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FIN 6860: International Finance Management

Professor Ghassem Homaifar
Middle Tennessee State University
Summer 2017


1. Chapter 1, Global Markets: Transactions and Risks 1

2. Chapter 2, Balance of Payments Exposure Management 39

3. Chapter 3, Foreign Exchange Rate Dynamics: Managing Exposure 79

4. Chapter 4, Applications of Options in Managing Exposure 147

5. Chapter 8, Swaps 185

6. Chapter 9, Translation, Transaction, and Operating Exposure 249

7. Chapter 10, Debt, Equity, and Other Synthetic Structures 307

8. Chapter 11, Measuring, Managing, and Mitigating Credit Risk 355

9. Chapter 12, Measuring and Managing Market Risk 375

10. Chapter 16, Credit Derivatives: Pricing and Applications 415

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Global Markets for Debt, Equity, and Derivatives



Chapter 1

Global Markets: Transactions and Risks


Exposure has increased for the major players in the financial market as the world economy has seen

a major restructuring of financing transactions since March, 1973 (the beginning of floating rate

arrangement). The increased volatility of exchange rates and innovations in derivative products has

created opportunities and challenges for individuals, corporations, and governments. Most firms

have been able to rise to the occasion, adapted to new challenges and prospered. Some have not

fared so well and in extreme cases have like dinosaurs been unable to adapt to environmental

changes and have become extinct. Lehman Brothers and the Bear Stern, unable to manage their

exposure, are the classic examples of dinosaurs. Increased volatility of exchange rates since 1973

coupled with rising equity price risk, commodity price risk and interest rate risk; has created

challenges and opportunities for multinational corporations. As risk has increased so has the

expected reward.

Risk taking is the foundation of a capitalist economy as it is positively correlated to the reward for

entrepreneurial behavior. Global financial management in the 21st century integrates mathematical and

physical science along with behavioral finance and economics. The result is a mushrooming set of

derivative products where price is contingent on the behavior of underlying assets such as stocks, bonds,

commodities, currencies, indices and other exotic instruments. The global markets for debt, equities, and

derivatives play an ever-increasing important role in transferring risk from risk averse individuals and

institutions to those who are willing to take it for a profit. Risk taking and risk management is balanced in

the marketplace by regulatory oversight. Bank and financial services industry regulators continue to



search for an optimum balance that protects the integrity of the banking system and provides regulatory capital relief while enhancing the return on capital to financial institutions. there exists no coherent and concrete literature for 2 3 .. tax laws and business and financial risks with further innovations in derivatives using financial engineering. Managing and mitigating these risks are crucial in creating value for the shareholders. i. and interest rate changes within the context of value creation for their stakeholders. Wall Street’s brightest minds continue to respond to changes in the regulatory landscape. Using financial derivatives such as forward. commodity price. foreign exchange. Recent events highlighted by the sub-prime mortgage mess in the financial markets have cast considerable doubts on the ability of the financial markets to weather a financial storm induced by the action of major players. hid over the course of five years. Financial risk that is induced by credit. banks. market. My objective is to present a coherent analysis of the financing and investment decisions of multinational financial and non-financial corporations facing various risks in an integrated global market and to consider portfolio management approaches for mitigating exposures to equity price. hedge funds. and operation risk exposure of multinational financial institutions as well as transnational corporations have a significant impact on the profitability of these institutions. Other huge losses stemming from loss of internal control are exhibited by the actions of rogue trader Jerome Krevel of Société Générale. underwriters. also a rogue trader. rating agencies in particular. As a result systematic risk has risen to a point that threatens the well being of the economy.e. Numerous real world examples are employed throughout the book to illustrate how derivatives can be used to mitigate these risks. investment bankers. futures. Unfortunately. options and swaps these various risks can be mitigated. who incurred losses in excess of $7 billion in 2008 as well as a $691 million loss on February 2002 by Allied Irish Bank which John Rusnack. and regulators at large.

This trigger was the $1 trillion sub-prime mortgage originated in 3 4 . the markets have developed various types of insurance for managing and transferring those risks to risk arbitrageurs.g. and a mushrooming innovative financial products that increased leverage and encouraged excessive risk taking raising exposure for the major players such as banks. What remains to be managed is the macro risk: the market risk that cannot be avoided. according to the International Swaps and Derivatives Association (ISDA) survey of 2008. defined by Webster's dictionary as “the fact of being exposed in a helpless condition to the elements” is truly revealing. liberalization of trade policies. investments banks. friendly or lax regulatory environments. The increase in market (systematic) risk to socially unacceptable level needed only a trigger event to send shock waves around the globe. Exposure. Increased Volatility: Opportunities and Challenges This chapter outlines the foundation of global markets for debt. and hedge funds. increased integration of financial markets around the world. insurers. insurance and reinsurance companies. Over the course of the last three decades. Fortunately. we have witnessed major restructuring in the world economy e. equities and derivatives. Over the course of the last 10 years macro risk has continued to rise as reflected in the phenomenal growth of highly leveraged transactions (HLTs) in derivatives with notional principal of over $600 trillion. for unforeseen events such as death or natural disasters. floating rate arrangements in 1973.1 The elements can be events (some unforeseen) such as sub-prime mortgage mess that unraveled in 2007-08 or unique to a particular company such as the Société Générale scandal highlighted earlier. greater cooperation of economic units.students of finance or practitioners that explain the underlying principle in simple yet easily understood concepts without alienating the intended target audience unless they hold a post graduate degree in finance.

The bank had approximately $307bn of assets but only about $188bn of deposits. The resulting higher mortgage payments induced mounting foreclosures. WAMU was hit by mortgage defaults due to its significant exposure to sub-prime and other risky mortgages as well as the collapse of the US housing market. which had become increasingly expensive. which has been very costly for the major players in general and the US and world economy in particular. had to raise funds on money markets. Washington Mutual (WAMU) filed for Chapter 11 bankruptcy protection on September 26. some of the innovations such as default insurance (credit default swap) initially hailed as one of the most important vehicles for transferring counterparty credit risk. and Bear Sterns. Exposure has also increased for the major players in the market as the world economy has seen a major restructuring of financing transactions since March.the real estate boom of early 2000 at teaser rate (initial low interest rate) and was stepped up in 2007. The Office of Thrift Supervision (OTS) sold WAMU’s assets to JPMorgan Chase for $1. 2008 one day after regulators seized its assets and sold it to JPMorgan Chase in the largest bank failure in the United States. 1973 (the beginning of floating rate arrangements). For example. Lehman Brothers. The increased volatility of exchange rates and innovations in derivative products has created opportunities and challenges for corporations.7bn of deposits had been withdrawn in 10 days. is at the heart of the major collapse or near collapse for such Wall street giants as AIG.9bn (£1bn) after $16. which had a snowball effect leading to the collapse of real estate markets and markets for equities and debt. The increased innovations in derivative products has proven to be a two edge sword. The increased volatility of exchange rate provided opportunities in the risk management arena as Wall Street created innovative products for mitigating foreign exchange risk. 4 5 . raising efficiency of financial intermediation and increasing leverage coupled with little regulatory oversight. which meant it.

and forward trades — are unaffected by automatic stays.S. gets immediate protection from its creditors which prevents those creditors from going forward with lawsuits and seizing the debtor’s assets. As Lehman’s parent corporation filed for bankruptcy protection . Individual investors who have accounts with Lehman’s broker-dealer subsidiaries are supposed to be protected. repurchase agreements. 5 6 . and maybe even allow the company to re-emerge in sound health. with a financial institution the automatic stay offers no protection against many of its most important creditors. In a trend that began in 1978 and was greatly expanded in 2005. the counterparty — banks or other institutions that entered into a securities contract with Lehman — are allowed to cancel the contract and seize whatever collateral may cover it. In the 1990s the Federal Reserve Bank of New York decided to place Long Term Capital Management (LTCM) with banks and other institutions with which it had prime brokerage relationships instead of letting it to collapse. most financial contracts — including securities contracts. and their accounts are further protected by the Federal Securities Investor Protection Corporation. subsidiaries such as its brokerage-dealer subsidiaries. theoretically. and investment management division are supposed to continue operating as normal. An ordinary bankruptcy petitioner such as an airline or a manufacturing company. However. This is intended to reduce spillover effect of an investment bank or commercial bank failure to the rest of the economy. swaps. The counterparties are provided the opportunity to free themselves immediately from Lehman’s troubles rather than getting mired in a bankruptcy proceeding. 2008. Lehman Brothers’ holding company filed for Chapter 11 bankruptcy protection on September 14. and management gets time to organize its affairs in a way that will. Runs on banks are prevented. asset management unit. but none of the U. maximize value for all creditors. as their assets are not available to Lehman’s creditors. commodities contracts.

05 -0. The dollar was devalued to $38/ounce of gold in December 17- 18. The percentage changes in the yen/$ exchange rate appears to be randomly distributed. Exhibit 1. It is also notable to observe the absence of volatility in the foreign exchange market for yen/$ in a pre-floating rate arrangement. while allowing occasional dollar devaluations such as in 1934 when the dollar was devalued to $35/ounce of gold from $20. Despite these devaluations March 1973 marks the end of fixed exchange rate arrangement when the British Pound and Swiss Franc were allowed to float on June 1972 and January 1973. This period coincided with the fixed exchange rate arrangement of 1945-1971 known as the Bretton Woods Arrangement.1 -0.15 P e r c e n ta g e c h a n g e in 0. 1979- 80 and 1995-96. Notable in the exhibit is the beginning of the floating rate arrangement of 1973 and the subsequent significant increase in the volatility of the exchange rate particularly in the periods of 1973-74.15 Time (monthly data) 6 7 . which came to be known as Smithsonian Agreement. EXHIBIT 1.1 shows the percentage monthly change in yen/$ exchange rates from 1957 to 2007.1 Monthly Percentage Change¥/$ (1957-2005) 0.1 0.05 0 1957M 1 1959M 1 1961M 1 1963M 1 1965M 1 1967M 1 1969M 1 1971M 1 1973M 1 1975M 1 1977M 1 1979M 1 1981M 1 1983M 1 1985M 1 1987M 1 1989M 1 1991M 1 1993M 1 1995M 1 1997M 1 1999M 1 2001M 1 2003M 1 2005M 1 -0.2 m o n th ly e x c h a n g e ra te ¥ /$ 0. respectively. 1971. The dollar devalued by an average of 10 percent by June of 1973.67/ounce to remedy huge deficits in the US.

Laker Airways was a victim of this mismatch. where the yield curve was downward sloping (i. the double digit inflation of the late 1970s and concurrent rise in short term interest rates as well as recession of the early 1980s and the slow down in economic activities reduced the incentive to borrow squeezing profit and reversing the fortunes of the S&Ls. raising revenue of Laker Airways and inducing it to borrow U.S. The mismatch of revenue (mostly fixed rate) and cost (mostly floating rate) created exposure for S&L. The risk of the mismatch of assets/liabilities in the case of S&L did not disappear..e. the risk of rising interest rates shifted to borrowers. as it paid for to borrow short term and lend long term profitably when the yield curve was upward sloping. However. Consider a scenario where revenue is denominated in one currency and cost is incurred in another currency. A weak dollar in the early1970s made travel to United States a bargain for British travelers. After the S&L debacle. The high interest rate of the late1970s and early 1980s produced an inverted yield curve in1982. Exhibit 1. short term rate was higher than long term rate) forcing the entire industry into bankruptcy. thereby increasing the probability of default of the borrower.2 shows the rate of monthly percentage of pound devaluation (revaluation) over 1971-2009 periods. banks simply transferred it to the individual borrowers.Saving and Loans Hit by Double Whammy: Savings and Loans corporations (S&Ls) had high duration assets on the left hand side of the balance sheet in the form of mostly fixed rate mortgages. 7 8 . These were funded on the right hand side of the balance sheet with mostly low duration. short term floating rate demand deposit and fixed rate time deposit of two to five years maturity. dollar to purchase new aircrafts.

Exhibit 1. It appears that the monthly basis point change in 1-year T/bills dramatically increased in the late 70s due to double-digit inflation raising the exposure for the financial institutions particularly the savings and loans associations.Exhibit 1.3 provides some interesting statistics on the monthly change in basis points for the one- year treasury bills since 1934.2: Monthly Percentage change in $/£ Exchange Rate 9 8 .

