international finances prepared by chan bonnivoit
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INTERNATIONAL FINANCES
Prepared by:MSc. Chan Bonnivoit
For Human Resource University
2010-2011
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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
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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
International Finance
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1. Overview and History of
International Finance
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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
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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
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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
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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.
The International Gold Standard,
1879-1913
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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.
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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.
The International Gold Standard,
1879-1913
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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.
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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.
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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.
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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
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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
$2.78
D
D
S
S
a D’
D’
e
f g
The Bank of England uses
its US$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.
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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.
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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
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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.
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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
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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.
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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.
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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.
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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
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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 .
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2. The Foreign Exchange
Market
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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.
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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.
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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
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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.
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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
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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.
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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
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Retail foreign exchange brokers: There are two types of
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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.
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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 $369 billion of remittances (an increase of 8% on the previous year). The largest
and best known provider is Western Union with 345,000 agents globally.
The Foreign Exchange Market Setting
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The Foreign Exchange Market Setting
The foreign exchange market is unique because of its trading volumes,
the extreme liquidity of the market,
its long trading hours: 24 hours a day except on weekends (from 22:00 UTC on Sunday until 22:00 UTC Friday),
the variety of factors that affect exchange rates.
the low
margins
of profit
compared
with
other
markets
of
fixed income (but profits can be high due to very large trading volumes)
The foreign exchange market is a geographical dispersion,
broker‐dealer market, and hence lacks transparency. Dealers can trade in a number of ways:
direct telephone contact with a dealer at another bank (direct dealing)
telephone contact with a voice broker electronic direct trading and broking systems
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F i E h M k t P d t d A ti iti
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The spread The difference between selling and buying rates
called the spread, e.g. Bank bid to buy foreign exchange rate at lower rates than the exchange rate quoted to sell.
Spot market
Spot market is where currencies are traded for current delivery (actually, deposits traded in the foreign exchange market generally take 2 working days to clear).
Foreign Exchange Market Products and Activities
Settlement and Settlement Risk
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Settlement and Settlement Risk
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Spot Rate Quotations Direct quotation US$ 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
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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
Spot Rate Quotations
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Spot Rate Quotations
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
Spot Rate Quotations
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Spot Rate Quotations
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)
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
Forward exchange market
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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.
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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
$1.5445 = £1.00
What’s up with that?
Forward Rate Quotations
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Forward Rate Quotations
Clearly the
market
participants
expect that
the pound
will be
worth lessin dollars in
six months.1.49751.51060.66780.6626 Months Forward
1.48881.5020.67170.66583 Months Forward
1.48351.49680.67410.66811 Month Forward
1.48131.49430.67510.6692Canada (Dollar)
0.64610.64751.54771.54456 Months Forward
0.64230.64371.55681.55353 Months Forward
0.63980.64121.56291.55961 Month Forward
0.63860.63991.5661.5627Britain (Pound)
3.47343.40250.28790.2939Brazil (Real)
1.68521.69320.59340.5906Australia (Dollar)
3.03773.02210.32920.3309Argentina (Peso)
Currency per
USD Thursday
Currency per
USD Friday
USD equiv
Thursday
USD equiv
FridayCountry
F d P i di t
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Forward Exchange Market: where currencies may be bought and sold for delivery in a future period.
For 1 month S(£/$) = 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(£/$) = 0.71
If I sign the forward contract I would need £7,000 instead of £7,100.
Forward Premium or discount
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Payoff
Profiles
S 30(£/$)
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
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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 ( )
($/€)n
n n t t
F fp f s
S n n
⎡ ⎤= × = − ×⎢ ⎥
⎣ ⎦
2 = .02750
Forward Premium or discount (Exercise)
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To calculate the sum of dollar that need to sell in order to purchase the pound for buying the England‐car in
England and to calculate the percentage of return from forward rate in this case base on the following supposed data:
Suppose I need to pay my supplier of England‐car in pound (10,000£ ) in 3 month:
Spot rate S(£/$) = 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)
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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
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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.
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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
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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(¥/$) = 105
short position
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Payoff
Profiles
S 180(¥/$)
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
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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
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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
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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
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S(£/$) = 0.69; for 1 month F(£/$) = 0.70
Annual % return of pound : 0.014 x 12 = 0.17
Foreign e change option (commonl
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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
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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
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(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.
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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
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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
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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
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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.
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Triangular Arbitrage
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$
£¥
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.
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Triangular Arbitrage
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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
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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.
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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.
The Demand for Currency
The Demand for Currency
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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 $/€)
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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.
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F
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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
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Equilibrium:
RD= RF at E *
If St > E *, RF > RD, sell $, St ↓
If St < E *, RF < RD, buy $, St ↑
Factors affecting RD
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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
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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
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Factors that Shift R F and R D
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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
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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
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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
Bank claims, liabilities, obligations, etc.
