1 | P a g e FUNDAMENTALS OF MULTINATIONAL BUSINESS FINANCE NOTES (CHAPTERS 3-7 & 9) CHAPTER 3 ? THE INTERNATIONAL MONETARY SYSTEM Learning Objectives ? Learn how the international monetary system has evolved from the days of the gold standard to today?s eclectic currency arrangement ? Analyze the characteristics of an ideal currency ? Explain the currency regime choices faced by emerging market countries ? Examine how the euro, a single currency for the European Union, was created History of the International Monetary System: ? The Gold Standard, 1876-1913 ? Countries set par value for their currency in terms of gold ? This came to be known as the gold standard and gained acceptance in Western Europe in the 1870s ? The US adopted the gold standard in 1879 ? The ?rules of the game? for the gold standard were simple ? Example: US$ gold rate was $20.67/oz, the British pound was pegged at £4.2474/oz ? US$/£ rate calculation is $20.67/£4.2472 = $4.8665/£ ? Because governments agreed to buy/sell gold on demand with anyone at its own fixed parity rate, the value of each currency in terms of gold, the exchange rates were therefore fixed ? Countries had to maintain adequate gold reserves to back its currency?s value in order for regime to function ? The gold standard worked until the outbreak of WWI, which interrupted trade flows and free movement of gold thus forcing major nations to suspend operation of the gold standard ? The Inter-War years and WWII, 1914-1944 ? During WWI, currencies were allowed to fluctuate over wide ranges in terms of gold and each other, theoretically, supply and demand for imports/exports caused moderate changes in an exchange rate about an equilibrium value ? The gold standard has a similar function ? In 1934, the US devalued its currency to $35/oz from $20.67/oz prior to WWI ? From 1924 to the end of WWII, exchange rates were theoretically determined by each currency's value in terms of gold. ? During WWII and aftermath, many main currencies lost their convertibility. The US dollar remained the only major trading currency that was convertible ? Bretton Woods and the IMF, 1944 ? Allied powers met in Bretton Woods, NH and created a post-war international monetary system ? The agreement established a US dollar based monetary system and created the IMF and World Bank ? Under original provisions, all countries fixed their currencies in terms of gold but were not required to exchange their currencies ? Only the US dollar remained convertible into gold (at $35/oz with Central banks, not individuals) 2 | P a g e ? Therefore, each country established its exchange rate vis-à-vis the US dollar and then calculated the gold par value of their currency ? Participating countries agreed to try to maintain the currency values within 1% of par by buying or selling foreign or gold reserves ? Devaluation was not to be used as a competitive trade policy, but if a currency became too weak to defend, up to a 10% devaluation was allowed without formal approval from the IMF ? The Special Drawing Right (SDR) is an international reserve assets created by the IMF to supplement existing foreign exchange reserves ? It serves as a unit of account for the IMF and is also the base against which some countries peg their exchange rates ? Defined initially in terms of fixed quantity of gold, the SDR has been redefined several times ? Currently, it is the weighted average value of currencies of 5 IMF members having the largest exports ? Individual countries hold SDRs in the form of deposits at the IMF and settle IMF transactions through SDR transfers ? Fixed exchange rates, 1945-1973 ? Bretton Woods and IMF worked well post WWII, but diverging fiscal and monetary policies and external shocks caused the system?s demise ? The US dollar remained the key to the web of exchange rates ? Heavy capital outflows of dollars became required to meet investors? and deficit needs and eventually this overhang of dollars held by foreigners created a lack of confidence in the US? ability to meet its obligations ? This lack of confidence forced President Nixon to suspend official purchases or sales of gold on Aug. 15, 1971 ? Exchange rates of most leading countries were allowed to float in relation to the US dollar ? By the end of 1971, most of the major trading currencies had appreciated vis-à-vis the US dollar; i.e. the dollar depreciated ? A year and a half later, the dollar came under attack again and lost 10% of its value ? By early 1973 a fixed rate system no longer seemed feasible and the dollar, along with the other major currencies was allowed to float ? By June 1973, the dollar had lost another 10% in value The IMF?s Exchange Rate Index of the Dollar: 3 | P a g e Contemporary Currency Regimes: ? The IMF today is composed of national currencies, artificial currencies (such as the SDR), and one entirely new currency (Euro) ? All of these currencies are linked to one another via a ?smorgasbord? of currency regimes ? IMF Exchange Rate Regime Classifications ? Exchange Arrangements with No Separate Legal Tender: Currency of another country circulates as sole legal tender or member belongs to a monetary or currency union in which same legal tender is shared by members of the union ? Currency Board Arrangements: Monetary regime based on implicit national commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate ? Other Conventional Fixed Peg Arrangements: Country pegs its currency (formal or de facto) at a fixed rate to a major currency or a basket of currencies where exchange rate fluctuates within a narrow margin or at most ± 1% around central rate ? Pegged Exchange Rates w/in Horizontal Bands: Value of the currency is maintained within margins of fluctuation around a formal or de facto fixed peg that are wider than ± 1% around central rate ? Crawling Peg: Currency is adjusted periodically in small amounts at a fixed, preannounced rate in response to changes in certain quantitative measures ? Exchange Rates w/in Crawling Peg: Currency is maintained within certain fluctuation margins around a central rate that is adjusted periodically ? Managed Floating w/ No Preannounced Path for Exchange Rate: Monetary authority influences the movements of the exchange rate through active intervention in foreign exchange markets without specifying a pre-announced path for the exchange rate ? Independent Floating: Exchange rate is market determined, with any foreign exchange intervention aimed at moderating the rate of change and preventing undue fluctuations in the exchange rate, rather than at establishing a level for it ? Fixed Versus Flexible Exchange Rates and why countries pursue certain exchange rate regimes; based on premise that all else equal, countries would prefer fixed exchange rates ? Fixed rates provide stability in international prices for the conduct of trade ? Fixed exchange rates are inherently anti-inflationary, requiring the country to follow restrictive monetary and fiscal policies ? Fixed exchange rates regimes necessitate that central banks maintain large quantities of international reserves for use in occasional defense of fixed rate ? Fixed rates, once in place, may be maintained at rates that are inconsistent with economic fundamentals 4 | P a g e World Currency Events 1971-2007: 5 | P a g e Attributes of the ?Ideal? Currency: ? Exchange rate stability ? the value of the currency would be fixed in relationship to other currencies so traders and investors could be relatively certain of the foreign exchange value of each currency in the present and near future 6 | P a g e ? Full financial integration ? complete freedom of monetary flows would be allowed, so traders and investors could willingly and easily move funds from one country to another in response to perceived economic opportunities or risk ? Monetary independence ? domestic monetary and interest rate policies would be set by each individual country to pursue desired national economic policies, especially as they might relate to limiting inflation, combating recessions and fostering prosperity and full employment The Impossible Trinity: ? This is referred to as The Impossible Trinity because a country must give up one of the three goals described by the sides of the triangle, monetary independence, exchange rate stability, or full financial integration. The forces of economics do not allow the simultaneous achievement of all three Emerging Markets & Regime Choices: ? Currency Boards ? exist when a country?s central bank commits to back its monetary base, money supply, entirely with foreign reserves at all times ? This means that a unit of the domestic currency cannot be introduced into the economy without an additional unit of foreign exchange reserves being obtained first ? Example is Argentina in 1991 when it fixed the Argentinean Peso to the US Dollar ? Dollarization ? the use of the US dollar as the official currency of the country ? Arguments for dollarization include ? Country removes possibility of currency volatility ? Theoretically eliminate possibility of future currency crises ? Greater economic integration with the US and other dollar based markets ? Arguments against dollarization include ? Loss of sovereignty over monetary policy ? Loss of power of seignorage, the ability to profit from its ability to print its own money ? The central bank of the country no longer can serve as lender of last resort ? Examples include Panama circa 1907 and Ecuador circa 2000 7 | P a g e The Currency Regime Choices for Emerging Markets: The Birth of a Currency: The Euro: ? 15 Member nations of the European Union are also members of the European Monetary System (EMS) ? Maastricht Treaty specified timetable and plan for replacing currencies for a full economic and monetary union ? Convergence criteria called for countries? monetary and fiscal policies to be integrated and coordinated 8 | P a g e ? Nominal inflation should be no more than 1.5% above average for the three members of the EU with lowest inflation rates during previous year ? Long-term interest rates should be no more than 2% above average for the three members of the EU with lowest interest rates ? Fiscal deficit should be no more than 3% of GDP ? Government debt should be no more than 60% of GDP ? European Central Bank (ECB) was established to promote price stability within the EU The Euro and Monetary Unification: ? The euro, ?, was launched on Jan. 4, 1999 with 11 member states ? Effects for countries using the euro currency include ? Cheaper transaction costs, ? Currency risks and costs related to exchange rate uncertainty are reduced, ? All consumers and businesses, both inside and outside of the euro zone enjoy price transparency and increased price-based competition ? Successful unification of the euro relies on two factors: ? Monetary policy for the EMU has to be coordinated via the ECB ? Focus should be on price stability of euro and inflationary pressures of economies ? Fixing the Value of the euro ? On 12/31/1998, the national exchange rates were fixed to the euro ? On 1/4/1999 the euro began trading on world currency markets and value slid steadily until early 2002 when the euro began a sustained climb against the dollar and other foreign currencies ? The euro peaked against the dollar at $1.36/? in late 2004 ? After dropping against the dollar in 2005, the euro has risen to $1.47/? by year-end 2007 ? The decline of the dollar since 2002 has been caused by severe balance of payments deficits as well as massive federal budget deficits ? 