International Finances Prepared by Chan Bonnivoit

INTERNATIONAL
FINANCES
Prepared by:
MSc. Chan Bonnivoit
For Human Resource University
2010-2011
International Finance
cTheInternationalFinancialSystem
historicaloverview
dForeignExchangeMarkets
marketstructure,
Spot,ForwardContracts,Futures,OptionsandSwaps
DeterminantsandGovernmentintervention
e BalanceofPayments
Currentaccount,capitalaccountandfinancialaccount
BP&XR
fExchangeRatesandtheOpenEconomy
FixedExchangeRateSystems
FloatingExchangeRateSystems
PurchasingPowerParity
gInternationalParityConditions
TheInternationalFisherEffect
CoveredInterestParity
UncoveredInterestParity
RealInterestRateParity
hPortfoliomanagement
iForecastingExchangeRates
EfficientMarketsApproach
FundamentalApproach
TechnicalApproach
PerformanceoftheForecasters
8Recentdevelopmentsofinternationalfinance
InternationalFinance
1. Overview and History of
International Finance
InternationalMonetaryArrangementsinTheoryand
Practice
TheBimetallism,17911879
TheInternationalGoldStandard,18791913
TheSpiritoftheBretton WoodsAgreement,1945
TheFixedRateDollarStandard,19501970
TheFloatingRateDollarStandard,19731984
ThePlazaLouvre InterventionAccordsandthe
FloatingRateDollarStandard,19851999
Forexample,ifthedollarispeggedtosilverat
U.S.$1.293=1ounceofsilver,andifthedollaris
peggedtogoldatU.S.$19.395=1ounceofgold
(28.35ggold).
Themintratio was15to1.Inotherword,themint
priceofgoldwas15timesthatofsilver.
Reestablishmentin1834,thedollarispeggedtogold
atU.S.$20.67=1ounceofgold.
Then,themintratiowas16to1inUSA,whilein
Abroad15 to1.
The Bimetallism, 1791-1879
Forexample,ifthedollarispeggedtogoldatU.S.$30
=1ounceofgold,andtheBritishpoundispeggedto
goldat6=1ounceofgold,itmustbethecasethat
theexchangerateisdeterminedbytherelativegold
contents:
The International Gold Standard,
1879-1913
$30 = 6
$5 = 1
Thereareshortcomings:
Thesupplyofnewlymintedgoldissorestrictedthatthe
growthofworldtradeandinvestmentcanbehampered
forthelackofsufficientmonetaryreserves.
Eveniftheworldreturnedtoagoldstandard,any
nationalgovernmentcouldabandonthestandard.
Andasizeableshareoftheworld'sknowngoldreserves
werelocatedintheSovietUnion,whichwouldlater
emergeasaColdWarrivaltotheUnitedStatesand
WesternEurope.
1879-1913
The Relationship Between Money and
Growth
Moneyisneededtofacilitateeconomictransactions.
MV=PYTheequationofexchange.Assumingvelocity(V)
isrelativelystable,thequantityofmoney(M)determines
thelevelofspending(PY)intheeconomy.
Ifsufficientmoneyisnotavailable,saybecausegold
suppliesarefixed,itmayrestrainthelevelofeconomic
transactions.
Ifincome(Y)growsbutmoney(M)isconstant,either
velocity(V)mustincreaseorprices(P)mustfall.Ifthe
latteroccursitcreatesadeflationarytrap.
DeflationaryepisodeswerecommonintheU.S.duringthe
GoldStandard.
Theonlycurrencystrongenoughtomeettherising
demandsforinternationalliquiditywastheU.S.dollar.
ThestrengthoftheU.S.economy,thefixedrelationshipof
thedollartogold($35anounce),andthecommitmentof
theU.S.governmenttoconvertdollarsintogoldatthat
pricemadethedollarasgoodasgold.
Infact,thedollarwasevenbetterthangold:itearnedinterest
anditwasmoreflexiblethangold
Yet,inaneraofmoreactivisteconomicpolicy,
governmentsdidnotseriouslyconsiderpermanentlyfixed
ratesonthemodeloftheclassicalgoldstandardofthe
nineteenthcentury.
1879-1913
The Spirit of the Bretton Woods Agreement,
1945
Fix an official par value for domestic currency in
terms of gold or a currency tied to gold as a
numeraire. In the short run, keep the exchange
rate pegged within 1% of its par value, but in
the long-run leave open the option to adjust the
par value unilaterally if the IMF agrees.
In essence, the Agreement removed countries from the tyranny of the
gold standard and permitted greater autonomy for national monetary
policies.
Bretton Woods System: 1945-1972
Namedfora1944meetingof44nationsatBretton
Woods,NewHampshire.
Thepurposewastodesignapostwarinternational
monetarysystem.
Thegoalwasexchangeratestabilitywithoutthe
goldstandard.
TheresultwasthecreationoftheIMFandthe
WorldBank.
Bretton Woods System: 1945-1972
UndertheBretton Woodssystem,theU.S.dollarwas
peggedtogoldat$35perounceandothercurrencies
werepeggedtotheU.S.dollar.
Eachcountrywasresponsibleformaintainingits
exchangeratewithin1%oftheadoptedparvalueby
buyingorsellingforeignreservesasnecessary.
TheU.S.wasonlyresponsibleformaintainingthegold
parity.
Thiscreatedstrongdemandfor$reservesandallowed
theU.S.toruntradedeficits.
TheBretton Woodssystemwasadollarbasedgold
exchangestandard.
The Spirit of the Bretton Woods
Agreement, 1945
The Role of International Reserves in
Exchange Rate Determination
Price of
Sterling
Quantity of sterling/Time
$2.82
$2.78
D
D
S
S
a
$2.80
1945
Price of
Sterling
$2.82
$2.78
D
D
S
S
a
D
D
e
f
g
The Bank of
England uses
its US$
reserves to
buy up fg
each period.
S
h
i
j
T
h
e
B
a
n
k

m
u
st b
u
y

u
p
ij
e
a
c
h

p
e
r
io
d
.
D
D
b
c d
The Bank
must supply
cd each
period.
The Fixed-Rate Dollar Standard,
1945-1972
Inpractice,theBretton Woodssystemevolvedintoa
fixedratedollarstandard.
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 foreign
exchange market; practice free trade without a
balance of payments or exchange rate target.
Bretton WoodsSystem:1945
1972
German
mark
British
pound
French
franc
U.S. dollar
Gold
Pegged at $35/oz.
Par
Value
P
a
r