Government assets abroad
snÞsSn_éfø (Price Index)
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( ) 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
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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
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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
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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)
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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)
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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.
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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
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• 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
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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
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FX Turnover (2002)
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FX Turnover (2008)
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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
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3. The exchange rate
E h R
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Exchange Rates
The rate at which one currency can be exchanged for another e.g.
£1 = $1.90
£1 = €1.50
Important in trade
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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
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Exchange Rates
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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
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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 = $1.91
UK exports appear to be more expensive
( Xp)
Imports to the UK appear to be cheaper ( Mp)
Exchange Rates
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Exchange Rates
Depreciation of the Exchange Rate
A fall in the value of the £ in relation to other currencies ‐ each £ buys less of the foreign currency e.g.
£1 = € 1.50 £1 = € 1.45
UK exports appear to be cheaper
(
Xp) Imports to the UK appear more expensive
( Mp)
Exchange Rates
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Exchange Rates A depreciation in exchange rate should lead to a
rise in demand for exports, a fall in demand for imports – the balance of payments should ‘improve’
An appreciation of the exchange rate should lead to a fall in demand for exports and a rise in
demand
for
imports
– the
balance
of
payments
should get ‘worse’ BUT
Imports (Debits) Current Account: (M)
Exports (Credits) Current Account: (X)
International Transactions: Data
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Current Account: (M)
Goods and services
Factor‐ and assets income
Assets transfer (= transfer account)
Aids, gifts etc. (= unilateral transfer)
Capital Account: (CM)
Direct investments
Security purchase
Bank claims, liabilities, obligations, etc.
Government assets abroad
Current Account: (X)
Goods and services
Factor‐ and assets income
Assets transfer (= transfer account)
Aids, gifts etc. (= unilateral transfer)
Capital Account: (CX)
Direct investments
Security purchase
Bank claims, liabilities, obligations, etc.
Government assets abroad
The U.S. Balance of Payments, 2005 (Millions of Dollars)
International Transactions: Data
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112
Exchange RatesS£
Assume an initialexchange rate of
Investing in theUK would now bemore attractiveand demand for £would rise
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g$ 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
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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.
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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
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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
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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
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Fixed vs Flexible Exchange RateRegimes
Pro & Cons for Floating Exchange Rate
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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.
Fixed vs Flexible Exchange RateRegimes
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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.
Fixed vs Flexible Exchange RateRegimes
r £
)Supply
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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
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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.
Fixed vs Flexible Exchange RateRegimes
Supplyp
e r £
t e )
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(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
Fixed vs Flexible Exchange RateRegimes
I t d th h t i “fi d” t
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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.
Fixed vs Flexible Exchange RateRegimes
SupplyContractionary
p e r £
e )
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(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
The Spirit of the Bretton Woods Agreement,1945
Price of Sterling
D S D”
The Bank
must supply cd £ eachperiod.
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The Role of International Reserves in
Exchange Rate Determination
Sterling
Quantity of sterling/Time
$2.82
$2.78
DS
a D”
b
c d
Purchasing Power Parity (PPP)
Th i l h t i th i i f i
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The nominal exchange rate e is the price in foreign
currency
of
one
unit
of
a
domestic
currency.
The real exchange rate (RER) is defined as
RER = e(P/P f ), where P f is the foreign price level
(price index) and P the domestic price level (price index).
P and P f must have the same arbitrary value in some
chosen base year. Hence in the base year, RER = e.
Purchasing Power Parity
in a Perfect Capital Market Purchasing power parity (PPP) is built on the notion
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Purchasing power parity (PPP) is built on the notion of arbitrage across goods markets and the Law of One Price.
The Law of One Price is the principle that in a PCM
setting, homogeneous
goods
will
sell
for
the
same
price in two markets, taking into account the exchange rate.
£/$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)
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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
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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.
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The exchange rate would be a proper reflection of the
Purchasing Power Parity and Exchange Rate
Determination
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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.
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Real Exchange Rates
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Purchasing Power Parity and Overvalued
or Undervalued Currencies
i l h h h i li d
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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/£
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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
Purchasing Power Parity and Exchange Rate
Determination
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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.
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4. The Balance of Payments
The Balance of Payments
A record of the trade between one Country
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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
Imports (Debits) Current Account: (M)
Goods and services
Exports (Credits) Current Account: (X)
Goods and services
The Balance of Payments
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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
Factor‐ and assets income
Assets transfer (= transfer account)
Aids, gifts etc. (= unilateral transfer)
Capital Account: (CX) Direct investments
Security purchase
Bank
claims,
liabilities,
obligations, etc.
Government assets abroad
U.S. Balance of Payments DataCredits DebitsCurrent Account
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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:
The Balance of Payments
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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
The Balance of Payments
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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.
