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2011 Examination Question (7)

(a) Are there conflicts in foreign exchange transactions between market practices and the Shari’ah principles?

(b) Are there viable Islamic alternatives to currency forwards?

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2011 Exam Q&A (7a)• Islamic stance on Riba, Gharar, Maysir and short selling. (a) currency exchange ** (Yes) (b) currency arbitrage ** (Yes) (c) interest arbitrage ** (No) (d) currency forwards** (IFI) (e) currency options** (IFI) (f) currency futures** (IFI) (g) currency swaps** (Conditional) (g) risk-shifting (invoicing)** (Conditional) (h) risk-sharing** (Yes) (i) exposure netting** (Yes)

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2011 Exam Q&A (7b)• Many IFIs do use currency forwards and futures for hedging purposes

as required by regulators (despite Islamic prohibition)• As risk management is an Islamic virtue, it is argued that the use of

these contracts for hedging purposes makes sense. Argument: hedging is not an income earning activity, but Riba is. No Riba involved in hedging per se. Besides, hedging reduces Gharar (uncertainty).

• Forwards and futures transacted based on Islamic nominate contracts such as Salam, Sarf a Wa’ad, Istisna to buy or sell at a future date.

• Islamic FX swap: Tawarruq contract and Wa’ad principle: each contract must be actual, fictitious; each contract gives ownership; each contract is separate and independent, not conditional to one another

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2011 Exam Q&A (7a) con’d• The Wa’ad principle: The unilateral agreement involves two parties, where

first party promises to buy or sell currency for settlement on a forward value date at the rate and agreed today. The party that makes the promise is obliged to honor the agreement whereas the other party is not obliged to do the same. MYR for USD, JPY, GBP etc are available for contract of <12 months.

• Deutch Bank’s “Promissory Currency Sale Undertaking” based on a unilateral promise the bank to sell a currency at a predetermined price and agreed upon future date (Wa’ad-based product).

• Wa’ad and Commodity Murabaha (CM) based product: “Dual Currency Structured Investment”. Two components: Murabaha, based on a commodity and “unilateral promise to exchange currencies”. Investment enables one to earn a return from CM while receiving a unilateral promise from HSBC to exchange pre-determined amt of FX within given time frame, locking-in a FX rate.

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2011 Examination Question (8)

• Examine the implications of the on-going quantitative easing in the US and fiscal tightening in the euro zone for USD and EUR currencies.

(10 marks)

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2011 Exam Q&A (8)• Background: The 2008 global financial crisis and the US and Euro Zone

responses had led to colossal fiscal stimulus packages.• Bailouts by governments had converted private debts into public debts.• Ballooning sovereign debt is a serious problem in the US and EU (US due to

wars; EU due to unsustainable welfare states)• The US, more concerned about unemployment than inflation, keeps interest

rate close to zero, pumping in liquidity.• Europe, less tolerant toward inflation, more concerned about sovereign debt

problem and fearful of the contagion from PIIGS is stressing the importance of fiscal discipline and austerity programs.

• The US, one of the most debt-laden nation has lost its AAA rating.• Quantitative easing to stimulate the US economy will lead to higher inflation

which will cause USD to depreciate. Much would, however, depend on whether BOP surplus countries like China would let this.

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2011 Exam Q&A (8) cont’d• Fiscal austerity in the euro zone would sedate EZ economies into

near-zero growth.• Imports into US and EZ will decline, partly due to slower economic

growth and partly due to the weakening of their currencies.• Prognosis for EUR: will Greece quit EZ? More to follow? If they

don’t will Germany exit? No clear yes or no answers.• PIIGS need growth badly but austerity would work in the opposite

direction.• With weak economic growth and/or inflation, USD and EUR are

likely to depreciate, which is not a good news for Asia, as their currencies will appreciate making their exports uncompetitive.

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INTERNATIONAL FINANCE REVISITED

LECTURE 14

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[1.1] Balance of Payments

• Statistical record of international transactions for a given period – based on double-entry book-keeping.

• Split into Current Account and Capital Account: Surplus in one country is offset by Deficit in some others.

• Visible Trade Balance = Xg - Mg

• Balance of Trade = X - M (inc services; exc uni transfers).• Basic Balance = Current Acc Balance + Net FDI flows• Overall Balance (Official Settlement Balance) = Basic

Balance + short-term capital flows: if >0, it will add to CB reserves; if negative, it will reduce reserves.