V
a
l
u
e
P
a
r

V
a
l
u
e
Collapse of Bretton Woods
In 1960 Robert Triffin noticed that holding dollars was
more valuable than gold because constant U.S. balance
of payments deficits helped to keep the system liquid and
fuel economic growth.
What would later come to be known as Triffin's
Dilemma was predicted when Triffin noted that if the
U.S. failed to keep running deficits the system would
lose its liquidity, not be able to keep up with the world's
economic growth, and, thus, bring the system to a halt.
Throughout the 1960s countries with large $ reserves
began buying gold from the U.S. in increasing quantities
threatening the gold reserves of the U.S.
Collapse of Bretton Woods
Large U.S. budget deficits and high money growth
created exchange rate imbalances that could not be
sustained, i.e. the $ was overvalued and the DM
and were undervalued.
Several attempts were made at re-alignment but
eventually the run on U.S. gold supplies prompted
the suspension of convertibility in September 1971.
Smithsonian Agreement December 1971
The Floating-Rate Dollar Standard, 1973-
1984
Withoutanagreementonwhowouldsetthe
commonmonetarypolicyandhowitwouldbeset,a
floatingexchangeratesystemprovidedtheonly
alternativetotheBretton Woodssystem.
Essentially,theforeignexchangeratewaslefttoplay
theroleofaresidualvariablethatdidagreatdealof
theadjustingtooffsetthemacroeconomicpolicy
differencesacrosscountries.
The Floating-Rate Dollar Standard, 1973-
1984
Industrial 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-term
exchange rate stability.
United States : Remain passive in the foreign exchange
market; practice free trade without a balance of
payments or exchange rate target. No need for sizable
official foreign exchange reserves.
The Plaza-Louvre Intervention Accords and
the Floating-Rate Dollar Standard, 1985-1999
Germany, Japan, and the United States (G-3) : Set
broad target zones for the $/DM and $/ exchange
rates. Do not announce the agreed-upon central rates,
and allow for flexible zonal boundaries. Allow the
implicit central rates to adjust when economic
fundamentals among the G-3 countries change
substantially.
Other industrial countries : Support or do not oppose
interventions by the G-3 to keep the dollar within its
target zone limits.
The Plaza-Louvre Intervention Accords and
the Floating-Rate Dollar Standard, 1985-1999
An episode started by an expansive U.S. fiscal
policy introduced in 1981 combined with tight
monetary control convinced policymakers
that
cexchange rates were too important to be left
to market forces
intervention was deemed appropriate
dexchange rates were too important to be the
residual from uncoordinated economic
policies
better policy coordination was required.
Current Exchange Rate
Arrangements
FreeFloat
Thelargestnumberofcountries,about48,allow
marketforcestodeterminetheircurrencysvalue.
ManagedFloat
About25countriescombinegovernment
interventionwithmarketforcestosetexchange
rates.
Peggedtoanothercurrency
SuchastheU.S.dollaroreuro.
Nonationalcurrency
Somecountriesdonotbotherprintingtheirown,
theyjustusetheU.S.dollar.Forexample,Ecuador,
Panama,andElSalvadorhavedollarized.
2. The Foreign Exchange
Market
OriginsoftheMarket
Internationaltrade Nosinglecurrencyisparticularly
efficientasamediumofexchange.
Internationalinvestment Foreignassetsarean
alternativestoreofvalue.Theymayalsoservetooffset
certainfinancialrisks.Someoftheirfeaturesmaynotbe
availabledomesticallytoo.
Speculation Theaimispurelytoearnhigherreturns.
In a typical foreign exchange transaction a party
purchases a quantity of one currency by paying a
quantity of another currency.
The modern foreign exchange market started forming
during the 1970s when countries gradually switched to
floating exchange rates from the previous exchange rate
regime, 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 centers
such as New York or London trading foreign-currency-
dominated deposits with each other.
Thepurposeoftheforeignexchangemarket
istoassistinternationaltradeand
investment.
Theforeignexchangemarketallows
businessestoconvertonecurrencyto
another.
Forexample,itpermitsaU.S.businessto
importEuropeangoodsandpayEuros,even
thoughthebusiness'sincomeisinU.S.
dollars.
The purpose of FX
MeasuresofMoneyStock
MeasuresofMoneyStock
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 usually
described as the money supply. The components of money supply are
currency with the public (i.e., notes in circulation, circulation of coins
and circulation of small coins) and deposits (demand deposits with
banks 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 is
money supply plus fixed deposits with the banks. M3 is usually
referred to as aggregate monetary resources.
M4 : M4 is M3 plus the total Post Office Deposits.
Market participants
Banks: Theinterbank marketcatersforboththemajorityof
commercialturnoverandlargeamountsofspeculativetrading
everyday.Alargebankmaytradebillionsofdollarsdaily.
Commercialcompanies: Animportantpartofthismarketcomes
fromthefinancialactivitiesofcompaniesseekingforeign
exchangetopayforgoodsorservices.Commercialcompanies
oftentradefairlysmallamountscomparedtothoseofbanksor
speculators
CentralBank: Nationalcentralbanksplayanimportantrolein
theforeignexchangemarkets.Theytrytocontrolthemoney
supply,inflation,and/orinterestratesandoftenhaveofficial or
unofficialtargetratesfortheircurrencies.Theycanusetheir
oftensubstantialforeignexchangereservestostabilizethe
market.
Hedgefundsasspeculators: About70%to90%ofthe
foreignexchangetransactionsarespeculative.In
otherwords,thepersonorinstitutionthatboughtor
soldthecurrencyhasnoplantoactuallytakedelivery
ofthecurrencyintheend;rather,theyweresolely
speculatingonthemovementofthatparticular
currency.
Investmentmanagementfirms: Investment
managementfirms(whotypicallymanagelarge
accountsonbehalfofcustomerssuchaspension
fundsandmutualfunds)usetheforeignexchange
markettofacilitatetransactionsinforeignsecurities.
DistinctionBetweenInterest
RatesandReturns
RateofReturn
C +P
t+1
P
t
RET = =i
c
+g
P
t
C
where: i
c
= = current yield
P
t
P
t+1
P
t
g = = capital gain
P
t
Retailforeignexchangebrokers:Therearetwotypesof
retailbrokersofferingtheopportunityforspeculative
trading:retailforeignexchangebrokersandmarket
makers.Retailtraders(individuals)areasmall
fractionofthismarketandmayonlyparticipate
indirectlythroughbrokersorbanks.
Nonbankforeignexchangecompanies: Nonbank
foreignexchangecompaniesoffercurrencyexchange
andinternationalpaymentstoprivateindividualsand
companies.Thesearealsoknownasforeignexchange
brokersbutaredistinctinthattheydonotoffer
speculativetradingbutcurrencyexchangewith
payments.
Moneytransfer/remittancecompanies: Moneytransfer
companies/remittancecompaniesperformhigh
volumelowvaluetransfersgenerallybyeconomic
migrantsbacktotheirhomecountry.In2007,the
estimatedthattherewere$369billionofremittances
(anincreaseof8%onthepreviousyear).Thelargest
andbestknownproviderisWesternUnionwith
345,000agentsglobally.
TheForeignExchangeMarketSetting
The foreign exchange market is unique because of
itstradingvolumes,
theextremeliquidity ofthemarket,
itslongtradinghours:24hoursadayexceptonweekends
(from22:00UTC onSundayuntil22:00UTCFriday),
thevarietyoffactorsthataffectexchangerates.
thelowmarginsofprofitcomparedwithothermarketsof
fixedincome(butprofitscanbehighduetoverylarge
tradingvolumes)
Theforeignexchangemarketisageographicaldispersion,
brokerdealermarket,andhencelackstransparency.
Dealerscantradeinanumberofways:
directtelephonecontactwithadealeratanotherbank(direct
dealing)
telephonecontactwithavoicebroker
electronicdirecttradingandbrokingsystems
Thespread
Thedifferencebetweensellingandbuyingrates
calledthespread,e.g.Bankbidtobuyforeign
exchangerateatlowerratesthantheexchangerate
quotedtosell.
Spotmarket
Spotmarket iswherecurrenciesaretradedfor
currentdelivery(actually,depositstradedinthe
foreignexchangemarketgenerallytake2working
daystoclear).
Foreign Exchange Market Products and Activities
Settlement and Settlement Risk
Spot Rate Quotations
DirectquotationUS$forYen
theU.S.dollarequivalent
e.g. aJapaneseYenisworthaboutapenny
IndirectQuotationUS$forYen
thepriceofaU.S.dollarintheforeigncurrency
e.g. youget100yentothedollar
Country USD
equiv
Friday
USDequiv
Thursday
Currencyper
USDFriday
Currencyper
USDThursday
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
1MonthForward 1.5596 1.5629 0.6412 0.6398
3Months
Forward
1.5535 1.5568 0.6437 0.6423
6Months
Forward
1.5445 1.5477 0.6475 0.6461
Canada(Dollar) 0.6692 0.6751 1.4943 1.4813
1MonthForward 0.6681 0.6741 1.4968 1.4835
3Months
Forward
0.6658 0.6717 1.502 1.4888
6Months
Forward
0.662 0.6678 1.5106 1.4975
The direct quote
for British pound
is: 1 = $1.5627
The indirect
quote for
British pound
is:
0.6399 = $1
1.4975 1.5106 0.6678 0.662 6 Months Forward
1.4888 1.502 0.6717 0.6658 3 Months Forward
1.4835 1.4968 0.6741 0.6681 1 Month Forward
1.4813 1.4943 0.6751 0.6692 Canada (Dollar)
0.6461 0.6475 1.5477 1.5445 6 Months Forward
0.6423 0.6437 1.5568 1.5535 3 Months Forward
0.6398 0.6412 1.5629 1.5596 1 Month Forward
0.6386 0.6399 1.566 1.5627 Britain (Pound)
3.4734 3.4025 0.2879 0.2939 Brazil (Real)
1.6852 1.6932 0.5934 0.5906 Australia (Dollar)
3.0377 3.0221 0.3292 0.3309 Argentina (Peso)
Currency per
USD Thursday
Currency per
USD Friday
USD equiv
Thursday
USD equiv
Friday Country
Note that the
direct quote is
the reciprocal of
the indirect
quote:
1
1.5627
0.6399
=
1.4975 1.5106 0.6678 0.662 6 Months Forward
1.4888 1.502 0.6717 0.6658 3 Months Forward
1.4835 1.4968 0.6741 0.6681 1 Month Forward
1.4813 1.4943 0.6751 0.6692 Canada (Dollar)
0.6461 0.6475 1.5477 1.5445 6 Months Forward
0.6423 0.6437 1.5568 1.5535 3 Months Forward
0.6398 0.6412 1.5629 1.5596 1 Month Forward
0.6386 0.6399 1.566 1.5627 Britain (Pound)
3.4734 3.4025 0.2879 0.2939 Brazil (Real)
3.0377 3.0221 0.3292 0.3309 Argentina (Peso)
Currency per
USD Thursday
Currency per
USD Friday
USD equiv
Thursday
USD equiv
Friday Country
Forwardexchangemarket
Forwardexchangemarketiswherecurrencies
maybeboughtandsoldfordeliveryinfuture
period.
Forwardpremiummeansthattheforward
exchangerateexceeds thecurrentspotrate.
Forwarddiscountmeansthattheforward
exchangerateislessthan thecurrentspotrate.
Forward Rate Quotations
Considertheexamplefromabove:
forBritishpound,thespotrateis
$1.5627 =1.00
Whilethe180dayforwardrateis
$1.5445 =1.00
Whatsupwiththat?
Forward Rate Quotations
Clearly the
market
participants
expect that
the pound
will be
worth less
in dollars in
six months.
1.4975 1.5106 0.6678 0.662 6 Months Forward
1.4888 1.502 0.6717 0.6658 3 Months Forward
1.4835 1.4968 0.6741 0.6681 1 Month Forward
1.4813 1.4943 0.6751 0.6692 Canada (Dollar)
0.6461 0.6475 1.5477 1.5445 6 Months Forward
0.6423 0.6437 1.5568 1.5535 3 Months Forward
0.6398 0.6412 1.5629 1.5596 1 Month Forward
0.6386 0.6399 1.566 1.5627 Britain (Pound)
3.4734 3.4025 0.2879 0.2939 Brazil (Real)
3.0377 3.0221 0.3292 0.3309 Argentina (Peso)
Currency per
USD Thursday
Currency per
USD Friday
USD equiv
Thursday
USD equiv
Friday Country
ForwardExchangeMarket:wherecurrenciesmaybe
boughtandsoldfordeliveryinafutureperiod.
For1monthS(/$)=forwardrateF(/$)for:
iffor1monthS(/$)<F(/$)!forwardpremium
iffor1monthS(/$)>F(/$)!forwarddiscount
Usedtoavoidtheriskofexchangeratechanges
SupposeIneedtopaymysupplierofUScarsindollar
(10,000$)in1month:
S(/$)=0.69;for1monthF(/$)=0.70butinonemonth
S(/$)=0.71
IfIsigntheforwardcontractIwouldneed7,000insteadof
7,100.
ForwardPremiumordiscount
PayoffProfiles
S
30
(/$)
If, in 30 days, S
30
(/$) = 0.71, the short will make a profit
by buying at S
30
(/$) = 0.71 and delivering at F
30
(/$) =
0.70.
profit
loss
0
F
180
(/$) = 0.70
0.71
0.1
short
position
ForwardPremium
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:
180
180,/ $
($/ ) ($/ ) 360 .5307 .5235
.01375
($/ ) 180 .5235
F S
FP
S