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CA deficit
0
CA(S0)
Domestic
Income (Y)
Y0
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What affects the CA?
CA surplusS ↑ → domestic depreciationcausing imports to fall and
exports to rise, both of
which lead to an
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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
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KA deficit
r - r *
What affects the KA?What affects the KA?
KA surplusKA
If r > r * then capital will
flow into the domestic
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KA deficit
r - r *
economy and create a
capital account surplus.
What affects the KA?What affects the KA?
KA surplusKA
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KA deficit
r - r *
If r < r * then capital will
flow out of the domesticeconomy and create a
capital account deficit.
What affects the KA?What affects the KA?
KA surplusKA
If r = r * then capital will
not have any incentive to
d h i l
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KA deficit
r - r *
move and the capital
account will be in
balance.
The Balance of Payments Identity
BCA + BKA + BRA = 0 where
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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)
International Transactions: Data
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Lecture 12: Trade Balance 152
The U.S. Current Account Balance, 2005 (Millions of Dollars)
International Transactions: Data
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Statistical Discrepancy
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Components of the U.S. Financial Account, 2005 (Millions of Dollars)
International Transactions: Data
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Private Flows in the U.S. Financial Account, 2005 (Millions of Dollars)
International Transactions: Data
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FDI
International Transactions: Data
Reserve Assets
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International Transactions: Data
Reserve Assets
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SDRs :
Special
Drawing
Rights
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U.S.
Balance
of
Payments
DataCredits DebitsCurrent Account
1 Exports $1,418.64
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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
U.S.
Balance
of
Payments
DataIn 2000, the
Credits DebitsCurrent Account
1 Exports $1,418.64
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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
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
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U.S.
Balance
of
Payments
DataUnder a pure
Credits DebitsCurrent Account
1 Exports $1,418.64
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flexibleexchange rate
regime, these
numbers would balance each
other out.
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
U.S.
Balance
of
Payments
DataIn the real
Credits DebitsCurrent Account
1 Exports $1,418.64
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world, thereis a statistical
discrepancy.
p $ ,
2 Imports ($1,809.18)
3 Unilateral Transfers $10.24 ($64.39)Balance on Current Account ($444.69)
Capital Account4 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
U.S. Balance of Payments Data
Including that,
Credits DebitsCurrent Account
1 Exports $1,418.64
2 Imports ($1,809.18)
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the balance of payments
identity should
hold:BCA + BKA = – BRA
- ($444.69) + $444.26 + $0.73 = $0.30= –($0.30)
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
$0.30Official 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
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Q
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 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
Balance of Payments and the Exchange
Rate
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Q
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
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
Balance of Payments and the Exchange
Rate
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Q
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
D
P S
As the U.S. government sells dollars, the supply of dollars increases.
Credits DebitsCurrent Account
1 Exports $1,418.64
Exchange rate $
Balance of Payments and the Exchange
Rate
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Q
D
S 12 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
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Balances on the Current (BCA) and Capital (BKA)
Accounts of the United States
400
500
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-500
-400-300
-200
-100
0
100
200
300
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
U.S. BCAU.S. BKA
Balances on the Current (BCA) and Capital (BKA)
Accounts of United Kingdom
30
40
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-50
-40
-30
-20
-10
0
10
20
30
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000UK BCA
UK BKA
Balances on the Current (BCA) and Capital (BKA)
Accounts of Japan
100
150
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-150
-100
-50
0
50
100
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
Japan BCA
Japan BKA
Balances on the Current (BCA) and Capital (BKA)
Accounts of Germany
60
80
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-80
-60
-40
-20
0
20
40
60
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
Germany BCA
Germany BKA
Balances on the Current (BCA) and Capital (BKA)
Accounts of China
30
35
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-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
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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
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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
What Does the Trade Balance
Really Mean? From National Income Accounting
(Thi ti ith t)
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(This time with government)
Even more simply
Y = C + I + G + (X −
M)
implies
X −
M = Y −
(C + I + G)
What Does the Trade Balance
Really Mean? From National Income Accounting
X − M = Y − (C + I + G)
T ade Surp l u s E
xpendiIncome
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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)
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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.
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Annual Deficit (2002)Annual Deficit (2001)
Annual Deficit (2000)Annual Deficit (1999)
Annual Deficit (1998)Annual Deficit (1997)
The government debt
is an accumulation
of all past annual
deficits. In 2001, the
debt of the U.S. federalgovernment was $3.2
trillion.
What Does the Trade Balance
Really Mean? So in spite of its name, and it’s definition, the
trade balance
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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
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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
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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
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$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
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⇒
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
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Yield to Maturity: Bonds
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Yield to Maturity: Bonds
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Current Price or (Current Price + Par Value)/2
Distinction Between Interest
Rates and ReturnsRate of Return
C + P t+1 – P tRET i
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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
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CASH FLOW CHARACTERISTICS
107
1 2 3 4 5
7 7 77
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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
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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
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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
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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
The International Fisher Effect
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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?
