓ because expected

appreciation of Foreign Deposits

causes R F ↑

Other factors that will shift R F

rightward:

1. Domestic P ↑

2. Imports ↑

3. Exports ↓

4. Productivity ↓

Factors that Shift R F and R D



Factors that Shift R F and R D



Determinants of FX rates International parity conditions: purchasing power parity , interest rate

parity , domestic fisher effect, international fisher effect. Though to some

h b h i id l i l l i f h fl i i

http://en.wikipedia.org/wiki/Purchasing_power_parity





http://en.wikipedia.org/wiki/Interest_rate_parity



































extent the above theories provide logical explanation for the fluctuations in exchange rates, yet these theories falter as they are based on challengeable assumptions [e.g., free flow of goods, services and capital] which seldom hold true in the real world.

Balance of payments: This model, however, focuses largely on tradable goods and services, ignoring the increasing role of global capital flows. It failed to provide any explanation for continuous appreciation of dollar during

1980s and most part of 1990s in face of high US current account deficit.

Asset market: It views currencies as an important asset class for constructing investment portfolios. Assets prices are influenced mostly by

people’s willingness to hold the existing quantities of assets, which in turn depends on their expectations on the future worth of these assets. The asset market model of exchange rate determination states that “the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies.”

I t (D bit )

E t (C dit )

International Transactions: Data



Imports (Debits) Current Account: (M)

Goods and services

Factor‐

and

assets

income Assets transfer (= transfer

account)

Aids, gifts etc. (= unilateral

transfer) Capital Account: (CM)

Direct investments

Security purchase

Bank claims, liabilities, obligations, etc.

Government assets abroad

Exports (Credits) Current Account: (X)

Goods and services

Factor‐

and

assets

income Assets transfer (= transfer

account)

Aids, gifts etc. (= unilateral

transfer) Capital Account: (CX)

Direct investments

Security purchase



snÞsSn_éfø (Price Index)



( ) t

i

t

i

t

i

t

i

p Q P

Q P o P Σ

Σ=

( ) oo

o

t

i

t

i

t it i

p Q P Q P L Σ

Σ=

rUbmnþKNnasnÞsSn_éfø

snÞsSn_éføPassch

³ snÞsSn_éføenH RtUv)aneRbIedIm,IKNnaGDP deflator :

snÞsSn_éfø Laspeyres ³ snÞsSn_éføenH RtUv)aneRbIedIm,I KNna CPI b¤ PPI ³

G t i t ti & f t



Government intervention & factorsinfluenced

Supply and demand for any given currency, andthus its value, are not influenced by any single

element, but rather by several. These elements

generally fall into three categories:

Economic factors,

Political conditions and Market psychology.

Economic factors

Th i l d



These include:1. Economic policy comprises:

Government fiscal policy (budget/spending practices) andmonetary policy (the means by which a government'scentral bank influences the supply and "cost" of money,which is reflected by the level of interest rates).

2. Economic conditions include:• Government budget deficits or surpluses• Balance of trade levels and trends

• Inflation levels and trends• Economic growth and health• Productivity of an economy

The Mundell-Fleming Model

Under Floating Exchange Rates

http://en.wikipedia.org/wiki/Fiscal_policy

http://en.wikipedia.org/wiki/Monetary_policy

http://en.wikipedia.org/wiki/Interest_rates

http://en.wikipedia.org/wiki/Interest_rates

http://en.wikipedia.org/wiki/Monetary_policy

http://en.wikipedia.org/wiki/Fiscal_policy



e

Income, Output, Y

LM*

IS*

e

Income, Output,

LM*

IS*IS*'

LM*'

When income rises in a small open economy, due tothe fiscal expansion, the interest rate tries to rise but

capital inflows from abroad put downward pressure

on the interest rate.This inflow causes an increase in

the demand for the currency pushing up its value

and thus making domestic goods more expensiveto foreigners (causing a –ΔNX). The –ΔNX offsetsthe expansionary fiscal policy and the effect on Y.

When income rises in a small open economy, due to

the fiscal expansion, the interest rate tries to rise but

capital inflows from abroad put downward pressure

on the interest rate.This inflow causes an increase in

the demand for the currency pushing up its value

and thus making domestic goods more expensive

to foreigners (causing a –ΔNX). The –ΔNX offsetsthe expansionary fiscal policy and the effect on Y.

When the increase in the money supply puts downwardpressure on the domestic interest rate, capital flows out

as investors seek a higher return elsewhere. The capital

outflow prevents the interest rate from falling. The

outflow also causes the exchange rate to depreciate

making domestic goods less expensive relative toforeign goods, and stimulates NX. Hence, monetary

policy influences the e rather than r.

When the increase in the money supply puts downward

pressure on the domestic interest rate, capital flows out

as investors seek a higher return elsewhere. The capital

outflow prevents the interest rate from falling. The

outflow also causes the exchange rate to depreciate

making domestic goods less expensive relative to

foreign goods, and stimulates NX. Hence, monetarypolicy influences the e rather than r.

+ΔG, or –ΔT⇒+Δe, no ΔY

+ΔG, or –ΔT⇒+Δe, no ΔY

+ΔM⇒-Δe, +ΔY+ΔM⇒-Δe, +ΔY

ExSekag IS (The IS Curve)

(Open Economy)



esdækic©ebIkcMhr (Open Economy)

eBlEdlbBa©ÚlRbeTseRkAeTAkñúgKMrUrbs;eyIg enaHcMnUllMnwgGacsresrdUcxag

eRkam ³

a + I0 + G0 + EX0 – IM0 – bTx0 + bTr0 - bi

Y =1- b + bt + m

EY=E

Pl d E dit

An increase in the

interest rate (in graph) l l d

(b)

http://macroeconimics-uk.pdf/

http://macroeconimics-uk.pdf/



Income, Output, Y

Planned Expenditu

E = C + I

r

Income, Output, Y

r

Investment, I

I(r) IS

interest rate (in grapha), lowers planned

investment, which shifts

planned expenditure

downward (in

graph b) and lowers

income (in graph c).(a) (c)

You probably noticed from the IS and LM diagrams that r and Y were on the two axes. Now we’re going to bring a thirdvariable, the price level (P) into the analysis. We can accomplish this by linking both two-dimensional graphs.



rr

PPYY

YY

ISIS

LM(PLM(P11))

AA

AA

ADAD

To derive AD, start at point A in the top graph. Now increase the pricelevel from P1 to P2.

An increase in P lowers the value of real money balances, and Y, shifting LM leftwardto point B.

The +ΔP triggers a sequence of events that endwith a -ΔY, the inverse relationship that definesthe downward slope of AD.

Notice that r increased. Since r increased, we knowthat investment will decrease as it just got morecostly to take on various investment projects. Thissets off a multiplier process since -ΔI causes a –ΔY.The - ΔY triggers -ΔC as we move up the IS curve.

LM(PLM(P22))

BB

BBP2

P1

Political conditions

• Internal regional and international political conditions and events can



• Internal, regional, and international political conditions and events canhave a profound effect on currency markets.