12 countries have been added to the EU since 2005 and they will allowed to adopt the euro only after meeting the same rigorous criteria met by all euro members The U.S. Dollar/Euro Spot Exchange Rate, 1999-2010: 9 | P a g e Global Finance in Practice: The Trade-offs Between Exchange Rate Regimes: Summary: ? The international monetary system has evolved from the days of the gold standard to today?s eclectic currency arrangement ? Gold Standard (1876 ? 1913) ? Inter-war period (1914 ? 1944) ? Bretton Woods (1944) ? Elimination of dollar convertibility into gold (1971) ? Exchange rates began to float ? If the ideal currency existed in today?s world, it would have three attributes: a fixed value, convertibility, and independent monetary policy ? Emerging market countries must often choose between two extreme exchange rate regimes, either free-floating or fixed regime such as a currency board or dollarization 10 | P a g e ? The members of the EU are also members of the EMS. ? Members of this group have formed an island of fixed exchange rates amongst themselves in a sea of floating currencies ? They rely heavily on trade among themselves, so day-to-day benefits are great ? The euro affects markets in three ways ? Countries within the zone enjoy cheaper transaction costs ? Currency risks and costs related to exchange rate uncertainty are reduced, ? All consumers and businesses, both inside and outside of the euro zone enjoy price transparency and increased price-based competition CHAPTER 4 ? THE BALANCE OF PAYMENTS: Learning Objectives: ? Learn how nations measure their own levels of international economic activity, and how that is measured by the balance of payments ? Examine the economic relationships underlying the two basic sub-components of the balance of payments ? the Current and Capital Accounts ? Consider the financial dimensions of international economic activity, and how they differ between merchandise & services trade The Balance of Payments: ? Identify balance of payment activities by nations in pursuit of macroeconomic policies ? Examine how exchange rate changes and volatility influence trade balances over time ? Evaluate the history of capital mobility, and conditions that lead in times of crisis to capital flight ? The measurement of all international economic transactions between the residents of a country and foreign residents is called the Balance of Payments (BOP) ? The IMF is the primary source of similar statistics worldwide ? Multinational businesses use various BOP measures to gauge the growth and health of specific types of trade or financial transactions by country and regions of the world against the home country ? Monetary and fiscal policy must take the BOP into account at the national level ? Businesses need BOP data to anticipate changes in host country?s economic policies driven by BOP events ? BOP data may be important for the following reasons ? BOP is important indicator of pressure on a country?s exchange rate, thus potential to either gain or lose if firm is trading with that country or currency ? Changes in a country?s BOP may signal imposition (or removal) of controls over payments, dividends, interest, etc ? BOP helps to forecast a country?s market potential, especially in the short run Typical BOP Transactions: ? Examples of BOP transactions from US perspective ? Honda US is the distributor of cars manufactured in Japan by its parent, Honda of Japan ? US based firm, Fluor Corp., manages the construction of a major water treatment facility in Bangkok, Thailand ? US subsidiary of French firm, Saint Gobain, pays profits (dividends) back to parent firm in Paris ? An American tourist purchases a small Lapponia necklace in Finland 11 | P a g e ? A Mexican lawyer purchases a US corporate bond through an investment broker in Cleveland ? A rule of thumb that aids in understanding the BOP is to ?follow the cash flow? Generic Balance of Payments: Fundamentals of BOP Accounting: ? The BOP must balance ? Three main elements of actual process of measuring international economic activity ? Identifying what is/is not an international economic transaction ? Understanding how the flow of goods, services, assets, money create debits and credits ? Understanding the bookkeeping procedures for BOP accounting Defining International Economic Transactions: ? Current Account Transactions ? The export of merchandise, goods such as trucks, machinery, computers is an international transaction ? Imports such as French wine, Japanese cameras and German automobiles are international transactions ? The purchase of a glass figure in Venice by an American tourist is a US merchandise import ? Financial Account Transactions ? The purchase of a US Treasury bill by a foreign resident BOP as a Flow Statement: ? Exchange of Real Assets ? exchange of goods and services for other goods and services or for monetary payment ? Exchange of Financial Assets ? Exchange of financial claims for other financial claims The Current Account: ? Goods Trade ? export/import of goods. ? Services Trade ? export/import of services; common services are financial services provided by banks to foreign investors, construction services and tourism services ? Income ? predominately current income associated with investments which were made in previous periods. Additionally the wages & salaries paid to non-resident workers ? Current Transfers ? financial settlements associated with change in ownership of real resources or financial items. Any transfer between countries which is one-way, a gift or a grant,is termed a current transfer 12 | P a g e ? Typically dominated by the export/import of goods, for this reason the Balance of Trade (BOT) is widely quoted The United States Current Account, 2002-2009 (billions of USD) US Trade Balance and Balance on Services and Income, 1985-2009 (billions of USD) The Capital and Financial Accounts: ? Capital account is made up of transfers of fixed assets such as real estate and acquisitions/disposal of non-produced/non-financial assets ? Financial account consists of three components and is classified either by maturity of asset or nature of ownership. The three components are ? Direct Investment ? Net balance of capital which is dispersed from and into a country for the purpose of exerting control over assets. This category includes foreign direct investment 13 | P a g e ? Portfolio Investment ? Net balance of capital which flows in and out of the country but does not reach the 10% ownership threshold of direct investment. The purchase and sale of debt or equity securities is included in this category ? This capital is purely return motivated ? Other Investment Assets/Liabilities ? Consists of various short and long-term trade credits, cross-border loans, currency and bank deposits and other accounts receivable and payable related to cross-border trade The United States Financial Account and Components, 2002-2009 (billions of USD) The United States Financial Account, 1985-2009 (billions of USD) 14 | P a g e Current and Combined Financial/Capital Account Balances for the United States, 1992-2009 (billions of USD) The Other Accounts: ? Net Errors and Omissions ? Account is used to account for statistical errors and/or untraceable monies within a country ? Official Reserves ? total reserves held by official monetary authorities within a country. ? These reserves are typically comprised of major currencies that are used in international trade and financial transactions and reserve accounts (SDRs) held at the IMF ? Under a fixed rate regime official reserves are more important as the government assumes the responsibility to maintain parity among currencies by buying or selling its currency on the open market ? Under a floating rate regime the government does not assume such a responsibility and the importance of official reserves is reduced China?s Twin Surpluses: ? China?s twin surpluses aka ?double surplus? in the current and financial accounts is highly unusual ? Typically, these relationships are inverses of one another ? The reason for the twin surpluses is due to the exceptional growth of the Chinese economy China?s Twin Surpluses, 1998-2009 15 | P a g e Official Foreign Exchange Reserves: The Rise of China ? Between 2001 ? 2010 China increased foreign exchange reserves from $200 billion to $2,500 billion, more than a 10-fold increase ? China is now able to manage it currency, the yuan, to maintain competitiveness worldwide ? China can also maintain a relatively stable fixed exchange rate against other major currencies China?s Foreign Exchange Reserves: Rising Reserves in Asia (billions of USD, 2009) Balance of Payments Interaction with Key Macroeconomic Variables: ? A nation?s balance of payments interacts with nearly all of its key macroeconomic variables: ? Gross domestic product (GDP) ? The exchange rate ? Interest rates ? Inflation rates 16 | P a g e The United States Balance of Payments, Analytic Presentation, 1995-2005 (billions of USD) 17 | P a g e Balance of Payments Interaction with Key Economic Variables: ? In a static (accounting) sense, a nation?s GDP can be represented by the following equation: GDP = C + I + G + X ? M C = consumption spending I = capital investment spending G = government spending X = exports of goods and services M = imports of goods and services Balance of Payments and Exchange Rates: ? A country?s BOP can have a significant impact on the level of its exchange rate and vice versa depending on that country?s exchange rate regime ? The effect of an imbalance in the BOP of a country works somewhat differently depending on whether that country has fixed exchange rates, floating exchange rates, or a managed exchange rate system ? Under a fixed exchange rate system the government bears the responsibility to assure a BOP near zero ? Under a floating exchange rate system, the government of a country has no responsibility to peg its foreign exchange rate The Balance of Payments and Exchange Rates: ? The relationship between BOP and exchange rates can be illustrated by use of a simplified equation: CI = capital inflows CO = capital outflows FI = financial inflows FO = financial outflows FXB = official monetary reserves The Balance of Payments and Interest Rates: ? Apart from the use of interest rates to intervene in the foreign exchange market, the overall level of a country?s interest rates compared to other countries does have an impact on the financial account of the balance of payments ? Relatively low interest rates should normally stimulate an outflow of capital seeking higher interest rates in other country-currencies ? In the U.S. however, the opposite has occurred as a result of attractive growth rate prospects, high levels of productive innovation, and perceived political stability The Balance of Payments and Inflation Rates: ? Imports have the potential to lower a country?s inflation rate ? In particular, imports of lower priced goods and services places a limit on what domestic competitors charge for comparable goods and services 18 | P a g e Trade Balances and Exchange Rates: ? A simple concept in principle: Changes in exchange rates changes the relative prices of imports and exports which in turn result in changes in quantities demanded ? In reality the process is less straight-forward The J-Curve Adjustment Path: ? Trade balance adjustment occurs in three stages over a varying and often lengthy period of time 1. The currency contract period ? Adjustment is uncertain due to existing contracts that must be fulfilled 2. The pass-through period ? Importers and exporters must eventually pass along the cost changes 3. Quantity adjustment period ? The expected balance of trade is eventually realized ? U.S. trade balance = (P$xQx) ? (S$/fc PfcM QM) Trade Balance Adjustment to Exchange Rate Changes: The J-Curve: Capital Mobility: ? The degree to which capital moves freely cross-border is critically important to a country?s balance of payments ? Historical patterns of capital mobility ? 