The governing principle to settle claims between principal and agent. Laker Airways was hit by a double whammy that forced the company into bankruptcy. Agency problems: Domestic or multinational corporations can be defined as a portfolio of various activities.3: First difference in 3 Months Treasury bills 1934-2009 The US dollar strengthened against the British pound by early 1980. where each activity is intended to produce pay-offs in sustaining and creating value for the stakeholders. In organizing various activities firms issue claims to the assets of the corporations to various claimants based on priority of claims. thereby making travel to United States very expensive and increasing the pound cost of the dollar to service the dollar denominated debt. Stakeholders develop a comprehensive system of checks and balance to insure that one class of claimants such as creditors is protected against the abuse of power of another class of claimants such as stockholders. management and the stockholders. management and the employee and management and any other injured party is defined 9 10 . stockholders and bondholders. Exhibit 1.

further reducing their ability to access the credit market. Madoff was convicted of operating a Ponzi 10 11 . Monster Mess The Bernard Madoff scandal. a party wishing to establish an agency relationship with another party might require a “prenuptial agreement. without an appropriate and well-defined agency relationship that defines the contractual obligations of various claimants the firm runs the risk of lengthy legal battles that drain scarce resources and destroy the agency relationship. In the context of domestic or multinational firms. where he defrauded investors over a period of 10 years in excess of $50 billion is the classic example of operational risk and its interaction with market and credit risk leading to severe loss of confidence in Wall Street. However. conflict of interest lands the parties in “divorce court” for the resolution and division of assets (physical and human) and liabilities. To manage stakeholders’ exposure to abuses by the management a compensation scheme is designed by most firms' stakeholders to direct the management actions toward maximizing value of the firms. The conflict of interest between the parties in an agency relationship gives rise to agency-related problems and cost. the conflict of interest between stakeholders and management need to be managed and mitigated. The credit rating plummeted for institutions weakened by this scandal. The cost associated with managing and mitigating agency related risk could be substantial. To alleviate agency related problems and the cost associated with that. In this case the operational risk exacerbated the market as well as credit risk.” In this case a prenuptial agreement can be an exposure management vehicle to avoid the cost and pain arising in the future in the event of dissolution of the agency relationship. Whether management acts in the best interest of stockholders or creditors. In the context of two individuals in an agency relationship such as marriage. or pursues its own self-interest by giving themselves large severance packages or golden parachutes in the event of a corporate buyout or merger is an empirical issue.

which included fabricated gains. Domestic or multinational firms should strike a balance between the costs and benefits of agency relations to a point where the marginal cost of additional agency relationship is equal to marginal benefits realized of entering into the additional agency relationships. Federal prosecutors estimated client losses. he was sentenced to 150 years in prison. the maximum allowed. TYPES OF MARKETS Markets for Real Assets In this market individuals and corporations organize their economic activities efficiently for producing real goods (tangible) such as food. The following section describes the types of the markets. of almost $65 billion. clothing and shelter and (intangible) services such as counseling. excluding the fabricated gains. how to and for 11 12 .scheme that has been called the largest investor fraud ever committed by anyone. raw materials and capital in such a way that pays for the cost of the factors and leave a profit for the producer. transactions and risks facing individual and corporations in a global economy. Here value is created and opportunities expanded and the welfare of individuals in the society is increased. Multinational corporations are far more exposed to agency-related problems and costs due to operational and locational diversification and various regulatory requirements than their domestic counterparts. 2009. education and other services for allocation and distribution in meeting the demands of the society. other estimates of the fraud. The producers employ factors of production labor. that is what to. Executives of Japanese multinational corporations usually sit on the board of the directors of each other and are far more effective in managing agency related cost between management and unions than their North American counterparts. are $13 to $21 billion. On June 29. The governing principle to address the three basic questions of the market economy.

Derivatives derive their value from the underlying assets such as stocks. The derivative markets perform two valuable functions: transferring risk and price discovery. This market also is known as the sum zero game market.2 12 13 . The profit and loss potential is symmetrical and can be devastating to the well being of individuals or corporations. Projects that produce more pay-offs than their costs create value for the providers of capital. it is simply transferred from one party to another in a given transaction. the financial and real markets are not complete and may not function efficiently in managing. Some even refer to derivative markets as speculative markets where two parties take offsetting position based on their own expectations. bond markets and foreign exchange spot markets. The capital is expected to be channeled in such a way that maximizes the welfare of the economic system. bonds. where the underlying asset is the spot exchange rates representing claim on the purchasing power of one currency relative to another currency. where the gain of one party is exactly equal to loss of another party. The corporations issue claims to assets of their company in the form bonds and stocks for acquiring long term capital or short term vehicles such as commercial paper or banker’s acceptances known as money market instruments for securing short term debt. This mechanism ensures the production of goods and services that the economy demands and is willing to pay for. Without derivative markets. corporations and other entities.whom to produce is the price mechanism. where the most promising projects are funded based on the merits of the projects. Markets for Derivatives In this market value is neither created nor destroyed. Examples of financial markets are stock markets. Markets for Financial Assets Market for financial assets is where the capital is distributed and channeled from lenders (investors) to ultimate users of capitals (borrowers) individuals. mitigating and transferring risks. commodities or foreign currency spot exchange rates.

000 11/19/2009 0.010 11:03 5-YEAR 2.4.000 11:14 12-MONTH 0.0050 99. 2009.43 -0-03 / .008 11:23 Exhibit 1.40 -0. Treasuries (Spot) August 18.01 0-00 / .S.000 07/31/2011 99-31+ / 1. commodity prices.002 / -.5600 99.S.55 -0-01 / .004 / .5525 +0.750 08/15/2012 100-19 / 1. procuring and executing production as well as managing and mitigating exposure to various risks. This price discovery mechanism provided by derivative markets is essential for planning.625 07/31/2014 100-29½ / 2.485 200 8/18/2009 13 14 . 10:29:50 AM CST Eurodollar Futures IMM index Sep 2009 10:29:50 AM CST 99.U.18 0. stocks or bonds prices and foreign currency exchange rate will be.020 11:21 7-YEAR 3.5475 99.004 11:00 6-MONTH 0.250 07/31/2016 101-00 / 3.5 highlight the price discovery mechanism of the derivatives market and the link between markets for financial assets and derivatives: Exhibit 1.48 -0-02+ / .26 / .09 -0-01 / .000 11:00 3-YEAR 1.32 0-04+ / -. That is this market enables individuals and corporations and other agencies to discover today the expected market consensus of what for example future interest rate.4 and exhibit 1.625 08/15/2019 101-07+ / 3. Treasuries MATURITY CURRENT PRICE/YIELD COUPON TIME DATE PRICE/YIELD CHANGE 3-MONTH 0. 2009.005 99. The derivative markets serve to provide valuable information to participants for taking current actions to remedy expected problems in the near future.26 0 / .485 99.000 02/18/2010 0. August 18.500 08/15/2039 103-02+ / 4.485 99.475 99.5450 99.18 / .4 / .009 11:22 30-YEAR 4.002 11:04 2-YEAR 1. Exhibit 1. U.480 a +0.005 11:21 10-YEAR 3.5-Tuesday.5400 76971 8/18/2009 Oct 2009 10:28:20 AM CST 99.000 07/29/2010 0.

56)in Exhibit 1.560 8/17/2009 Oct 2009 101.99.385 +0.510 7:00:00 PM CST .- 97.56 is 44 basis points (100. The T/bills futures predict that the short-term interest rate is expected to go up by 28 basis points by September. The futures interest rate yield for the 90-day T/bill futures at current price of 99..430 99.380 99.435. 2009 from the Chicago Mercantile Exchange is 56.- 97. priced on August 18. 2009.Nov 2009 10:28:20 AM CST 99.355 106229 8/18/2009 T/bills Futures Sep 2009 101. 18 2009. The spot transaction may take place in an organized exchange such as New York Stock Exchange NYSE or 14 15 .380 99.560 7:00:00 PM CST .435 +0.430 361 8/18/2009 Dec 2009 10:29:50 AM CST 99..5 for September 18.005 99..S Treasury markets as of August 18.510 8/17/2009 Source: Chicago Mercantile Exchange As shown in Exhibit 1..99.005 99.510 .. The Eurodollar interest rate futures.560 .435 99. the most active future for November 2009 delivery. the short term interest rate hike by Federal Reserve board by as much as 25 basis points to take place by September 2009.440 99. TYPES OF TRANSACTIONS Spot Transaction Most transactions in every economy are spot for immediate delivery of the goods or services for cash or credit in transactions in the markets for real assets or the markets for financial assets. 2009 priced on August 18. The interest rate futures have priced as of August. 2009..5 basis points at current index of 99. or those who have a line of credit at the floating rate may consider converting to the fixed rate before the rates go up.99. The price discovery function of derivatives is a reminder to the participants of the markets that those who wish to borrow short term in the near future should take advantage of the lower rate right now.4 the 90-day zero-coupon T/bills interest rate is 18 basis points in U.390 99.

Options Transaction A unilateral transaction where one party has the right but not an obligation to buy (to call) or to sell (to put) real or financial assets at a specific price (strike price) for a given future delivery period is called an option transaction. The market for options where the call is the right to purchase or the put is the right to sell. In still other scenarios the parties may arrange that no physical delivery of the goods is to take place and the parties settle their transactions on cash basis on or before the delivery date. For example the parties to a transaction involving the purchase and sale of 100 shares of IBM stock remain anonymous to one another. assets (i.. The only difference between the spot transaction in the real and financial market is that the transaction is personal in the former and impersonal in the latter.. life insurance.g. the size. life. property and vehicles) over centuries for profit. motor vehicle insurance that an individual buys is a put option. the price.e. These types of transactions are executed in the forward. bonds and bills. For example.. the time of delivery. property casualty and other specialized companies have underwritten put options (i. occurs where one party enters into unilateral transaction with no obligation to buy or sell (from. futures or options markets. fire etc) in individual life. settlement and any other agency related provisions are negotiated today between the two parties. Insurance companies (e.e. In other situations.e. health.Over the Counter (OTC) such as NASDAQ for t financial assets such as stocks. which gives the right to an individual to sell the vehicle to an insurance company at strike price (the price at which the car is insured) in the event of an accident in which the vehicle is totaled. to) another party at strike price and for a given future date. transactions may call for delivery to take place sometime in future provided that the terms of the contract i. While the purchase and sale of vehicle by buyer and seller is personal where the buyer takes the delivery in return for immediate payment. The insurance company 15 16 .

bills. when individuals borrow against their real assets by leveraging their portfolio to purchase financial assets such as stocks. they are effectively buying a call option on the underlying assets and in the event stock price goes down. However. bonds. indices. The parties are obligated to perform on the settlement or delivery date. in an informal and non-standardized arrangement to buy or sell at current market price for delivery in the future. without having a physical building. the brokerage firm will liquidate the position to recover the money that was lent unless individual can put up more money to avoid being squeezed out of the margin position. Although forward transaction 16 17 . which renders forward transactions risky. For centuries. Absence of organized exchange for the execution of transaction in the forward market and absence of any formal and standardized arrangement that details and outlines the provisions of transaction as to the size. forward transactions have existed e. Options on financial assets such as stocks. commodities and interest rate futures take place in an organized exchange where the counterparty risk is eliminated. Examples of such markets are the Philadelphia Options Exchange and Chicago Mercantile Exchange and other exchanges worldwide. in early civilizations where crop producers entered into forward agreements. settlement date and actual physical delivery of the goods or services raises the agency related problems and costs associated with that in the event that one of the party to the transaction fails to perform.g.who sold the put option in this case is obligated to perform and purchase the vehicle at the strike price even though the vehicle is nearly worthless. currency. In this market value is transferred from one party to another in a sum zero game where the gain of one party is exactly equal but opposite of the other party’s loss. Forward Market Transactions These are the over the counter transactions between two or more parties where the buyer and seller enter into an agreement for future delivery of something of value priced today.

For example. Exhibit 1.6: Interactions of Various Markets Types of Market Spot futures forward swap Futures Transactions 17 18 .these days take place between and individual or corporation and usually a major bank or financial institution the counter-party risk still raises the exposure of the bank or the financial institution to possible non-performance risk. Markets for forward and swaps are closely aligned as a swap is created by a portfolio of forward contracts. Exhibit 1. To alleviate the problems associated with counterparty risk. futures and forward transactions are close cousins. The transactions in the organized forward market came to be known as futures. inconvenience of physical delivery and storage related cost an organized forward exchange was created to address the above problems. one is traded in the organized exchange.6 demonstrates the interaction of various transactions and markets. and the other one in the over the counter market.

Exhibit 1. the contracts are standardized to size. As current futures price (spot) changes daily as a result of the change in the underlying value of the assets (real or financial) due to various macro or micro factors the profit or loss is recognized and is posted to individual account by the clearinghouse. Silver Interest Rate Futures Commodities Equity & Index Aluminum & Options 10 –years Notes Commodity Palladium Index Futures & Options & Futures Platinum Options Copper Commodity Futures & Options Weather Futures & Options 18 19 . settlement date and other agency-related provisions at the current spot price for delivery in the future. Clearinghouses created by member participants of organized exchanges ensures the integrity of transactions and eliminates the counterparty risk by marking individual transactions to market on a daily basis. orderly and cost efficient exchange market where parties enter into an agency contract to buy or sell claims on financial or real assets known as derivatives.7 provides partial lists of contracts traded in the four different organized futures exchanges in the United States and the United Kingdom. Because the exchange of value takes place in an organized physical location. Exhibit 1.While transactions in the forward market are personal.7: Partial Lists of Contracts Traded in Four Different Futures Exchanges LIFFE NYMEX CME CBOT STIR 14 Energy Related Currency Futures Long Term Bonds Long Term Bonds Contracts & Options Municipal Bond Index SWAPS Gold. This daily settlement requires transfer of value from one individual to another individual in a sum zero game. the futures market provides impersonal transaction between two parties in an organized.

Exhibit 1. 1992-2003.S. Chicago Mercantile Exchange CME and Chicago Board of Trade CBOT.8 shows monthly volatility of stocks. Exhibit 1. and Interest Rate Instruments Monthly price Volatility. STIR refers to short-term interest rate contracts traded at LIFFE. commodities. Equities. London International Financial Futures and Options Exchange LIFFE. and commodities due to emergence of hedge funds and major banks’ proprietary trading replicating hedge funds trading. As is demonstrated in the graph volatility has increased in the market for stocks. Commodities. and interest rate instruments. New York Mercantile Exchange NYMEX.8: Volatility of U. CBOT [ 19 20 .