• All exchange rates are susceptible to political instability andanticipations about the new ruling party. Political turmoil andinstability can have a negative impact on a nation's economy. Forexample, destabilization of coalition governments in Pakistan and

Thailand can negatively affect the value of their currencies.

• Similarly, in a country experiencing financial difficulties, the rise of apolitical faction that is supposed to be fiscally responsible can have the

opposite effect.

• Also, events in one country in a region may spur positive or negativeinterest in a neighboring country and, in the process, affect its

currency.

Market psychology



Market psychology and trader perceptions influence theforeign exchange market in a variety of ways:

• Flights to quality• Long-term trends

• "Buy the rumor, sell the fact"• Economic numbers• Technical trading considerations

Daily Trading Volumes by Hour



FX Turnover (2002)



FX Turnover (2008)



This approximately $3.21 trillion in main

foreign exchange market turnover wasbroken down as follows:

• $1.005 trillion in spot transactions• $362 billion in outright forwards• $1.714 trillion in foreign exchange swaps

• $129 billion estimated gaps in reporting

http://en.wikipedia.org/wiki/Foreign_exchange_spot_trading

http://en.wikipedia.org/wiki/Forward_contract

http://en.wikipedia.org/wiki/Forex_swap

http://en.wikipedia.org/wiki/Forex_swap

http://en.wikipedia.org/wiki/Forward_contract

http://en.wikipedia.org/wiki/Foreign_exchange_spot_trading



3. The exchange rate

E h R



Exchange Rates

The rate at which one currency can be exchanged for another e.g.

£1 = $1.90

£1 = €1.50

Important in trade



Exchange Rates

Converting currencies:

To convert £ into (e.g.) $ ‐ Multiply the sterling

amount

by

the

$

rate To convert $ into £ ‐ divide by the $ rate: e.g. To convert £5.70 to $ at a rate of £1 = $1.90,

multiply 5.70 x 1.90 = $10.83 To convert $3.45 to £ at the same rate, divide 3.45 by 1.90

= £1.82



Exchange Rates



Exchange Rates

Relative interest rates

Changes in relative inflation rates

The demand for imports

The demand for exports Investment opportunities

Speculative sentiments

Global trading patterns

Exchange Ratesf h h



Exchange Rates Appreciation of the exchange rate:

A rise in the value of £ in relation to other currencies – each £ buys more of the other currency e.g.

£1 = $1.85 £1 = $1.91

UK exports appear to be more expensive

( Xp)

Imports to the UK appear to be cheaper ( Mp)

Exchange Rates



Exchange Rates

Depreciation of the Exchange Rate

A fall in the value of the £ in relation to other currencies ‐ each £ buys less of the foreign currency e.g.

£1 = € 1.50 £1 = € 1.45

UK exports appear to be cheaper

(

Xp) Imports to the UK appear more expensive

( Mp)

Exchange Rates



Exchange Rates A depreciation in exchange rate should lead to a

rise in demand for exports, a fall in demand for imports – the balance of payments should ‘improve’

An appreciation of the exchange rate should lead to a fall in demand for exports and a rise in

demand

for

imports

– the

balance

of

payments

should get ‘worse’ BUT






Current Account: (M)

Goods and services

Factor‐ and assets income

Assets transfer (= transfer account)

Aids, gifts etc. (= unilateral transfer)

Capital Account: (CM)

Direct investments

Security purchase



Current Account: (X)

Goods and services




Capital Account: (CX)

Direct investments

Security purchase



The U.S. Balance of Payments, 2005 (Millions of Dollars)




112

Exchange RatesS£

Assume an initialexchange rate of

Investing in theUK would now bemore attractiveand demand for £would rise



g$ per £

Quantity onForeign Ex. Markets

D£

S£

1.85

Q1

D£1

Q2

Shortage

1.90

Q3

g£1 = $1.85. Thereare rumours thatthe UK is going toincrease interest

rates

The rise in demandcreates a shortagein the relationshipbetween demand

for £ and supply –the price (exchangerate) would rise



What is the government debtand the annual budget deficit?

When a government spends more than it collects in taxes, it borrows

from the private sector to finance the budget deficit.



Annual Deficit (2002)Annual Deficit (2001)

Annual Deficit (2000)

Annual Deficit (1999)Annual Deficit (1998)Annual Deficit (1997)

The government debtis an accumulation

of all past annual

deficits. In 2001, thedebt of the U.S. federal

government was $3.2

trillion.

Exchange Rates

The volumes and the actual amount of income



The volumes and the actual amount of income and expenditure will depend on the relative price

elasticity of demand for imports and exports.

Elasticity of M = %ΔQM/% ΔPM

Elasticity of X = %ΔQ X /% ΔP X

Exchange Rates Fl ti E h R t



g Floating Exchange Rates: Price determined only by demand and supply of the

currency – no government intervention

Fixed Exchange Rates: The value of a currency fixed in relation to an

anchor currency – not allowed to fluctuate

Dirty Floating or Managed Exchange Rate:– rate influenced by government via central bank

around a preferred rate



Fixed vs Flexible Exchange RateRegimes

Pro & Cons for Floating Exchange Rate



Arguments in favor of flexible exchange rates: Easier external adjustments.

National policy autonomy.

Arguments against flexible exchange rates:

Exchange rate uncertainty may hamper international trade.

No safeguards to prevent crises.




Suppose the exchange rate is $1.40/£ today.

In the next slide, we see that demand for British pounds far exceed supply at this exchange rate.

The U.S. experiences trade deficits.


r £

)Supply



S D

Q of £

D o l l a r p r i

c e p e r

( e x c h a n g e

r a t e )

$1.40

Trade deficit

Demand

(D)

pp y

(S)

Flexible Exchange RateRegimes

U d fl ibl h i h d ll ill



Under a flexible exchange rate regime, the dollar will simply depreciate to $1.60/£, the price at which supply equals demand and the trade deficit disappears.


Supplyp

e r £

t e )



(S)

Demand

(D)

Demand (D*)

D = S

Dollar depreciates

(flexible regime)

Q of £

D o l l a r p

r i c e p

( e x c h a n g e r a t

$1.60

$1.40


I t d th h t i “fi d” t



Instead, suppose the exchange rate is “fixed” at $1.40/£, and thus the imbalance between supply and demand cannot be eliminated by a price change.

The government would have to shift the demand

curve from

D to D*

In this example this corresponds to contractionary monetary and fiscal policies.


SupplyContractionary

p e r £

e )



(S)

Demand

(D)

Demand (D*)

D* = S

Contractionary

policies

(fixed regime)

Q of £

D o l l a r p r i c e p

( e x c h a n g

e r a t e

$1.40


Price of Sterling

D S D”

The Bank

must supply cd £ eachperiod.



The Role of International Reserves in

Exchange Rate Determination

Sterling


$2.82

$2.78

DS

a D”

b

c d

Purchasing Power Parity (PPP)

Th i l h t i th i i f i



The nominal exchange rate e is the price in foreign

currency

of

one

unit

of

a

domestic

currency.

The real exchange rate (RER) is defined as

RER = e(P/P f ), where P f is the foreign price level

(price index) and P the domestic price level (price index).