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[1.2]Current vs Capital Account• Current Account shows how foreign exchange is earned and

spent.• Capital Account shows how the surplus is used or the deficit

is financed.• Strength of the currency will depend, among others, on the

strength of BOP: currency to depreciates, if deficit persists; currency to appreciate, if surplus continues.

• Wrong to view BOP deficit as bad and BOP surplus as good: both represent imbalance; deficit may be a sign of boom; surplus may be a sign of deceleration/stagnation.

• One country’s surplus is another’s deficit (zero-sum).

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[1.3] When BOP Becomes An IssueBOP becomes an issue if:• the deficit is large relative to GNP or GDP• there is international pressure (in the face of growing BOP

surplus and reserves: Japan before, China now)• the imbalance is persistent• the deficit is financed by rundown of reserves (esp. where

reserves are at low levels)• deficit is financed largely by short-term capital flows• external debt is large• the currency is overvalued• the economy is overheating

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[1.4] When BOP Is Not An Issue

BOP is not an issue when:• deficit/surplus is small relative to GNP or GDP• Imbalance is perceived to be temporary• deficit is financed by long-term (FDI) capital inflows• external debt is small• reserves are at comfortable levels (capacity to

import and to service external debt).• currency is not overvalued• economy is not overheating

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[1.5] BOP & Exchange Rate

• Generally, BOP influences currency values in the FX market: positive influence during surplus and negative influence during deficit.

• However, it is not unusual for deficit-country currency to strengthen, if the economy is booming and deficit is financed by large FDI inflows and the currency is perceived to be undervalued.

• XR may appreciate temporarily, if country borrows! (MYR appreciation in early 80s)

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[2.1] International Monetary Theory

• BOP can adjust itself automatically, thanks to built-in mechanism.

• In the Classical Model, the adjustment takes place through gold movements and price changes (relative prices of X and M).

• In the Keynesian Model, the adjustment is via changes in output and employment (DD for M and SS of X).

• In the Absorption Model, through changes in CB reserves and C+I.

• In a flexible XR system, through XR appreciation or depreciation.

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[2.2] BOP Corrections

• Main problem with automatic mechanisms is that they tend to be either slow or incomplete and in conflict with other domestic policy objectives.

• Hence the call for policy measures to reduce, if not eliminate, BOP deficit ( e.g. currency devaluation, IR increase, fiscal austerity)

• Devaluation would work only if demand for X and M are price-elastic (Marshall-Learner condition that sum of the X and M demand elasticity must exceed unity)

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[2.3] How Devaluation Works

• Devaluation affects demand for X and M not only through price changes but also through changes in income (Y) and absorption (C+I), where

dB=dY-dA• In the Absorption Approach, the impact on BOP will

depend on dY and dA. BOP will improve (dB>0), if dY>dA, and worsen (dB<0) if dY<dA, where dY and dA are positive

• Where dY and dA are negative, BOP will improve (dB>0), if dY<dA, and worsen (dB<0) if dY>dA

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[2.4] Devaluation: Reservations • Since the impact on BOP (dB) depends on the elasticity of

demand for X and M (diagrams help) and on income (Y) and absorption (A=C+I), where A would depend largely on the marginal propensity to absorb (refer to equations and diagrams), the outcome is uncertain and therefore there is a tendency to devalue excessively to ensure stronger impact.

• Competitiveness gained by devaluation may be lost by rising costs at home or competitive devaluation by rivals abroad.

• For competitiveness, it is RER, not NER that matters.

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[3.1] Exchange Rate Determination

• FX market is almost perfect, as it has nearly all the attributes of a perfect market.

• Exchange rate (XR) is determined by SS & DD for the currencies.

• Macroeconomic factors (e.g. IR) influence XR.• Exports add to SS of FC (= DD for LC)• Imports add to SS of LC (= DD for FC)• CB intervention in FX market is not uncommon.

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[3.2] Interventions in FX Market• CB interventions in FX mkt. can cause domestic problems

(e.g. inflation, unemployment).• CB can neutralize such impacts through sterilization (Open

Market Operations, mopping up excess liquidity or adding liquidity).