= = =
, / $ ,
($ / ) 360 360
ln ( )
($ / )
n
n n t t
F
fp f s
S n n

= =

2=.02750
Tocalculatethesumofdollarthatneedtosellinorderto
purchasethepoundforbuyingtheEnglandcarin
Englandandtocalculatethepercentageofreturnfrom
forwardrateinthiscasebaseonthefollowingsupposed
data:
SupposeIneedtopaymysupplierofEnglandcarinpound
(10,000 )in3month:
SpotrateS(/$)=0.69;for3monthForwardrate($/)=
1.42,butin3monthSpotrateS($//)=1,36
Istheresultfoundasforwardpremiumfor$or?
ForwardPremiumordiscount(Exercise)
LongandShortForwardPositions
Ifyouhaveagreedtosellanything(spotorforward),youare
short.
Ifyouhaveagreedtobuyanything(forwardorspot),youare
long.
Ifyouhaveagreedtosellforex forward,youareshort.
Ifyouhaveagreedtobuyforex forward,youarelong.
PayoffProfiles
S
180
($/) 0
F
180
($/) = 0.009524
Short position
loss
profit
If 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.
PayoffProfiles
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
PayoffProfiles
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
(/$) = 105
short position
PayoffProfiles
S
180
(/$)
If, in 180 days, S
180
(/$) = 120, the short will make a profit
by buying at S
180
(/$) = 120 and delivering at F
180
(/$)
= 105.
profit
loss
0
F
180
(/$) = 105
120
15
short
position
PayoffProfiles
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
PayoffProfiles
The 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
ForeignExchangeSwap
anagreementtotradecurrenciesatonedateand
reversethetradeatalatertrade.
Citibanks wantspoundsnowandarrangesaswap
withBarclays.
Citibanks tradesdollarsforpoundsnowandpounds
fordollarsinonemonth.
Swapislikeborrowingononecurrencywhile
lendinganothercurrencyforthedurationofthe
swapperiod
ForeignExchangeMarketProductsand
Activities
S(/$) = 0.69; for 1 month F(/$) = 0.70
Annual % return of pound : 0.014 x 12 = 0.17
Foreignexchangeoption(commonly
shortenedtojustFXoptionorcurrency
option)
FXoptionisaderivativefinancialinstrument
wheretheownerhastherightbutnotthe
obligationtoexchangemoneydenominatedin
onecurrencyintoanothercurrencyatapre
agreedexchangerateonaspecifieddate
ForexampleaGBPUSDFXoptionmightbe
specifiedbyacontractgivingtheownertheright
butnottheobligationtosell1,000,000andbuy
$2,000,000onDecember31.
Inthiscasethepreagreedexchangerate,orstrike
price,is2.0000USDperGBP(or0.5000GBPper
USD)andthenotionalare1,000,000and
$2,000,000.
Iftherateislowerthan2.0000comeDecember31
(sayat1.9000),meaningthatthedollarisstronger
andthepoundisweaker,
thentheoptionwillbeexercised,allowingthe
ownertosellGBPat2.0000andimmediatelybuyit
backinthespotmarketat1.9000,
makingaprofitof(2.0000GBPUSD 1.9000
GBPUSD)*1,000,000GBP=100,000USDinthe
process.Iftheyimmediatelyexchangetheirprofit
intoGBPthisamountsto100,000/1.9000=52,631.58
GBP.
Speculationentailsmorethantheassumptionofa
riskyposition.Itimpliesfinancialtransactions
undertakenwhenanindividualsexpectationsdiffer
fromthemarketsexpectation.
SimpleHedgingStrategies
ActivitytoHedge Strategy
Payableindomesticcurrency Nothing,noFXrisk.
Payableinforeigncurrency Acceleratepaymentifforeigncurrency
expectedtoappreciate.
Delaypaymentifforeigncurrency
expectedtodepreciate.
Receivableindomestic
currency
NoFXrisk.
Receivableinforeigncurrency Acceleratepaymentifforeigncurrency
expectedtodepreciate.
Delaypaymentifforeigncurrency
expectedtoappreciate.
ALittleMoreSophisticatedHedgingStrategies
ActivitytoHedge Strategy
Payableindomesticcurrency Nothing,noFXrisk.
Payableinforeigncurrency Borrowatthedomesticinterestratei
andconverttheproceedstoforeign
currency.Lendattheforeigninterest
ratei
*
.Whenpayablecomesdue,sell
foreignassetandmakepayable.Use
domesticcurrencyreservedforpayable
topayoffloan.
Receivableindomesticcurrency NoFXrisk.
Receivableinforeigncurrency Borrowamountofreceivableatthe
foreigninterestratei
*
andconvertthe
proceedstodomesticcurrency.When
receivableispaid,useforeigncurrency
topayoffloan.
Arbitration
Arbitrageisthesimultaneous,ornearly
simultaneous,purchaseofsecuritiesinonemarket
forsaleinanothermarketwiththeexpectationofa
riskfreeprofit.
CrossRates arbitragecondition:
$/ =x$,/ =y =>$/ =($/)/(/)
Crossratemeansthatthethirdexchangerate
impliedbyanytwoexchangeratesinvolvingthree
currencies.
Cross Rates
Suppose that S($/) = .50
i.e. $1 = 2
and that S(/) = 50
i.e. 1 = 50
What must the $/ cross rate be?
$ $
since ,

=
$1 1 $1
($/ ) .01 or $1 100
2 50 100
S = = =
2
1
TriangularArbitrage
$
Credit
Lyonnais
S(/$)=1.50
Credit Agricole
S(/)=85
Barclays
S(/$)=120
First calculate the
implied cross
rates to see if an
arbitrage exists.
Suppose we
observe these
banks posting
these exchange
rates.
Triangular Arbitrage
Barclays
S(/$)=120
80
1
120
1 $
1 $
50 . 1
=
The implied S(/)
cross rate is S(/) = 80
Credit Agricole has
posted a quote of
S(/)=85 so there is an
arbitrage opportunity.
So, how can we make money?
Buy the @ 80; sell @ 85. Then trade yen for dollars.
$
Credit Lyonnais
S(/$)=1.50
Credit Agricole
S(/)=85
Triangular Arbitrage
Barclays
S(/$)=120
As easy as 1 2 3:
1. Sell $ for ,
2. Sell for ,
3. Sell for $.
$
Credit
Lyonnais
S(/$)=1.50
Credit Agricole
S(/)=85
1
2
3
$
Choosinganinvestment
currency.
Allthingsequal,choosethecurrency
withthehighestinterestrate.
Allthingsequal,choosethecurrency
withthelargestexpected
appreciation.
TheDemandforCurrency
ASimpleRule
The$rateofreturnoneurosdepositsisapproximately
theeurosinterestrateplustherateofdepreciation of
the$againsttheeuros.
The rateofdepreciation ofthe $againsttheeurosisthe
percentageincreaseinthedollar/euroexchangerateovera
year.
Whatisthereturnoninvestingindollar?
Take$100,convertintoeurostoday.
$100*S(/$)= 70.9(ifexchangerateis0.709/$or1.41043$/ )
Deposit 70.9inaeurosareabank
70.9*(1+r)= 73.6367(ifinterestrateis3.86%)
Convert 73.6367intodollars.
Whichexchangeratetouse?Usetheexchangerateexistingone
yearfromnow.
73.6367*$/
F
=$103.8594(ifforwardrateis1.41043$/)
Ifdollarsinterestrateis4.14%,whichcurrencyshouldwe
investin.Butthen,whatdoesthatmeanfortheexchange
rate?US$isexpectedtoappreciateup0.71/$(1.408
$/)
EquilibriuminFXMarket
MostFXtransactionsarepurchases/salesofbankdeposits.
Example:AFrenchresidentcanpurchase aeurodeposit
bydepositingeurosintoabankaccountorCD(Certificate
ofDeposit)andearnR
D
.
Or,theycanconverteurosintodollarsandpurchase a
EurodollardepositandearnR
F
.
R
D
isfixedbutR
F
dependsontheexchangeratebetween
eurosanddollars.SothatR
D
isknownwhenthe
investmentismade,butR
F
isnot.
R
F
isanexpected return.
EquilibriuminFXMarket
Determination of
the Equilibrium
Euro/Dollar
Exchange Rate
PointsontheR
F
Curve
Assume i
F
= 10%
Point A: S
t
=0.95 R
F
= [0.10 (1.0 0.95)] = 5%
Point B: S
t
=1.00 R
F
= [0.10 (1.0 1.00)] = 10%
Point C: S
t
=1.05 R
F
= [0.10 (1.0 1.05)] = 15%
ShortRunXRAdjustments
Equilibrium:
R
D
=R
F
atE*
IfS
t
>E*,R
F
>R
D
,sell$,S
t
IfS
t
<E*,R
F
<R
D
,buy$,S
t
FactorsaffectingR
D
R
D
shifts right when:
i
D
, because R
D
at each S
t
Note: This assumes that
domestic
e is
unchanged, so
domestic real rate
FactorsaffectingR
F
R
F
curve shifts right when:
i
F
because R
F
at each S
t
E(S
t+1
) because expected
appreciation of Foreign Deposits
causes R
F
Other factors that will shift R

F
rightward:
1. Domestic P
2. Imports
3. Exports
4. Productivity
Factors that Shift R
F
and R
D
Factors that Shift R
F
and R
D
Determinants of FX rates
Internationalparityconditions: purchasingpowerparity,interestrate
parity,domesticfishereffect,internationalfishereffect.Thoughtosome
extenttheabovetheoriesprovidelogicalexplanationforthefluctuationsin
exchangerates,yetthesetheoriesfalterastheyarebasedonchallengeable
assumptions[e.g.,freeflowofgoods,servicesandcapital]whichseldomhold
trueintherealworld.
Balanceofpayments:Thismodel,however,focuseslargelyontradable
goodsandservices,ignoringtheincreasingroleofglobalcapitalflows.It
failedtoprovideanyexplanationforcontinuousappreciationof dollarduring
1980sandmostpartof1990sinfaceofhighUScurrentaccountdeficit.
Assetmarket:Itviewscurrenciesasanimportantassetclassfor
constructinginvestmentportfolios.Assetspricesareinfluenced mostlyby
peopleswillingnesstoholdtheexistingquantitiesofassets,whichinturn
dependsontheirexpectationsonthefutureworthoftheseassets.Theasset
marketmodelofexchangeratedeterminationstatesthattheexchangerate
betweentwocurrenciesrepresentsthepricethatjustbalancestherelative
suppliesof,anddemandfor,assetsdenominatedinthosecurrencies.
Imports(Debits)
CurrentAccount:(M)
Goodsandservices
Factor andassetsincome
Assets transfer (= transfer
account)
Aids, gifts etc. (= unilateral
transfer)
CapitalAccount:(CM)
Directinvestments
Securitypurchase
Bank claims, liabilities,
obligations,etc.
Governmentassetsabroad
Exports(Credits)
CurrentAccount:(X)
Goodsandservices
account)
Aids,giftsetc.(=unilateral
transfer)
CapitalAccount:(CX)
Directinvestments
Securitypurchase
obligations,etc.
International Transactions: Data
( ) t
i
t
i
t
i
t
i
p
Q P
Q P
o
P