P and P f must have the same arbitrary value in some

chosen base year. Hence in the base year, RER = e.

Purchasing Power Parity

in a Perfect Capital Market Purchasing power parity (PPP) is built on the notion



Purchasing power parity (PPP) is built on the notion of arbitrage across goods markets and the Law of One Price.

The Law of One Price is the principle that in a PCM

setting, homogeneous

goods

will

sell

for

the

same

price in two markets, taking into account the exchange rate.

£/$wheatUK,wheatUS, S P P ×=

The RER is only a theoretical ideal. In practice, there f i i d i l l l

Purchasing Power Parity (PPP)



are many foreign currencies and price level values to

take into consideration. Correspondingly, the model calculations become

increasingly more complex. Furthermore, the model

is based on purchasing power parity (PPP), which implies a constant RER.

The empirical determination of a constant RER value

could never be realized, due to limitations on data collection.

Purchasing Power Parity and Exchange Rate

Determination



The relationship between the exchange rate and the price level in different countries. The price of £ in the foreign currency = Foreign

Country price level/UK price level

PPP would imply that the RER is the rate at which an organization can trade goods and services of

one economy

(e.g.

country)

for

those

of another.



The exchange rate would be a proper reflection of the


Determination



The exchange rate would be a proper reflection of the purchasing power in each country if the relative values

bought the same amount of goods in each country.

E.g. if the price of a pint of Stella in the UK was £3.00 and in Europe €4.50, the exchange rate between the two countries should be £1 = €1.50

If any lower than this value, the £ would be

undervalued and if any higher, the £ would be overvalued.



Real Exchange Rates



Purchasing Power Parity and Overvalued

or Undervalued Currencies

i l h h h i li d



Nominal exchange rates greater than the PPP implied

exchange rate represent foreign currency overvaluationagainst own currency,

while nominal exchange rates less than the PPP implied

exchange rate represent domestic currency overvaluation

against own currency (or foreign currency undervaluation

against own currency).

Purchasing Power Parity and Overvalued or Undervalued Currencies

Example

Base period nominal exchange rate = $1.50/£



p gPrices of U.S. goods had risen by 8%

Prices of U.K. goods had risen by 4%

PPP spot rate = $1.50/£ × 1.08/1.04 = $1.5577/£

A nominal exchange rate of $1.5577/£ would reestablish PPP incomparison to the base period.

Nominal exchange rates greater than $1.5577/£ represent £ “overvaluation”($ undervaluation), while rates less than $1.5577/£ represent $

“overvaluation” (£ undervaluation).

PPP exchange rates are especially useful when official exchange rates are artificially manipulated


Determination



official exchange rates are artificially manipulated

by

governments.

Countries with strong government control of the economy sometimes enforce official exchange rates that make their own currency artificially strong.

By contrast, the currency's black market exchange rate is artificially weak. In such cases a PPP exchange rate is likely the most realistic basis for economic comparison.



4. The Balance of Payments

The Balance of Payments

A record of the trade between one Country



y

(UK) and

the

rest

of

the

world.

Trade in goods

Trade in services

Income flows= Current Account

Transfer of funds and sale of assets and liabilities= Capital Account


Goods and services


Goods and services







Capital Account: (CM) Direct investments

Security purchase

Bank

claims,

liabilities,

obligations, etc.





Capital Account: (CX) Direct investments

Security purchase

Bank

claims,

liabilities,

obligations, etc.


U.S. Balance of Payments DataCredits DebitsCurrent Account



1 Exports $1,418.64

2 Imports ($1,809.18)

3 Unilateral Transfers $10.24 ($64.39)Balance on Current Account ($444.69)

Capital Account

4 Direct Investment $287.68 ($152.44)

5 Portfolio Investment $474.39 ($124.94)

6 Other Investments $262.64 ($303.27)Balance on Capital Account $444.26

7 Statistical DiscrepanciesOverall Balance $0.30

Official Reserve Account ($0.30)

0.73

Balance of payments equilibrium:




X

+

CM

=

M

+

CX => X – M = CX – CM

If X > M => CX > CM => The Country exports capital.

If X < M => CX < CM => The Country imports capital.

Balance of trade (BT) is the value of h di i i




merchandise exports minus import:

BT = X ‐ M

Basic Balance is the current account plus long term capital.

What affects the CA?

CA surplus Given the exchange rate, S0, thereexists some domestic income level, Y0,

where the current account is balanced.



CA deficit

0

CA(S0)

Domestic

Income (Y)

Y0



What affects the CA?

CA surplusS ↑ → domestic depreciationcausing imports to fall and

exports to rise, both of

which lead to an



CA(S1)CA deficit

0

CA(S0)

Domestic

Income (Y)

Y0 Y1

which lead to an

improvement in the currentaccount.

What affects the KA?What affects the KA?

KA surplusKA



KA deficit

r - r *


KA surplusKA

If r > r * then capital will

flow into the domestic



KA deficit

r - r *

economy and create a

capital account surplus.


KA surplusKA



KA deficit

r - r *

If r < r * then capital will

flow out of the domesticeconomy and create a

capital account deficit.


KA surplusKA

If r = r * then capital will

not have any incentive to

d h i l



KA deficit

r - r *

move and the capital

account will be in

balance.

The Balance of Payments Identity

BCA + BKA + BRA = 0 where



BCA = balance on current accountBKA = balance on capital account

BRA = balance on the reserves account

Under a pure flexible exchange rate regime,

BCA + BKA = 0

Because BRA = 0

The U.S. Balance of Payments, 2005 (Millions of Dollars)




Lecture 12: Trade Balance 152

The U.S. Current Account Balance, 2005 (Millions of Dollars)




Statistical Discrepancy



Components of the U.S. Financial Account, 2005 (Millions of Dollars)




Private Flows in the U.S. Financial Account, 2005 (Millions of Dollars)




FDI


Reserve Assets




Reserve Assets



SDRs :

Special

Drawing

Rights



U.S.

Balance

of

Payments

DataCredits DebitsCurrent Account

1 Exports $1,418.64



2 Imports ($1,809.18)


Capital Account






0.73

U.S.

Balance

of

Payments

DataIn 2000, the

Credits DebitsCurrent Account

1 Exports $1,418.64



U.S. importedmore than it

exported, thus

running acurrent account

deficit of

$444.69 billion.

p ,

2 Imports ($1,809.18)

3 Unilateral Transfers $10.24 ($64.39)

Balance on Current Account ($444.69)

Capital Account






0.73



U.S.

Balance

of

Payments

DataUnder a pure


1 Exports $1,418.64



flexibleexchange rate

regime, these

numbers would balance each

other out.

2 Imports ($1,809.18)



Capital Account






0.73

U.S.