This highly convex pay structure puts undue pressure on the management to take excessive risk. 30 or 40 percent of the profit. For example. the manager receives 2 percent of net asset value. (2-and-20) set up.Hedge Funds: Are largely unregulated private pools of capital provided by accredited investors. absence of transparency. 3. and in the event hedge fund managers performance beat the bench-mark. Liberal use of leverage. but falls very little with poor performance.. (wealthy individuals or institutional investors). expecting high risk ventures to payoff. 2. dual fee structure. Trading strategies.9 highlights the amount of assets under hedge funds management.e. in a (2-and-20) set up. or indirectly through leverage embedded with derivatives.  Efficiency of intermediation 20 21 . Highly convex compensation.  Risk arbitrage. The payoff of hedge funds are structured so that. derivatives. directly through the use of debt. 4. i. and 20 percent of the profit. Hedge Fund Characteristics: Four broadly defined attributes distinguish hedge funds from other money management funds: 1. they are compensated at least say 2 percent of net asset value. short selling. and other HLTS. Exhibit 1. options. they are likely to share say 20. Opacity to outsiders.  Price discovery. Functions of Hedge Funds  Liquidity providers. Very high with good performance.

o 20% of speculative debts. o 66% of distressed debts. o 58% of credit derivatives in 2006  Hedge funds survival rate 85-95 percent. Hedge funds as of 2005 accounts: o 89% of the trade in convertible debts. o 33% of emerging markets debts.  30 percent do not make it after 3-years 21 22 .

Banks are exposed to counterparty credit risk due to their extension of credit to hedge funds. Exhibit 1. Credit risk originates as the counterparties are unwilling or unable to fulfill their contractual obligations.9: Total Assets under Global Management of Hedge Funds TYPES OF RISKS Credit Risk Market Risk Operational Risk Credit Risk: Counterparty credit risk is a high frequency and low severity risk that is mitigated by banks through bad loan loss reserves. as well as having prime brokerage relationships. 22 23 .

1999). For example. 23 24 . measurement. it would not be a prudent practice to extend credit to a company whose failure can be devastating to the well being of a financial institution.  Setting margin. the lenders impose a significant haircut depending on the quality of the underlying collateral. financial institutions have developed counterparty credit risk management (CCRM) systems for identification. and mitigation of various risks. A haircut in finance terminology is a percentage that is an increasing function of the perceived riskiness of the underlying security that is subtracted from the par value of the assets that are being used as collateral. For example. In order to assess credit risk and limit counterparty exposure. while $1000 5-year corporate note will enable the borrower to secure $800 loan. as homeowners were required to post 20 percent equity for securing a 80 percent loan form banks. a bond dealer may impose a 1 percent haircut on a 5-year corporate note.  Haircut. LTCM was able to secure next-to-zero haircuts. $1000 Treasury as collateral would be accepted for securing $990 loan. The CCRM system is composed of:  Limits on the size of the exposure. Furthermore. and mitigation techniques The limit on the size of exposure to a particular obligor or particular state or region is intended to reduce concentration risk. while imposing 20 percent haircut on a 5 year corporate bond posted as collateral. This was likely due to the fact that no counterparty had a total picture of the extent of its exposure to various lenders (Jorion. measurement. In the above scenario. as it was considered fairly safe by its counterparties. initial and variation margin.  Establishing risk identification. Conventional banking imposed a 20 percent haircut on residential mortgages.  Collateral.

variation margin is demanded by the exchange and should be posted to the account to prevent liquidation of the individual position. and its banker advised the company to abandon the hedge nearly bankrupting the Oil giant. This creates a liquidity squeeze where a party is unable to post margin to prevent liquidation of the underlying futures by a clearinghouse. while marking to market in the organized exchange has eliminated counterparty credit risk. 24 25 . They rolled over short dated long futures contract to hedge long term exposure to rising price of oil. As the price of oil dropped. Market Risk  Risk of sudden shock. in which the wider economy would suffer is an example of systematic or market risk. MG sold oil and gas 5 to 7 years forward at 30 percent premium over the prevailing spot price to their customers. This risk arises when price of the futures contract moves against a party to huge futures contracts. Metallgesellschaft (MG). Example: In the early 1990s. which could damage the financial system. as the price of oil dropped below $20 per barrel. It is worth nothing that. Once margin falls below say 75 percent. debited and credited in a falling price scenario or credited and debited in a rising price scenario by a Clearinghouse in a sum zero game. the exchange imposes margins for mitigating counterparty credit risk. suffered a loss of $1.While in the over the counter market a haircut is intended to protect the lenders. it has created another risk. The margin is usually set using value at risk of the exposure at 95 percent confidence interval and assumed volatility of the underlying exposure. namely the liquidity risk. The margin is marked to market on a daily basis as individual accounts long and short simultaneously. MG faced significant margin calls. a German Oil company.33 billion in their short dated futures hedging contract. in the futures market.

Here are few definitions suggested by economists of various persuasions:  Unfolding of a systematic crisis.  Major damage to the financial system and the economy as a result of collapse of real estate and equity markets triggered by a sub-prime mortgage mess that caused substantial damage to the US economy. thereby impairing their ability to channel savings into promising investments. threatening the stability of the real economy.  Financial markets linkage to the real economy create systematic risk through players such as hedge funds and trading banks. Operational Risk:  The Basle Committee on Banking Supervision (BCBS) reported recently that 25 26 .  Collapse of LTCM. where a shock affects a considerable number of major players in the market. followed by flight to quality. Systematic Risk The systematic risk definition has been quite vague in the literature. or  Interruption in the payment system.  Panicky behavior of depositors or investors.  Shocks in one part of the financial system that lead to a shock elsewhere.  Optimal level of systematic risk is not zero.  Contagious transmission of the shock due to actual or suspected exposure to a failing bank or banks.

10: Break down of Financial Risks Break down of Financial risks Commercial Investment Treasury Retail Asset Banking Banking Management Management Management operational Credit Market 26 27 .” Exhibit 1. Risk arising from failure in operations such as back office problems. Exhibit 1. which have been at the heart of some important banking problems in recent years.  A few definitions of operational risk: 1. failure in processing transactions and in systems as well as technology breakdown. such as operational risk.“An informal survey …highlights the growing significance of risks other than credit and market risks. or from external events such as terrorism or natural disaster. and systems.10 shows break down of financial risks. 3. people. 2. The risk of loss from failed internal processes. Any financial risk other than credit and market risk can be categorized as operational risk.

Bank 2 goes bankrupt. transaction and accounting consequences of the fluctuation of exchange rates. who defaults at noon and does not deliver £10 million.000 to be realized in two B/days. In the 27 28 .50/£. the gain of $50.000 with bank 2 is now at risk. Currency exchange risk. and spot rate has fallen to $1.  Credit risk: The following day.  Settlement risk: Suppose XYZ bank wires $16. The loss of $150. the economic. Direct foreign investment (DFI) in the form of making foreign acquisition of real assets (buying a plant overseas or building manufacturing facilities) to take advantage of imperfections in off-shore markets and portfolio investment in the form of stocks. XYZ has a spot contract to buy £10 million in exchange for delivering $16.  Market risk  Credit risk  Settlement risk  Operational risk  Market risk: Suppose after few hours exchange rate changes to $1.5 million to a wrong bank. bonds and t. This simple transaction has the following risks. Risk Interactions: Example: Assume that on December 31.5 million in the morning to bank 1. strongly impacts many businesses in a variety of different ways.5 million in two business days from bank 1. XYZ enters a new trade with bank 3.  Operational risk: Suppose the XYZ bank wired the $16.45/£.bills and other short term assets entail opportunities for greater return (exchange rate gains) and higher risk due to foreign exchange losses. The loss of interest on the amount due is attributed to operational risk Foreign Exchange Risk Foreign exchange risk is unique to multinational corporations (MNCs) as the foreign denominated cash inflows or outflows must at some time in the future be converted to the domestic currency of the operating unit creating windfall gains or losses. The back office gets the money back after 2 days. This is known as Herestatt risk. The trader cuts the position and enters a spot sale with Bank 2.

Later in the 1980's the strong dollar eased inflationary pressure in the U.S currency.S.S dollar exchange rate that turned its $24 million operating loss into a $76 million profit for the year. historically a world leader in construction of heavy equipment. France and U. making the U. This led to a flight of capital from the U. This in turn resulted in a high value of the dollar compared to other currencies. a Japanese manufacturer of hydraulic excavators. financial assets. contracted with Boeing to purchase 20 aircrafts for $500 million in January 1985.S dollar the company purchased dollars forward in the foreign exchange market fearing revaluation of the U.S dollar relatively very strong and in turn U. as foreign investors were no longer so interested in trading their currencies for dollars to invest in U. As a result of this experience Caterpillar established a special unit for managing currency risk exposure.early 1980's the tight monetary policy of Paul Volker.S. economy leading to lower inflationary expectations and a decline in the long-term U.S. Consequently Caterpillar. which could increase the Deutsche Mark cost of the planes. found itself at a disadvantage compared to its main competition Komatsu. In 1986 Caterpillar had a $100 million profit on foreign exchange due to a favorable (weak) U.S. The forward contracts cost Lufthansa $140 to $160 28 29 . The value of the dollar also fell sharply following the September 1985 Plaza agreement in New York as the chairman of the G-5 central banks (U. To manage exposure to the U.K. Japan Germany. What actually happened is that the dollar devalued against the German Mark.) concluded a meeting in New York and collectively decided to put downward pressure on the value of U. compared to other countries. interest rates. the German Airline. Lufthansa.S. the chairman of the Federal Reserve resulted in high real interest rates in the U.S dollar by selling dollars from their inventory in order to buy other foreign currency.3 Other companies did not fare as well.S exports very expensive and unattractive for foreigners.S.

4 To appreciate the severity of losses that firms experience due to unexpected change in spot and forward rates.11 lists case histories of various types of losses and the short description of the events for a number of institutions around the world.million more for the planes than if it had simply waited and purchased the dollars on the spot market. reputation damaged Morgan Grenfell Stock Sep 1996 $720 M Speculative loss as trader exceeds his limit June 1996 2. exhibit 1.11: Case History of Losses ------------------------------------------------------------------------------------------------------- Company Transaction Date Approximate Description (Home country) inducing Loss Loss SocGen Futures 2007 $7 billion Speculative losses stemming from loss (France) of internal control Allied Irish Bank Foreign Exchange Feb 2002 $691 M Rogue trader hides loss over 3 years NatWest Swaption March 1997 $127 M Trader misprice options.6 Billion Sumitomo Futures Unauthorized (Japan) copper trader over three years Daiwa futures Sept 1995 $1.1 billion Unreported loss over 11 years Bankers Trust swaps Oct 1994 $150 M Legal risk and reputational damage ------------------------------------------------------------------------------------------------------------ 29 30 . Exhibit 1.

Source: company reports and various newspapers Does foreign exchange risk raise the cost of capital and lower optimum debt ratio for MNCs?5 The author’s own research provides evidence to the contrary. The capital market has ensured and insulated capital providers from such risk by imposing grave penalty on the perpetrators of such acts by simply refusing capital the blood line of progress to the nations engaged in such phenomena. Due to MNCs ability to exploit imperfections in product. foreign direct investment and portfolio investment. This risk was significant in the past and firms mostly multinationals used to spend precious resources identifying. Political Risk Political risk refers to changing political landscape and its effects on the way individuals or firms conduct business in the world market. global securitization. Greater integration of the world financial markets. innovations of new financial products and expansion of opportunities in a global environment have reduced and presumably eliminated the need for consideration of political risk for all practical 30 31 . 6 This result does not negate the fact that MNCs attach higher hurdle rates for analyzing cash flows of foreign projects as higher risk adjusted required rate of return of foreign projects embody additional premium for foreign exchange risk. they are able to earn monopoly rents. The risk of takeover or expropriation of foreign owned assets or nationalization of foreign assets as proxy for political risk has been mitigated by the disciplining mechanism of the international capital market. New political arrangements may impose various restrictions on the flow of goods and services. quantifying and micro managing it in cases involving acquisitions. liberalization of trade. This is evidenced by higher market to book value ratio for MNCs relative to domestic corporations as documented by the author elsewhere. factor and financial markets across international boundaries.

therefore the institution is exposed with the risk of availability (rollover) for the funding of the loan for the remainder of the next three months for which some type of hedging in the forward or futures market is necessitated to mitigate the risk of higher interest rate in the next 3-months. This risk is also synonymous with the availability of the fund. Furthermore. For example a financial institution may extend a 6-months fixed rate loan to a party and be able to fund the loan for 3-months.e.7  Liquidity Risk: associated with lack of efficient secondary markets in which a long or short position can be liquidated without substantial discount at current market price.  Rollover Risk: the risk of being forced to close out the position without being able to renew the contract at the market prevailing price or rate. These risks can be classified in an agency relationship context as follows:  Counterparty risk: The risk that one of the parties to the agency contract fails to perform for whatever reasons and does not fulfill its financial obligations.  Risk Risk: the risk of not knowing and understanding the ramification of the type of the agency relation one has entered and the risks entailed in such relationship. the greater interdependencies among various economic units and the increase in the use and abuse of derivatives as well as greater coordination of fiscal and monetary policies in the context of various treaties (i.purposes.8 While most of these risks to a considerable degree have been eliminated in the derivative markets in which the trade takes place in an organized exchange. European Union.. The increased volatility in financial markets due to a floating exchange rate arrangement since 1973 and greater interdependency of global economies have created new opportunities as well as additional risks associated with innovative derivatives. 31 32 . the risks remain fairly substantial involving the over the counter transactions worldwide. The risk of not understanding the risk of security the (long or short) position one has taken.