=
( )
u-u-:- (Price Index)
o o
o
t
i
t
i
t
i
t
i
p
Q P
Q P
L

=
...:
.: Passch . .:.. ...... GDP deflator :
.: Laspeyres . .:.. .... .. CPI PPI .
Government intervention & factors
influenced
Supply and demand for any given currency, and
thus 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
These include:
1. Economic policy comprises:
Government fiscal policy (budget/spending practices) and
monetary policy (the means by which a government's
central 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
e
Income, Output, Y
LM*
IS*
e
Income, Output, Y
LM*
IS*
IS*'
LM*'
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 NX). The NX offsets
the 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 NX). The NX offsets
the expansionary fiscal policy and the effect on Y.
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, 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, monetary
policy influences the e rather than r.
+G, or T
+e, no Y
+G, or T
+e, no Y
+M
-e, +Y
+M
-e, +Y
The Mundel l -Fl emi ng Model
Under Fl oat i ng Exchange Rat es
:-:-:- IS (The IS Curve)
.. .. . (Open Economy)
...:............. ............
. .
a + I
0
+ G
0
+ EX
0
IM
0
bTx
0
+ bTr
0
- bi
Y =
1- b + bt + m
E
Income, Output, Y
Y=E
Planned Expenditur
E = C + I
r
Income, Output, Y
r
Investment, I
I(r)
IS
An increase in the
interest rate (in graph
a), lowers planned
investment, which shifts
planned expenditure
downward (in
graph b) and lowers
income (in graph c).
(a)
(b)
(c)
You probably noticed from the IS and LM diagrams that r and Y were on the two axes. Now were going to bring a third
variable, the price level (P) into the analysis. We can accomplish this by linking both two-dimensional graphs.
r r
P P
Y Y
Y Y
IS IS
LM(P LM(P
1 1
) )
A A
A A
AD AD
To derive AD, start at point A in the top graph. Now increase the price
level from P
1
to P
2
.
An increase in P lowers the value of real money balances, and Y, shifting LM leftward
to point B.
The +P triggers a sequence of events that end
with a -Y, the inverse relationship that defines
the downward slope of AD.
Notice that r increased. Since r increased, we know
that investment will decrease as it just got more
costly to take on various investment projects. This
sets off a multiplier process since -I causes a Y.
The - Y triggers -C as we move up the IS curve.
LM(P LM(P
2 2
) )
B B
B B
P
2
P
1
Political conditions
Internal, regional, and international political conditions and events can
have a profound effect on currency markets.
All exchange rates are susceptible to political instability and
anticipations about the new ruling party. Political turmoil and
instability can have a negative impact on a nation's economy. For
example, 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 a
political 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 negative
interest in a neighboring country and, in the process, affect its
currency.
Market psychology
Market psychology and trader perceptions influence the
foreign 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
FXTurnover(2002)
FXTurnover(2008)
This approximately $3.21 trillion in main
foreign exchange market turnover was
broken 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
3. The exchange rate
Exchange Rates
Therateatwhichonecurrencycanbeexchangedfor
anothere.g.
1=$1.90
1=1.50
Importantintrade
Exchange Rates
Convertingcurrencies:
Toconvert into(e.g.)$ Multiplythesterling
amountbythe$rate
Toconvert$into dividebythe$rate:e.g.
Toconvert5.70to$atarateof1=$1.90,
multiply5.70x1.90=$10.83
Toconvert$3.45to atthesamerate,divide3.45by1.90
=1.82
Exchange Rates
DeterminantsofExchangeRates:
Exchangeratesaredeterminedbythedemandfor
andthesupplyofcurrenciesontheforeign
exchangemarket
Thedemandandsupplyofcurrenciesisinturn
determinedby:
Exchange Rates
Relativeinterestrates
Changesinrelativeinflationrates
Thedemandforimports
Thedemandforexports
Investmentopportunities
Speculativesentiments
Globaltradingpatterns
Exchange Rates
Appreciationoftheexchangerate:
Ariseinthevalueof inrelationtoother
currencies each buysmoreoftheother
currencye.g.
1=$1.851=$1.91
UKexportsappeartobemoreexpensive
(Xp)
ImportstotheUKappeartobecheaper
(Mp)
Exchange Rates
DepreciationoftheExchangeRate
Afallinthevalueofthe inrelationtoother
currencies each buyslessoftheforeign
currencye.g.
1= 1.501= 1.45
UKexportsappeartobecheaper
(Xp)
ImportstotheUKappearmoreexpensive
(Mp)
Exchange Rates
Adepreciationinexchangerateshouldleadtoa
riseindemandforexports,afallindemandfor
imports the balanceofpayments should
improve
Anappreciationoftheexchangerateshouldlead
toafallindemandforexportsandarisein
demandforimports thebalanceofpayments
shouldgetworse BUT
Imports(Debits)
CurrentAccount:(M)
Goodsandservices
account)
transfer)
CapitalAccount:(CM)
Directinvestments
Securitypurchase
obligations,etc.
Exports(Credits)
CurrentAccount:(X)
Goodsandservices
account)
transfer)
CapitalAccount:(CX)
Directinvestments
Securitypurchase
obligations,etc.
112
TheU.S.BalanceofPayments,2005(MillionsofDollars)
Exchange Rates
$ per
Quant it y on
Foreign Ex. Market s
D
S
1.85
Q1
D
1
Q2
Short age
1.90
Q3
Assume an init ial
exchange rat e of
1 = $1. 85. There
are rumours t hat
t he UK is going t o
increase int erest
rat es
I nvest ing in t he
UK would now be
more at t ract ive
and demand for
would rise
The rise in demand
creat es a short age
in t he relat ionship
bet ween demand
for and supply
t he price ( exchange
rat e) would rise
WhatDoestheTradeBalance
Really Mean?
Soinspiteofitsname,anditsdefinition,the
tradebalance
Isnotreallyabouttrade,whichisjustthesymptom
Itis aboutwhetherwearelivingwithinourmeans
Whenisatradedeficitgood?
Whenthecountry(likeayoungperson)isinvesting
forthefuture(likeasuccessfuldevelopingcountry)
Notwhenitisgoingintodebtjusttofinancecurrent
consumption(liketheUS)
What i s t he gover nment debt
and t he annual budget def i ci t ?
Annual Deficit (2002)
The government debt
is an accumulation
of all past annual
deficits. In 2001, the
debt of the U.S. federal
government was $3.2
trillion.
When a government spends more than it collects in taxes, it borrows
from the private sector to finance the budget deficit.
Exchange Rates
Thevolumesandtheactualamountofincome
andexpenditurewilldependontherelativeprice
elasticityofdemandforimportsandexports.
ElasticityofM=%Q
M
/%P
M
ElasticityofX=%Q
X
/%P
X
Exchange Rates
FloatingExchangeRates:
Pricedeterminedonlybydemandandsupplyofthe
currency nogovernmentintervention
FixedExchangeRates:
Thevalueofacurrencyfixedinrelationtoan
anchorcurrency notallowedtofluctuate
DirtyFloatingorManagedExchangeRate:
rateinfluencedbygovernmentviacentralbank
aroundapreferredrate
Fixed vs Flexible Exchange Rate
Regimes
Pro&ConsforFloatingExchangeRate
Argumentsinfavorofflexibleexchangerates:
Easierexternaladjustments.
Nationalpolicyautonomy.
Argumentsagainstflexibleexchangerates:
Exchangerateuncertaintymayhamper
internationaltrade.
Nosafeguardstopreventcrises.
Regimes
Supposetheexchangerateis$1.40/ today.
Inthenextslide,weseethatdemandforBritish
poundsfarexceedsupplyatthisexchangerate.
TheU.S.experiencestradedeficits.
Regimes
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)
Supply
(S)
Flexible Exchange Rate
Regimes
Underaflexibleexchangerateregime,thedollarwill
simplydepreciateto$1.60/,thepriceatwhichsupply
equalsdemandandthetradedeficitdisappears.
Regimes
Supply
(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
r

(
e
x
c
h
a
n
g
e

r
a
t
e
)
$1.60
$1.40
Regimes
Instead,supposetheexchangerateisfixed at
$1.40/,andthustheimbalancebetweensupplyand
demandcannotbeeliminatedbyapricechange.
Thegovernmentwouldhavetoshiftthedemand
curvefromDtoD*
Inthisexamplethiscorrespondstocontractionary
monetaryandfiscalpolicies.
Regimes
Supply
(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
r