Balance

of

Payments

DataIn the real


1 Exports $1,418.64



world, thereis a statistical

discrepancy.

p $ ,

2 Imports ($1,809.18)


Capital Account4 Direct Investment $287.68 ($152.44)





0.73

U.S. Balance of Payments Data

Including that,


1 Exports $1,418.64

2 Imports ($1,809.18)



the balance of payments

identity should

hold:BCA + BKA = – BRA

- ($444.69) + $444.26 + $0.73 = $0.30= –($0.30)


Capital Account


5 Portfolio Investment $474.39 ($124.94)6 Other Investments $262.64 ($303.27)

Balance on Capital Account $444.26

7 Statistical DiscrepanciesOverall Balance

$0.30Official Reserve Account ($0.30)

0.73

Balance of Payments and the Exchange

Rate

P

Exchange rate $Credits Debits

Current Account

1 Exports $1,418.64

2 Imports ($1,809.18) S



Q


Capital Account




7 Statistical Discrepancies

Overall Balance $0.30Official Reserve Account ($0.30)

0.73 D

P

As U.S. citizens import, they supply dollars to the FOREX market.Credits Debits

Current Account

1 Exports $1,418.64

Exchange rate $

S


Rate



Q

2 Imports ($1,809.18)



Capital Account






0.73

D

P

As U.S. citizens export, others demand dollars in the FOREX market.Credits Debits

Current Account

1 Exports $1,418.64

Exchange rate $

S


Rate



Q

2 Imports ($1,809.18)



Capital Account






0.73

D

P S

As the U.S. government sells dollars, the supply of dollars increases.


1 Exports $1,418.64

Exchange rate $


Rate



Q

D

S 12 Imports ($1,809.18)


Capital Account






0.73



Balances on the Current (BCA) and Capital (BKA)

Accounts of the United States

400

500



-500

-400-300

-200

-100

0

100

200

300

1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

U.S. BCAU.S. BKA


Accounts of United Kingdom

30

40



-50

-40

-30

-20

-10

0

10

20

30

1982 1984 1986 1988 1990 1992 1994 1996 1998 2000UK BCA

UK BKA


Accounts of Japan

100

150



-150

-100

-50

0

50

100

1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

Japan BCA

Japan BKA


Accounts of Germany

60

80



-80

-60

-40

-20

0

20

40

60

1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

Germany BCA

Germany BKA


Accounts of China

30

35



-15

-10

-5

0

5

10

15

20

25

1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

China BCA

China BKA

What Does the Trade BalanceReally Mean? From National Income Accounting

(I’ll do this first without government)

Recall from Econ

GDP O t t I Y



GDP = Output = Income = Y

Output and Income:

Y = C + I + (X − M)

Y = C + S

Therefore

X − M = S − I

Where C = Consumption

I = Investment

X = Exports

M = Imports S = Savings

What Does the Trade Balance

Really Mean? From National Income Accounting

Th



Thus Trade surplus ⇒ savings > investment

Trade deficit ⇒ savings < investment

If we are not saving enough to finance investment, how do we pay for it? By borrowing from abroad, or

By selling assets



(Thi ti ith t)



(This time with government)

Even more simply

Y = C + I + G + (X −

M)

implies

X −

M = Y −

(C + I + G)



X − M = Y − (C + I + G)

T ade Surp l u s E

xpendiIncome



So a trade deficit

(X − M) < 0

means that we are spending

(C + I + G)

more than

our

income

Y

T r a d e S u r px p e n d i t u r e

Income

Balance of Payments and National Income

Accounting

GNP = Y = C + I + G + X – M

Y = C + S + T (Income allocation)

X M = (S ‐ I) + (T ‐ G)



X – M = (S ‐ I) + (T ‐ G) If a developing economy experiences large trade

deficits (X ‐M <0), the remedies are:

1. Savings must increase, S↑

2. Investment must fall, I↓

3. Government spending must fall, G↓4. Taxes must rise, T↑

What is the government debt

and the annual budget deficit?

Annual Deficit (2002)

When a government spends more than it collects in taxes, it borrows

from the private sector to finance the budget deficit.






The government debt

is an accumulation

of all past annual

deficits. In 2001, the

debt of the U.S. federalgovernment was $3.2

trillion.


Really Mean? So in spite of its name, and it’s definition, the

trade balance



trade balance Is not really about trade, which is just the symptom

It is about whether we are living within our means

When is a trade deficit good? When the country (like a young person) is investing

for the future (like a successful developing country)

Not when it is going into debt just to finance current consumption (like the US)

5. Interest Rates, Interest rate parity &Exchange Rates

What is the interest rate?

What is its relationship to exchange rates?

What useful properties can we take from this



What useful properties can we take from this relationship?

Four Types of Credit Instruments

1. Simple loan

2. Fixed‐payment loan

3. Coupon bond

4. Discount (zero coupon) bond

Concept of Present Value

Present Value



Concept of Present Value

Simple loan of $1 at 10% interest

Year 1 2 3 n

$1.10 $1.21 $1.33 $1x(1 + i)n

$FV PV of future $1 = (1 + i)n

Yield to Maturity: Loans

1. Simple Loan (i = 10%)

$100 = $110/(1 + i) ⇒

$110 – $100 $10

i = = = 0.10 = 10%$100 $100



$100 $100

2. Fixed Payment Loan (i = 12%)

$126 $126 $126 $126$1000 = + + + ... +

(1+i) (1+i)2 (1+i)3 (1+i)25

FP FP FP FP

LV = + + + ... +(1+i) (1+i)2 (1+i)3 (1+i)n

Yield to Maturity: Bonds3. Coupon Bond (Coupon rate = 10% = C/F)

$100 $100 $100 $100 $1000 P = + + + ... + +(1+i) (1+i)2 (1+i)3 (1+i)10 (1+i)10

C C C C F P = + + + ... + +

(1+i) (1+i)2 (1+i)3 (1+i)n (1+i)n

Consol: Fixed coupon payments of $C forever



⇒

4. Discount Bond ( P = $900, F = $1000), one year

$1000$900 =

(1+i)

$1000 – $900i = = 0.111 = 11.1%$900

F – P i =

P

Consol: Fixed coupon payments of $C forever

C C P = i =

i P



Yield to Maturity: Bonds



Yield to Maturity: Bonds



Current Price or (Current Price + Par Value)/2

Distinction Between Interest

Rates and ReturnsRate of Return

C + P t+1 – P tRET i



t+1 tRET = = ic + g

P tC

where: ic = = current yield P t

P t +1 – P t g = = capital gain P t

Relationship Between Price

and

Yield

to

Maturity



CASH FLOW CHARACTERISTICS

107

1 2 3 4 5

7 7 77



A FIVE‐ YEAR BOND WITH A 7% COUPON.

PRICE

IS THE

SUM

OF

THE

PRESENT

VALUE

OF

THE CASH FLOWS, DISCOUNTED AT AN

APPROPRIATE MARKET YIELD: AS YIELD RISES,

PRICE

FALLS;

AS

YIELD

FALLS,

PRICE

RISES.

PRICE

1 2 3 4 5

CLASSIFYING BONDS WHERE ISSUED

DOMESTIC BONDS

FOREIGN BONDS

EUROBONDS

THE ISSUER



THE ISSUER

CENTRAL GOVERNMENTS AND GOVERNMENT AGENCIES

STATE AND LOCAL GOVERNMENTS COMPANIES

SUPRANATIONAL INSTITUTIONS (EG. WORLD BANK)

THE TYPE OF BOND

THE TYPE OF BOND Fixed rate bonds have a coupon that remains constant throughout the

life of the bond.