The International Fisher Effect
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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
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Interest Rate Parity
Interest Rate Parity Defined
Covered Interest Parity
Interest Rate Parity & Exchange Rate Determination
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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
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exploiting the arbitrage opportunity.
Since we don’t typically observe persistent arbitrage
conditions, we can safely assume that IRP holds.
Covered Interest Parity (CIP)
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
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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 = $100,000( F /S )(1 + i £ )
Since both of these investments have the same risk, they must have
the same future value—otherwise an arbitrage would exist, therefore( F /S )(1 + i £) = (1 + i$)
Covered Interest Parity (CIP)
$100,000 $100,000(1 + i$)
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$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
Covered Interest Parity (CIP)
Formally,
( F /S )(1 + i £) = (1 + i$)
or if you prefer,
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IRP is sometimes approximated as
1 + i£
1 + i$
= S
F
i$ – i£ =S
F – S
Covered Interest Parity (CIP)
Depending upon how you quote the exchange rate ($ per £or £ per $) we have:
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1 + i$
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)
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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
$1,071.
Covered Interest Arbitrage
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Covered Interest ArbitrageCovered Interest Arbitrage
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Covered Interest ArbitrageCovered Interest Arbitrage
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Interest Rate Parity
& Exchange Rate Determination
According to IRP only one 360-day forward rate,
F 360($/£), can exist. It must be the case that
F 360($/£) = $1.20/£Why?
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y
If F 360($/£) ≠ $1.20/£, an smart trader could make money
with one of the following strategies:
Arbitrage Strategy I
If F 360($/£) > $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÷$1.25/£) invest £800
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at 11.56% (i£) for one year to achieve £892.48
iii. Translate £892.48 back into dollars, if F 360($/£) > $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
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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
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Uncovered Interest rate parityUncovered Interest rate parity
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6.
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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.
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Methods to DiversifyDiversify by a
1. Trade in American Depository Receipts (ADRs)
2.Trade in American shares3.Trade internationally diversified mutual funds:
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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
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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%?
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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 '
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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
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1. A Security’s Returns may be
segmented intoSystematic Risk
Total Risk
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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
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within a nation, outside the country it may be nonsystematic and diversifiable
The Benefits of Int’l
Diversification
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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
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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
∂ ∂ ∂
= > = > = <∂ ∂ ∂
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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
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Technical Analysis
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Technical Analysis
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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:
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The founder of Forbes Magazine once said:
“You can make more money selling financial advice than following it.”
Forecasting Performance
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Bank’s Forecasts
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8.
Recent
developments
of
international finance
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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
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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)
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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.
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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.
The Spirit of the European MonetarySystem, 1979
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
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movements in bilateral rates - the Exchange RateMechanism.
• Hold foreign exchange reserves primarily in ECUswith the European Monetary Cooperation Fund, andreduce US$ reserves.
The Spirit of the European MonetarySystem, 1979
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
,
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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:
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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),
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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
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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
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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
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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
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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)
( )
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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
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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
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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
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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
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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
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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
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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
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In their rush to get out the peso fell by as much as 40 percent.
The value of the Peso 1994-1995
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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
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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
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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
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country
Asian Crisis, 1997‐98
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”
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meltdown
Asian Crisis, 1997‐98
Economic and financial crisis
Began in financial sector, spread to real economy
Began in Thailand, spread to nearby countries (contagion)
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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
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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
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Trade was 30 40 percent of GDP
Asian Crisis, 1997‐98
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
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Asian Currency Values versus U.S. $ 1997-1998
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Asian Crisis, 1997‐98
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
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p y 4 All now floating except the ringgit
Asian Crisis, 1997‐98
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
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Asian Crisis, 1997‐98
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
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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.
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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
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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
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Argentina Crisis – 2001‐
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
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g
Argentina Crisis – 2001‐
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
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Argentina’s 2nd largest trading partner
Argentina Crisis – 2001‐
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
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Argentine Peso vs U.S. Dollar:
Collapse of a Currency Board
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Argentina Crisis – 2001‐
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
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Argentina Crisis – 2001‐
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
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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.
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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
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of last resort” is there
Measure of Financial Vulnerability of Various Developing
Economies as of June 1997
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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
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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
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Lender of Last Resort
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
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Lender of Last Resort
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?
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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
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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
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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)
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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
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sUmGrKuNTHANKS YOU
8/6/2019 International Finances Prepared by Chan Bonnivoit
http://slidepdf.com/reader/full/international-finances-prepared-by-chan-bonnivoit 299/299