J. Lee. “Determinants of Capital Structure for Multinational and Domestic Corporations.Y. 189-210 Jensen.C. Kowk. 1976. Moffett. Addison Wesley Longman 2001.”Theory of the Firm: managerial Behavior.C. No. PP. 195-217. Myers. Asian free trade Agreement (AFTA) and Economic Cooperation of West African Economies (ECOWAS)) have created an environment in which a shock to a local economy can easily spread to other trading partners. Eiteman. Meckling. 3. Benkato. M. 1998. LI. PP. Agency Costs. K. and W. Zietz. 147-175. Don. and Ownership Structure. “Multinational Business Finance” Ninth Edition.. M “ An Introduction to Options and Futures ” Dryden Press 2000.” International Economics Vol. Stonehill and M.” Journal of Financial Economics.C. 305-360. Homaifar. O. 2.North American free trade agreement (NAFTA).”Journal of International Business Studies ( Summer 1988 ). No. References: Chance. A.” Determinants of Corporate Borrowing.” Journal of Financial Economics.” 5 (November 1977). and C.D.G. 32 33 . S.”Multinational Corporations VS Domestic Corporations: International Environmental Factors and Determinants of Capital Structure.

4 Millman 1990. Simon and Schuster 1980. 7 Credit Suisse First Boston counterparty to forward ruble/$ contract fails to deliver $ when Russian government freezes access to $ in August 1997. The loss for British Merchant Bank of Barings stemming from the speculative transactions by Nick Leeson the Barings head of trading division in Singapore was in excess of $1. 2 The speculative loss in the futures market for Bank Negara the central Bank of Malaysia was in excess of $2. According to Homaifar et al (1988) the significant difference in tax shelter ratio between MNCs and DCs imply that the MNCs are better equipped to arbitrage institutional restrictions than DCs for the purpose of reducing their tax liabilities. P-3) maintain that the foreign exchange risk raises cost of capital and lowers optimal debt ratios for MNCs without substantiating the above hypotheses. MNCs appear to have higher agency cost of debt than DCs. et al (2001. This evidence is consistent with those of Myers (1977) and Lee and Kowk (1988). 5 See Eiteman. This transaction was a speculative in nature and was not intended to hedge or transfer risk. MNCs have more non-debt tax shelter than DCs. 8 Orange County California state retirement plan invested in derivative interest rate futures for enhancing the yield of the portfolio expecting interest rate to fall. l990. MNCs employ less long term debt in their capital structure than their domestic counterparts (DCs) which corroborate with the finding of Lee and Kowk’s (1988) evidence that MNCs have lower debt ratio than domestic corporations. Baring was acquired in the bankruptcy 3 The Floating Battle Field: Corporate Strategies in the Currency War by Gregory Millman.1 billion in 1993.End Notes: 1 See Webster’s New World Dictionary of the American Language Second Edition. et al (1998) find that in contrast to conventional wisdom. The interest rate actually did go up against the expectation of the retirement fund and the result was the loss 33 34 .2 billion forcing the bank in to bankruptcy. 6 Homaifar.

Is the futures market anticipating a rate increase/decrease by the Federal Reserve Board? And by how much? 18. this firm is said to be exposed to …… risk. What was the net profit/loss for the year? 34 35 .67/oz to $35/oz. the dollar is said to devalued/revalued. Explain the absence of volatility in the foreign exchange market prior to 1970s. When gold price rises from $20.S.of nearly $1. 15. The retirement planner did not realize a priori what risk is entailed in interest rate futures transaction. the institution is exposed to ……… of assets and liabilities. 5.94% 6. In the previous question the dollar devalued by how much (in percent)? -40. 2. What forward (future) interest rate does the IMM index imply for the above contract? 16. Suppose the spot interest rate on T-bills on July 31 is 2 percent in the previous question. while foreign exchange gains due to a weak dollar was $100 million for that year. Give an example of each transaction. The IMM index for Eurodollar futures is 93. What distinguishes forward and futures market transactions? 21. 20.7 billion when interest rate futures liquidated for massive loss in December 1994. The IMM index for Treasury bill futures is 97.32% 7. In the previous question the gold revalued by how much (in percent)? +69. 4. When an institution funds its capital requirements with floating rate notes and invest its assets in fixed rate instruments. 10. 3. Identify broadly the types of risks a multinational corporation faces in the market? 22. Is macro risk more relevant than micro risk for an individual with a well diversified portfolio? 23. What information is the T-bill futures contract conveying to the market participants? 17. Identify the types of transactions in the market. Why are multinational corporations exposed to greater amount of agency-related problems than their domestic counterparts? 12. The conflict of interest between two parties gives rise to what type of problem? 11. Give an example of foreign exchange risk for a corporation. Markets for financial assets……. Explain two major functions performed by derivatives.50 for December futures at the Chicago Mercantile Exchange CME on July 31. When firm revenue is denominated in dollars and its debt service cost is denominated in pounds. Chapter 1 Questions and problems 1. Laker Airways derived revenues in pounds while borrowing in dollars exposed the company to what type of risk? 9. Identify a transaction creating an agency relation and an agency problem. Caterpillar had operating losses of $24 million in 1986. 8. 14. What forward (future) interest rate does the IMM index imply for the above contract? 19. 24. Markets for real assets are…… 13. Identify an event that caused an increase in exposure for individuals and corporations in the early 1970s. dollars? 25.45 for July futures at CME on April 21. Elaborate why Caterpillar’s profit is highly influenced by the strength/weakness of the U.

$75000 over the last 30 years. Political risk arises in an international transaction with a sovereign nation. Has the volatility of this currency increased (decreased) since 1972? HW # 2.stls. Look at the short term interest rate (AA. while it remains fairly significant in the ------market. 35 36 . What rate is the Eurodollar futures market dollar? 2. $ http://www.S. None of the above 38.commercial paper for a non-financial corporation’s monthly rate at www. 10 percent b. Analyze the monthly percentage change in exchange The value of the portfolio has increased by 15 percent over the course of 1 year. Compare the rate implied from Eurodollar futures with that of the spot AA. How much profit did the NRP realized in this investment? 37. 28. What is market risk? Give an example of market risk. How is this risk being mitigated in the 21- century? 27.cme.000 b. 34. None of the above HW # 1. 12. 1. $100. Has the currency appreciated (depreciated) against the U.5 percent d. What is credit risk? Give an example of credit risk.frb.commercial paper rate. Analyze the trend in the exchange rate. for the expected spot interest rate to prevail in 90 days using the IMM index? Is the futures market implying a rate increase or rate decrease? Useful Links: Chicago Mercantile Exchange provides real time prices for futures contracts at the http://www. The -----risk in the organized futures markets is mitigated through a clearing corporation. Savings and Loans (S&Ls) faced ---. A forward transaction exposes parties to -----risk. Chicago Board of Trade http://www. What characteristics distinguish hedge funds from tradition mutual funds? 36.5 million in a hedge fund with a 2/20 fee structure. Provide an example of this risk to a multinational corporation. Look at the Eurodollar futures at the www.cbot. NRP has invested $2. 12 percent c. In the previous question how much money does the hedge fund make for managing the above portfolio? a. 35. Give an example of liquidity risk. Take any foreign currency exchange rate (monthly statistics) from www. When you buy an instrument imbedded with many options that you do not understand you are said to be exposed to------- 31. What is operational risk? Give an example of operational risk.000 d. 26. 29. What is the annual return net of all fees for the NRP investors? a.frb.cme.risk in borrowing short term and lending long term.

frb.stls.ny.Federal Reserve Bank of St Louis 36 37 .org Federal Reserve Bank of New York http://www.frb.

Chapter 2 Balance of Payments Exposure Management Chapter outline Introduction Balance of payments as a source and use of fund statement Components of BOP: Current Account Balance Capital Account Balance Official Foreign Exchange Balance Statistical Discrepancy for Error and Omissions Current Account and Economic Fundamentals Capital Account. bonds and bills. etc. government entities and countries over a specific period. services.S.) and direct investments (i. The trade 30 39 . corporations. The goods and services flow from one country to another to fulfill the individual desire to consume what is not available or cannot be produced competitively in the importing local economy and desire to expand production by the producer in the exporting country to earn a profit. Dollarization and Peg Argentina’s Peso Doomed to Collapse Managing Balance of Payment Exposure in Emerging Market Economies Introduction: The balance of payments (BOP) provide a summary of all transactions involving real goods. Expectation and Interest Rate U.e.. joint ventures and divestitures). financial assets (Portfolio investments such as stocks. capital (import/export) and transfer payments in cash or in kind between any two individuals. foreign acquisitions. Balance of Payments: Recent Evidence and Historical perspective Exposure Related to Capital Account The Brazilian Experience Currency Crisis in South East Asia and Balance of Payment Problems Exchange Rate Arrangements.

The effect of such agreements is that production of goods shifts from countries that have a comparative advantage to countries that are less efficient producers but have been given a competitive advantage through lowered tariffs.” Comparative Advantage refers to specialization as a key for Key Concept producing goods at a minimum average cost and trading these goods for other products in which trading partners can produce more efficiently. manufacturing and technology sectors 31 40 . The pattern of trade between countries can provide a guiding principle for the resurgence of trade rooted in the theory of comparative advantage. The following excerpt from the Wall Street journal as of April 04. This is why economists call FTAs by another name.takes place when one party acquires the knowledge and technology to produce goods or services far more efficiently than another party in order to buy goods and services that either she does not have or cannot produce as cheaply. The theory of comparative advantage provides a reasonable explanation why countries trade with one another. Based on this theory it pays off to specialize in production of certain goods or services and trade these goods and services with others where they have comparative advantage in production of those goods and services. 2002 highlights the above argument: “Unlike multilateral trade accords where all members of the World Trade Organization are treated equally. For example U. It should be noted that the various regional free trade agreements (FTAs) such as the North American Free Trade Agreement (NAFTA). Free trade is not a sum zero game since the parties realize real gain and enhance their own welfare by producing in the areas for which they have achieved specialization. thereby producing at minimum average cost. preferential trade agreements. bilateral and regional "free trade" deals create inequities by granting preferential treatment to some countries at the expense of others.S. the Asian Free Trade Agreement (AFTA) and others have provided a competitive advantage through reduced or elimination of tariffs or quotas to a member country at the cost of non-member.

have acquired comparative advantage in production of goods requiring a highly skilled labor

force 2.1: USA
and trading these goodstofor
Export goods
Major that the
Trading trading1999-2009
Partners partners produce more efficiently.

It is important to distinguish between absolute advantage and comparative advantage.

While most of our trading partners in Latin America, South East Asia and Eastern Europe

have absolute advantage in hourly wages in manufacturing, U.S. manufacturing has absolute

advantage in productivity (output per man hour). The wage or productivity alone (absolute

advantage) cannot be used as an argument in favor of protectionism; the ratio of the

productivity over wage (comparative advantage) may dictate which goods or services we buy

from our trading partners and the goods and services we sell. For example, the wage in

Mexico is much lower than that of the U.S, and so is their productivity. It then follows that

we buy goods and services from countries where the ratio of productivity over wage is

greater in that sector than the one in the U.S., and sell goods and services where our

productivity over wage is greater than our trading partners. It is no surprise that we buy steel

and auto from Japan and sell food, lumber, aircraft and semiconductors. Exhibit 2.1 and 2.2


provides some preliminary evidence on the behavior of U.S. exports and imports to and from

its major trading partners during the 1999 to 2009 period.

It appears that the U.S. imports more goods and services from its trading partners with the

exception of France than it sells thereby running a deficit, which is financed by issuing an

IOU to its trading partners in the form of short or long-term financial assets and this creates

exposure to currency and interest rate risk. The deficit appears to be much larger with China

followed by Japan Germany, Mexico, Canada and United Kingdom (UK), while experiencing

a small surplus against France. The larger the deficit the greater the chances that interest rates

need to go up in order to entice the creditors to extend the short or long term credit.

Exhibit 2.2: USA Imports from Major Trading Partners

The difference between import and export significantly widen between China and the

USA, as is shown in Exhibit 2.3. For every dollar of export USA imports over $11 of goods

and servives from China as import/export ratio dramatically increased to 12 by 2008.


Exhibit 2.3: Import /Export ratio for the US Major Trading Partners

Absolute Advantage in wage or productivity alone is a necessary but
Key Concept not a sufficient condition for producing goods at a minimum average

The ratio of productivity over wage (comparative advantage)
dictates why a country such as U.S. with very high wages and high
Key Concept productivity in high tech trades with a country such as Mexico with
low wages (absolute advantage) and low productivity.