Floating rate notes (FRNs) have a variable coupon that is linked to a

reference rate of interest. The coupon rate is recalculated periodically, typically every one or three months.

Zero‐coupon bonds pay no regular interest. They are issued at a substantial discount to par value, so that the interest is effectively

rolled up to maturity (and usually taxed as such). Inflation linked bonds in which the principal amount and the

http://en.wikipedia.org/wiki/Fixed_rate_bond





http://en.wikipedia.org/wiki/Floating_rate_note





http://en.wikipedia.org/wiki/Zero-coupon_bond





http://en.wikipedia.org/wiki/Inflation_linked_bond











Inflation linked bonds, in which the principal amount and the interest payments are indexed to inflation. However, as the principal amount grows, the payments increase with inflation.

Treasury bond, also called government bond. Municipal bond is a bond issued by a state, U.S. Territory, city, local

government, or their agencies.

Bearer bond is an official certificate issued without a named holder.

Registered bond is a bond whose ownership (and any subsequent purchaser) is recorded by the issuer, or by a transfer agent. It is the alternative to a Bearer bond.

Real Interest Rate (the Fisher hypothesis (sometimes Fisher parity)Interest rate that is adjusted for expected changes in the price level

ir = in – πe

R l i (i ) l fl f

Distinction Between Real & NominalInterest Rates






http://en.wikipedia.org/wiki/Treasury_bond



http://en.wikipedia.org/wiki/Municipal_bond



http://en.wikipedia.org/wiki/Bearer_bond









Real interest rate (ir ) more accurately reflects true cost of borrowing

When real rate is low, greater incentives to borrow and less to lend

if in = 5% and πe = 3% then:

ir = 5% – 3% = 2%if in = 8% and πe = 10% then

ir

= 8% – 10% = –2%

The Fisher hypothesis says that the real interest rate in an economy is independent of monetary variables. If

we add to this the assumption that real interest rates t d t i th th t ith


http://en.wikipedia.org/wiki/Fisher_hypothesis



http://en.wikipedia.org/wiki/Real_versus_nominal_in_economics

http://en.wikipedia.org/wiki/Interest_rate



http://en.wikipedia.org/wiki/Money

http://en.wikipedia.org/wiki/Money


http://en.wikipedia.org/wiki/Real_versus_nominal_in_economics




are equated across countries, then the country with the lower nominal interest rate would also have a

lower rate of inflation and hence the real value of its currency would rise over time.

Suppose that the current spot exchange rate for U.S.

Dollars into British Pounds is $1.4339 per pound. If the current interest rate is 5 percent in the U.S. and 7 percent in Britain, what is the expected spot exchange per pound

rate 12 months from now according to the International Fi h Eff t?


http://en.wikipedia.org/wiki/Nominal_interest_rate





http://en.wikipedia.org/wiki/Inflation



http://en.wikipedia.org/wiki/Spot_price








Fisher Effect?

The International Fisher Effect estimates future exchange

rates based on the relationship in nominal interest rates. Multiplying the current spot exchange rate by the nominal annual U.S. interest rate and dividing by the nominal

annual British interest rate yields the estimate of the spot exchange rate 12 months from now ($1.4339 * 1.05) / 1.07 = $1.4071.

U.S. Real and Nominal Interest Rates



Interest Rate Parity

Interest Rate Parity Defined

Covered Interest Parity

Interest Rate Parity & Exchange Rate Determination



Uncovered Interest Parity

Covered Interest Parity (CIP)

Defined IRP is an arbitrage condition.

If IRP did not hold, then it would be possible for an

smart trader to make unlimited amounts of money exploiting the arbitrage opportunity



exploiting the arbitrage opportunity.

Since we don’t typically observe persistent arbitrage

conditions, we can safely assume that IRP holds.


Suppose you have $100,000 to invest for one year.

You can either

1. invest in the U.S. at i$. Future value = $100,000(1 + i$)

or 2 trade your dollars for pounds at the spot rate invest in England at i



2. trade your dollars for pounds at the spot rate, invest in England at i £and be cautious your exchange rate risk by selling the future value of the British investment forward.

The future value = $100,000( F /S )(1 + i £ )

Since both of these investments have the same risk, they must have

the same future value—otherwise an arbitrage would exist, therefore( F /S )(1 + i £) = (1 + i$)


$100,000 $100,000(1 + i$)



$100,000( F /S )(1 + i£ )1. Trade $100,000 for £ at S

2. Invest $100,000 at i£

S

3. One year later,

trade £ for $ at F


Formally,

( F /S )(1 + i £) = (1 + i$)

or if you prefer,



IRP is sometimes approximated as

1 + i£

1 + i$

= S

F

i$ – i£ =S

F – S


Depending upon how you quote the exchange rate ($ per £or £ per $) we have:



1 + i$

1 + i£

S £/$

F £/$

=

1 + i$

1 + i£ S $/£

F $/£

=or

CIP and Covered Interest

ArbitrageA trader with $1,000 to invest could invest in the U.S., in one year

his investment will be worth $1,071 = $1,000×(1+ i$) =

$1,000×(1.071)



Alternatively, this trader could exchange $1,000 for £800 at the

prevailing spot rate, (note that £800 = $1,000÷$1.25/£) invest £800

at i£ = 11.56% for one year to achieve £892.48. Translate £892.48

back into dollars at F 360($/£) = $1.20/£, the £892.48 will be exactly

$1,071.

Covered Interest Arbitrage





Covered Interest ArbitrageCovered Interest Arbitrage



Covered Interest ArbitrageCovered Interest Arbitrage







Interest Rate Parity

& Exchange Rate Determination

According to IRP only one 360-day forward rate,

F 360($/£), can exist. It must be the case that

F 360($/£) = $1.20/£Why?



y

If F 360($/£) ≠ $1.20/£, an smart trader could make money

with one of the following strategies:

Arbitrage Strategy I

If F 360($/£) > $1.20/£

i. Borrow $1,000 at t = 0 at i$ = 7.1%.

ii. Exchange $1,000 for £800 at the prevailing spotrate, (note that £800 = $1,000÷$1.25/£) invest £800



at 11.56% (i£) for one year to achieve £892.48

iii. Translate £892.48 back into dollars, if F 360($/£) > $1.20/£ , £892.48 will be more than enough

to repay your dollar obligation of $1,071.

Arbitrage Strategy II

If F 360($/£) < $1.20/£

i. Borrow £800 at t = 0 at i£= 11.56% .

ii E h 800 f $1 000 t th ili t



ii. Exchange £800 for $1,000 at the prevailing spot

rate, invest $1,000 at 7.1% for one year to achieve$1,071.

iii. Translate $1,071 back into pounds, if

F 360($/£) < $1.20/£ , $1,071 will be more than enoughto repay your £ obligation of £892.48.

Uncovered Interest rate parityUncovered Interest rate parity



Uncovered Interest rate parityUncovered Interest rate parity



6.