(
e
x
c
h
a
n
g
e

r
a
t
e
)
$1.40
1945
Price of
Sterling
$2.82
$2.78
D
D
S
S
a
D
D
b
c d
The Bank
must supply
cd each
period.
Purchasing Power Parity (PPP)
Thenominalexchangeratee isthepriceinforeign
currencyofoneunitofadomesticcurrency.
Therealexchangerate(RER) isdefinedas
RER=e(P/P
f
),whereP
f
istheforeignpricelevel
(priceindex)andP thedomesticpricelevel(price
index).
P andP
f
musthavethesamearbitraryvalueinsome
chosenbaseyear.Henceinthebaseyear,RER =e.
PurchasingPowerParity
inaPerfectCapitalMarket
Purchasingpowerparity(PPP) isbuiltonthenotion
ofarbitrageacrossgoodsmarketsandtheLawofOne
Price.
TheLawofOnePrice istheprinciplethatinaPCM
setting,homogeneousgoodswillsellforthesame
priceintwomarkets,takingintoaccountthe
exchangerate.
/ $ wheat UK, wheat US,
S P P =
TheRERisonlyatheoreticalideal.Inpractice,there
aremanyforeigncurrenciesandpricelevelvaluesto
takeintoconsideration.
Correspondingly,themodelcalculationsbecome
increasinglymorecomplex.Furthermore,themodel
isbasedonpurchasingpowerparity(PPP),which
impliesaconstantRER.
TheempiricaldeterminationofaconstantRERvalue
couldneverberealized,duetolimitationsondata
collection.
Purchasing Power Parity (PPP)
Therelationshipbetweentheexchangerate
andthepricelevelindifferentcountries.
Thepriceof intheforeigncurrency=Foreign
Countrypricelevel/UKpricelevel
PPPwouldimplythattheRERistherateatwhich
anorganizationcantradegoodsandservicesof
oneeconomy(e.g.country)forthoseofanother.
PurchasingPowerParityandExchangeRate
Determination
Determination
The exchange rate between two currencies should equal the
ratio of the countries price levels:
S($/) =
P
P
$
S($/) =
P
P
$
150
$300
= = $2/
For example, if an ounce of gold costs $300 in the U.S. and 150
in the U.K., then the price of one pound in terms of dollars
should be:
Theexchangeratewouldbeaproperreflectionofthe
purchasingpowerineachcountryiftherelativevalues
boughtthesameamountofgoodsineachcountry.
E.g.ifthepriceofapintofStellaintheUKwas3.00
andinEurope4.50,theexchangeratebetweenthe
twocountriesshouldbe1=1.50
Ifanylowerthanthisvalue,the wouldbe
undervaluedandifanyhigher,the wouldbe
overvalued.
Determination
The Big Mac PPP Standard
RealExchangeRates
PurchasingPowerParityandOvervalued
orUndervaluedCurrencies
Nominal exchange rates greater than the PPP implied
exchange rate represent foreign currency overvaluation
against 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).
PurchasingPowerParityandOvervaluedor
UndervaluedCurrencies
Example
Base period nominal exchange rate = $1.50/
Prices 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 in
comparison to the base period.
Nominal exchange rates greater than $1.5577/ represent overvaluation
($ undervaluation), while rates less than $1.5577/ represent $
overvaluation ( undervaluation).
PPPexchangeratesareespeciallyusefulwhen
officialexchangeratesareartificiallymanipulated
bygovernments.
Countrieswithstronggovernmentcontrolofthe
economysometimesenforceofficialexchange
ratesthatmaketheirowncurrencyartificially
strong.
Bycontrast,thecurrency'sblackmarketexchange
rateisartificiallyweak.InsuchcasesaPPP
exchangerateislikelythemostrealisticbasisfor
economiccomparison.
Determination
4.TheBalanceofPayments
TheBalanceofPayments
ArecordofthetradebetweenoneCountry
(UK)andtherestoftheworld.
Tradeingoods
Tradeinservices
Incomeflows
=CurrentAccount
Transferoffundsandsaleofassetsandliabilities
=CapitalAccount
Imports(Debits)
CurrentAccount:(M)
Goodsandservices
account)
transfer)
CapitalAccount:(CM)
Directinvestments
Securitypurchase
obligations,etc.
Exports(Credits)
CurrentAccount:(X)
Goodsandservices
account)
transfer)
CapitalAccount:(CX)
Directinvestments
Securitypurchase
obligations,etc.
U.S.BalanceofPaymentsData
Credits Debits
Current Account
1 Exports $1,418.64
2 Imports ($1,809.18)
3 Unilateral Transfers $10.24 ($64.39)
Balance on Current Account
($444.69)
Capital Account
4 Direct Investment $287.68 ($152.44)
5 Portfolio Investment $474.39 ($124.94)
6 Other Investments $262.64 ($303.27)
Balance on Capital Account
$444.26
7 Statistical Discrepancies
Overall Balance
$0.30
Official Reserve Account
($0.30)
0.73
Balanceofpaymentsequilibrium:
X+CM=M+CX
=>X M=CX CM
IfX>M=>CX>CM=>TheCountryexports
capital.
IfX<M=>CX<CM=>TheCountryimports
capital.
Balanceoftrade(BT)isthevalueof
merchandiseexportsminusimport:
BT=X M
BasicBalanceisthecurrentaccountpluslong
termcapital.
WhataffectstheCA?
CA deficit
0
CA(S
0
)
CA surplus
Domestic
Income (Y)
Y
0
Given the exchange rate, S
0
, there
exists some domestic income level, Y
0
,
where the current account is balanced.
WhataffectstheCA?
CA deficit
0
CA(S
0
)
CA surplus
Domestic
Income (Y)
Y
0
Y
1
An increase in income, Y, will cause
imports to rise with no change in
exports leading to a deterioration in
the current account.
WhataffectstheCA?
CA(S
1
)
CA deficit
0
CA(S
0
)
CA surplus
Domestic
Income (Y)
Y
0
Y
1
S domestic depreciation
causing imports to fall and
exports to rise, both of
which lead to an
improvement in the current
account.
WhataffectstheKA?
WhataffectstheKA?
KA deficit
r - r
*
KA surplus
KA
WhataffectstheKA?
WhataffectstheKA?
KA deficit
r - r
*
KA surplus
KA
If r > r
*
then capital will
flow into the domestic
economy and create a
capital account surplus.
WhataffectstheKA?
WhataffectstheKA?
KA deficit
r - r
*
KA surplus
KA
If r < r
*
then capital will
flow out of the domestic
economy and create a
capital account deficit.
WhataffectstheKA?
WhataffectstheKA?
KA deficit
r - r
*
KA surplus
KA
If r = r
*
then capital will
not have any incentive to
move and the capital
account will be in
balance.
TheBalanceofPaymentsIdentity
BCA+BKA+BRA=0
where
BCA=balanceoncurrentaccount
BKA=balanceoncapitalaccount
BRA=balanceonthereservesaccount
Underapureflexibleexchangerateregime,
BCA+BKA=0
BecauseBRA=0
Lecture 12: Trade Balance
TheU.S.BalanceofPayments,2005(MillionsofDollars)
152
TheU.S.CurrentAccountBalance,2005(MillionsofDollars)
StatisticalDiscrepancy
ComponentsoftheU.S.FinancialAccount,2005(MillionsofDollars)
PrivateFlowsintheU.S.FinancialAccount,2005(MillionsofDollars)
FDI
ReserveAssets
ReserveAssets
SDRs :SpecialDrawingRights
SDRs :SpecialDrawingRights
Credits Debits
Current Account
1 Exports $1,418.64
2 Imports ($1,809.18)
($444.69)
Capital Account
$444.26
Overall Balance
$0.30
($0.30)
0.73
In 2000, the
U.S. imported
more than it
exported, thus
running a
current account
deficit of
$444.69
billion.
Credits Debits
Current Account
1 Exports $1,418.64
2 Imports ($1,809.18)
($444.69)
Capital Account
$444.26
Overall Balance
$0.30
($0.30)
0.73
During the
same year, the
U.S. attracted
net investment
of $444.26
billionclearly
the rest of the
world found the
U.S. to be a
good place to
invest.
Credits Debits
Current Account
1 Exports $1,418.64
2 Imports ($1,809.18)
($444.69)
Capital Account
$444.26
Overall Balance
$0.30
($0.30)
0.73
Under a pure
flexible
exchange rate
regime, these
numbers would
balance each
other out.
Credits Debits
Current Account
1 Exports $1,418.64
2 Imports ($1,809.18)
($444.69)
Capital Account
$444.26
Overall Balance
$0.30
($0.30)
0.73
In the real
world, there
is a statistical
discrepancy.
Credits Debits
Current Account
1 Exports $1,418.64
2 Imports ($1,809.18)
($444.69)
Capital Account
$444.26
Overall Balance
$0.30
($0.30)
0.73
Including that,
the balance of
payments
identity should
hold:
BCA + BKA = BRA
- ($444.69) + $444.26 + $0.73 = $0.30= ($0.30)
Credits Debits
Current Account
1 Exports $1,418.64
2 Imports ($1,809.18)
($444.69)
Capital Account
$444.26
Overall Balance
$0.30
($0.30)
0.73
BalanceofPaymentsandtheExchange
Rate
Q
P
Exchange rate $
Credits Debits
Current Account
1 Exports
$1,418.64
2 Imports
($1,809.18)
($444.69)
Capital Account
$444.26
Overall Balance
$0.30
($0.30)
0.73
S
D
Q
P
As U.S. citizens import, they supply dollars to the FOREX market.
Credits Debits
Current Account
1 Exports $1,418.64
2 Imports ($1,809.18)
($444.69)
Capital Account
$444.26
Overall Balance
$0.30
($0.30)
0.73
Exchange rate $
S
D
Rate
Q
P
As U.S. citizens export, others demand dollars in the FOREX market.
Credits Debits
Current Account
1 Exports $1,418.64
2 Imports ($1,809.18)
($444.69)
Capital Account
$444.26
Overall Balance
$0.30
($0.30)
0.73
Exchange rate $
S
D
Rate
Q
P S
D
As the U.S. government sells dollars, the supply of dollars increases.
S
1
Credits Debits
Current Account
1 Exports $1,418.64
2 Imports ($1,809.18)
($444.69)
Capital Account
$444.26
Overall Balance
$0.30
($0.30)
0.73
Exchange rate $
Rate
BalanceofPaymentsTrends
Since1982theU.S.hasexperiencedcontinuous
deficitsonthecurrentaccountandcontinuous
surplusesonthecapitalaccount.
Duringthesameperiod,Chinahasexperiencedthe
opposite.
BalancesontheCurrent(BCA)andCapital(BKA)
AccountsoftheUnitedStates
-500
-400
-300
-200
-100
0
100
200
300
400
500
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
U.S. BCA
U.S. BKA
AccountsofUnitedKingdom
-50
-40
-30
-20
-10
0
10
20
30
40
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
UK BCA
UK BKA
AccountsofJapan
-150
-100
-50
0
50
100
150
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
Japan BCA
Japan BKA
AccountsofGermany
-80
-60
-40
-20
0
20
40
60
80
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
Germany BCA
Germany BKA
AccountsofChina
-15
-10
-5
0
5
10
15
20
25
30
35
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
China BCA
China BKA
What Does the Trade Balance
Really Mean?
FromNationalIncomeAccounting
(Illdothisfirstwithoutgovernment)
RecallfromEcon
GDP=Output=Income=Y
OutputandIncome:
Y=C+I+(X M)
Y=C+S
Therefore
X M=S I
Where
C=Consumption
I=Investment
X=Exports
M=Imports
S=Savings
Really Mean?
Thus
Tradesurplus savings>investment
Tradedeficit savings<investment
Ifwearenotsavingenoughtofinance
investment,howdowepayforit?
Byborrowingfromabroad,or
Bysellingassets
Really Mean?
(Thistimewith government)
Evenmoresimply
Y=C+I+G+(X M)
implies
X M=Y (C+I+G)
Really Mean?
X M=Y (C+I+G)
Soatradedeficit
(X M)<0
meansthatwearespending
(C+I+G)
morethanourincomeY
T
r
a
d
e