1860-1914 ? period characterized by continuously increasing capital openness as more countries adopted the gold standard and expanded international trade relations ? 1914-1945 ? period of global economic destruction due to two world wars and a global depression ? 1945-1971 ? Bretton Woods era, saw great expansion of international trade in goods and services 19 | P a g e ? 1971-2002 ? period characterized by floating exchange rates, economic volatility, but rapidly expanding cross-border capital flows The Evolution of Capital Mobility: Capital Flight: ?International flows of direct and portfolio investments under ordinary circumstances are rarely associated with the capital flight phenomenon. Rather, it is when capital transfers by residents conflict with political objectives that the term ?flight? comes into general usage.? ?Ingo Walter, Capital Flight and Third World Debt ? Five primary mechanisms exist by which capital may be moved from one country to another: ? Transfers via the usual international payments mechanisms, regular bank transfers are easiest, cheapest and legal ? Transfer of physical currency by bearer (smuggling) is more costly, and for many countries illegal ? Transfer of cash into collectibles or precious metals, which are then transferred across borders ? Money laundering, the cross-border purchase of assets which are then managed in a way that hide the movement of money and its owners ? False invoicing on international trade transactions Summary: ? The Balance of Payments is the summary statement of all international transactions between one country and all other countries ? The Balance of Payments is a flow statement, summarizing all the international transactions that occur across the geographic boundaries of the nation over a period of time, typically a year ? Although the BOP must always balance in theory, in practice there are substantial imbalances as a result of statistical errors and misreporting of current account and financial/capital account flows ? The two major sub-accounts of the balance of payments, the current account and the financial/capital account, summarize the current trade and international capital flows of the country respectively 20 | P a g e ? The current account and financial/capital account are typically inverse on balance, one in surplus while the other experiences deficit ? Although most nations strive for current account surpluses, it is not clear that a balance on current or capital account, or a surplus on current account, is either sustainable or desirable ? Although merchandise trade is more easily observed, the growth of services trade is more significant to the BOP for many of the world?s largest industrialized countries today ? Monitoring of the various sub-accounts of a country?s BOP activity is helpful to decision-makers and policy-makers on all levels of government and industry in detecting the underlying trends and movement of fundamental economic forces driving a country?s international economic activity ? Changes in exchange rates change relative prices of imports and exports which in turn result in changes in quantities of demanded through the elasticity of demand ? A devaluation results initially in a further deterioration in the trade balance before an eventual improvement ? the path of adjustment takes on the shape of a flattened ?j? ? The ability of capital to move instantaneously and massively cross-border has been one of the major factors in the severity of recent currency crises ? Although not limited to heavily indebted countries, the rapid and sometimes illegal transfer of convertible currencies out of a country poses significant economic and political problems CHAPTER 5 ? CURRENT MULTINATIONAL FINANCIAL CHALLENGES: THE CREDIT CRISIS OF 2007-2009 Learning Objectives: ? Learn how a variety of economic, regulatory, and social forces led to the real estate market growth and collapse ? Examine the various dimensions of defining and classifying individual borrowers in terms of their credit quality ? Consider the role that financial derivatives and securitization played in the formation of the international credit crisis ? Examine how LIBOR, the most widely used cost of money, reacted to the growing tensions and risk perceptions between international financial institutions during the crisis ? Identify the characteristics and components of a number of the instrumental financial derivatives contributing to the spread of the credit crisis including collateralized debt obligations (CDOs), structured investment vehicles (SIVs), and credit default swaps (CDSs) ? Evaluate the various remedies and prescriptions being pushed forward by a variety of governments and international organizations for the infected global financial organism The Seeds of Crisis: Subprime Debt: ? The Repeal of Glass-Steagall ? 1933 legislation that separated commercial from investment banking ? FDIC had insured commercial bank deposits ? SEC had regulated the riskier investment banks ? Gramm-Leach-Bliley Financial Services Modernization Act of 1999 ? Repealed what remained of Glass-Steagall by allowing commercial and investment banks to engage in activities formerly reserved for the other ? The Housing Sector and Mortgage Lending ? Many new borrowers now qualified for loans ? Prime loans, also known as conventional or conforming loans, meet the requirements for resale to Government Sponsored Enterprises (GSEs) such as Fannie Mae or Freddie Mac 21 | P a g e ? Alt-A loans (Alternative-A paper) are considered low risk but have an initial non-conforming feature ? Subprime loans do not meet underwriting criteria and have higher risk of default ? Subprime loans continued ? Until 1980 most states prevented sale of subprime securities ? DIDMCA (1980) supersedes state laws ? Tax Reform Act (1986) eliminates the tax deductibility of many types of consumer debt but keeps the tax deductibility of loans associated with real estate including second mortgages and equity lines of credit ? By 2008 subprime loans equal approx 8% of outstanding mortgage obligations but are the source of over 65% of bankruptcy filings by U.S. homeowners ? Exhibit 5.1 ? Shows that from 1960 ? late 1980s almost no change in U.S. financial assets as a percentage of GDP ? From late 1980s to 2008 financial assets more than doubled from 450% of GDP to over 900% of GDP ? Rising housing prices were used as collateral for mortgage-backed assets and encouraged refinancing of mortgages to provide current income ? Exhibit 5.2 ? Debt obligations rose in a variety of countries and was not limited to the United States Exhibit 5.1 US Credit Market Borrowing, 1995-2010 Exhibit 5.2 Household Debt as a Percentage of Disposable Income: 22 | P a g e The Transmission Mechanism: Securitization and Derivatives of Securitized Debt: ? Liquidity ? the ability to turn an asset into cash quickly at a fair market value ? Securitization ? The process of turning an illiquid asset into a liquid salable asset ? A form of disintermediation, or bypassing traditional financial intermediaries ? Mortgage-backed securities (MSBs) by year-end 2007 had increased five-fold from 1990 to a total of $27 trillion ? Exhibit 5.3 - shows the growth of U.S. securitized loans ? Securitization continued ? Asset-backed securities (ABSs) consist of loans such as second mortgages, equity lines of credit, auto loans, and credit card receivables among others ? Securitization allows a disconnect between loan originator and borrower ? The practice of ?originated-to-distribute? (OTD) decreases the ability and the incentive of the loan originator to monitor borrower behavior Exhibit 5.3 Annual Issuances of MBSs, 1995-2009 ? Structured Investment Vehicles (SIVs) ? Off-balance sheet entity designed to allow banks to invest in long-term higher yielding assets and fund these assets through the sale of commercial paper (CP) ? Portfolio theory failed in assessing the risk of SIVs ? Banks had guaranteed the backup lines of credit for the CP ? Exhibit 5.4 - demonstrates how an SIV works 23 | P a g e Exhibit 5.4 Structured Investment Vehicles (SIVs) ? Collateralized Debt Obligations (CDOs) ? Asset-backed securities packaged and passed to an off-shore entity via a special purpose vehicle (SPV) to be sold in the market by security underwriters ? Allowed banks to make loans, collect upfront fees, sell the assets and repeat ? CDOs are categories in tranches classified as: ? Senior ? or AAA rated borrowers ? Mezzanine - AA ? BB rated borrowers ? Equity ? or below BB rated borrowers ? Collateralized Debt Obligations (CDOs) Cont. ? CDO ratings were hurried and proved to be difficult and ultimately inaccurate ? CDO market grows rapidly from 2001 ? 2007 thanks to booming real estate markets, slow equity markets, and low interest rates ? CDO value driven by cash flows from the original loan and liquidity ? Exhibit 5.5 illustrates how a CDO works ? Exhibit 5.6 shows CDO volume from 2004 - 2008 Exhibit 5.5 The Collateralized Debt Obligation 24 | P a g e Global CDO Issuance, 2004-2008 (billions of USD) ? Credit Default Swaps (CDSs) ? Initially CDSs were designed as insurance against payment default for purchasers of corporate debt ? Subsequently mutated to a form of speculation betting on the ability, or lack thereof, of the debt issuer?s ability to repay ? Purchaser of a CDS did not have to have ownership of the underlying asset, nor were there limits on how many speculative contracts could be sold on a particular asset, nor was the market publicly regulated ? The CDS market grew to $62 trillion ? far larger than the corresponding underlying assets ? Exhibit 5.7 explains how CDSs work ? Exhibit 5.8 charts the growth of CDSs ? Credit Enhancement ? Making investments more attractive to investors by reducing their perceived risk ? Commonly, ABSs were insured to appear safer ? Exhibit 5.9 shows how in the 1990s credit enhancement was provided in the form of subordination 25 | P a g e Exhibit 5.7 Cash Flows Under a Credit Default Swap Exhibit 5.8 Credit Default Swap Market Growth 26 | P a g e Exhibit 5.9 CDO Construction and Credit Enhancement The Fallout: The Crisis of 2007-2009 ? The housing market slows in 2005 and crashes in the spring of 2007 in several countries ? Two hedge funds at Bear Stearns fail in July 2007 ? Northern Rock Bank is bailed out by the Bank of England ? September 2007 sees several bank runs around the globe ? Commodity prices skyrocket in 2008 with crude oil peaking at $147/barrel in July ? US Government places Fannie Mae and Fredie Mac into conservatorship on September 7, 2008 ? Lehman Brothers fails on September 14, 2008 ? Equity markets plunge on September 15 ? AIG rescued with an $85 billion bailout September 16 ? September 2008 ? Spring 2009 corporate lending markets demonstrate the following: ? Risky investment banking activities overwhelmed commercial banking activities ? Corporate indebtedness was tiered ? Corporate balance sheets seem to have predicted the crisis with low levels of debt and high levels of cash and marketable securities ? Even low risk marketable securities were now failing ? Credit lines and lending was sharply reduced ? September 2008 ? Spring 2009 corporate lending markets demonstrate the following: Continued ? Commercial paper markets almost stopped operating in September and October of 2008 ? Traditional commercial bank lending for operating capital was squeezed out by huge investment banking losses ? Exhibit 5.10 illustrates a timeline of economic events and the impact on interest rates 27 | P a g e Exhibit 5.10 USD & JPY LIBOR Rates (Sept-Oct 2008) ? Global Contagion ? The collapse of mortgage-backed security markets in the U.S. spread globally ? Capital fled from equity markets worldwide cash in traditionally stable currencies such as yen, euro, and U.S. dollars ? Exhibit 5.11 highlights the fall of equity markets in select countries in September and October of 2008 Exhibit 5.11 Selected Stock Markets during the Crisis 28 | P a g e ? Global Contagion continued ? In spring 2009 mortgage delinquency rates reach record highs ? Domestic firms were favored over MNEs by rating agencies, financial institutions, and government agencies ? Credit crisis progresses from the failure of specific mortgage-backed securities to great risk put on commercial and investment banks, to a credit-induced global recession with the potential of a global recession and all that entails ? LIBOR ? The London Interbank Offered Rate ? Has always traded as a ?no-name? market with no differential credit risk among participating institutions ? As mortgages and derivatives failed and CDOs started suffering losses, individual banks were treated as risks in themselves ? LIBOR was estimated to be used in the pricing of over $350 trillion of assets globally ? Dramatic fluctuations and increases in LIBOR were a major course of concern for all Exhibit 5.12 LIBOR and the Crisis in Lending ? LIBOR ? The London Interbank Offered Rate, cont. ? July and August 2008 the TED spread is approximately 80 basis points (where the TED spread is the difference between the U.S Treasury Bill rate and the Eurodollar futures market) ? The TED spread leapt to 359 basis points at times during the next two months before the market somewhat returned to more normal differences The Remedy: Prescriptions for an Infected Global Financial Organism: ? Debt ? originate-to-distribute behavior combined with poor credit assessment but be addressed ? Securitization ? risk assessment is not properly evaluated by portfolio theory ? Derivatives ? some became so complex they were difficult to evaluate and were outside the oversight of regulators 29 | P a g e ? Deregulation ? new legislation is already in effect but the proof is in the implementation ? Capital Mobility ? greater openness will result in greater opportunity and more and bigger crises ? Illiquid Markets ? without liquidity markets soon fail ? Troubled Asset Recovery Plan (TARP) - $700 billion to bail-out banks and other entities deemed ?too big to fail?. Much of these funds have already been repaid ? Liquidity vs. Capital ? as asset values fell due to loan defaults banks suffered massive equity losses ? Golden Parachutes ? top executives resigned but were well-compensated due to earlier termination agreements ? Financial Reform Law of 2010 ? Key Features: ? Established an Office of Financial Research ? FDIC insurance increased to $250,000 per account ? SEC can sue professionals who knew about deceptive acts even if they did not instigate the acts ? Treasury to modernize and monitor state insurance regulators ? Institutions must disclose the amount of short selling in each stock Exhibit 5.13 The USD TED Spread (July 2008-January 2009) The Future: ? Exhibit 5.14 shows how cross-border capital flow fell by more than 80% due to the crisis ? Questions remain about how long until and how capital will return to international markets Exhibit 5.14 The Global Financial Crash 30 | P a g e Summary: ? The seeds of the credit crisis were sown in the deregulation of the commercial and investment banking sectors in the 1990s. ? The flow of capital into the real estate sector in thepost-2000 period reflected changes in social and economic forces in the U.S. economy. ? Mortgage loans in the U.S. marketplace are normally categorized as prime (A-paper), Alt-A Alternative- A paper), and subprime, in increasing order of riskiness. ? Subprime borrowers, historically not considered creditworthy for mortgages, became an acceptable credit risk as a result of major deregulation initiatives. ? The transport vehicle for the growing distribution of lower-quality debt was a combination of securitization and re-packaging provided by a series of new financial derivatives. ? Securitization allowed the re-packaging of different combinations of credit-quality mortgages in order to make them more attractive for resale to other financial institutions; derivative construction increased the liquidity in the market for these securities. ? The structured investment vehicle (SIV) was the ultimate financial intermediation device: It borrowed short and invested long. ? The SIV was an off-balance sheet entity designed to allow a bank to create an investment entity that would invest in long-term and higher yielding assets such as speculative grade bonds, mortgage- backed seucrities (MBSs) and collateralized debt obligations (CDOs), while funding itself through commercial paper (CP) issuances. ? The CDO, collateralized debt obligation, is a portfolio of debt instruments?mortgages?which are re- packaged as an asset-backed security. Once packaged, the bank passes the security to a special purpose vehicle (SPV). ? The credit default swap (CDS) is a contract, a derivative, which derived its value from the credit quality and performance of any specified asset. The CDS was designed to shift the risk of default to a third- party. In short, it was a way to bet whether a specific mortgage or security would either fail to pay on time or fail to pay at all. ? LIBOR, although only one of several key interest rates in the global marketplace, plays a critical role in the interbank market as the basis for all floating rate debt instruments of all kinds. This includes mortgages, corporate loans, industrial development loans, and the multitudes of financial derivatives sold throughout the global marketplace. ? With the onset of the credit crisis in September 2008, LIBOR rates skyrocketed between major international banks, indicating a growing fear of counterparty default in a market historically considered the highest quality and most liquid in the world. ? The U.S. Congress passed the Troubled Asset Recovery Plan (TARP), which authorized the U.S. government to use up to $700 billion to bail out the riskiest large banks. ? The U.S. Federal Reserve purchased billions in mortgage-backed securities, CDOs, in the months following the credit crisis in an attempt to inject liquidity into the credit markets. ? As a result of the massive write-offs of failed mortgages by the largest banks, the banks suffered weakened equity capital positions, making it necessary for the private sector and the government to inject new equity capital into the riskiest banks and insurers. CHAPTER 6 ? THE FOREIGN EXCHANGE MARKET Learning Objectives: ? Examine the what, when, where, and why of currency trading in the global marketplace ? Understand the definitions and distinctions among spot, forward, swap, and other types of foreign exchange financial instruments 31 | P a g e ? Learn the forms of currency quotations used by currency dealers, financial institutions, and agents of all kinds when conducting foreign exchange transactions ? Analyze the interaction among changing currency values, cross exchange rates and opportunities arising from intermarket arbitrage Foreign Exchange Markets: ? The FOREX market provides the physical and institutional structure through which ? The money of one country is exchanged for that of another country ? The rate of exchange between currencies is determined ? Foreign exchange transactions are physically completed ? A foreign exchange transaction is an agreement between a buyer and a seller that a fixed amount of one currency will be delivered for some other currency at a specified rate ? There are six main characteristics of the FOREX markets which will be discussed ? The geographic extent ? The three main functions ? The market?s participants ? Its daily transaction volume ? Types of transactions including spot, forward and swaps ? Methods of stating exchange rates, quotations, and changes in exchange rates Geographic Extent of the Market: ? Geographically, the FOREX market spans the globe with prices moving and currencies trading every hour of every business day ? Major world trading starts each morning in Sydney and Tokyo ? Then moves west to Hong Kong and Singapore ? Continuing to Europe and finishing on the West Coast of the U.S. Measuring Foreign Exchange Market Activity: Average Electronic Conversations Per Hour 32 | P a g e Global Currency Trading: The Trading Day Functions of the FOREX Market: ? The FOREX market is the mechanism by which participants ? Transfer purchasing power between countries ? This is necessary as international trade and capital transactions normally involve parties living in countries with different national currencies ? Obtain or provides credit for international trade transactions ? Inventories in transit must be financed ? Minimize exposure to exchange rate risk ? FOREX markets provide instruments utilized in ?hedging? or transferring risk to more willing parties Market Participants: ? The FOREX market consists of two tiers, the interbank or wholesale market, and the client or retail market ? Five broad categories of participants operate within these two tiers ? Bank and non bank foreign exchange dealers ? Individuals and firms conducting commercial or investment transactions ? Speculators and arbitragers ? Central banks and treasuries ? Foreign exchange brokers Bank and Non-bank Dealers: ? These participants profit from buying currencies at a bid price and then reselling them at an offer or ask price ? Competition among dealers narrows the spread between the bid and offer rate contributing to the market?s efficiency ? Dealers on behalf of large international banks often act as market makers, often willing to stand in and buy or sell these currencies without having a counterpart with which to unload the ?inventory? ? They trade amongst other banks and dealers in order to keep their inventory levels at manageable levels ? Currency trading is profitable and often contributes between 10% - 20% of a banks? average net income ? Small- to medium-sized banks rarely act as market makers yet still participate in the interbank market 33 | P a g e Importers and Firms Conducting Commercial/Investment Transactions: ? Importers, exporters, portfolio investors, MNEs, tourists and others use the FOREX market to facilitate execution of commercial or investment transactions ? Some of these participants use the market to hedge foreign exchange rate risk Speculators and Arbitragers: ? Speculators and arbitragers seek to profit from trading in the market itself ? They operate for their own interest, without need or obligation to serve clients or ensure a continuous market ? Speculators seek all their profit from exchange rate changes ? Arbitragers try to profit from simultaneous differences in exchange rates in different markets ? A large proportion of speculation and arbitrage is conducted on behalf of major banks by traders employed by those banks Central Banks and Treasuries: ? Central banks and treasuries use the market to acquire or spend their country?s currency reserves as well as to influence the price at which their own currency trades ? They may act to support the value of their currency because of their government?s policies or obligations or because of commitments entered through joint float agreements such as the European Monetary System (EMS) ? Consequently their motive is not to profit but rather influence the foreign exchange value of their currency in a manner that will benefit their interests Continuous Linked Settlement: ? Continuous Linked Settlement (CLS) system (since 2002) eliminates losses if either party unable to settle ? CLS links with Real-Time Gross Settlement (RTGS) systems in seven major currencies ? Eventually we expect same-day settlement instead of the current lag of two days ? The U.S. Commodity Futures Trading Commission (CFTC) regulates foreign exchange trading Transactions in the Interbank Market: ? Transactions within this market can be executed on a spot, forward, or swap basis ? A spot transaction requires almost immediate delivery of foreign exchange ? A forward transaction requires delivery of foreign exchange at some future date ? A swap transaction is the simultaneous exchange of one foreign currency for another 34 | P a g e Foreign Exchange Settlement in Europe Spot Transactions: ? A spot transaction in the interbank market is the purchase of foreign exchange, with delivery and payment between banks to take place, normally, on the second following business day ? The settlement date is often referred to as the value date ? This is the date when most dollar transactions are settled through the computerized Clearing House Interbank Payment Systems (CHIPS) in New York Outright Forward Transactions: ? This transaction requires delivery at a future value date of a specified amount of one currency for another ? The exchange rate is agreed upon at the time of the transaction, but payment and delivery are delayed ? Forward rates are contracts quoted for value dates of one, two, three, six, nine and twelve months ? Terminology typically used is buying or selling forward ? A contract to deliver dollars for euros in six months is both buying euros forward for dollars and selling dollars forward for euros Swap Transactions: ? A swap transaction in the interbank market is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates ? Both purchase and sale are conducted with the same counterpart 35 | P a g e ? A common type of swap is a spot against forward ? The dealer buys a currency in the spot market and simultaneously sells the same amount back to the same bank in the forward market ? Since this transaction occurs at the same time and with the same counterpart, the dealer incurs no exchange rate exposure ? Forward-forward swaps ? A dealer sells £20,000 forward for dollars for delivery in two months at $1.8420/£ and simultaneously buys £20,000 forward for delivery in three months at $1.8400/£ ? The difference between the buying and selling price is equivalent to the interest rate differential ? Thus a swap can be viewed as a technique for borrowing another currency on a fully collateralized basis ? Non-deliverable forwards (NDFs) ? NDFs possess the same characteristics as traditional forward contracts except that they are settled only in US dollars and the foreign currency being sold or bought forward is not delivered ? The dollar-settlement feature reflects the fact that NDFs are contracted offshore and are beyond the reach and regulatory frameworks of the home country governments ? Pricing of NDFs reflects basic interest rate differentials Size of the FOREX Market: ? The Bank for International Settlements (BIS) estimates that daily global net turnover in traditional FOREX market activity to be USD 3.7 trillion in April 2010 ? Spot transactions at $1,495 billion/day ? Outright forward transactions at $475 billion/day ? Swap transactions at $1,765 billion/day Global Foreign Exchange Market Turnover, 1989-2010 (average daily turnover in April, billions of USD) ? The United Kingdom (London) and the United States (New York) make up roughly 55% of the foreign exchange market ? The London trade alone makes up 36.7% of daily transactions in the foreign exchange market ? Followed by the US (17.9%), Japan (6.2%), Singapore (5.3%), Switzerland (5.2%) and Hong Kong (4.2%) ? Asian markets growing more rapidly than European markets 36 | P a g e Top 10 Geographic Trading Centers in the Foreign Exchange Market, 1992-2010 (average daily turnover in April) Foreign Exchange Market Turnover by Currency Pair (daily averages in April) Foreign Exchange Rates & Quotations: ? A foreign exchange quote is a statement of willingness to buy or sell at an announced rate ? In the retail market (newspapers and exchange booths), quotes are often given as the home currency price of the foreign currency ? Currency Traditional Symbol ISO 4217 Code ? U.S. dollar $ USD ? European euro ? EUR ? Great Britain pound £ GBP ? Japanese yen ¥ JPY ? Mexican peso Ps MXN ? Interbank quotes ? professional dealers or brokers may state quotes in one of two ways ? The foreign currency price of one dollar ? Sfr1.6000/$, read as 1.600 Swiss francs per dollar ? The dollar price of a unit of foreign currency ? $0.6250/Sfr, read as 0.625 dollars per Swiss franc ? The former quote is considered to be in ?European terms? and the latter is considered to be ?American terms? 37 | P a g e ? Almost all European currencies, except two, are quoted the European way ? The Pound Sterling and the Euro are the exceptions ? Additionally, Australian and New Zealand dollars are also quoted in American terms Foreign Currency Quotations Conversion ? Direct and Indirect Quotes ? A direct quote is a home currency price of a unit of a foreign currency ? Sfr1.6000/$ is a direct quote in Switzerland ? An indirect quote is a foreign currency price in a unit of the home currency ? Sfr1.600/$ is an indirect quote in the US, ? $0.625/Sfr is a direct quote in the US and an indirect quote in Switzerland ? Interbank quotes are given as a bid and ask ? The bid is the price at which a dealer will buy another currency ? The ask or offer is the price at which a dealer will sell another currency ? For example the bid and ask for spot euros would probably be shown ?1.2170/78? on a video screen. ? In some cases between professional traders, they may only quote the last two digits of both the bid and ask, ?70-78?, because they know what the other figures are. Bid, Ask and Mid-Point Quotation: 38 | P a g e ? Expressing Forward Quotations on a Points Basis ? The previously mentioned rates for yen were considered outright quotes ? Forward quotes are different and typically quoted in terms of points ? A point is the last digit of a quotation, with convention dictating the number of digits to the right of the decimal ? Hence a point is equal to 0.0001 of most currencies ? Expressing Forward Quotations on a Points Basis ? The yen is quoted only to two decimal points ? A forward quotation is not a foreign exchange rate, rather the difference between the spot and forward rates ? Example: ? Forward Quotations in Percentage Terms ? Forward quotations may also be expressed as the percent-per-annum deviation from the spot rate ? This is similar to the forward discount or premium calculated earlier ? The important thing to remember is which currency is being used as the home or base currency ? For indirect quotes (i.e. quote expressed in foreign currency terms), the formula is ? Forward Quotations in Percentage Terms ? For direct quotes (i.e. quote expressed in home currency terms), the formula is ? Forward Quotations in Percentage Terms ? Example: Indirect quote ? Example: Direct quote p.a. 2.32% 100 x 90 360 x 105.04 105.04 - 105.65 f 100 x days 360 x Foward Foward -Spot f FC 100 x days 360 x Spot Spot - Forward f H p.a. 2.32% 100 x 90 360 x 50.00946521 50.00946521-30.00952018 f $ 39 | P a g e ? Cross Rates ? Many currencies pairs are inactively traded, so their exchange rate is determined through their relationship to a widely traded third currency ? Example: A Mexican importer needs Japanese yen to pay for purchases in Tokyo. Both the Mexican peso (MXP) and Japanese yen (¥) are quoted in US dollars ? Assume the following quotes: Japanese yen ¥110.73/$ Mexican peso MXP 11.4456/$ Exchange Rates: New York Closing Snapshot 40 | P a g e Key Currency Cross Rates, Tuesday, January 4, 2011 ? Cross Rates ? The Mexican importer can buy one US dollar for 11.4456 Mexican pesos and with that dollar buy ¥110.73; the cross rate would be ? Intermarket Arbitrage ? Cross rates can be used to check on opportunities for intermarket arbitrage ? Example: Assume the following exchange rates are quoted Citibank $1.2223/? Barclays Bank $1.8410/£ Dresdner Bank ?1.5100/£ ? Intermarket Arbitrage ? The cross rate between Citibank and Barclays is ? This cross rate is not the same as Dresdner?s rate quote of ?1.5100/£ ? Therefore, an opportunity exists for risk-less profit or arbitrage Triangular Arbitrage by a Market Trader: 41 | P a g e Summary: ? The three functions of the foreign exchange market (FOREX) are to transfer purchasing power, provide credit, and minimize foreign exchange rate risk ? The FOREX is composed of two tiers: the interbank market and the client market. Participants within these tiers include bank and nonbank foreign exchange dealers, individuals and firms conducting commercial and investment functions, speculators and arbitragers, central banks and treasuries and foreign exchange brokers ? Geographically, the FOREX market spans the globe, with prices moving and currencies traded every hour of every business day ? A foreign exchange rate is the price of one currency expressed in terms of another currency ? A foreign exchange quotation is a statement of willingness to buy or sell currency at an announced price ? Transactions within the FOREX market are executed either on a spot basis requiring delivery two days after the transaction or on a forward basis requiring settlement at some designated future date ? European terms quotations are the foreign currency price of one US dollar. American terms are the dollar price of a foreign currency ? Quotations can also be direct or indirect. A direct quote is the home currency price of a unit of foreign currency, while an indirect quote is the foreign currency price of a unit of the home currency ? Direct and indirect are not synonymous for American and European terms, because the home currency will change for calculation purposes ? A cross rate is an exchange rate between two currencies, calculated from their common relationships with a third currency. When cross rates differ from the direct rates between two currencies, intermarket arbitrage is possible CHAPTER 7 ? INTERNATIONAL PARITY CONDITIONS: Learning Objectives: ? Examine how price levels and price