Markowitz Portfolio Theory A single asset or portfolio of assets is efficient if no

other asset or portfolio of assets offers higher

expected return with the same (or lower) risk, or lower risk with the same (or higher) expected return.





Methods to DiversifyDiversify by a

1. Trade in American Depository Receipts (ADRs)

2.Trade in American shares3.Trade internationally diversified mutual funds:



a. Global (all types)

b. International (no home country securities)

c. Single‐country

INTERNATIONAL PORTFOLIO

INVESTMENTCalculation of Expected Portfolio Return:

rp =

a rUS +

( 1‐

a) rrw

where



rp

= portfolio expected return

rUS = expected U.S. market return

rrw = expected global return

Expected Portfolio ReturnSample Problem

What is the expected return of a portfolio

with 35% invested in Japan returning 10%

and 65% in the U.S. returning 5%?



rp = a rUS + ( 1 ‐ a) rrw= .65(.05) + .35(.10)

= .0325 + .0350

= 6.75%

Capital assets pricing model

The capital asset pricing model (CAPM) is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be

added to an already well‐diversified portfolio, given that asset's non‐diversifiable risk. The

d l k h '



model takes into account the asset's sensitivity to non‐diversifiable risk (also known as systematic risk or market risk).

Arbitrage and the APT

Arbitrage and the APT

Arbitrage is the practice of taking advantage of a state

of imbalance between two (or possibly more) markets and thereby making a risk‐free profit







1. A Security’s Returns may be

segmented intoSystematic Risk

Total Risk



can not be eliminated

Non‐systematic Risk

can be eliminated by diversification

INTERNATIONAL

DIVERSIFICATIONInternational diversification and systematic risk

a. Diversify across nations with

different economic cyclesb. While there is systematic risk

ithi ti t id th t



within a nation, outside the country it may be nonsystematic and diversifiable

The Benefits of Int’l

Diversification













Efficient Markets Approach Financial Markets are efficient if prices reflect all available and

relevant information. If this is so, exchange rates will only change when new

information arrives, thus:

S t = E [S t +1]

and F t = E [S t +1| I t ]

Predicting exchange rates using the efficient markets approach is ff d bl d i h d t b t



affordable and is hard to beat.

Fundamental Approach

MV=PY → P=MV/Y PPP → S = P/P*

Combine so that s = a0+a1(m-m* )+a2(i-i* )+a3(y-y* )

Involves econometrics to develop models that use a variety of explanatory variables. This involves three steps:

1 2 30, 0, 0 s s s

a a am i y

∂ ∂ ∂

= > = > = <∂ ∂ ∂



p

step 1: Estimate the structural model. step 2: Estimate future parameter values.

step 3: Use the model to develop forecasts.

The downside is that fundamental models do not work any better than the

forward rate

model

or

the

random

walk

model.

Technical Approach Technical analysis looks for patterns in the past

behavior of exchange rates.

Clearly it is based upon the premise that history repeats itself.

Thus it is at odds with the EMH



Technical Analysis



Technical Analysis



Performance of the Forecasters Forecasting is difficult, especially with regard to the

future.

As

a

whole,

forecasters

cannot

do

a

better

job

of

forecasting future exchange rates than the forward rate.

The founder of Forbes Magazine once said:



The founder of Forbes Magazine once said:

“You can make more money selling financial advice than following it.”

Forecasting Performance



Bank’s Forecasts



8.

Recent

developments

of

international finance



The Spirit of the European Monetary System, 1979

This is a pursuit by European nations to limit exchange rate fluctuations against each other and to establish coordinated macroeconomic policies



across Europe.

The Spirit of the European Monetary System, 1979

The European Monetary System (EMS) was built upon three building blocks:

the European Currency Unit (ECU) as an accounting

currency , the Exchange Rate Mechanism (ERM) as a fixing

exchange rates onto the European Currency Unit (ECU)

http://en.wikipedia.org/wiki/European_Currency_Unit








in order to stabilise exchange rates and counter inflation, and

the European Monetary Cooperation Fund (EMCF).

The Spirit of the European MonetarySystem, 1979

•The European Currency Unit was a basket of the currenciesof the European Community member states, used as the unitof account of the European Community before beingreplaced by the euro on January 1, 1999, at parity.

• The ECU itself replaced the European Unit of Account, alsoat parity, on March 13, 1979.

http://en.wikipedia.org/wiki/European_Community

http://en.wikipedia.org/wiki/Unit_of_account




http://en.wikipedia.org/wiki/European_Unit_of_Account

http://en.wikipedia.org/wiki/European_Unit_of_Account




http://en.wikipedia.org/wiki/European_Community



p y

• The ECU was also used in some international financialtransactions, where its advantage was that securitiesdenominated in ECUs provided investors with theopportunity for foreign diversification without reliance onthe currency of a single country.


All member countries :• Fix a par value for each exchange rate in terms of theEuropean Currency Unit, a basket weighted according

to country size.

• Keep exchange rates stable in the short-run by limiting



movements in bilateral rates - the Exchange RateMechanism.

• Hold foreign exchange reserves primarily in ECUswith the European Monetary Cooperation Fund, andreduce US$ reserves.


The three building blocks of the EMS linked together European

exchange rates and monetary policies until the chaotic events of 1992and 1993

Leaders reached agreement on currency union with the MaastrichtTreaty

, signed on 7 February 1992. It agreed to create a single currency,although without the participation of the United Kingdom, by January1999.

Gaining approval for the treaty was a challenge. Germany wascautious about giving up its stable currency, i.e. the German Mark

,

http://en.wikipedia.org/wiki/Maastricht_Treaty




http://en.wikipedia.org/wiki/Germany

http://en.wikipedia.org/wiki/German_Mark


http://en.wikipedia.org/wiki/Germany






France approved the treaty by a narrow margin.

Denmark refused to ratify until they got an opt out from monetaryunion as the United Kingdom, an opt-out which they maintain as of2010.

On 16 September 1992, known in the UK as Black Wednesday, theBritish pound sterling was forced to withdraw from the fixed exchangerate system due to a rapid fall in the value of the pound.

The European Monetary System as a

“Greater DM” Area, 1979-1998

In practice, the DM was the centerpiece of the ERM, and

German monetary policy formed the anchor for the EMS pricelevel.

• Member countries except Germany:

Intervene to stabilize currency values vis-à-vis the DM.

• Germany:

http://en.wikipedia.org/wiki/Denmark

http://en.wikipedia.org/wiki/Black_Wednesday

http://en.wikipedia.org/wiki/Pound_sterling

http://en.wikipedia.org/wiki/Pound_sterling

http://en.wikipedia.org/wiki/Black_Wednesday

http://en.wikipedia.org/wiki/Denmark




Remain passive in the foreign exchange market withrespect to other EMS countries. Set German monetarypolicy independently to serve as an anchor for the EMSprice level.

EMU (European Monetary Union Some European leaders wanted to achieve an even

closer economic and social union.