S
u
r
p
l
u
s E
x
p
e
n
d
i
t
u
r
e
Income
BalanceofPaymentsandNationalIncome
Accounting
GNP=Y=C+I+G+X M
Y=C+S+T(Incomeallocation)
X M=(S I)+(T G)
Ifadevelopingeconomyexperienceslargetrade
deficits(XM<0),theremediesare:
1. Savingsmustincrease,S
2. Investmentmustfall,I
3. Governmentspendingmustfall,G
4. Taxesmustrise,T
What i s t he gover nment debt
and t he annual budget def i ci t ?
The government debt
is an accumulation
of all past annual
deficits. In 2001, the
debt of the U.S. federal
government was $3.2
trillion.
When a government spends more than it collects in taxes, it borrows
from the private sector to finance the budget deficit.
Really Mean?
Soinspiteofitsname,anditsdefinition,the
tradebalance
Isnotreallyabouttrade,whichisjustthesymptom
Itis aboutwhetherwearelivingwithinourmeans
Whenisatradedeficitgood?
Whenthecountry(likeayoungperson)isinvesting
forthefuture(likeasuccessfuldevelopingcountry)
Notwhenitisgoingintodebtjusttofinancecurrent
consumption(liketheUS)
5. Interest Rates, Interest rate parity &
Exchange Rates
Whatistheinterestrate?
Whatisitsrelationshiptoexchangerates?
Whatusefulpropertiescanwetakefromthis
relationship?
FourTypesofCreditInstruments
1. Simpleloan
2. Fixedpaymentloan
3. Couponbond
4. Discount(zerocoupon)bond
ConceptofPresentValue
Simpleloanof$1at10%interest
Year 1 2 3 n
$1.10 $1.21 $1.33 $1x(1+i)
n
$FV
PVoffuture$1=
(1+i)
n
PresentValue
YieldtoMaturity:Loans
1. SimpleLoan(i =10%)
$100=$110/(1+i)
$110 $100 $10
i = = =0.10=10%
$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
YieldtoMaturity:Bonds
4. Discount Bond (P = $900, F = $1000), one year

$1000
$900 =
(1+i)
$1000 $900
i = = 0.111 = 11.1%
$900
F P
i =
P
3. 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
C C
P = i =
i P
Current Price or (Current Price + Par Value)/2
DistinctionBetweenInterest
RatesandReturns
RateofReturn
C +P
t+1
P
t
RET = =i
c
+g
P
t
C
where: i
c
= = current yield
P
t
P
t+1
P
t
g = = capital gain
P
t
RelationshipBetweenPrice
andYieldtoMaturity
CASHFLOWCHARACTERISTICS
AFIVEYEARBONDWITHA7%COUPON.
PRICEISTHESUMOFTHEPRESENTVALUEOF
THECASHFLOWS,DISCOUNTEDATAN
APPROPRIATEMARKETYIELD:ASYIELDRISES,
PRICEFALLS;ASYIELDFALLS,PRICERISES.
107
PRICE
1
2 3 4
5
7 7 7 7
CLASSIFYINGBONDS
WHEREISSUED
DOMESTICBONDS
FOREIGNBONDS
EUROBONDS
THEISSUER
CENTRALGOVERNMENTSANDGOVERNMENTAGENCIES
STATEANDLOCALGOVERNMENTS
COMPANIES
SUPRANATIONALINSTITUTIONS(EG.WORLDBANK)
THETYPEOFBOND
THETYPEOFBOND
Fixedratebonds haveacouponthatremainsconstantthroughoutthe
lifeofthebond.
Floatingratenotes (FRNs)haveavariablecouponthatislinkedtoa
referencerateofinterest.Thecouponrateisrecalculatedperiodically,
typicallyeveryoneorthreemonths.
Zerocouponbonds paynoregularinterest.Theyareissuedata
substantialdiscounttoparvalue,sothattheinterestiseffectively
rolleduptomaturity(andusuallytaxedassuch).
Inflationlinkedbonds,inwhichtheprincipalamountandthe
interestpaymentsareindexedtoinflation.However,astheprincipal
amountgrows,thepaymentsincreasewithinflation.
Treasurybond,alsocalledgovernmentbond.
Municipalbond isabondissuedbyastate,U.S.Territory,city,local
government,ortheiragencies.
Bearerbond isanofficialcertificateissuedwithoutanamedholder.
Registeredbondisabondwhoseownership(andanysubsequent
purchaser)isrecordedbytheissuer,orbyatransferagent.It isthe
alternativetoaBearerbond.
RealInterestRate(theFisherhypothesis(sometimesFisher
parity)
Interestratethatisadjustedforexpectedchangesinthe
pricelevel
i
r
=i
n

e
Realinterestrate(i
r
)moreaccuratelyreflectstruecostof
borrowing
Whenrealrateislow,greaterincentivestoborrowandless
tolend
ifi
n
=5%and
e
=3%then:
i
r
=5% 3%=2%
ifi
n
=8%and
e
=10%then
i
r
=8% 10%=2%
Distinction Between Real & Nominal
Interest Rates
TheFisherhypothesis saysthatthereal interestrate in
aneconomyisindependentofmonetary variables.If
weaddtothistheassumptionthatrealinterestrates
areequatedacrosscountries,thenthecountrywith
thelowernominalinterestrate wouldalsohavea
lowerrateofinflation andhencetherealvalueofits
currencywouldriseovertime.
Supposethatthecurrentspotexchangerate forU.S.
DollarsintoBritishPoundsis$1.4339perpound.Ifthe
currentinterestrateis5percentintheU.S.and7percent
inBritain,whatistheexpectedspotexchangeperpound
rate12monthsfromnowaccordingtotheInternational
FisherEffect?
TheInternationalFisherEffectestimatesfutureexchange
ratesbasedontherelationshipinnominalinterestrates.
Multiplyingthecurrentspotexchangeratebythenominal
annualU.S.interestrateanddividingbythenominal
annualBritishinterestrateyieldstheestimateofthespot
exchangerate12monthsfromnow($1.4339*1.05)/1.07=
$1.4071.
U.S. Real and Nominal Interest Rates
InterestRateParity
InterestRateParityDefined
CoveredInterestParity
InterestRateParity&ExchangeRateDetermination
UncoveredInterestParity
CoveredInterestParity(CIP)
Defined
IRPisanarbitrage condition.
IfIRPdidnothold,thenitwouldbepossibleforan
smarttradertomakeunlimitedamountsofmoney
exploitingthearbitrageopportunity.
Sincewedonttypicallyobservepersistentarbitrage
conditions,wecansafelyassumethatIRPholds.
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
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 valueotherwise an arbitrage would exist, therefore
(F/S)(1 + i
) = (1 + i
$
)
$100,000 $100,000(1 + i
$
)
$100,000(F/S)(1 + i
) 1. Trade $100,000 for at S

2. Invest $100,000 at i
S
3. One year later,
trade for $ at F
Formally,
(F/S)(1 + i
) = (1 + i
$
)
or if you prefer,
IRP is sometimes approximated as
1 + i
1 + i
$
=
S
F
i
$
i
=
S
F S
Depending upon how you quote the exchange rate ($ per
or per $) we have:
1 + i
$
1 + i
S
/$
F
/$
=
1 + i
$
1 + i
S
$/
F
$/
=
or
CIPandCoveredInterest
Arbitrage
A trader with $1,000 to invest could invest in the U.S., in one year
his investment will be worth $1,071 = $1,000(1+ i
$
) =
$1,000(1.071)
Alternatively, this trader could exchange $1,000 for 800 at the
prevailing spot rate, (note that 800 = $1,000$1.25/) invest 800
at i
= 11.56% for one year to achieve 892.48. Translate 892.48

back into dollars at F
360
($/) = $1.20/, the 892.48 will be exactly
$1,071.
CoveredInterestArbitrage
$1,000 $1,071
$1,071 1. Trade $1,000 for 800
S($/) = $1.25/
3. One year later, trade
892.48 for $ at
F
360
($/) = $1.20/
2. Invest 800 at 11.56% = i
InterestRateParity
&ExchangeRateDetermination
InterestRateParity
&ExchangeRateDetermination
According to IRP only one 360-day forward rate,
F
360
($/), can exist. It must be the case that
F
360
($/) = $1.20/
Why?
If F
360
($/) $1.20/, an smart trader could make money
with one of the following strategies:
ArbitrageStrategyI
If F
360
($/) > $1.20/
i. Borrow $1,000 at t = 0 at i
$
= 7.1%.
ii. Exchange $1,000 for 800 at the prevailing spot
rate, (note that 800 = $1,000$1.25/) invest 800
at 11.56% (i
) for one year to achieve 892.48