• FX mkt. interventions tend to be ineffectual if not irresponsible: treating symptoms, not the disease.

• CBs intervenes in the spot mkt. to iron out short-term fluctuations without tempering with long-term trends.

• CB intervention in the forward mkt. can assist in managing spot rates but there are greater risks.

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[3.3] Forward Market Interventions

• Main argument against forward intervention: more dollars will be sold in the process, to shore up LC, than will be the case otherwise, resulting in bigger losses, should CB fail and LC is devalued.

• Counterargument: Yes, more dollars will be sold, but the extent of devaluation and the probability would be smaller with forward intervention, in which case losses may well be smaller with intervention than without.

• No easy answers!

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[4.1] Foreign Exchange Market• Spot market represents 33% of the FX market.• Forward market constitutes 12%.• Swap transactions form 55%.• Interbank market serves as the wholesale market.• Ask price > bid price: % spread = (a-b)/a x100.• Currency arbitrage takes advantage of ‘mispricing’ of currencies in different

markets, resulting price equalization.• Traders buy and sell FX in the spot market and take “cover” in the forward

market; arbitrageurs take advantage of differences in XRs and IRs; hedgers make forward contracts for protection; speculators just gamble on XR movements in both markets.

• Roles played by traders, arbitrageurs, hedgers and speculators in the FX market are different, but their outcomes are similar in the sense that they move XRs towards equilibrium and parity.

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[4.2] Forward Market

• Forward Contracts protect against XR risk• Traders “cover” exposures arising from X & M

transactions• Investors “hedge” to protect their foreign

assets/liabilities from XR risk• Forward discount = (Xt -Xo)/Xo, where Xt < Xo

• Forward premium = (Xt–Xo)/Xo, where Xt > Xo

• Forward Contracts, unlike Currency Options, are legally binding commitments for both sellers and buyers

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[5.1] Parity Conditions• PPP is about theoretical relationship between relative price levels and

spot exchange rates (inflation differential equals % change in XR at parity) - Diagram helps!

• Fisher Effect (FE) points to the connection between IR differential and inflation differential (inflation differential equals IR differential in % terms at parity) – Diagram helps!

• Intl. Fisher Effect combines PPP and FE so as to link IR differential to XR change (IR differential equals expected change in XR) – Diagram!

• IR Parity (IRP) relates to relationship between IR differential and the forward spread (forward premium/discount).

• Unbiased Forward Rate (UFR) connects expected future spot rate to current forward rate (forward rates serve as unbiased predictors/estimators of future spot rates).

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[5.2] Parity Implications• According to PPP, XR between HC and FC will adjust to reflect changes

in price levels of the two countries (thus, a 3% higher domestic inflation is offset by 3% appreciation of FC or 3% depreciation of HC) so that real exchange rate remains unchanged although nominal XR has changed.

• According to Fisher Effect, the nominal IR differential will roughly equal the inflation differential, so that currencies with high rates of inflation should bear correspondingly higher IRs than currencies with lower rates of inflation (3% higher inflation warrants 3% higher IR).

• Int’l Fisher Effect: a currency with lower IR should appreciate relative to currency with higher IR.

• IR Parity Theory: currency of the country with a lower IR should enjoy a forward premium vis-à-vis currency of the country with higher IR (higher IR implies forward discount for the currency)

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[5.3] Capital Flows• Funds flow from one country to another to take advantage of higher

returns abroad (from low-IR country to high-IR country, after adjusting for FX risk through forward contracts (so long as IR differential > forward discount).

• Funds also flow from high-IR country to low-IR country, if forward premium > IR differential.

• Funds will stop moving between countries until forward spread (premium/discount) equals the IR differential.

• Capital movement will cause IR to fall in capital-importing country and rise in capital-exporting country (reducing IR differential) and raise the spot rate of the former’s currency and lower its forward rate (widening the forward spread) until IR differential equals the forward spread – in which case there is no incentive to move funds between the 2 countries.

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[6.1] Currency Futures Market• Currency Futures and Currency Options provide (a) protection

against FX risk for traders and investors and (b) opportunities for arbitrageurs and speculators.

• Combination of low cost and high degree of leverage make futures contracts attractive for the participants.