level changes (inflation) in countries determine the exchange rate at which their currencies are traded ? Show how interest rates reflect inflationary forces within each country and currency ? Explain how forward markets for currencies reflect expectations held by market participants about the future spot exchange rate ? Analyze how, in equilibrium, the spot and forward currency markets are aligned with interest differentials and differentials in expected inflation ? The economic theories which link exchange rates, price levels, and interest rates together are called international parity conditions ? These theories may not always work out to be ?true? when compared to what students and practitioners observe in the real world, but they are central to any understanding of how multinational business is conducted Prices and Exchange Rates: ? The economic theories which link exchange rates, price levels, and interest rates together are called international parity conditions ? These theories may not always work out to be ?true? when compared to what students and practitioners observe in the real world, but they are central to any understanding of how multinational business is conducted P$ ? S = P¥ 42 | P a g e Where the price of the product in US dollars (P$), multiplied by the spot exchange rate (S, yen per dollar), equals the price of the product in Japanese yen (P¥) ? Conversely, if the prices were stated in local currencies, and markets were efficient, the exchange rate could be deduced from the relative local product prices Purchasing Power Parity & The Law of One Price: ? If the Law of One Price were true for all goods, the purchasing power parity (PPP) exchange rate could be found from any set of prices ? Through price comparison, prices of individual products can be determined through the PPP exchange rate ? This is the absolute theory of purchasing power parity ? Absolute PPP states that the spot exchange rate is determined by the relative prices of similar basket of goods The Hamburger Standard: ? The ?Big Mac Index,? as it has been christened by The Economist is a prime example of this law of one price: ? Assuming that the Big Mac is identical in all countries, it serves as a comparison point as to whether or not currencies are trading at market prices ? Big Mac in China costs Yuan 13.2 (local currency), while the same Big Mac in the US costs $3.73 ? The actual exchange rate was Yuan 6.78/$ at the time ? The price of a Big Mac in Chinese Yuan in U.S. dollar-terms was therefore: ? The Economist then calculates the implied purchasing power parity rate of exchange using the actual price of the Big Mac in China over the price of the Big Mac in U.S. dollars: ? Now comparing the implied PPP rate of exchange, Yuan 3.54/$, with the actual market rate of exchange at that time, Yuan 6.78/$, the degree to which the Chinese yuan is either undervalued or overvalued versus the U.S. dollar is calculated: Yuan 3.54/$ - Yuan 6.78/$ = -48% Yuan 6.78/$ 43 | P a g e Selected Rates from the Big Mac Index: Relative Purchasing Power Parity: ? If the assumptions of absolute PPP theory are relaxed, we observe relative purchasing power parity ? This idea is that PPP is not particularly helpful in determining what the spot rate is today, but that the relative change in prices between countries over a period of time determines the change in exchange rates ? Moreover, if the spot rate rate between 2 countries starts in equilibrium, any change in the differential rate of inflation between them tends to be offset over the long run by an equal but opposite change in the spot rate Relative Purchasing Power Parity (PPP): ? Empirical tests of both relative and absolute purchasing power parity show that for the most part, PPP tends to not be accurate in predicting future exchange rates ? Two general conclusions can be drawn from the tests: ? PPP holds up well over the very long term but is poor for short term estimates ? The theory holds better for countries with relatively high rates of inflation and underdeveloped capital markets 44 | P a g e Exchange Rate Indices: Real and Nominal: ? In order to evaluate a single currency?s value against all other currencies in terms of whether or not the currency is ?over? or ?undervalued,? exchange rate indices were created ? These indices are formed by trade-weighting the bilateral exchange rates between the home country and its trading partners ? The nominal exchange rate index uses actual exchange rates to create an index on a weighted average basis of the value of the subject currency over a period of time ? The real effective exchange rate index indicates how the weighted average purchasing power of the currency has changed relative to some arbitrarily selected base period ? Example: The real effective rate for the US dollar (E$ ) is found by multiplying the nominal rate index (E$ ) by the ratio of US dollar costs (C$) over foreign currency costs (CFC) IMF?s Real Effective Exchange Rate Indexes for the US, Japan and the Euro Area Nominal and Real Exchange Rate Indices for the US Dollar (monthly 1990-2010) FC $ $ N $ R C C x E E 45 | P a g e Nominal and Real Exchange Rate Indices for the European Euro (monthly 1990-2010) ? If changes in exchange rates just offset differential inflation rates ? if purchasing power parity holds ? all the real effective exchange rate indices would stay at 100 ? If a rate strengthened (overvalued) or weakened (undervalue) then the index value would be ± 100 Exchange Rate Pass-Through: ? Incomplete exchange rate pass-through is one reason that country?s real effective exchange rate index can deviate from its PPP equilibrium point ? The degree to which the prices of imported & exported goods change as a result of exchange rate changes is termed pass-through ? Example: assume BMW produces a car in Germany and all costs are incurred in euros. When the car is exported to the US, the price of the BMW should be the euro value converted to dollars at the spot rate ? Where P$ is the BMW price in dollars, P? is the BMW price in euros and S is the spot rate S x PP BMW$BMW ? Incomplete exchange rate pass-through is one reason that a country?s real effective exchange rate index can deviate for lengthy periods from its PPP-equilibrium level ? If the euro appreciated 20% against the dollar, but the price of the BMW in the US market rose to only $40,000, and not $42,000 as is the case under complete pass-through, the pass-through is partial ? The degree of pass-through is measured by the proportion of the exchange rate change reflected in dollar prices The degree of pass-through in this case is partial, 14.29% ÷ 20.00% or approximately 0.71. Only 71.0% of the change has been passed through to the US dollar price 14.29%or ,1429.1000,35$ 000,40$ P P $ 1 BMW, $ 2 BMW, 46 | P a g e Exchange Rate Pass-Through: Interest Rate and Exchange Rates: ? Prices between countries are related by exchange rates and now we discuss how exchange rates are linked to interest rates ? The Fisher Effect states that nominal interest rates in each country are equal to the required real rate of return plus compensation for expected inflation. As a formula, The Fisher Effect is i = r + ? + r ? Where i is the nominal rate, r is the real rate of interest, and ? is the expected rate of inflation over the period of time The cross-product term, r ?, is usually dropped due to its relatively minor value ? Applied to two different countries, like the US and Japan, the Fisher Effect would be stated as It should be noted that this requires a forecast of the future rate of inflation, not what inflation has been, and predicting the future can be difficult! ? The international Fisher effect, or Fisher-open, states that the spot exchange rate should change in an amount equal to but in the opposite direction of the difference in interest rates between countries ? if we were to use the US dollar and the Japanese yen, the expected change in the spot exchange rate between the dollar and yen should be (in approximate form) ? Justification for the international Fisher effect is that investors must be rewarded or penalized to offset the expected change in exchange rates ? The international Fisher effect predicts that with unrestricted capital flows, an investor should be indifferent between investing in dollar or yen bonds, since investors worldwide would see the same opportunity and compete it away i i 100 x S S S $ 2 21 47 | P a g e ? The Forward Rate ? A forward rate is an exchange rate quoted today for settlement at some future date ? The forward exchange agreement between currencies states the rate of exchange at which a foreign currency will be bought or sold forward at a specific date in the future (typically 30, 60, 90, 180, 270 or 360 days) ? The forward rate is calculated by adjusting the current spot rate by the ratio of euro currency interest rates of the same maturity for the two subject currencies ? The Forward Rate ? The Forward Rate example with spot rate of Sfr1.4800/$, a 90-day euro Swiss franc deposit rate of 4.00% p.a. and a 90-day euro-dollar deposit rate of 8.00% p.a. ? The forward premium or discount is the percentage difference between the spot and forward rates stated in annual percentage terms ? When stated in indirect terms (foreign currency per home currency units, FC/$) then formula is For direct quotes ($/FC), then F-S/S should be applied Currency Yield Curves and the Forward Premium: ? ? ? ? ? ? ÷ ? ? ? ? ? ? ? ? ? ? ? ÷ ? ? ? ? ? 360 90 x i 1 360 90 x i 1 x S F $ FC FC/$FC/$ 90 $Sfr1.4655/ 1.02 1.01 x Sfr1.4800 360 90 x 0.800 1 360 90 x 0.400 1 xSfr1.4800 Sfr/$ 90 F ? ? ? ? ? ? ÷ ? ? ? ? ? ? ? ? ? ? ? ÷ ? ? ? ? ? 100 x days 360 x Foward Foward -Spot f FC 48 | P a g e ? Using the previous Sfr example, the forward discount or premium would be as follows: The positive sign indicates that the Swiss franc is selling forward at a premium of 3.96% per annum (it takes 3.96% more dollars to get a franc at the 90-day forward rate) Interest Rate Parity (IRP): ? Interest rate parity theory provides the linkage between foreign exchange markets and international money markets ? The theory states that the difference in the national interest rates for securities of similar risk and maturity should be equal to, but opposite sign to, the forward rate discount or premium for the foreign currency, except for transaction costs ? In the diagram in the following slide, a US dollar-based investor with $1 million to invest, is shown indifferent between dollar-denominated securities for 90 days earning 8.00% per annum, or Swiss franc-denominated securities of similar risk and maturity earning 4.00% per annum, when ?cover? against currency risk is obtained with a forward contract Interest Rate Parity (IRP) 100 x days 360 x Foward Foward -Spot f FC p.a. 3.96% 100 x 90 360 x Sfr1.4655 Sfr1.4655 - Sfr1.4800 f Sfr 49 | P a g e Covered Interest Arbitrage (CIA): ? Because the spot and forward markets are not always in a state of equilibrium as described by IRP, the opportunity for arbitrage exists ? The arbitrageur who recognizes this imbalance can invest in the currency that offers the higher return on a covered basis ? This is known as covered interest arbitrage (CIA) ? The following slide describes a CIA transaction in much the same way as IRP was transacted Covered Interest Arbitrage (CIA) ? A deviation from CIA is uncovered interest arbitrage, UIA, wherein