iii. Translate 892.48 back into dollars, if
F
360
($/) > $1.20/ , 892.48 will be more than enough
to repay your dollar obligation of $1,071.
ArbitrageStrategyII
If F
360
($/) < $1.20/
i. Borrow 800 at t = 0 at i
= 11.56% .
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 enough
to repay your obligation of 892.48.
UncoveredInterestrateparity
6.
Markowitz PortfolioTheory
Asingleassetorportfolioofassetsisefficientifno
otherassetorportfolioofassetsoffershigher
expectedreturnwiththesame(orlower)risk,or
lowerriskwiththesame(orhigher)expectedreturn.
ModernPortfolioTheory
MPTisamathematicalformulationoftheconceptof
diversificationininvesting,withtheaimofselectinga
collectionofinvestmentassetsthathascollectively
lowerriskthananyindividualasset.Thatthisis
possiblecanbeseenintuitivelybecausedifferent
typesofassetsoftenchangeinvalueinoppositeways.
Forexample,aspricesinthestockmarkettendto
moveindependentlyfrompricesinthebondmarket,
acollectionofbothtypesofassetscanthereforehave
loweroverallriskthaneitherindividually.
MethodstoDiversify
Diversifybya
1. TradeinAmericanDepositoryReceipts(ADRs)
2.TradeinAmericanshares
3.Tradeinternationallydiversifiedmutualfunds:
a. Global(alltypes)
b. International(nohome
countrysecurities)
c. Singlecountry
INTERNATIONALPORTFOLIO
INVESTMENT
CalculationofExpectedPortfolioReturn:
r
p
=ar
US
+(1 a)r
rw
where
r
p
=portfolioexpectedreturn
r
US
=expectedU.S.marketreturn
r
rw
=expectedglobalreturn
ExpectedPortfolioReturn
SampleProblem
Whatistheexpectedreturnofaportfolio
with35%investedinJapanreturning10%
and65%intheU.S.returning5%?
r
p
=ar
US
+(1 a)r
rw
=.65(.05)+.35(.10)
= .0325+.0350
= 6.75%
Capitalassetspricingmodel
Thecapitalassetpricingmodel(CAPM) isused
todetermineatheoreticallyappropriaterequired
rateofreturnofanasset,ifthatassetistobe
addedtoanalreadywelldiversifiedportfolio,
giventhatasset'snondiversifiablerisk.The
modeltakesintoaccounttheasset'ssensitivityto
nondiversifiablerisk(alsoknownassystematic
riskormarketrisk).
ArbitrageandtheAPT
ArbitrageandtheAPT
Arbitrageisthepracticeoftakingadvantageofastate
ofimbalancebetweentwo(orpossiblymore)markets
andtherebymakingariskfreeprofit
1.ASecuritysReturnsmaybe
segmentedinto
SystematicRisk
cannotbeeliminated
NonsystematicRisk
canbeeliminatedbydiversification
TotalRisk
INTERNATIONAL
DIVERSIFICATION
Internationaldiversificationandsystematicrisk
a. Diversifyacrossnationswith
differenteconomiccycles
b. Whilethereissystematicrisk
withinanation,outsidethecountry
itmaybenonsystematicand
diversifiable
TheBenefitsofIntl
Diversification
7.ForecastingExchangeRates
FundamentalApproach
TechnicalApproach
FinancialMarketsareefficient ifpricesreflectallavailableand
relevantinformation.
Ifthisisso,exchangerateswillonlychangewhennew
informationarrives,thus:
S
t
= E[S
t+1
]
and
F
t
= E[S
t+1
| I
t
]
Predictingexchangeratesusingtheefficientmarketsapproachis
affordableandishardtobeat.
FundamentalApproach
MV=PY P=MV/Y
PPP S=P/P
*
Combinesothats = a
0
+a
1
(m-m
*
)+a
2
(i-i
*
)+a
3
(y-y
*
)
Involveseconometricstodevelopmodelsthatuseavarietyofexplanatory
variables.Thisinvolvesthreesteps:
step1:Estimatethestructuralmodel.
step2:Estimatefutureparametervalues.
step3:Usethemodeltodevelopforecasts.
Thedownsideisthatfundamentalmodelsdonotworkanybetterthanthe
forwardratemodelortherandomwalkmodel.
1 2 3
0, 0, 0
s s s
a a a
m i y