• Futures contracts differ from forward contracts in many ways. Main advantage: small size of the contract and freedom to liquidate at any time before maturity with low default risk. Main disadvantage: limited number of currencies traded, limited delivery dates and rigid contractual amount to be delivered.

• Futures contracts are of value to customers with stable and continuous stream of payments/receipts in foreign currency.

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[6.2] Currency Futures/Forwards• Currency futures are poor substitutes for currency forwards

(for hedging purposes) but can be good supplements.• “Forwards-Futures Arbitrage” applications bid up the futures

price and bid down the forwards price, where the forward price > the futures price ( the other way around where the forward price < the futures price) until approximate equality is established.

• Empirical evidence: forward and futures prices converge and do not differ significantly (they often influence each other, especially through arbitrage applications)

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[6.3] Currency Options• Currency Options comprise (a) Call Options and (b) Put Options,

where “the holder” is the customer and “the writer” is the dealer or the agent.

• Call Options give the customer the rights “to buy” (with no obligations to buy) contracted currencies at the expiration date.

• Put Options give the customer the rights “to sell” (with no obligations to sell) the contracted currencies at the expiration date.

* Note: American option can be exercised at any time up to the expiration date, whereas the European option can be exercised only at maturity.

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[6.4] Currency Options Implications• The “holder” has the rights to buy (Call Option)or sell (Put Option)

but is not obliged to buy or sell, while the “writer” is obliged to sell or buy as stipulated in the contract, should the holder demand so.

• If the strike price < spot rate, the holder of a Call Option is at an advantage (buying at a discount); if the strike price > spot rate, the holder of a Put Option will benefit (selling at a premium) – both instances are described as “in-the-money” situation (the holder will exercise the rights).

• Where the strike price > spot rate, the holder of a Call Option is at a disadvantage (buying at a premium); where the strike price < spot rate, the holder of a Put Option stands to lose (selling at a discount) – both represent “out of the money” situation (the holder will not to exercise the rights).

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[7.1] Accounting Exposure

• Accounting exposure consists of (1) translation exposure and (2) transaction exposure (more of the former).

• Translation exposure impacts on balance sheet assets & liabilities and existing income statement items.

• Transaction exposure impacts on FC denominated contracts already signed but to be settled at a future date.

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[7.2] Exposure Risk•Translation exposure is simply the difference between FC exposed assets and FC exposed liabilities (no translation exposure, if FC exposed assets = FC exposed liabilities).

• Where exposed assets > exposed liabilities, the risk is linked to depreciation of FC; conversely where exposed assets < exposed liabilities, the risk is linked to appreciation of FC.

•Depreciation of FC is good for FC denominated liabilities but bad for FC denominated assets. Appreciation of FC is good for FC denominated assets but bad for FC denominated liabilities.

•Accounting exposure can be measured and managed by using historical XR or current XR or average XR so as to minimize effects of XR movements on dollar returns.

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[8.1] Economic Exposure

• Economic exposure comprises (1) transaction exposure and (2) operating exposure.

• Transaction exposure impacts on FC denominated contracts already signed but yet to be settled.

• Operating exposure impacts on revenues and costs associated with future sales and future cash flows.

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[8.2] Measuring Economic Exposure

• It is real XR not nominal XR that holds the key to measuring economic exposure.

• Changes in real XR affect firm’s competitiveness.

• Impact depends on many variables such as: location of the firm’s markets and its competitors, SS/DD elasticity, substitutability of inputs (local vs. foreign) and offsetting inflation.

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[8.3] Managing Economic Exposure• Transaction and operating exposures call for hedging

applications: e.g. currency forwards, currency options, currency futures, currency collars, money market hedge, currency risk sharing arrangements, exposure netting, etc.

• The key to effective exposure management is to integrate currency considerations into the general management process.

• Integrated XR risk program: (a) provide forecasts of inflation and XR trends, (b) identify and highlight the risk of competitive exposure, (c) estimate and hedge the remaining exposure (mentioned above).

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[9] Country Risk Analysis

• Main concern centers on FX risks associated with LC which may wipe out profits in HC terms.

• Monitoring changes in the investment environment that may impinge on MNC profits

• Focus on institutional factors (lean government, rule of law, independent judiciary, property rights)

• Foreign banks providing external loans face country risk in addition to commercial risk

• Credit risk depends on the variability of the country’s Terms of Trade and social flexibility in difficult times.