The rising cost of financing the current account deficit, particularly at the floating rate,

coupled with the availability (roll-over) risk is particularly acute for the emerging economies

and economies plagued with high inflation. Fabio de Olivera Barbosa, Brazilian Secretariat of

the National Treasury sums up the above argument:1

“The turbulence involving emerging economies in general and Brazil in particular, deeply
affected countries’ access to international capital markets. The magnitude of change can be
seen in the widening spreads for sovereign bonds. In June 1997, the [Brazilian] Treasury
issued a global, thirty-year bond with a 395 basis point spread; two years later, a global, ten-
year bond was bearing an 850 basis point spread. The spread is over and above the equivalent
dollar denominated bond of the same maturity.”
Roll over risk refers also to the availability risk as major international
Key Concept banks refuse to extend credit to a borrower at prevailing market
interest rates on a maturing debt or demand and require good
collateral and or a substantial increase in interest rate.


services and capital creates source of funds and the import of goods. Where the export of goods. however. imposing various restrictions “austerity” on the borrower which may or may not be in the best interest of the borrowing country. services and capital generates demand for the currency of the exporting country and supply of foreign currency as foreign buyers use their own currency to purchase the currency of the exporter in order to pay for the export. any imbalance (surplus or deficit) in the supply of and demand for currency of the export and or import create temporary disequilibria and exposure to currency and interest rate risks. and capital over a given period. Likewise. net income balance on direct investment and portfolio investment. BOP is virtually an accounting identity. services and capital generate supply of currency of the importer and demand for foreign currency in order to settle transactions. and net transfer payments in cash or in kind over a specific period. COMPONENTS OF BOP The Current Account The current account summarizes all transactions on the net merchandise trade balance of goods and services. Therefore. When a country runs a deficit 35 44 . Balance of Payments as a Source and Use of Funds BOP is a double entry of all goods. Key Concept The Balance of Payments summarizes revenue and expenditure on all international transactions. The export of goods. services. When a trading partner exhausts all its options to acquire financing in the private sector. the lender of last resort the International Monetary Fund (IMF) or the World Bank may provide funding. those transactions reducing purchasing power of a country. services and financial assets where each entry is a credit and the debit over a specific period. services and capital produces the use of funds. import of goods. involving export/import of goods. where the sources of funds are those transactions increasing the purchasing power of a nation that must equal use of fund.

Official Foreign Exchange Reserve This is the central bank’s portfolio holding of foreign currencies. This phenomenon creates an excess demand for the currency of the country where more goods and services are imported from than exported and simultaneously increases the excess supply of currency of the country running the deficit. Countries experiencing chronic and persistent 36 45 . The excess supply of currency as a result of trade imbalance induces a chain reaction in the financial markets leading to the eventual devaluation of the country’s currency to eliminate the excess supply in a floating rate environment. it should be noted that. bonds. it is essentially supplying more of its currency in the market than the market demands. Deficit in the current account is financed by issuing IOUs to foreign Key Concept individuals or institutions as the supply of domestic currency exceeds its demand and ultimately to the eventual devaluation of that currency. bills and other net short or long term financial assets of the private sector and or government agencies over a specific period. issued as a form of reserve credit to members by the IMF whereas a member can borrow from other members up to 625% of the member’s its current account by issuing claims to the assets acquired. However. gold and other certificates and near money such as special drawing rights (SDR). The net current and capital account make up the Overall Balance of a nation. since the floating rate arrangement of 1973 the short term capital account has become increasingly volatile leading to the importance of the Basic Balance composed of the net current account and the net long term capital account. The ability of a country’s central bank to maintain its currency at a desired exchange rate is directly related to the amount of reserves it has accumulated as a buffer against the temporary disequilibria. Capital Account The capital account summarizes transactions on the net direct foreign investment and net portfolio investment in stocks.

smuggling. Summarizing the components of BPs that produce the balance of payments equation as follows Current Account + Capital Account+ Official Reserve+ Statistical Discrepancy = 0 The following statistics (the cumulative 4-quarter balances) for the U.e. thereby dwindling reserves and running the risk of severe depreciation. countries with a surplus in their current account normally build up their reserves and enjoy the benefits of a strong currency that can be anti-inflationary as import prices fall and local producers are forced to maintain the price of their domestic production at current prices. Statistical Discrepancy for Errors and Omissions This category is created to balance source and use of fund statements due to transactions involving barter (i.e. However. 2008.. beneficial to exports as goods and services becomes attractive to foreigners and detrimental to the economy as import prices go up (in addition. domestic producers may see this as an opportunity to raise their product price) and inflation occurs in the economy. money laundering and other illegal transactions) where no entry is made on the port of entry as to the value of the goods over specific period of time. 4th quarter in billions.S. Merchandise Trade: -$178.82 + + 37 46 . Depreciation can be a double-edged sword. an exchange of service for service) and underground economic activities (i. current account and key components of the capital account as well as statistical error in 2001 are taken from the Federal Reserve Bank of St Louis: United States Balance of Payments.deficits in their current account are forced to tap into their reserve in order to maintain their currency value.

Net: Outflow $114.236 + Capital Account = $170.326 Balance on Investment Income: $21. Assets Abroad. Capital Inflow -$11.S.527 + Current Account = -$154.888 + U.146 + Balance on Net Transfer: -$31. However. Demand for particular good in the asset market is a function of price.730 + Statistical Discrepancy $67.S. let us approach the above relationship from a different angle. 38 47 . in the interest of clarity and providing a foundation on which later analysis will be more meaningful.: Net. Where the quantity demanded of a good is inversely related to its price and directly related to price of substitute goods and income. The current account summarizes all transactions originating in the asset markets between a country’s residents and the rest of the world. income and price of other goods. In reality such baskets do not exist due to differences in individual taste across the globe. What about exchange rates? The exchange rate is the ratio of the prices of baskets of identical goods and services in two different currencies theoretically.Balance on Service: +$34. the role of government and the action it can take to promote or curb trade by eliminating trade barriers or by imposing tariffs and quotas. The same principle is applicable to the demand for imports and supply of exports originating in the current account with few exceptions.078 Current Account and Economic fundamentals The relationship between the current account and economic fundamentals is discussed briefly in the following section.875 Foreign Assets in the U.

The above simplistic analysis assumes among other things that the pass-through from the exchange rate to prices of goods and services in the exports and imports sector of the economy is complete and simultaneous. becomes relatively more attractive to foreign buyers. Exchange Rate: As the dollar weakens against foreign currencies. consumer confidence rises. The evidence for the U. propelling consumer propensity to consume and spend including acquisition of more foreign goods and services imported from overseas causing a deficit in the current account.2 Factors such as income and expectations are interrelated. The exports in this scenario are expected to improve as the domestic goods become cheaper for foreigners to acquire and imports are expected to fall as foreign goods and services tend to be more expensive. economy and its 39 48 . suppose the dollar appreciates by 5% against all other currencies. then the pass-through is complete and simultaneous. As the state of the economy improves (income rise). thus creating an increase and improvement in the current account balance.S. For example. The factors inducing change in current account can be summarized as follows: Key Concept -Exchange Rate  ratio of two prices -Income -Government -Expectations  Consumer Confidence Other factors such as inflation and the unemployment rate affect the exchange rate and consumer confidence respectively and shape individuals expectations about one’s own state in particular and state of the economy in general.S. the goods and services made in the U. If the export price goes up by 5% and import price goes down 5% immediately following dollar appreciation. requiring more dollars to acquire foreign currency.

In a complete pass-through a currency appreciation/depreciation i.S.. Such actions have common denominators: It makes imported foreign steel from countries that the Congress imposes tariffs on more expensive at the expense of those given preferential treatment of no or less tariffs.S.e. the short-term capital account is highly sensitive to interest rates and the yield in the emerging markets stock and bonds markets. For years. which invites domestic producers to raise their prices. Key Concept say 5 percent causes export price/import price to go up/down simultaneously by 5 percent. individual and institutions overseas as well as for their foreign counterparts in U.implication for managing exposure are contrary to the above analysis. goods) by tariff-impacted countries is expected to reduce imports and help exports thereby improving the current account balance for the U. Investors seeking far better return overseas are usually attracted to emerging economies with a promise of expected high yield. markets.. other countries impose no tariffs on U. Expectations play a major role in making foreign direct investment and portfolio investment by U.e. Particularly. Steel Industry has been lobbying congress for the imposition of a tariff and/or quota on imported cheap steel from other countries to protect domestic producers. Expectation and Interest Rate: The capital account tends to be interest rate and yield sensitive. The so called “hot” capital in pursuit of high returns moves swiftly from one country to another and retreats at the sign of any weakness and financial 40 49 .S. This action. assuming it is not reciprocated (i. Government: The government can and does play an important role in shaping policies that lead to improving overall economic activities in a democracy.S. This important issue is discussed in chapter 3. Capital Account. the struggling U.S.

current and capital account as a percentage of gross domestic product (GDP) over the 1961 to 2008 period. Promise of higher yields attract short and long term capital as the Key Concept capital account is interest sensitive.S.S. the net capital account provides a picture of an economy which has attracted long and short term net capital in the form of foreign direct investment. While the current account as a percentage of GDP is paints a widening deficit over time.006 2001. market as the pace investments in the U. unsystematic risk).806 billion by the fourth quarter of the 2001. However.S. Balance of Payments Recent Evidence: Exhibit 2.S. It appears that the world capital market has treated the September 11 as an isolated event (i. in billions of $ during the year 2001: 2001. rose over and above the pre- September 11 to $263.crises creating substantial exposure to users and providers of capital. If the promise is unfulfilled capital flight continues as investors liquidate their investments and run for the exit. The net capital flows dramatically fell to $57.S.S.e. foreign investors returned to the U. due to rising concerns of international terrorism and its adverse impact on the performance of the overall U.4 illustrates some interesting patterns of U.2 226.718 billion by the end of the third quarter as foreign investors divested their portfolio investment in the U. economy.S. 41 50 .S dollar in capital account.718 2001. U.S.1 347.S.3 57.806 The above example vividly reflects the impact of the September 11 attack on the World Trade Center on the quarterly net capital in-flows to U. portfolio investment and other short or long term capital to finance the deficit. The current account is the balance of country’s income derived from exports and expenditure due to imports.4 263. The following example shows the net capital in-flows (+) to U.927 2001. The excess supply of U. currency created as a result of deficit in current account appears more than offset by the excess demand for the U.

3% to -. ranging nearly -.S trade remained fairly the same as the 1960s with a gradual increase in international trade where the current account as percentage of GDP remaining positive in all of years except 1971. was negative. The 1980s witnessed a gradual deterioration in the current account. however.6% and 3. in particular the deficit in the current account reached 3.4. the capital account. 1972. International trade.2% during the same span.24% and 3. In the 1960s the current account as a percentage of GDP was positive.2% by the end of 1970. ranging from . nominal interest rate 42 51 . While. was nearly 5% of GDP in the mid 1960s. In the 1970s to 1980s the pattern of U.4% of GDP during the same period. the sum of exports and imports. However. a rising annual budget deficit and tripling of national debt by the end of 1989.5% in 1960 to .3 The 80s decade coincides with the defense buildup of the Reagan presidency.28% of GDP by 1986 and 1987. 1977- 1979 and capital account behaved the opposite of the current account during the same period as indicated in Exhibit 2. the capital account was positive reaching 2.

By the late 1990s and beginning of 2000 and 2001.e. a deficit can be harmful to the well-being of an economy. helped to entice enormous foreign capital to the U. it follows then that the deficit and the resulting exposure to interest rate and exchange rate changes will not adversely affect the economy.4% and 4. or putting it in financial terms a positive net present value. services and credit) and net capital flows are used to build up a country’s infrastructure and foreign reserve. where the current account had a small surplus due to huge transfer receipts from U. the deficit is invested at a rate below the cost of capital in “negative net present value projects”.S. coupled with a strong U.S. the deficits in current account and in the annual government budget. This.0% of the GDP.S dollar and a rising equity price. Assuming a nation’s productive capacity increases as a result of importing more capital (i. goods. the deficit in current account ballooned to 3. 4. the surplus in the capital account more than offset the deficit during the same period. to finance huge twin deficits.S. the current account continued to behave similarly to the 80s with the exception of 1991. the real interest rate remained fairly attractive. 43 52 . allies in the Gulf War to pay for the execution of the war. international trade as a percentage of GDP reached nearly 20% in the U. However. In the 90s decade. The deficit and resulting exposure in this scenario is a value creating phenomena.. In the scenario discussed. The increase in imports over the exports is invested at the rate exceeding the cost of funding the deficit.had fallen significantly by the mid 1980s due to falling inflation and inflationary expectations. The current account deficit can cut both ways.4%. If an increase in the deficit is primarily used to finance current but not future consumption then the resulting exposure to interest rate and foreign exchange risk can be devastating. However. respectively. By 2000.

capital gains (losses) +/.1340-1 Return in $ =. The return of the original capital as well as the capital gain or loss.’s economic fundamentals and a huge protracted deficit in its balance of payments. money manager invests in one year par bonds denominated in British pounds promising 8 percent interest rate. Foreign exchange gains/losses (1+ Return in $) = (1+Return in Pound) (1+ % change in exchange rate) 2.05) = 1.K interest rate as well as the volatility of the percentage change in the exchange rate.1340 Return in $ = 1.1 is: 13. and interest income are exposed to foreign exchange risk as well as interest rate and market risk. The risk as measured by the variance of Equation 2. the rate of return in dollars will be simply equal to 13% the sums of 8% interest and windfall gain due to favorable exchange rate movement of 5%.e. bills and other long term instruments) are related to: Interest. bonds. royalties. assume the pound appreciates by 5% during the year. Example: Suppose a U. the return to the U. Suppose the pound devalues by 50%. This creates opportunities for a windfall gain as a result of favorable exchange rate movements and falling interest rates or losses stemming from unfavorable exchange rates and rising interest rates. stocks.08) (1+. investor as defined in equation 2.1340 Ignoring the co-variation between the return in foreign currency and percentage change in dollar value of pound.. The returns realized by the U. causing a substantial 44 53 .K.40 percent.1 (1+ Return in $) = (1+.Exposure Related to Cap ital Account: The exposure in the capital account is related to foreign direct investment and portfolio investment overseas. dividend.1 will be: Volatility in $ = volatility in £ + volatility of percentage change in $/£ exchange rate 4 The volatility (variance) of the return realized by U.S. investors investing in foreign assets (i.S.S investor is directly related to the volatility of U.S. due to a weakness in the U.