The Delors report of 1989 set out a plan to introduce the EMU in three stages and it included the creation of institutions such as the European System of Central Banks (ESCB),



Under the EMU, a single central bank would set monetary policy for a single European money.

The 1991 Maastricht Treaty spelled out the steps needed to transfer the responsibilities for monetary policy and national monies to a new EC institution.

Three

of

steps

EMU Beginning the first of these steps, on 1 July 1990, exchange controls were abolished, thus capital movements were completely liberalised in the

European Economic Community. Leaders reached agreement on currency union with

the Maastricht Treaty, signed on 7 February 1992.

EMU (European Monetary Union



It agreed to create a single currency, although without the participation of the United Kingdom, by January 1999.

The Spirit of the European Economic andMonetary Union, 1999

The EMU was launched on January 1, 1999 with 11 member

countries. The European Central Bank (ECB) has sole

responsibility for monetary policy among EMUcountries.

National governments set other economic policies



such as taxation and expenditures within a set ofcommonly agreed rules.

Old “legacy currencies (replacing the name Ecu used

for the previous accounting currency),” areexchanged for the new surviving currency, the euro.

The Spirit of the European Economic andMonetary Union, 1999

In order to participate in the new currency, member stateshad to meet strict criteria such as a budget deficit of lessthan 3% of their GDP, a debt ratio of less than 60% of

GDP, low inflation, and interest rates close to the EUaverage.

f l d h d l d d f

http://en.wikipedia.org/wiki/Convergence_criteria

http://en.wikipedia.org/wiki/Gross_domestic_product


http://en.wikipedia.org/wiki/Greece



http://en.wikipedia.org/wiki/Gross_domestic_product

http://en.wikipedia.org/wiki/Convergence_criteria



Greece failed to meet the criteria and was excluded fromparticipating on 1 January 1999.

The Value of the Euro in Terms of the ElevenLegacy Currencies of the EMU Countries

Irrevocable Conversion Rates Set on January 1, 1999

Country Units Equal to One Euro ( € )

Austria 13.7603 schillings

Belgium 40.3399 francs

Finland 5.94573 markkaabFrance 6.55957 francs

Germany 1.95583 marks

I l d 0 787564





Ireland 0.787564 puntItaly 1,936.27 lire

Luxembourg 40.3399 francs

Netherlands 2.20371 guildersPortugal 200.482 escudos

Spain 166.386 pesetas

Global Financial Crises and the IMF

IMF bailouts for troubled economies

Mexico (1995)

Thailand, Indonesia, Korea (1997) Russia, Brazil (1998)

Turkey (2001)

( )



Argentina (2001)

Financial Crisis

Financial Crisis – banking crisis, exchange rate crisis, or a combination of the two

Banking

crisis

– banking

system’s

becoming

unable

to

perform its normal lending functions

Disintermediation – banks becoming unable to serve as intermediaries between savers and investors

E h i i dd d d ll



Exchange rate crisis – sudden and unexpected collapse in the value of a nation’s currency

Financial Crisis Financial Crisis often followed by severe recession Banking crisis – banks fail as result of bad lending policies, and

bank lending dries up

Exchange rate crisis – banks often have borrowed dollars abroad, converted to local currency to invest – then when local currency collapses, can’t pay back dollar loans – banks fail and bank lending dries up ‐‐ also, foreign investment dries up



Financial Crisis and Exchange Rates Under a fixed exchange rate system, crisis entails the loss of

international reserves and devaluation

Under a flexible exchange rate system, crisis means an

uncontrolled, rapid depreciation of the currency Countries with a pegged exchange rate may be more

vulnerable to a crisis – even crawling pegs



Two Causes of Financial Crises

Crises caused by macroeconomic imbalances, such as large budget deficits caused by overly expansionary fiscal policies

Example: Argentina financial crisis in 2001

Crises caused by volatile capital flows

Example the East Asian financial crisis of 1997 1998



Example: the East Asian financial crisis of 1997–1998

Domestic Issues in Crisis Avoidance Problem in financial sector regulation

Moral hazard – incentive to do the wrong thing: banks have an incentive to make riskier investments when they know

they will be bailed out

Moral hazard problems are exacerbated by governments’

providing incentives or threatening banks to make bad loans



providing incentives or threatening banks to make bad loans for political ends

Escaping Moral Hazard

The problem of moral hazard is inescapable if policies to protect the financial sector exist

Way to decrease the problem: establish supervision and

regulation standards

for

internationally

active

banks

Basel Capital Accord – formulated in 1989 by bank regulators from industrialized countries; adopted by more than 100 countries

The New Basel Capital Accord of 2001 updated the previousd d



The New Basel Capital Accord of 2001 updated the previous standards

The Mexican Peso Crisis On 20 December, 1994, the Mexican government

announced a plan to devalue the peso against the dollar by 14 percent.

This decision changed currency trader’s expectations about the future value of the peso.

They stampeded for the exits.

In their rush to get out the peso fell by as much as 40



In their rush to get out the peso fell by as much as 40 percent.

The value of the Peso 1994-1995



How does a devaluation affect foreign

investors?

If a foreign investor (assume U.S.) purchases a Mexican asset, they must purchase pesos first.

When the asset is sold the proceeds must be exchanged for $

prior to being

repatriated,

the

U.S.

investor’s

return

is affected

by the exchange rate at that time.

If it is higher (peso appreciation) the return to U.S. investor is larger in $ terms.

If peso has depreciated the $ returns will be lower



If peso has depreciated, the $ returns will be lower.

The Mexican Peso Crisis The Mexican Peso crisis is unique in that it represents the first

serious international financial crisis touched off by cross‐border flight of portfolio capital.

Two lessons emerge: It is essential to have a multinational safety net in place to

safeguard the world financial system from such crises.

An

influx

of

foreign

capital

can

lead

to

an

overvaluation

in

the first

place



An influx of foreign capital can lead to an overvaluation in the firstplace.

Asian Crisis, 1997‐98

Five countries: South Korea, Thailand, Malaysia, the Philippines, Indonesia

Indonesia

is

world’s

fifth

largest

country

by

population (200 million people back then)

South Korea is now considered an “industrialized”

country



country


1967‐97, these five countries averaged real GDP growth of 6‐10 percent per year

they

were

called

“the

Asian

tigers” their performance was called “the Asian miracle”

1997‐98, they went from “Asian miracle” to “Asian

meltdown”



meltdown


Economic and financial crisis

Began in financial sector, spread to real economy

Began in Thailand, spread to nearby countries (contagion)



Asian Crisis, 1997‐98 “Hot” economies had attracted a lot of foreign investment ‐

much of it short term that could be quickly withdrawn at first sign of trouble

Banking systems and financial systems couldn’t handle all this capital ‐ much of it went into questionable loans, real estate, stock market, etc.