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[10.1] Cost of Capital in Foreign Investment

FACTORS DETERMINING DEBT-EQUITY MIX:• Cost of equity for the parent company • Cost of debt for the parent (after tax)• Parent’s debt-equity ratio• Cost of foreign debt (taking into account inflation rate, IR and

XR changes)• Taxes in the country of foreign subsidiary (corporate and

withholding taxes)• Systematic risk and risk premium• Extent of unsystematic risks that can be diversified away

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[10.2] Risks Affecting Cost of Capital

• Systematic risks are non-diversifiable and therefore warrant risk premium, while unsystematic risks can be eliminated by diversification

• Rate of return on risk-free asset (e.g. UST) is low• Market risk premium = rate of return on market portfolio minus rate of

return on risk-free assets• LDCs offer more diversification benefits than DCs for foreign

investment• LDCs’ ratio of systematic to total risk is relatively low• Corporate int’l diversification is beneficial to shareholders• Shareholders accept lower rate of return on MNC shares than on

shares of uninational firms• Cost of equity capital (Ke) > cost of borrowed capital (Kd)

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[10.3] Calculating the Discounting Factor in Foreign Investment

Three categories of fund sources :* Funds from Parent* Internal funds of the foreign Subsidiary* Debt raised in the foreign country of investment

1. Cost of funds from Parent (Kep): Parent’s cost of equity at home (Ke) adjusted for increased risk abroad, and taking into account Parent’s debt-equity ratio and cost of debt (Kd)

2. Cost of internal funds of Subs (Ks): Kep, with allowances for withholding tax3. Cost of new foreign debt (Kndf): IR with adjustments for expected

devaluation (i.e. inflation) and corporate taxAll 3 components will then be weighted (weights based on respective fund

size) to arrive at the discounting factor

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[11.1] The Euro Market• Eurocurrency and Eurobond markets are a response to restrictions,

regulations and costs that govts. impose on domestic financial transactions • Eurocurrency operates like offshore currencies, not subject to regulations of

the country of currency or the country where it operates (e.g. eurodollar, euroyen, europound, euroeuro)

• Eurocurrency loans: Loans denominated in Eurocurrency (no selling or buying of Eurocurrency, just borrowing and lending)

• Eurobanks receive Eurocurrency deposits and make Eurocurrency loans (offer higher deposit rates to attract funds and lower lending rates – thin margin but in large amounts, truly a wholesale market)

• Euromarket has nothing to do with the currency Euro or the continent Europe (Thus, Eurodollar market can exist anywhere outside US, just as Euroyen market can exist outside Japan, or Euroeuro market outside Euro Zone)

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[11.2] Eurobonds/Euronotes • Eurobonds compete with Eurocurrency loans• Euronotes are short-term papers (underwritten euro

commercial papers) issued by borrowers• Euro-CPs are non-underwritten short-term Euronotes• Most MNCs raise funds through Eurocurrency loans,

Eurobonds, and Euronotes, because it is cheaper (thanks to absence of regulations and restrictions, and the wholesale nature)

• Asiacurrency and Asiabond markets are technically or generically no different from Eurocurrency and Eurobond, respectively, and therefore no more than a copy/imitation

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[11.3] Interest Rate Swaps (IRS)

• Swap arrangements represent financial transactions in which 2 counterparties agree to exchange streams of payments over time so as to lower their cost of funds.

• In IRS, what is exchanged is interest payments but not the principal.

• “Coupon Swaps” refer to swaps from fixed to floating rate.

• “Basis Swaps” refer to swaps from one reference floating rate to another reference floating rate.

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[11.4] Currency Swaps• Currency Swap refers to transaction in which 2 parties exchange

specific amounts of 2 currencies at the outset and repay over time interest payments and amortization of principal.

• In a Currency Swap, notional principal is exchanged at the start and reversed at the end of the contract.

• Currency Swaps can help manage XR risk.• In the process, one party shoulders the other party’s higher

interest rate (which reflects higher inflation rate and forward discount on the currency).

• Currency Swap behaves like a long-dated forward FX contract, in which the forward rate is the current spot rate. Interest differential is the implicit forward premium/discount.