the sums of 8% interest.S.188 -1 Return $ = .037 percent of the GDP as reflected in Exhibit 2.10) = .S. The spillover contagion effects to U. Starting in 1994.K banking sector. causing a massive flight of capital and further depreciation of the pound.hike in the interest rate.S. due to the interaction term between the interest rate in pounds and the percentage change in exchange rates. investors as defined by Equation 2.S. institutions realize large losses in their portfolio investments due to rising interest rates and the falling market value of stocks and bonds inducing a banking crisis in the U.S. thereby inducing a crisis in the U.10)/(1. U.S providers of capital to British borrowers can range from massive losses to U. based hedge fund assuming the Euro appreciates to $1. Foreign exchange gain (loss) = (1. and by 1998 the deficit reached nearly -.5. institutions as British borrowers default and U. 45 54 .1880 Brazilian Experience: The current account deficit in Brazil and subsequent devaluation of its currency in January 1999 is at the center of the Brazilian currency crisis. investors in this scenario will most likely to divest their holdings in British denominated bonds. the current account as a percentage of GDP began to deteriorate. Example: Strong hedge fund invested in a one year Yankee bond promising 8 percent interest rate with the Euro currently at $1.1 to –46%.21 -1.21/€ by the end of the year.10 (1+ return $) = (1+. Estimate the return realized by the U. This in turn causes a substantial drop in the rate of return to U. which results in an increase in non-performing loans due to an inability of the borrowers to service their debt.S.10/€.10) = 1. –50% loss due to unfavorable foreign exchange rate movements and –4%.08) (1+.

2 According to Brazil’s Central Bank. As seen in the Exhibit 2. started a significant downward spiral particularly in from 1998 to 2000 losing more than 50% of its value since its inception in 1995.11994 1995 1996 1997 1998 1999 2000 2001 2002 -0.The Brazilian currency (real). 59. This implies that the significant increase in the current account deficit and subsequent speculative attack 46 55 . the real remained fairly stable since its inception.6. which at times was relatively overvalued against the U.3 0.2 0. dollar.6% of the domestic debt to finance deficit by 1999 was primarily in the form of overnight borrowing at the floating rate interest.6: Percentage of change in Brazilian Real 1995- 2000 0. however it nearly depreciated by over 25% and 27% compound rates between the 1988 to 1999 period. Exhibit 2.S.1 0 -0.

interest rates. By That time. the exchange rate. The exposure to interest rates changes could have been mitigated by changing the composition of debt and lengthening the duration of the bond issues. The currency crises and the risk associated with that is directly related (co- vary) with the interest rate risk and associated banking crises that it entails. thereby using finite reserve to save the currency from speculative attack and its 47 56 . particularly reducing the size of the overnight borrowing and restructuring the debt by reducing the Central Bank’s adverse selection of accepting more poor risk associated with the short term borrowing than the long term fixed rate borrowing. The Central Bank’s attempt to shore up the supply of its own currency on the one hand.” It looks like the Brazilian Central Bank was at the center of the Brazilian financial turbulence. fixed-rate instruments represented no more than 6 percent of total outstanding debt. This action of the Central Bank amounted to implanting a ticking time bomb in the Brazilian economy expected to go off at any time without warning. the basic strategy was to modify the domestic debt structure by gradually increasing the share and average maturity of fixed-rate instruments. where short term debt financing mitigated the long-term structural deficit problems. nominal. At that point. public debt structure was almost fully indexed—most of it to inflation indexes. high inflation and high interest rate leads to currency crises. which marked the beginning of the Real Plan and the successful process of macroeconomic stabilization. short-term. mostly through bonded debt. After 1994.7 The Central Bank’s reaction to the currency crises can lead to a crisis in banking sector as weak banks with substantial non-performing loans are forced into bankruptcy due to rising interest rates.6 The run in currency and speculative attack by short sellers and arbitrageurs following the deterioration of the country’s economic fundamentals such as prolonged deficit in the current account. budget deficit. or to floating. The following excerpt from the Secretariat Treasury of Brazil (1999) points in the right direction as to the cause of the Brazilian financial crisis of 1998-99:5 “The bulk of the federal budget deficit in Brazil is financed by domestic capital markets.on the Brazilian real was not a coincidence. it was clear that the federal government’s debt management strategy should be adapted to the new environment.

simultaneously providing liquidity to the banking system in order to bail out the weak banks leads to the creation of excessive money. the return on investment is usually greater than the cost of capital. Indonesia. When the imbalance is financed primarily with large capital inflows and short-term credit from large foreign banks at times of economic growth and rising prosperity.9 When the imbalance is financed primarily with large capital inflows and short-term credit from large foreign banks at times of economic growth. bankruptcies mount. higher inflation and interest rates that chocks up the economy.6% for the Korean won and as low as –34. 48 57 . short-term “hot” capital in search of high yield. Key Concept However.4 % for the Philippines peso. Currency Crisis in South East Asia: The currencies of Thailand. putting the solvency of local banks in doubt due to currency and banking crises. portfolio investment and bank loans that fueled the engine of the economic growth in the 1980s and much of the 1990s were reversed due to the severity of the currency devaluation and the fall out in the equity markets as capital flight from the region led to the retrenchment of exposed capital to both currency and interest rate risk. private. Korea. the return on investment is usually greater than the cost of capital. According to Kowai et al (1999) the influx of global.attempt to tighten monetary aggregate by raising interest rates while. The capital flows to the region in the form of foreign direct investment.8 Currency and interest rate risks and the ensuing crises can result from the way the imbalance in the current account is financed in economic booms. Malaysia and the Philippines severely depreciated during the 1997 to 1998 periods. inflows of un-hedged capital to finance the domestic credit boom. as the boom ends and foreign short term capital retreats as a result of actual and expected severe currency devaluation and as the cost of servicing foreign currency denominated loans skyrocket and bankruptcies mount. as the boom ends and local currency devalues and as the cost of servicing foreign currency denominated loans skyrocket. the solvency of local banks is put in doubt due to currency and banking crises. However. ranging from as high as –52.

82% -52. P. Pesenti.52 0. pp.0 Singapore 16.43 0.67 -15.9 Source: Corsetti.6% Indonesia -3. the fixed exchange rate arrangement in the pre-crisis period provided the illusion that the foreign currency denominated loans at lower interest rate as compared to higher interest rates at home was immune from the exchange rate and interest rate risks. 1998. "What Caused the Asian Currency and Financial Crisis?" Japan and the World Economy.23 -16. Implicit or explicit guarantees by the government provided the incentive for financial institutions to borrow excessively and encouraged excessive risk taking creating ”moral hazard” problems for borrowers and lenders.51 -44.4 Thailand -8.2 Philippines -4. Corsetti et al (1998) provide a link between the current account (CA) deficit as a percentage of GDP and extent of the depreciation of the currencies in East Asia during 1997 as shown in Exhibit 2.67 -34. Exhibit 2. Roubini.4 China 0.10 It appears that the currency crisis in East Asia was due to the systematic failures in several key areas and banks and finance companies supervisory institutions lacked the moral courage and incentives to take actions that could have prevented the chaos or at least reduce the extent and severity of the crisis. and N. 49 58 . G.1 Taiwan 4.0 Hong Kong -2. October 1999. 305-73.7.3 -49.7: CA/GDP and the Percentage Changes in Exchange Rates CA/GDP Exchange Rate Change Country (1996) ______ (1996-97) Korea -4.6 Malaysia -3. Furthermore.insufficiently regulated domestic financial markets with highly leveraged corporations and increasing political uncertainty made East Asian economies vulnerable to external shocks in the period preceding the crisis.73 -35.

Since short-term capital flows are highly sensitive to expectations of higher yield.  Capital account liberalization. The effects of the above factors were seen in:  Widening current account deficit.  Moral hazard associated with financial intermediaries. According to Cosetti et al (1998) countries with severe devaluations in 1996-97. 181% for Indonesia.  Rising roll-over risk. 169% for Thailand. Hong Kong. The short-term foreign liabilities to major foreign banks as a percentage of reserves at the end of 1996 was 213% for South Korea. Korea and Thailand financed only 10 and 16 percent of the current account deficit with long- term direct foreign investment. experienced high current account deficit in the 1990s financed primarily with short-term debt.  Asset price inflation (bubble in equity and real estate prices. 50 59 .  Lax regulation.  Export slow down. 77% for the Philippines and 47% for Malaysia based on an estimate provided by Corsetti et al. therefore these countries were not affected as much and as severely as the other five countries in the region. Singapore and Taiwan were near zero or positive. The current account for China.  Appreciation of real exchange rate.  Lack of transparency. it also runs the risk of quick reversal when expectations fail to materialize. These factors were:  Rigid exchange rate mechanism.11 Causes of Financial and currency crisis in South East Asia Many factors contributed to the collapse of currencies in the South East Asian economies in 1997.

25 .59 June 1994 1.  Interest rate risk Most of the economies in the region experienced protracted deficit in their respective current account as the goods and services in their export sector became fairly expensive.06 .21 .61 . When the value of short term international debt denominated in hard currency 51 60 . South Korea and Thailand. Exhibit 2.45 Source: Bank for International Settlements.73 . thereby these countries would not have had enough reserves to meet their short-term obligations.18 1.8.41 1. International Monetary Fund Short-term foreign liabilities exceeded international reserves for Indonesia.70 . allowing them to earn excess arbitrage profit. Private banks and finance companies borrowed dollar denominated loans in the offshore market at small spreads over the London inter-bank offered rate (LIBOR). which was an indicator of international bankers’ refusal to roll over credit. Current account liberalization fueled speculative capital flowing to the region. This speculative capital was mostly invested in equity and real estate creating asset bubble in these markets.99 June 1997 1.  Mismatch of revenue and cost (un-hedged exposure to currency risk). lending it to the local clients at a significant margin without regard to exchange rate and interest rate risks.61 . By 1997 the party was over and rising rollover risk forced many banks and finance companies into bankruptcy as the cost of dollar denominated loans skyrocketed because of severe devaluation of the currencies in the South East Asia.o6 1. The Banks and finance companies perceived that the Central Bank would maintain fixed exchange rates. Short-term foreign liabilities as a percentage of international reserves for the five Asian economies are presented in Exhibit 2.22 3. without regard to possible devaluation of the underlying currencies. taken from Chang and Velasco (1998).85 2.8: Short Term Foreign Liabilities/ International Reserves Indonesia Malaysia Philippines South Korea Thailand June 1990 2.

These countries and their respective currencies are pegged to the U.12 Current account deficit can be a source of extending economic growth beyond the country’s own means. dollar Hungary forint Composite of European currencies Saudi Arabia riyal U.S. the imported capital is invested in increasing productive capacity of a country where the cost of capital is less than return on capital. dollar China Yaun U.exceeds the liquidation value of its assets in hard currency.S.9. portfolio investment and bank loans have provided the necessary ingredients for the creation of jobs and opportunities in the U.S. Washington DC. That is the way in which assets are financed in the emerging economies and the mismatch of the assets maturity and that of the foreign liabilities was at the center of the financial panics in the South East Asian crises. dollar Bahamas dollar U. dollar Bermuda dollar U.S. economy so far.S. dollar Source: International Financial Statistics. The capital imported from overseas economies in the form of foreign direct investment (FDI). So long as.9: Currencies Pegged to U.S.S.S. Dollarization and Pegs: Several countries particularly those hard hit with chronic inflations such as Brazil and Argentina have attempted to establish a currency regime that protects the purchasing power of their currency. dollar Barbados dollar U. the deficit in the current account is essentially a value producing phenomena. dollar with the exception of Hungary as shown in Exhibit 2. economy as well as a fair rate of return to the providers of capital. This has been the case for the U. dollar Hong Kong –China HK$ U. 52 61 .S. a country’s financial system is internationally illiquid. International Monetary Fund.S. Exchange Rate Arrangements. July 1999. dollar ------------------------------------------------------------------------------- Country Currency Currency pegged to Argentina Peso U.S. Exhibit 2.