investors borrow in currencies exhibiting relatively low interest rates and convert the proceeds into currencies which offer higher interest rates ? The transaction is ?uncovered? because the investor does not sell the currency forward, thus remaining uncovered to any risk of the currency deviating ? Rule of Thumb: ? If the difference in interest rates is greater than the forward premium (or expected change in the spot rate), invest in the higher yielding currency. ? If the difference in interest rates is less than the forward premium (or expected change in the spot rate), invest in the lower yielding currency. Uncovered Interest Arbitrage (UIA): The Yen Carry Trade 50 | P a g e Interest Rate Parity (IRP) and Equilibrium Forward Rates as an Unbiased Predictor: ? If the foreign exchange markets are thought to be ?efficient? then the forward rate should be an unbiased predictor of the future spot rate ? This is roughly equivalent to saying that the forward rate can act as a prediction of the future spot exchange rate, and it will often ?miss? the actual future spot rate, but it will miss with equal probabilities (directions) and magnitudes (distances) Forward Rates as an Unbiased Predictor for Future Spot Rate: Prices, Index Rates and Exchange Rates in Equilibrium: ? (A) Purchasing power parity ? forecasts the change in the spot rate on the basis of differences in expected rates of inflation ? (B) Fisher effect ? nominal interest rates in each country are equal to the required real rate of return (r) plus compensation for expected inflation ( ?) ? (C) International Fisher effect ? the spot exchange rate should change in an amount equal to but in the opposite direction of the difference in interest rates between countries 51 | P a g e ? (D) Interest rate parity ? the difference in the national interest rates should be equal to, but opposite in sign to, the forward rate discount or premium for the foreign currency, except for transaction costs ? (E) Forward rate as an unbiased predictor ? the forward rate is an efficient predictor of the future spot rate, assuming that the foreign exchange market is reasonably efficient International Parity Conditions in Equilibrium (approximate form) Summary: ? Parity conditions have traditionally been used by economists to help explain the long run trend in an exchange rate ? Under conditions of freely floating rates, the expected rate of change in the spot exchange rate, differential rates of national inflation and interest, and the forward discount or premium are all directly proportional to each other and mutually determined. A change in one of these variables has a tendency to change all of them with a feedback on the variable that changes first. ? If the identical product or service can be sold in two different markets, and there are no restrictions on its sale or transportation costs of moving the product between markets, the product?s price should be the same in both markets. This is called the law of one price. ? The absolute version of the theory of purchasing power parity states that the spot exchange rate is determined by the relative prices of similar baskets of goods. ? The relative version of the theory of purchasing power parity states that if the spot exchange rate between two countries starts in equilibrium, any change in the differential rate of inflation between them tends to be offset over the long run by an equal but opposite change in the spot exchange rate. ? The Fisher effect, named after economist Irving Fisher, states that nominal interest rates in each country are equal to the required real rate of return plus compensation for expected inflation. ? The international Fisher effect, ?Fisher-open? as it is often termed, states that the spot exchange rate should change in an equal amount but in the opposite direction to the difference in interest rates between two countries. ? The theory of interest rate parity (IRP) states that the difference in the national interest rates for securities of similar risk and maturity should be equal to, but opposite in sign to, the forward rate discount or premium for the foreign currency, except for transaction costs. ? When the spot and forward exchange markets are not in equilibrium as described by interest rate parity, the potential for ?riskless? or arbitrage profit exists. This is called covered interest arbitrage (CIA). ? Some forecasters believe that for the major floating currencies, foreign exchange markets are ?efficient? and forward exchange rates are unbiased predictors of future spot exchange rates. 52 | P a g e CHAPTER 9 ? FOREIGN EXCHANGE RATE DETERMINATION AND FORECASTING: Learning Objectives: ? Examine how the supply and demand for any currency can be viewed as an asset choice issue within the portfolio of investors ? Explore how the three major approaches to exchange rate determination ? parity conditions, the balance of payments, and the asset approach ? combine to explain in the numerous emerging market currency crises experienced in recent years ? Observe how forecasters combine technical analysis with the three major theoretical approaches to forecasting exchange rates Foreign Exchange Rate Determination and Forecasting: ? Three basic approaches ? Parity conditions ? Balance of Payments ? Asset market ? These are not competing theories but are in fact complimentary theories ? Without the depth and breadth of the various approaches combined, our ability to capture the complexity of the global market for currencies is lost ? Along with an understanding of the theories, an understanding of the complexities of international political economy, societal and economic infrastructures, and random political and social events is needed when viewing the foreign exchange markets ? Infrastructure weaknesses were among the major causes of the exchange rate collapses in emerging markets in the late 1990s ? Speculation contributed greatly to the emerging market crises. Uncovered interest rate arbitrage caused by extremely low interest rates in Japan coupled with high real interest rates in the US was a problem in the 1990s ? Cross-border foreign direct investment and international portfolio investment into emerging markets dried up during the recent crises ? Foreign political risks have been much reduced in recent years as capital markets became less segmented from each other and more liquid ? Finally, note that most determinants of spot exchange rates are also in turn affected by changes in the spot rate ? in other words, they are not only linked but mutually determined 53 | P a g e The Determinants of Foreign Exchange Rates: Purchasing Power Parity Approach: ? PPP is the oldest and most widely followed of the exchange rate theories ? PPP is embedded within most theories of exchange rate determination ? PPP calculations and forecasts have structural differences across countries and significant data challenges in estimation ? Many versions of PPP (see chapter 7) but perhaps the relevant for explaining exchange rate values is Relative Purchasing Power Parity which explains that changes in relative prices between countries drive the change in exchange rates over time Balance of Payments (Flows) Approach: ? Essentially BOP approach says equilibrium exchange rate is achieved when current account inflows match current account outflows ? BOP transactions are widely appealing, captured, and reported ? Criticism of the BOP approach is that it focuses on flows rather than stocks of money or financial assets ? Relative stocks of money or financial assets do not play a role in the theory ? Practitioners use BOP but academics largely dismiss it Monetary Approaches: ? Changes in supply and demand for money largely determine inflation which in turn alter exchange rates ? Prices are flexible in both the short and long-run thus, the transmission impact is immediate ? Real economic activity influences exchange rates through any alterations in demand for money ? Omits a number of important factors for exchange rate determination including: ? The failure of PPP to hold in the short to medium term ? Money demand appears to be relatively unstable over time 54 | P a g e ? The level of economic activity and the money supply do not appear to be independent ? Do to these significant omissions the authors choose to ignore this approach Asset Market Approach (Relative Price of Bonds): ? AKA relative price of bonds or portfolio balance approach ? argues that exchange rates are determined by supply and demand for a wide variety of assets ? Shifts in supply and demand alter exchange rates ? Changes in monetary and fiscal policy alter expectations and thus exchange rates ? Theories of currency substitution follow the same basis premises of portfolio rebalance framework ? The Asset market approach assumes that whether foreigners are willing to hold claims in monetary form depends on an extensive set of investment considerations or drivers (as per the previous exhibit) ? In highly developed countries, foreign investors are willing to hold securities and undertake foreign direct investment based primarily on relative real interest rates and the outlook for economic growth and profitability ? Prospects for economic growth and profitability are an important determinant of cross-border equity investment in both securities and foreign direct investment ? Capital market liquidity is particularly important to foreign institutional investors. Cross-border investors are not only interested in the ease of buying assets, but also in the ease of selling those assets quickly for fair market value if desired ? A country?s economic and social infrastructure is an important indicator of its ability to survive unexpected external shocks and to prosper in a rapidly changing world economic environment ? Political safety is exceptionally important to both foreign portfolio and direct investors. The outlook for political safety is usually reflected in political risk premiums for a country?s securities and for purposes of evaluating foreign direct investment in that country ? The credibility of corporate governance practices is important to cross-border portfolio investors. A firm?s poor corporate governance practices can reduce foreign investors 'influence and cause subsequent loss of the firm?s focus on shareholder wealth objectives ? Contagion is defined as the spread of a crisis in one country to its neighboring countries and other countries with similar characteristics?at least in the eyes of cross-border investors. Contagion can cause an ?innocent? country to experience capital flight with a resulting depreciation of its currency ? Speculation can both cause a foreign exchange crisis or make an existing crisis worse Currency Market Intervention: ? Foreign currency intervention, the active management, manipulation, or intervention in the market?s valuation of a country?s currency, is a component of currency valuation and forecast that cannot be overlooked. ? Central bank?s driving consideration ? inflation or unemployment? ? ?beggar-thy-neighbor,? policy to keep currency values low to aid in exports, may prove inflationary if some goods MUST be imported ? e.g. oil ? Direct Intervention - This is the active buying and selling of the domestic currency against foreign currencies. This traditionally required a central bank to act like any other trader in the currency market 55 | P a g e ? Coordinated Intervention - in which several major countries, or a collective such as the G8 of industrialized countries, agree that a specific currency?s value is out of alignment with their collective interests ? Indirect Intervention - This is the alteration of economic or financial fundamentals which are thought to be drivers of capital to flow in and out of specific currencies ? Capital Controls - This is the restriction of access to foreign currency by government. This involves limiting the ability to exchange domestic currency for foreign currency ? The Chinese regulation of access and trading of the Chinese yuan is a prime example over the use of capital controls over currency value. Disequilibria: Exchange Rates in Emerging Markets: ? Although the three different schools of thought on exchange rate determination make understanding exchange rates appear to be straightforward, that is rarely the case ? The problem lies not in the theories but in the relevance of the assumptions underlying each theory ? After several years of relative global economic tranquility, the second half of the 1990s was racked by a series of currency crises which shook all emerging markets ? The Asian crisis of July 1997 ? The Argentine crisis (1998 ? 