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[12.1] International Monetary System: Evolution

• Classical Gold Std (1821-1914); Gold Exchange Std (1925-1931); Bretton Woods System(1946-1971); Current Hybrid System (1971 onward).

• Classical Gold Std: currency was backed fully by gold; XR was determined by gold content (Mint Par); BOP adjustments through gold and price movements.

• Gold Exchange Std: US & England holding gold reserves, while others holding US dollars and British pounds as reserves in addition to some gold.

• Bretton Woods System: gold price fixed at US$35 an ounce; Pegged XRs with little flexibility (1%); Govts. were obliged to intervene to keep XR within the narrow band with IMF help if necessary. Devaluation was permitted only at rare intervals , in case of “fundamental disequilibrium”.

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[12.2] Post-Bretten Woods• US, bleeding from Vietnam War and domestic inflation, could not

honor its promise to redeem $ for gold @ $35 per ounce: the system broke down in 1971.

• Hybrid System consists of 4 broad categories: Free Float, Managed Float, Target Zone Arrangement, and Pegged XRs.

• Experience shows XR can’t be fixed for long; XR is often used as policy tool to achieve domestic policy objectives (no genuine desire for equilibrium XR).

• Returning to gold is not a viable proposition: not enough gold to go around; won’t work unless gold price is fixed (a wishful thinking).

• Going back to fixed XRs will make sense, only if all else can adjust to XRs – politically unpalatable.

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[12.3] The Way Forward• Some XR flexibility will do good for BOP adjustments and domestic

policy independence.• Floating rates are not inherently unstable, if underlying economic

conditions are fairly stable.• For XR to be stable, inflation rate and interest rate must also be

stable.• Maintaining unrealistic XR is an uphill task and there is no escape

from market forces.• Regional arrangements such as OCA and CCA are fraught with

difficulties, if the European experience is any indicator.• Impossible to craft a new international financial architecture that

would suit all countries under existing fluid conditions.

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[13.1]Islamic Issues in International Finance

• Islamic Finance is still at an embryonic stage, with some controversy over the permissibility and applicability of several Islamic financial instruments (e.g. Tawarruq Financing, Sukuk).

• Rules that govern Islamic banking and finance also apply equally to international finance in the Islamic paradigm.

• Most conventional instruments currently used against FX risks fail to meet the basic Islamic criteria relating to interest rate, ambiguity, speculation and murky link to real sector activities (esp. currency forwards, currency futures, currency options, currency swaps, money market hedging).

• Hedging techniques that seem to comply with Shari’ah requirements include: CRSA, Exposure Netting and Pricing Strategy.

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[13.2] Islamic Perspective • Need to devise Shair’ah compliant instruments for managing FX risks – but

these must be cost-effective.• Many IFIs do use currency forwards and futures for hedging, based on the

logic that these are required by regulators and rationalisation that hedging unlike Riba is not an income earning activity, while it reduces Gharar (uncertainty).

• Islamic FX Swap (Tawarruq & Wa’ad); Promissory Currency Sale Undertaking (Deutsche Bank); Dual Currency Structured Investment (HSBC Amanah); FX Option-I, FX Calendar Plus-I, TARF-I, Zero Cost Collar-i

• Liberal interpretations in grey areas can be a stop-gap measure but cannot be a long-term solution.

• Some hedging activities that are non-Shari’ah compliant under certain conditions may be treated as “necessary evil”.

• Are these permissible if they do more good than harm?

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Presented Articles• Takatoshi Ito (2007), “Asian Currency Crisis and the International

Monetary Fund, 10 Years Later: Overview” Asian Economic Policy Review, Vol. 2, No.1

• Stephen Grenville (2007), “Regional and Global Responses to the Asian Crisis”, Asian Economic Policy Review, Vol. 2, No. 1

• Mitsuhiro Fukao (2008), “Financial Crisis and the Lost Decade”, Asian Economic Policy Review, Vol. 2, No. 2

• Morris Goldstein and Daniel Danxia Xie (2009), “US Credit Crisis and Spillovers to Asia”, Asian Economic Policy Review, Vol. 4, No. 2

• Takatoshi Ito (2010), “China as Number One: How About the Renminbe?”, Asian Economic Policy Review, Vol. 5, No.2

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END OF LECTURE 14

ALL THE BEST! FLYING COLOURS!!