= > = > = <

TechnicalApproach
Technicalanalysislooksforpatternsinthepast
behaviorofexchangerates.
Clearlyitisbaseduponthepremisethathistory
repeatsitself.
ThusitisatoddswiththeEMH
TechnicalAnalysis
TechnicalAnalysis
Forecastingisdifficult,especiallywithregardtothe
future.
Asawhole,forecasterscannotdoabetterjobof
forecastingfutureexchangeratesthantheforward
rate.
ThefounderofForbes Magazineoncesaid:
Youcanmakemoremoneysellingfinancialadvice
thanfollowingit.
ForecastingPerformance
BanksForecasts
8.Recentdevelopmentsof
internationalfinance
The Spirit of the European Monetary System, 1979
ThisisapursuitbyEuropeannationstolimit
exchangeratefluctuationsagainsteachotherandto
establishcoordinatedmacroeconomicpolicies
acrossEurope.
The Spirit of the European Monetary System, 1979
TheEuropeanMonetarySystem(EMS)wasbuilt
uponthreebuildingblocks:
theEuropeanCurrencyUnit(ECU)asanaccounting
currency,
theExchangeRateMechanism(ERM)asafixing
exchangeratesontotheEuropeanCurrencyUnit (ECU)
inordertostabiliseexchangeratesandcounter
inflation,and
theEuropeanMonetaryCooperationFund(EMCF).
The Spirit of the European Monetary
System, 1979
The European Currency Unit was a basket of the currencies
of the European Community member states, used as the unit
of account of the European Community before being
replaced by the euro on January 1, 1999, at parity.
The ECU itself replaced the European Unit of Account, also
at parity, on March 13, 1979.
The ECU was also used in some international financial
transactions, where its advantage was that securities
denominated in ECUs provided investors with the
opportunity for foreign diversification without reliance on
the currency of a single country.
System, 1979
All member countries :
Fix a par value for each exchange rate in terms of the
European Currency Unit, a basket weighted according
to country size.
Keep exchange rates stable in the short-run by limiting
movements in bilateral rates - the Exchange Rate
Mechanism.
Hold foreign exchange reserves primarily in ECUs
with the European Monetary Cooperation Fund, and
reduce US$ reserves.
System, 1979
The three building blocks of the EMS linked together European
exchange rates and monetary policies until the chaotic events of 1992
and 1993
Leaders reached agreement on currency union with the Maastricht
Treaty, signed on 7 February 1992. It agreed to create a single currency,
although without the participation of the United Kingdom, by January
1999.
Gaining approval for the treaty was a challenge. Germany was
cautious about giving up its stable currency, i.e. the German Mark,
France approved the treaty by a narrow margin.
Denmark refused to ratify until they got an opt out from monetary
union as the United Kingdom, an opt-out which they maintain as of
2010.
On 16 September 1992, known in the UK as Black Wednesday, the
British pound sterling was forced to withdraw from the fixed exchange
rate 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 price
level.
Member countries except Germany:
Intervene to stabilize currency values vis--vis the DM.
Germany:
Remain passive in the foreign exchange market with
respect to other EMS countries. Set German monetary
policy independently to serve as an anchor for the EMS
price level.
EMU(EuropeanMonetaryUnion
SomeEuropeanleaderswantedtoachieveaneven
closereconomicandsocialunion.
TheDelors reportof1989setoutaplanto
introducetheEMUinthreestages anditincluded
thecreationofinstitutionssuchastheEuropean
SystemofCentralBanks(ESCB),
UndertheEMU,asinglecentralbankwouldset
monetarypolicyforasingleEuropeanmoney.
The1991MaastrichtTreatyspelledoutthestepsneeded
totransfertheresponsibilitiesformonetarypolicyand
nationalmoniestoanewECinstitution.
ThreeofstepsEMU
Beginningthefirstofthesesteps,on1July1990,
exchangecontrolswereabolished,thuscapital
movementswerecompletelyliberalisedinthe
EuropeanEconomicCommunity.
Leadersreachedagreementoncurrencyunionwith
theMaastrichtTreaty,signedon7February1992.
Itagreedtocreateasinglecurrency,although
withouttheparticipationoftheUnitedKingdom,
byJanuary1999.
EMU(EuropeanMonetaryUnion
The Spirit of the European Economic and
Monetary Union, 1999
TheEMUwaslaunchedonJanuary1,1999with11
member
countries.
The European Central Bank (ECB) has sole
responsibility for monetary policy among EMU
countries.
National governments set other economic policies
such as taxation and expenditures within a set of
commonly agreed rules.
Old legacy currencies (replacing the name Ecu used
for the previous accounting currency), are
exchanged for the new surviving currency, the euro.
The Spirit of the European Economic and
Monetary Union, 1999
In order to participate in the new currency, member states
had to meet strict criteria such as a budget deficit of less
than 3% of their GDP, a debt ratio of less than 60% of
GDP, low inflation, and interest rates close to the EU
average.
Greece failed to meet the criteria and was excluded from
participating on 1 January 1999.
The Value of the Euro in Terms of the Eleven
Legacy 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 markkaab
France 6.55957 francs
Germany 1.95583 marks
Ireland 0.787564 punt
Italy 1,936.27 lire
Luxembourg 40.3399 francs
Netherlands 2.20371 guilders
Portugal 200.482 escudos
Spain 166.386 pesetas
GlobalFinancialCrisesandtheIMF
IMFbailoutsfortroubledeconomies
Mexico(1995)
Thailand,Indonesia,Korea(1997)
Russia,Brazil(1998)
Turkey(2001)
Argentina(2001)
FinancialCrisis
FinancialCrisis bankingcrisis,exchangeratecrisis,
oracombinationofthetwo
Bankingcrisis bankingsystemsbecomingunableto
performitsnormallendingfunctions
Disintermediation banksbecomingunabletoserveas
intermediariesbetweensaversandinvestors
Exchangeratecrisis suddenandunexpectedcollapse
inthevalueofanationscurrency
FinancialCrisis
FinancialCrisisoftenfollowedbysevererecession
Bankingcrisis banksfailasresultofbadlendingpolicies,and
banklendingdriesup
Exchangeratecrisis banksoftenhaveborroweddollars
abroad,convertedtolocalcurrencytoinvest thenwhenlocal
currencycollapses,cantpaybackdollarloans banksfailand
banklendingdriesup also,foreigninvestmentdriesup
FinancialCrisisandExchangeRates
Underafixedexchangeratesystem,crisisentailsthelossof
internationalreservesanddevaluation
Underaflexibleexchangeratesystem,crisismeansan
uncontrolled,rapiddepreciationofthecurrency
Countrieswithapeggedexchangeratemaybemore
vulnerabletoacrisis evencrawlingpegs
TwoCausesofFinancialCrises
Crisescausedbymacroeconomicimbalances,suchas
largebudgetdeficitscausedbyoverlyexpansionary
fiscalpolicies
Example:Argentina financialcrisisin2001
Crisescausedbyvolatilecapitalflows
Example:theEastAsianfinancialcrisisof19971998
DomesticIssuesinCrisisAvoidance
Probleminfinancialsectorregulation
Moralhazard incentivetodothewrongthing:bankshave
anincentivetomakeriskierinvestmentswhentheyknow
theywillbe
bailedout
Moralhazardproblemsareexacerbatedbygovernments
providingincentivesorthreateningbankstomakebadloans
forpoliticalends
EscapingMoralHazard
Theproblemofmoralhazardisinescapableifpoliciestoprotect
thefinancialsectorexist
Waytodecreasetheproblem:establishsupervisionand
regulationstandardsforinternationallyactivebanks
BaselCapitalAccord formulatedin1989bybankregulators
fromindustrializedcountries;adoptedbymorethan100
countries
TheNewBaselCapitalAccordof2001updatedtheprevious
standards
TheMexicanPesoCrisis
On20December,1994,theMexicangovernment
announcedaplantodevaluethepesoagainstthe
dollarby14percent.
Thisdecisionchangedcurrencytradersexpectations
aboutthefuturevalueofthepeso.
Theystampededfortheexits.
Intheirrushtogetoutthepesofellbyasmuchas40
percent.
The value of the Peso 1994-1995
Howdoesadevaluationaffectforeign
investors?
Ifaforeigninvestor(assumeU.S.)purchasesaMexicanasset,
theymustpurchasepesosfirst.
Whentheassetissoldtheproceedsmustbeexchangedfor$
priortobeingrepatriated,theU.S.investorsreturnisaffected
bytheexchangerateatthattime.
Ifitishigher(pesoappreciation)thereturntoU.S.investoris
largerin$terms.
Ifpesohasdepreciated,the$returnswillbelower.
TheMexicanPesoCrisis
TheMexicanPesocrisisisuniqueinthatitrepresentsthefirst
seriousinternationalfinancialcrisistouchedoffbycrossborder
flightofportfoliocapital.
Twolessonsemerge:
Itisessentialtohaveamultinationalsafetynetinplaceto
safeguardtheworldfinancialsystemfromsuchcrises.
Aninfluxofforeigncapitalcanleadtoanovervaluationinthe first
place.
AsianCrisis,199798
Fivecountries:SouthKorea,Thailand,Malaysia,the
Philippines,Indonesia
Indonesiaisworldsfifthlargestcountryby
population(200millionpeoplebackthen)
SouthKoreaisnowconsideredanindustrialized
country
AsianCrisis,199798
196797,thesefivecountriesaveragedrealGDP
growthof610percentperyear
theywerecalledtheAsiantigers
theirperformancewascalledtheAsianmiracle
199798,theywentfromAsianmiracle toAsian
meltdown
AsianCrisis,199798
Economicandfinancialcrisis
Beganinfinancialsector,spreadtorealeconomy
BeganinThailand,spreadtonearbycountries
(contagion)
AsianCrisis,199798
Hot economieshadattractedalotofforeigninvestment
muchofitshorttermthatcouldbequicklywithdrawnatfirst
signoftrouble
Bankingsystemsandfinancialsystemscouldnthandleallthis
capital muchofitwentintoquestionableloans,realestate,
stockmarket,etc.
Otherinternalproblems:laxregulation,nepotism,expectation
ofgovernmentbailoutifinvestmentswentbad
AsianCrisis,199798
ExternalFactor StrengthofU.S.Dollar
U.S.dollarroseby50%againstJapaneseyen,199597
Eachcountryusedbasketpegwith$asdominant
currencyinbasket(80%+)
Risingdollarmeanteachcurrencywasalsorising,so
bigexportslowdown
Tradewas3040percentofGDP
AsianCrisis,199798
Speculativebubbleofinflatedpricesburst(stock,real
estate,etc.),thencapitalflightoutofcountryas
investmentsturnedsour
Peggedexchangeratescouldnthold,socurrencies
devalued,thenfloated
Asian Currency Values versus U.S. $ 1997-1998
AsianCrisis,199798
FromJuly1,1997toJanuary24,1998
Thaibahtfellby55%againstdollar
Malaysianringgit fellby45%
Koreanwonfellby49%
Philippinepesofellby39%
Indonesianrupiah fellby84%
Allnowfloatingexcepttheringgit
AsianCrisis,199798
in1998,negativerealGDP growthrangingfrom0.6%
(Philippines)to13.2%percent(Indonesia) severe
recession
weakJapaneseeconomycouldntprovidesupport
neededforquickrecovery
AsianCrisis,199798
Allfivecountriesreturnedtopositiverealgrowthin
1999,butsomehavestillnotfullyrecoveredfrom
crisis
thiscontrastswithcaseofMexico,whichwas
expandingnicelyoneyearafterits1995crisis,dueto
boomingU.S.economy
TheAsianCurrencyCrisis
TheAsiancurrencycrisisturnedouttobefarmoreserious
thantheMexicanpesocrisisintermsoftheextentofthe
contagionandtheseverityoftheresultanteconomicandsocial
costs.
Manyfirmswithforeigncurrencybondswereforcedinto
bankruptcy.
Theregionexperiencedadeep,widespreadrecession.
ArgentinaCrisis 2001
Priorto1990s,yearsofgovernmentdeficits,politicalcorruption,
hyperinflation,bankruptcy,economicstagnation
In1991,reformsincludedCurrencyBoard everypesobacked
byonedollarinreserves,withpesosconvertibleintodollars
Monetarypolicynowtiedtobalanceofpayments government
couldntjustprintmorepesostofinancedeficitsrestored
credibilitytopeso
Workedwellforawhile
Weakdollarpriorto1995madeiteasiertomaintain
pesodollarpeg
RealGDPgrewby10%ineachoffirsttwoyears,6%in
eachofnexttwoyears
ContinuingProblemgovernmentspendingand
budgetdeficitsgrewrapidlythroughout1990s
Atfirst,privatization hidproblem
Provincialgovernmentsespeciallyprofligate,benefiting
mainlyelectedofficialsandfriends
Spendingbingefinancedlargelybyexternaldebt,
whichbecameunmanageable
NewProblems
Strengtheningdollarafter1995
Hurtexports,increasedimports
16percentoftradewaswithU.S.,sopeggingtojustthe
dollarmaynothavebeenwise
Brazildevaluedrealin1999from1.16perdollarto1.82
perdollar
Argentinas2
nd
largesttradingpartner
CrisiscametoaheadinDecember2001
Defaults,unemployment,largepriceincreases,
violenceinthestreets,runonbanks,peopledenied
accesstotheirmoney,etc.
FivePresidentswithinonemonth
Argentine Peso vs U.S. Dollar:
Collapse of a Currency Board
Pesodevalued(floated)againstdollarand
convertibilityended(bothinviolationoflaw)
Dollardenominatedaccountsfrozen
Pesodenominatedaccountsfellinvaluevisvisthe
dollarfrom$1.00to$0.34perpeso
RealGDPfellby4%in2001andby11%in2002
Largeincreaseinpovertyasresult
ButArgentinahasbeendoingmuchbettersince,
with8%realgrowthin2003and8%(est.)realgrowth
in2004
ArgentinarecentlyreceivednewIMFloans(early
2003)enablingittoavoiddefaultingonpreviousIMF
loans
IMFusuallyprescribesdevaluationplusbudget
austerity(highertaxesandreducedgovernment
spending)asconditionforloans
CurrencyCrisisExplanations
Intheory,acurrencysvaluemirrorsthefundamentalstrengthof
itsunderlyingeconomy,relativetoothereconomies.Inthelong
run.
Intheshortrun,currencytradersexpectationsplayamuchmore
importantrole.
Intodaysenvironment,tradersandlenders,usingthemost
moderncommunications,actbyfightorflightinstincts.For
example,iftheyexpectothersareabouttosellBrazilianreals for
U.S.dollars,theywanttogettotheexitsfirst.
Thus,fearsofdepreciationbecomeselffulfillingprophecies.
MoralHazardAgain
Probleminfinancialsectorregulation
Moralhazard incentivetodothewrongthing:bankshave
anincentivetomakeriskierinvestmentswhentheyknow
theywillbe
bailedout
Moralhazardproblemsareexacerbatedbygovernments
providingincentivesorthreateningbankstomakebadloans
forpoliticalends
AppliestoIMFloansaswell countriesknowlender
oflastresort isthere
Measure of Financial Vulnerability of Various Developing
Economies as of June 1997
ReformoftheInternationalFinancial
Architecture
Reformoftheinternationalfinancialarchitecture new
internationalpoliciesforavoidingandmanagingfinancialcrises
Thegreatvarietyofreformproposalsfocusontwoissues:
Roleofaninternationallenderoflastresort
Conditionality thechangesineconomicpolicythat
borrowingnationsarerequiredtomakeinordertoreceive
loansfromthelenderoflastresort
LenderofLastResort
Lenderoflastresort asourceofloanable fundsafter
allcommercialsourcesoflendingbecomeunavailable
Thecentralbankinthenationaleconomy
TheIMF,withthesupportofhighincomecountries,in
theinternationaleconomy
LenderofLastResort
Opponentsofinternationallenderoflastresortcite
moralhazardproblems
Proponents:moralhazardcanbedecreasedby
financialsectorregulations,suchastheBaselCapital
Accord
Ifownersoffinancialfirmsrisklossesintheeventofa
meltdown,theywillnotengageinexcessiverisk
LenderofLastResort
DebateontheIMFs roleasalenderoflastresortand
moralhazardcenters on:
LevelofIMFinterestrates:shouldtheratesbehigher?
Lengthofthepaybackperiod:shouldtheperiodbeshorter?
Sizeofloans:countriesoftenexceedtheborrowing
limitationof300%abovetheirquota;shouldtheborrowing
limitsbecurbed?
Conditionality
Conditionality thechangesineconomicpolicythat
borrowingnationsarerequiredtomakeinorderto
receiveloansfromthelenderoflastresort(IMF)
Typicallycoversmonetaryandfiscalpolicies,exchange
ratepolicies,andstructuralpoliciesaffectingthe
financialsector,internationaltrade,andpublic
enterprises
Conditionality
Criticsofconditionalityargue:
Theneedtocomplywithconditionsmayintensifythe
recessionaryeffectsofacrisis
Conditionalitymayentailhighsocialcostsonthe
poorestmembersofthesociety
International Monetary Fund
(IMF)
TheIMFdescribesitselfas"anorganizationof186
countries(asofJune29,2009),workingtofoster
globalmonetarycooperation,securefinancial
stability,facilitateinternationaltrade,promotehigh
employmentandsustainableeconomicgrowth,and
reducepoverty".
WiththeexceptionofTaiwan (expelledin1980),
NorthKorea,Cuba (leftin1964), Andorra,Monaco,
Liechtenstein,Tuvalu andNauru,allUNmember
states participatedirectlyintheIMF.
DomesticIssuesinCrisisAvoidance
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
u-a:-
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Other factors that will shift R

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

) 1. Trade $100,000 for at S

= 11.56% for one year to achieve 892.48. Translate 892.48

) for one year to achieve 892.48

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