Argentina was in a managed exchange rate regime and after 1991. after which it was allowed to float against other currencies.S. the 100% reserve requirement imposed unnecessary burdens to an economy with a relatively small foreign sector. weary and distrustful of their government and its own currency continued to accumulate U. While the IMF and World Bank hailed this policy early on. it made Argentina’s monetary policy completely dependent on the U. the central bank allowed Argentineans to hold dollar denominated savings and checking accounts. Prior to 1991.S. Since Argentina was required to either earn a dollar or attract a dollar in the form of FDI or portfolio investment in order to issue pesos. There are more then eight different currency regimes in the world and countries move from one regime to another in hopes of finding a system of exchange rates that can provide financial stability and maintain purchasing power of a country’s currency.10 as follows: Exhibit 2. The currency board system expected to provide stability for Argentina’s economy was destined to collapse. dollars as a percentage of total deposit as of 1992 to 1999 reported by the Argentina’s central bank is demonstrated in Exhibit 2. monetary policy. the South Korean won was pegged to the U. established a currency board fixing the exchange rate against the U. The distribution of outstanding bank certificates of deposit held in the banking system in U. thereby creating excessive demand for dollars.S.S. The Argentineans.S.13 For example. dollar prior to its collapse in 1997.9: Ownership of Dollar Denominated Time Deposits by Argentineans Year Dollar Denominated Time Deposit as a percentage of Total 53 62 . dollar at a one on one ratio requiring the central bank to maintain a 100% reserve in the form of dollars or gold for every peso issued by the government. To add insult to injury. dollars making maintenance of the peg at a one to one ratio impossible.

82 billion total CDs.70 1999 .11 shows the interest rate differential between Argentina’s monthly 30 to 59 days Central Bank time deposit rate and U. The CD holders knew more about the real value of the peso than the currency board despite the higher interest rate differential in favor of peso. 1992 . 90-day time deposit rate from 1992 to 2002. by December 1999 of the 47. For example. The ownership of the dollar denominated certificate of deposits (CD) held by individuals and institutions is nearly in the low 60s as a percentage of the total up until 1995.32 billion was denominated in U.S. Exhibit 2.58 1994 .61 1995 . only 28 percent of total certificate of deposit was in peso. dollars. and the percentage grows to the low 70s from 1996 to 1999.65 1996 .S.72 1997 . dollars as opposed to their own currency. $34.S.72 1998 . and they demonstrated this by their action of holding more dollars than pesos. 54 63 .72 The evidence from the above data indicates Argentinean preference for the U.61 1993 .

Since the supply of dollars was limited. The interest rate differential remains under 5 percent for part of 1995 and throughout 1999 with a small spike in 1997 due to the Asian crises and the 1998 Russian ruble devaluation.S.00 5.00 0.00 30. Money illusion refers here to the inability of individuals to distinguish between lower interest rates in hard currency (dollar) and higher interest rates in soft currency (peso). E xibit 2. property owners and service providers far exceeded the supply of dollars. restaurants.00 25. 55 64 .00 20.00 15. dollars despite relatively higher interest rate denominated in pesos. with the collapse of the peso and rising inflation in 2001. Argentina and USA 35. Particularly notable is the rising interest rate differential to nearly 14% by early 1995 that are attributed to the spill-over effect from currency and banking crises in Mexico in 1994. the demand for dollars by all individuals. cab drivers. Finally the interest rates differential approaches nearly 30%.00 2 3 4 5 6 7 8 9 0 1 2 9 9 9 9 9 9 9 9 0 0 0 9 9 9 9 9 9 9 9 0 0 0 1 1 1 1 1 1 1 1 2 2 2 The higher interest rate and the greater volatility in Argentina’s differential reflect the higher risk premium due to exchange rate risk and sovereign risk.11: Interest Rate Differentials.00 10. It appears that there was no money illusion at least for those individuals and institutions holding CDs denominated in U.

14 Devaluation re-ignited the inflation and inflationary expectations in Argentina. falling to 3.1 pesos per U. after nearly four years of recession with an unemployment rate of 20%. it was essentially a bottled genie trying to get out. ballooning foreign debt at $141 billion. dollar. 1995-2002 85 80 75 70 65 Percent Change in Price Index 60 55 50 45 40 35 30 25 20 15 10 5 0 -5 -10 1994 1995 1996 1997 1998 1999 2000 2001 2002 Time Change in Consumer Price Change in Producer Price While inflation appeared to be under control nearly falling to zero by 1996 and under zero (deflation) for much of the 1999 and 2000 under the currency board. Exhibit 2. According to the Wall Street Journal report massive devaluation resulted in a default of Argentina’s $141 billion loans to major foreign banks and a banking holiday occurred on December 1 to avoid a run in the banking system. Exhibit 2.S. The peso had lost more than 70 percent of its value.12: Argentina’s Producer and Consumer Price Changes. for years hidden under the disguise of currency board. Argentina’s Peso Doomed to Collapse: Argentina. decided to devalue the peso in early December 2001 at the urging of IMF. After the collapse of the peso the consumer (retail) inflation 56 65 .12 provides the percentage change in consumer and producer price index in Argentina during the 1995 to 2002 period.The result is familiar: the peso had to devalue and the dollar had to appreciate and that is exactly what happened.

fixed and managed exchange rate may provide financial stability that policy makers in different countries seek provided that the imbalance in the current account is used to finance projects that pays more than they cost. 57 66 . this was followed by the recession of 1996 to 1997 and the three years thereafter. To the contrary. however. It is. thereby aggravating and prolonging the recession. absolutely impossible to require a system with significant differences in its socioeconomic. the foreign lenders received no more than 30 cent on the dollar in one of the lowest recovery rates ever seen by sovereign Argentina. devaluing by more than 70 percent. Exhibit 2. After Argentina’s currency collapsed. Had the peso been allowed to adjust at least periodically to macro economic forces. As Argentina defaulted in one of the largest sovereign default in history in 2001.exceeded 24 percent. political and markets structure as compared to the U. The current account deficit as a percentage of GDP continued to deteriorate and reached over -5% by 1995. This is not to say that the currency board and/or any other fixed exchange rate regime are inherently untenable. to be dollarized overnight. The overvalued peso choked the export sector by making goods produced in Argentina extremely uncompetitive. while banks’ assets to be converted at the old exchange rate of one peso equal to one dollar. the Central Bank made an extremely provocative decree that banks’ dollar denominated liabilities be converted into new devalued Peso.S.13 provides a clue as to the collapse of the peso and failure of the currency board in maintaining and restoring stability in the formerly inflation ravaged economy of Argentina. effectively bankrupting the Argentina’s banking system as liabilities far exceeded the assets. the gradual transition to a system of independent float that the recent government in Argentina is seeking would have been less painful and less costly.

required Argentina to cut spending as a precondition to extend additional lines of credits. Brazilian devaluation of January 1999. 58 67 .The rest is history and the IMF. as related to the extension of credit to emerging market economies. The external debt of the emerging and developing economies is primarily financed either through short term or long-term jumbo loans syndicated by large banks at a floating rate (usually LIBOR plus spread). South East Asian Crisis of 1996-97 and more recently Argentina’s financial and currency crisis of 2002. the Russian currency devaluation of August 1998. while long-term is at a fixed rate). as known in the West (short-term is usually at a floating rate. as a lender of last resort. Managing Balance of Payment Exposure in the Emerging Market Economies The imbalance in the current account and the way in which it is financed is at the center of the various crises we have witnessed particularly starting with the devaluation of the Mexican peso in 1994. There is almost no distinction between short-term and long-term credit.

It will be in the best long term interest of the suppliers of foreign capital. especially in the U. as compared to short term credit. This restructuring increases equity and reduces interest charges for servicing debt. particularly large banks to afford the same options to the users of capital in the emerging markets similar to the own market. as we have seen in the 1990s. The banks. For emerging market economies external borrowing coupled with the excessive use of leverage by corporate borrowers and associated interest rate risk and foreign exchange rate risk has been a recipe for impending disaster. Here is the problem.S. In this scenario the creditors are protected from the interest and foreign exchange risk and borrowers are locked in at the fixed foreign denominated interest rate where the cost of servicing debt is known and the borrower can take steps to manage exposure to both types of risk. The one distinction between short and long term credit is related to the roll-over risk. such an option is not usually available to the borrowers in the emerging market economies. it indeed has increased as the exchange rate has become more volatile since the floating rate arrangement of 1971. That is to extend long term credit at fixed rate denominated in foreign currency to emerging market economies with the option to refinance the loan when and if it pays off for the borrowers to do so. individual and corporate borrowers in the West have the option of refinancing their long-term debt when rates fall. which at times has to be rolled over at its maturity at short term current interest rates denominated in major foreign currency. Corporate borrowers in the emerging market economies need to restructure their balance sheet through equity for debt swaps in order to reduce debt equity ratios. The risk did not disappear. learned a valuable lesson and started to pass the interest rate risk to the ultimate borrower. and Europe during the aftermath of the S&L debacle. Suggested Readings: 59 68 . This is mitigated in the long term debt at least until its maturity. While.

1998. No 3. "Financial Fragility and the Exchange Rate Regime. Processed. Kaminsky. M. 1999. Radelet." American Economic Review 89:473-500. "Roots of the Asian Crises and the Road to a Stronger Global Financial System. et al (2001) "Crisis and Contagion in East Asia: Nine Lessons. "What Happened to Asia?" Massachusetts Institute of Technology. Current Account Deficit: Is there trouble ahead? Economics Update. Paul. Summers." Journal of Political Economy 91: 401-19. Stiglitz." National Bureau of Economic Research Working Paper 6469." American Economic Review 76:72-81. Paul. Corsetti.'" In Takatoshi Ito and Anne O. Washington. Kawai. Graciela. "The East Asian Currency Crises: Causes and Lessons. "The Twin Crises: The Causes of Banking and Balance-of-Payments Problems. Masahiro. 1998a. 1996. and Philip H. and Jeffrey D. but the unusually dank 60 69 . The U. 1998b. Diamond." Journal of Money. Cambridge. and Jeffrey D. Furman. Deposit Insurance. October 1999. Vol. and Andrews Velasco. Krueger.Chang. July-September 1998. Prospects. Douglas W. 1998. 305-73. "The East Asian Financial Crisis: Diagnosis." Contemporary Economic Policy 14:157-72. D. McKinnon. Mass. Credit. scarcely noticing the murky haze which spread over Athens." NBER Working Paper 6680. KAIROS CAPITALa Merlina Katapodis stared through her office window. Dybvig. and Joseph E. and Liquidity.S. Jason. 1998a. Lawrence H. "Bank Runs. Paolo Pesenti. "A Model of Balance-of-Payments Crises. Sachs. "What Caused the Asian Currency and Financial Crisis?" Japan and the World Economy." Remarks made at the Institute of International Finance. 1998a. Steven. Krugman. "The Onset of the East Asian Financial Crises. Whitt. Radelet." Brookings Papers on Economic Activity 2:1-135. and Nouriel Roubini. "Rational and Self-Fulfilling Balance of Payments Crises. Ronald I. eds. 1999. pp.C.. 1998.: World Bank. The Aeropagus rose in the distance. 11. Financial Deregulation and Integration in East Asia. Krugman. Roberto. and Huw Pill. and Banking 11:311-25. March. Reinhart. J (Sep 1998). Kowai. Giancarlo. Sachs. "Credible Liberalizations and International Capital Flows: The 'Overborrowing Syndrome. Maurice. Chicago: University of Chicago Press." Brookings Papers on Economic Activity 1:1-90. 1979. 1986. Obstfeld. "Economic Crises: Evidence and Insights from East Asia. Remedies." World Bank 2001. Steven. and Carmen M. 1983.

they were loath to disclose the methods on which their own success depended. that had provided her with inspiration in past difficulties. her eagerness had been replaced by apprehensiveness. I’ll start with what I can do. Condoratos was especially impressed with the undergraduate business degree she had earned from a major American university. though it was not outwardly apparent. she knew little about the emerging nations of Africa and Asia. and while she considered herself an expert in this area. Merlina had concentrated on the socio-economics of Latin American countries. offering no particular guidance. it bluntly stated. she felt confident that her academic background in International Economics would provide her with the appropriate analytical tools needed to identify exceptional investment opportunities in developing countries. while impressive on paper. Mr. she pondered her first major assignment with Kairos Capital. The memorandum was terse. two of the nine days had passed. Thus. At the moment. a very private investment partnership comprised of a number of extremely wealthy and powerful shipping magnates. and noticed the framed adage. 1. After only one week on the job. Condoratos’s e-mail naming China as the focus of her initial investigation. had primarily emphasized abstract modeling and theory. and had been quickly recruited by Mr. 4. Did China have a financial account surplus or deficit? 61 70 . George Condoratos. Now. and perhaps even jealous of Merlina’s educational background and beginning salary. She mused to herself. and began. Is there a positive or negative relation between the two? Use simple regression analysis for answering the above question. Merlina had returned to her native Greece only two months before. on paper and orally. “Well. Additionally. Was China’s current account in surplus or deficit? 3. where current account as a percentage of GDP is the dependent variable. Her academic background. she had been dismayed when she received Mr. in English translation: “Many fail to grasp what is right in the palm of their hand. Attributed to Heraclitus. she felt little of the ambitious drive that had launched her into her present position. accomplished anything of substance. and she had not. Moreover.morning rendered the mountain indistinct. and inflation differentials between China and USA as an independent variable. Relate the current account as a percentage of GDP to the percentage changes in the all-urban CPI during the same period. except for some half-hearted exploratory forays. Deep in thought. Her attempts to elicit suggestions from the other analysts had been politely rebuffed. and the expertise she did possess. Did China have a merchandise (goods and services) trade surplus or deficit? What is the trend? 2. and learn the rest on my own as I go. in Greek script.” As she considered the years of dedicated study she had spent. her doubt began to dissipate. and the additional graduate work she had been exposed to at the London School of Economics. as all three were currently involved in their own assignments and facing their own deadlines. Merlina swiveled her chair from the bleak window-view back to her desk. Kairos Capital’s primary managing partner. the results of her first-stage analysis on Thursday afternoon of the following week. and only one restriction--that Merlina present. Although Merlina had not completed the Master’s degree requirements. China’s balance of payment The following table is the China’s balance of payment from 1989 to 1998.” She clicked the mouse.