2002) The Asian Crisis ? July 1997: ? The roots of the Asian crisis extended from a fundamental change in the economies of the region, the transition of many Asian countries from being net exporters to net importers ? Starting in 1990 in Thailand, the rapidly expanding economies of the Far East began importing more than they were exporting, requiring major net capital inflows to support their currencies ? As long as capital kept flowing in, the currencies were stable, but if this inflow stopped then the governments would not be able to support their fixed currencies ? The most visible roots of the crisis were in the excesses of capital inflows into Thailand in 1996 and 1997 ? Thai banks, firms and finance companies had ready access to capital and found US dollar denominated debt at cheap rates ? Banks continued to extend credits and as long as the capital inflows were still coming, the banks, firms, and government was able to support these credit extensions abroad ? After some time, the Thai Baht came under attack due to the country?s rising debt ? The Thai government intervened in the foreign exchange markets directly to try to defend the Baht by selling foreign reserves and indirectly by raising interest rates ? This caused the Thai markets to come to a halt along with massive currency losses and bank failures ? On July 2, 1997 the Thai central bank allowed the Baht to float and it fell over 17% against the dollar and 12% against the Japanese Yen ? By November 1997, the baht fell 38% against the US dollar ? Within days, other Asian countries suffered from the contagion effect from Thailand?s devaluation ? Speculators and capital markets turned towards countries with similar economic traits as Thailand and their currencies fell under attack ? In late October, Taiwan caught the markets off-guard with a 15% devaluation and this only added to the momentum ? The Korean Won fell from WON900/$ to WON1100/$ (18.2%) 56 | P a g e ? The Malaysian ringgit fell 28.6% and the Filipino peso fell 20.6% against the dollar ? The only currencies that were not severely affected were the Hong Kong dollar and the Chinese renminbi The Thai Baht and the Asian Crisis ? The Asian currency crisis was more than just a currency collapse ? Although the varying countries were different they did have similar characteristics which allow comparison ? Corporate socialism ? Post WWII Asian companies believed that their governments would not allow them to fail, thus they engaged in practices, such as lifetime employment, that were no longer sustainable ? Corporate governance ? Most companies in the Far East were often largely controlled by either families or groups related to the governing body or party of that country ? This was labeled cronyism and allowed the management to ignore the bottom line at times when this was deteriorating ? Banking liquidity and management ? Although bank regulatory structures and markets have been deregulated across the globe, their central role in the conduct of business has been ignored ? As firms collapsed, government coffers were emptied and investments made by banks failed ? The banks became illiquid and they could no longer support companies? need for capital The Russian Crisis of 1998: ? 1995 ? 1998 Russian govt and nongovt borrowing very high, servicing the debt becomes difficult ? Russian exports are mostly commodity-based and world commodity prices drop as a result of the Asian crisis of 1997 ? thus, Russian exports values decline ? The Ruble was under a managed float with a band of 1.5% and most days the Russian Central Bank is forced to enter the market to buy rubles ? The August Collapse ? Currency reserves had fallen, Russia announces it will raise an extra $1 billion in foreign bonds to help pay for rising debt 57 | P a g e ? The August Collapse ? Russian stocks drop by 5% on August 10 on fears that China would cut its currency value ? Russia claims they will not devalue the Ruble then at RUB6.3/USD ? August 17, the ruble is devalued by 34% by the 26th the Ruble is down to RUB13/USD ? Exhibit 9.3 traces the fall of the Russian Ruble The Fall of the Russian ruble The Argentine Crisis ? 2002 ? In 1991 the Argentine peso had been fixed to the U.S. dollar at a one-to-one rate of exchange ? This policy was a radical departure from traditional methods of fixing the rate of a currency?s value ? Argentina adopted a currency board, which was a structure rather than just a commitment, to limiting the growth of money in the economy ? Under a currency board, the central bank of a country may increase the money supply in the banking system only with increases in its holdings of hard currency reserves ? By removing the ability of government to expand the rate of growth of the money supply, Argentina believed it was eliminating the source of inflation which had devastated its standard of living ? The idea was to limit the rate of growth in the country?s money supply to the rate at which the country receives net inflows of U.S. dollars as a result of trade growth and general surplus The Collapse of the Argentine peso 58 | P a g e ? A recession that began in 1998, as a result of a restrictive monetary policy, continued to worsen by 2001 and revealed three very important problems with Argentina?s economy: ? The Argentine peso was overvalued ? The currency board regime had eliminated monetary policy alternatives for macroeconomic policy ? The Argentine government budget deficit ? and deficit spending ? was out of control ? While the value of the peso had been stabilized, inflation had not been eliminated ? The inability of the peso?s value to change with market forces led many to believe increasingly that it was overvalued ? Argentine exports became some of the most expensive in all of South America as other countries saw their currencies slide marginally against the dollar over the past decade while the peso did not ? Because the currency board eliminated expansionary monetary policy as a means to stimulate economic growth in Argentina, the Argentine government was left with only fiscal policy as a means to this end ? The Argentine government continued to spend as a means to quell increasing social and political tensions and unrest, but without the benefit of increasing (or even stable) tax receipts ? Continued government spending and the injection of foreign capital into the country steadily increased the debt burden ? Many began to fear an impending devaluation, removing their peso denominated funds (as well as U.S. dollar funds) from Argentine banks ? Capital flight as well as rampant conversion of peso holdings into U.S. dollar deposits put additional pressure on the value of the peso ? On Sunday January 6, 2002, in the first act of his presidency (the fifth president in two weeks), President Eduardo Duhalde devalued the peso from Ps 1.00/$ to Ps 1.40/$ ? On February 3, 2002, the government announced that the peso would be floated, beginning a slow but gradual depreciation ? In addition to the three approaches to forecasting discussed earlier (Parity Conditions, Balance of Payments, Asset Approach) forecasting practitioners also utilize technical analysis ? These analysts, traditionally referred to as chartists, focus on price and volume data to determine past trends that are expected to continue into the future ? The longer time horizon of the forecast, the more inaccurate the forecast is likely to be ? The following summarizes the various forecasting periods, regimes and preferred forecasting methods for each 59 | P a g e Exchange Rate Forecasting in Practice Forecasting in Practice: ? Decades of theoretical and empirical studies show that exchange rates do adhere to the fundamental principles and theories outlined in the previous sections ? fundamentals do apply in the long term ? Therefore, there is something of a fundamental equilibrium path for a currency?s value ? In the short term, a variety of random events, institutional frictions, and technical factors may cause currency values to deviate significantly from their long term fundamental path ? this is sometimes referred to as noise The Short-Term Noise versus Long-Term Trends ? Although the various theories surrounding exchange rate determination are clear and sound, it may appear on a day-to-day basis that the currency markets do not pay much attention to the theories ? The difficulty is understanding which fundamentals are driving markets at which points in time ? One example of this relative confusing over exchange rate dynamics is the phenomenon known as overshooting 60 | P a g e Exchange Rate Dynamics: Overshooting Summary: ? The asset approach suggests that whether foreigners are willing to hold claims in monetary form depends partly on relative real interest rates and partly on a country?s outlook for economic growth and profitability ? Longer-term forecasting requires a return to basic analysis of exchange rate fundamentals such as BOP, relative inflation, interest rates and long-run properties of PPP ? Technical analysis focus on price and volume data to determine past trends that are expected to continue in the future ? Exchange rate forecasting in practice is a mix of both fundamental and technical forms of exchange rate analysis ? The Asian crisis was primarily a BOP crisis in its origins and impacts on exchange rates. A weak economic and financial infrastructure, corporate governance problems and speculation also contributed ? The Argentina crisis of 2002 was probably a combination of disequilibrium in international parity conditions (different rates of inflation) and balance of payments disequilibrium (current account deficits combined with financial account outflows) ? The Russian ruble crisis of 1998 was a complex combination of speculative pressures best explained by the asset approach to exchange rate determination ? The Argentine crisis of 2002 was probably a combination of a disequilibrium in international parity conditions (differential rates of inflation) and balance of payments disequilibrium (current account deficits combined with financial account outflows) 61 | P a g e FORMULA SHEET Olivia
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