Other

internal

problems:

lax

regulation,

nepotism,

expectation

of government bailout if investments went bad



p g , p , pof government bailout if investments went bad

Asian Crisis, 1997‐98 External Factor – Strength of U.S. Dollar

U.S. dollar rose by 50% against Japanese yen, 1995‐97

Each country used basket peg with $ as dominantcurrency in basket (80% +)

Rising dollar meant each currency was also rising, so big export slowdown

Trade was 30‐40 percent of GDP



Trade was 30 40 percent of GDP


Speculative bubble of inflated prices burst (stock, real estate, etc.), then capital flight out of country as investments turned sour

Pegged exchange rates couldn’t hold, so currencies devalued, then floated



Asian Currency Values versus U.S. $ 1997-1998




From July 1, 1997 to January 24, 1998

Thai baht fell by 55% against dollar

Malaysian

ringgit fell

by

45% Korean won fell by 49%

Philippine peso fell by 39%

Indonesian rupiah fell by 84%All fl i h i i



p y 4 All now floating except the ringgit


in 1998, negative real GDP growth ranging from ‐0.6%

(Philippines) to ‐13.2% percent (Indonesia) – severe recession

weak Japanese economy couldn’t provide support needed for quick recovery




All five countries returned to positive real growth in 1999, but some have still not fully recovered from

crisis

this contrasts with case of Mexico, which was expanding nicely one year after its 1995 crisis, due to booming U.S. economy



The Asian Currency Crisis

The Asian currency crisis turned out to be far more serious than the Mexican peso crisis in terms of the extent of the contagion and the severity of the resultant economic and social

costs. Many firms with foreign currency bonds were forced into

bankruptcy.

The

region

experienced

a

deep,

widespread

recession.



Argentina Crisis – 2001 Prior to 1990s, years of government deficits, political corruption,

hyperinflation, bankruptcy, economic stagnation

In 1991, reforms included Currency Board – every peso backed

by one dollar in reserves, with pesos convertible into dollars Monetary policy now tied to balance of payments – government

couldn’t just print more pesos to finance deficits –restored

credibility

to

peso



Argentina Crisis – 2001‐

Worked well for a while

Weak dollar prior to 1995 made it easier to maintain peso‐dollar peg

Real GDP grew by 10% in each of first two years, 6% in each of next two years




Continuing Problem…government spending and budget deficits grew rapidly throughout 1990s

At first, “privatization” hid problem

Provincial governments especially profligate, benefiting mainly elected officials and friends

Spending

binge

financed

largely

by

external

debt,

which became unmanageable



g


New Problems Strengthening dollar after 1995 Hurt exports, increased imports

16 percent of trade was with U.S., so pegging to just the dollar may not have been wise

Brazil devalued real in 1999 from 1.16 per dollar to 1.82

per dollarA ti ’ nd l t t di t



Argentina’s 2nd largest trading partner


Crisis came to a head in December 2001

Defaults, unemployment, large price increases, violence in the streets, run on banks, people denied access to their money, etc.

Five Presidents within one month



Argentine Peso vs U.S. Dollar:

Collapse of a Currency Board




Peso devalued (floated) against dollar and convertibility ended (both in violation of law)

Dollar‐denominated accounts frozen

Peso‐denominated accounts fell in value vis‐à‐ vis the dollar from $1.00 to $0.34 per peso






Argentina recently received new IMF loans (early 2003) enabling it to avoid defaulting on previous IMF loans

IMF usually prescribes devaluation plus budget austerity (higher taxes and reduced government spending) as condition for loans



Currency Crisis Explanations In theory, a currency’s value mirrors the fundamental strength of

its underlying

economy,

relative

to other

economies.

In

the

long

run.

In the short run, currency trader’s expectations play a much more important role.

In today’s environment, traders and lenders, using the most modern communications, act by fight‐or‐flight instincts. For example, if they expect others are about to sell Brazilian reals for U.S. dollars, they want to “get to the exits first”.

Thus,

fears

of

depreciation

become

self ‐

fulfilling

prophecies.



Moral Hazard Again Problem in financial sector regulation

Moral hazard – incentive to do the wrong thing: banks have an incentive to make riskier investments when they know

they will be bailed out

Moral hazard problems are exacerbated by governments’providing incentives or threatening banks to make bad loans

for political ends Applies to IMF loans as well – countries know “lender

f l ” h



of last resort” is there

Measure of Financial Vulnerability of Various Developing

Economies as of June 1997



Reform of the International Financial

Architecture

Reform of the international financial architecture – new

international policies for avoiding and managing financial crises

The great variety of reform proposals focus on two issues:

Role of an international lender of last resort Conditionality – the changes in economic policy that

borrowing nations are required to make in order to receive loans from the lender of last resort



Lender of Last Resort

Lender of last resort – a source of loanable funds after all commercial sources of lending become unavailable

The central bank in the national economy

The IMF, with the support of high‐income countries, in the international economy




Opponents of international lender of last resort cite moral hazard problems

Proponents: moral hazard can be decreased by financial sector regulations, such as the Basel Capital Accord

If owners of financial firms risk losses in the event of a meltdown, they will not engage in excessive risk




Debate on the IMF’s role as a lender of last resort and moral hazard centers on: Level of IMF interest rates: should the rates be higher?

Length of the payback period: should the period be shorter?

Size of loans: countries often exceed the borrowing limitation of 300% above their quota; should the borrowing

limits be curbed?



Conditionality

Conditionality – the changes in economic policy that borrowing nations are required to make in order to receive loans from the lender of last resort (IMF)

Typically covers monetary and fiscal policies, exchange rate policies, and structural policies affecting the financial sector, international trade, and public

enterprises



Conditionality

Critics of conditionality argue: The need to comply with conditions may intensify the

recessionary effects of a crisis

Conditionality may entail high social costs on the poorest members of the society



International Monetary Fund(IMF)

The IMF describes itself as "an organization of 186 countries (as of June 29, 2009),working to foster global monetary cooperation, secure financial

stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty".

With the exception of Taiwan (expelled in 1980)

http://en.wikipedia.org/wiki/Republic_of_China




With the exception of Taiwan (expelled in 1980),

North

Korea,

Cuba (left

in

1964), Andorra,

Monaco,

Liechtenstein, Tuvalu and Nauru, all UN member states participate directly in the IMF.

Domestic Issues in Crisis Avoidance

Problem in financial sector regulation Moral hazard – incentive to do the wrong thing: banks

have an incentive to make riskier investments when

they know they will be bailed out

Moral hazard problems are exacerbated by

governments’ providing incentives or threateningbanks to make bad loans


http://en.wikipedia.org/wiki/North_Korea



http://en.wikipedia.org/wiki/Cuba

http://en.wikipedia.org/wiki/Andorra

http://en.wikipedia.org/wiki/Monaco

http://en.wikipedia.org/wiki/Liechtenstein

http://en.wikipedia.org/wiki/Tuvalu

http://en.wikipedia.org/wiki/Nauru

http://en.wikipedia.org/wiki/UN_member_states





















http://en.wikipedia.org/wiki/Nauru

http://en.wikipedia.org/wiki/Tuvalu

http://en.wikipedia.org/wiki/Liechtenstein

http://en.wikipedia.org/wiki/Monaco

http://en.wikipedia.org/wiki/Andorra

http://en.wikipedia.org/wiki/Cuba





sUmGrKuNTHANKS YOU



Documents

International Finances Prepared by Chan Bonnivoit