62 71 . 7. where current account scaled by GDP is used as dependent variable and China’s currency Yaun/$ as an explanatory variable. Calculate the index of real exchange rates for China (assuming base year of 1994 and the index is set at 100). What is the current account deficit or surplus as percentage of GDP? 6. How devaluation of China’s currency affected the current account balance? Use regression analysis to answer this question.5.

3 14207.5 ‐46528 37383.93 35422 2003  438270  ‐393618  44651.1 ‐24066.1 ‐72132.O.3 ‐1428.2 220667 31577.B.  AND  SERV.I.7 30430.6 ‐2378.1 183.1 6860.1 ‐83795.9 ‐2349. : CRE  DEB  N.3 62434.  F.6 13795.8 2004  593393  ‐534410  58982.6 18482.28 45874.4 2001  266075  ‐232058  34017 33334 ‐39267 28084 9388 ‐28563 8909 9125 ‐633 17401 2002  325651  ‐281484  44166.  TRANSFERS:  ACCOUNT.53 20518. IMF 63 .6 28873.8 ‐39485.96 ‐23289.  F.75 1826.I. Current Account ( Units: US$ Scale: Millions) During  GOODS  GOODS  TRADE  SERVICES:  SERVICES:  BALANCE  INCOME:  INCOME:  BALANCE  CURRENT  CURRENT  CURRENT  Period  EXPORTS:  IMPORTS:  BALANCE CREDIT  DEBIT  ON  CREDIT  DEBIT  ON  TRANSFERS.7 ‐23933.5 22437.5 ‐36030.6 20544.39  160818  2006  969682  ‐751936  217746 91999.7 49283.E.6 5191.5 ‐848.1 28240.5 12549.3 ‐25222.4 ‐810.6 39744.E.6 46733.B  GOODS  GOODS.73 ‐392.39  249866  Source: International Financial Statistics.39 72 1996  151077  ‐131542  19535 20601 ‐22585 17551 7318 ‐19755 5114 2368 ‐239 7243 1997  182670  ‐136448  46222 24569 ‐27967 42824 5710 ‐16715 31819 5477 ‐333  36963  1998  183529  ‐136915  46614 23895 ‐26672 43837 5584 ‐22228 27193 4661 ‐382  31472  1999  194716  ‐158734  35982 26248 ‐31589 30641 8330 ‐22800 16171 5368 ‐424  21115  2000  249131  ‐214657  34473.26 ‐16965. &  SERVICES  INC.9 ‐27216.O.8 45761 24326.09 1618.84 ‐549.1 ‐28324 135433 27734.8 11957.  N.3 36079 16094.  1989  43220  ‐48840  ‐5620 4603 ‐3910 ‐4927 1894 ‐1665 ‐4698 477 ‐96  ‐4317  1990  51519  ‐42354  9165 5855 ‐4352 10668 3017 ‐1962 11723 376 ‐102  11997  1991  58919  ‐50176  8743 6979 ‐4121 11601 3719 ‐2879 12441 890 ‐59 13272 1992  69568  ‐64385  5183 9249 ‐9434 4998 5595 ‐5347 5246 1206 ‐51  6401  1993  75659  ‐86313  ‐10654 11193 ‐12036 ‐11497 4390 ‐5674 ‐12781 1290 ‐118  ‐11609  1994  102561  ‐95271  7290 16620 ‐16299 7611 5737 ‐6775 6573 1269 ‐934  6908  1995  128110  ‐110060  18050.6 ‐55306.15  68659.5 124798 38959.1 19130.1 8343.2 ‐100833 208912 51239.2  2005  762484  ‐628295  134189 74404.

  ACCOUNT:   ACCOUNT.a.I.2 79 710..6  2006  4102.28  ‐35.94 ‐11747.65 ‐13047.15  1993  0  0  0 ‐4400 27515 ‐597 3646 ‐2114 ‐576 23474 ‐10096.4 ‐1081 5116.5 12328.9 21224.4 1979.5 12039.2  2005  4155.I.74 ‐1029.44 13203.1 ‐48947.5 6486.08 152.8  1999  0  ‐26  ‐26 ‐1775 38753 ‐10535 ‐699 ‐24394 3854 5204 ‐17640.93  1992  0  0  0 ‐4000 11156 ‐450 393 ‐3267 ‐4082 ‐250 ‐8211.  N. N.  AND  N.9 1957.I.3 ‐11307.I.48  ‐82.19 38673.28 ‐916 38399.7 78094.7 45117.7 ‐26156.E.  PORTFOLIO  PORTFOLIO  OTHER  OTHER  FINANCIAL  NET ERRORS  Period  ACCOUNT.E.08  ‐48.11 ‐17829.36  4020.63  ‐49.66 35928.  ASSETS  LIAB.5  2000       n.4 44921.5 7316.02 ‐3076.I.  OMISSIONS  CREDIT  ECON.E.35 ‐1805.5  64 .9  2001       n.E..  ‐35.46  2002  0  ‐49.64 ‐17921.12 8443.  INVESTMENT  INVESTMENT  INVESTMENT  INVESTMENT  ACCOUNT.79 ‐11305.8 52774 17985.  N.a.25  1995  0  0  0 ‐2000 35849.3 58862.15  ‐53.7 79126.35  4101.35  ‐69.  ‐54  ‐54 ‐6884 44241 ‐20654 1249 20813 ‐3933 34832 ‐4732.4  2004  0  ‐69..4  1994  0  0  0 ‐2000 33787 ‐380 3923 ‐1189 ‐1496 32645 ‐9100.9 6016.61  1990  0  0  0 ‐830 3487 ‐241 0 ‐231 1070 3255 ‐3205.  ABROAD  IN REP.E.I.8  1998  0  ‐47  ‐47 ‐2634 43751 ‐3830 98 ‐35041 ‐8619 ‐6275 ‐18901.E.5 1752.74 ‐43863.7 ‐110419 42861.41 49308 ‐12094.  ASSETS  LIAB.17  1991  0  0  0 ‐913 4366 ‐330 565 ‐156 4500 8032 ‐6766.28 47076.7 2983.  1989  0  0  0 ‐780 3393 ‐320 140 ‐229 1519 3723 114.53  2003  0  ‐48.63 ‐2518.1 ‐16440.05 54936.1 110729 26834.:   DEBIT  N.  INVESTMENT  INVEST.2 ‐31808. Capital Account( Units: US$ Scale: Millions) During  CAPITAL  CAPITAL  CAPITAL  DIRECT  DIR. N.31 32341 7503.8 ‐17823.2  73 1996  0  0  0 ‐2114 40180 ‐628 2372 ‐1126 1282 39966 ‐15504  1997  0  ‐21  ‐21 ‐2563 44237 ‐899 7842 ‐39608 12028 21037 ‐22121.

Source: International Financial Statistics. IMF 74 65 .

Explain the theory of comparative advantage in the context of an example in which two producers in two different nations produce a commodity for trade.05 2.46 2001  47446.85 1998  6248.64 3.5 2002  75216.26  21192.15 0 5.47  8967. 3.71 1.45  ‐8652.45 20.15 0 8.9  ‐75216.48 2.28 2.03 5.34  18321.45  ‐8652.Overall( Units: US$ Scale: Millions) Period  Overall  Financing  Reserve  Use of  National  China  US GDP  China GDP  Balance  Assets  Fund  Currency  GDP  deflator %  (Billions ¥)  Credit  per US  deflator  change  and  Dollar  %  Loans  change  1989  ‐479.26  10965.15  13582.15  ‐6248.11  5021.15  2060.45 0 8.37  2756.4 2007  461691  ‐461691 0 7.13 1990  12046. Distinguish between absolute and comparative advantage.3 2004  206153  ‐206153  ‐206153 0 8.1  ‐14537.83 7.62  12033.1  ‐14083 ‐454.71 2000  10693.1 3.8  ‐30452.36 1997  35857.D Student in Economics at Middle Tennessee State University.78  1731.6 2.07 3.9 0 8.8 5.73 1. IMF a This case was prepared by Jonathan Adongo.75 6.8 0 8.7 2006  246855  ‐246855  ‐246855 0 7.2  ‐35857. Ph. 66 75 . T/F 2.5  ‐47446.5  ‐47446.3 7.25 2.1 0 8.62 0 5.3 6.78 3.2 0 8.13  8653.43 6.77  8165.1  ‐10693.39  479.3 2003  116586  ‐116586  ‐116586 0 8.64 1.98 4.87 2.14  30067 Source: International Financial Statistics.05 2.74 1995  22469  ‐22469  ‐22469 0 8.28 0.15  2060.1  ‐10693.8  ‐30452.32 13.2  ‐35857.28 2.84  15987.9  7416.21  3693.72 8.8 2005  207342  ‐207342  ‐207342 0 8.59 2.41 2.39  558.28 2.78 1991  14537.62  ‐1768.81 3.86  25730.16  9921.8 17.5 0 8.6 3.69 1996  31705  ‐31705  ‐31705 0 8.59 1.81 1994  30452.28 ‐3.8  ‐11555 ‐491. Balance of payments provides a summary of revenues on exports and expenditures on imports over a given period for a country.08  6321.28 6.6 2008  418993    ‐418993 0 6.93 2.8  ‐12046.16 1999  8652.52 1993  1768.55  2257.87 3.28 0.75 1.9  ‐75216.22 2.37 ‐78.28 ‐1.15  ‐6248.82  1934. Chapter 2 Questions and problems: 1.62  ‐1768.22 7.74 1992  ‐2060.

this implies an excess supply of Euro.S.10/€. Deficit in the current account is financed at 4. Other things remaining the same. dollar will appreciate. T/F 21. the United States run the highest trade deficit with (a) Japan.S. T/F 14. T/F 25. Other things remaining the same. 5.stls. the greater the upward pressure on the interest rates. In the previous question the Euro is expected to weaken against foreign currencies. Weakening of the U. Central Banks hold portfolio of foreign currency in the foreign exchange reserve account to manage currency exposure to speculative attack. current account in deficit or surplus? Check it out using balance of payments statistics at www. T/F 15. Elaborate on the fundamental economic factors influencing the current account. This deficit is a value creating phenomena. while the amount financed is invested at LIBOR. T/F 24.S. 9. 12.S.4. T/F 18.S.S dollar makes John Deere products less expensive for foreigners to buy.369 billion for the 04/01/2003 Using the above statistics estimate current account for the 04/01/2003 period. however the consensus is that by the end of the year it is expected to appreciate to $1. Deficit in current account is financed at LIBOR plus 2 %. Strom hedge fund invested in a one year Matador bond promising 9 percent interest rate.S. weakening of the U. (c) China or (d) Germany. (b) UK. T/F 8.€12 billion for France. Define trade deficit. T/F 17. 10. Capital account is highly interest sensitive T/F 11. The merchandise trade was -$135. Statistical discrepancy for errors and omissions is the balancing account that equates source and use of funds in the BOP equation. What makes up the current account? Is the U. T/F 23.21/€. appreciation of Yen makes Japanese goods less expensive for the U. T/F 13. appreciation of the U. 7.5 percent. T/F 16.533 billion for the 04/01/2003 Service trade was 12. T/F 22. This deficit is value destroying phenomena.S. devaluation (depreciation) of Yen makes Japanese goods less expensive for for the most recent quarter. Statistical discrepancy for errors and omissions captures all forms of illegal activities in the BOP equation. Productivity and wages are high in industrialized countries relative to their developing country counterparts. The higher the trade deficit. This is a sure sign that U. Estimate the return realized by the U. T/F 19. dollar strengthens against the Euro as the Federal Reserve Board raises short term interest rates. Other things remaining the same. dollar is a boon for exporters and inflationary for the economy. How trade deficit is financed between any two countries? 6. When current account as a percentage of GDP is -4 percent. while the amount financed is invested at 6 percent.874 billion for the 04/01/2003 Unilateral net transfer was -$16. dollars makes caterpillar products affordable for foreigners to buy. elaborate your reasoning for the resurgence of trade based on the ratio of productivity over wages rooted in the theory of comparative advantage. Does productivity or wages alone explain why nations trade with one another? If not. Other things remaining the same. The U. 67 76 .153 billion for the 04/01/2003 Investment income was 5. When current account is . T/F 26. In the year 2003-2004. T/F 20. The Euro is currently at $1. consumers. consumers.frb. based hedge fund assuming the consensus holds.

98/€ by the end of the year. In question 30 the capital gains on the index was +14 percent. 31. based hedge fund? 28. or real estates will not benefit if the underlying foreign currency revalues against the U. A run on a currency and speculative attack by arbitrageurs following deterioration in economic fundamentals leads to --------. Estimate the realized yield by the U.27. Deficit in current account in excess of 4 percent of GDP. Did Argentinean savers experience money illusion? If not. A U. The index goes up to 11.S. In the previous question the foreign exchange gain (loss) was -14 percent. Define money illusion. T/F 37. T/F 32.S.230 by the end of the year. or real estates will benefit if the underlying foreign currency devalues. The index was at 9874 at the time of investment. A foreign investor investing in the U. T/F 33. Indonesian (Rupiah) in July 1996 was 2400 R/$ in the November. the exchange rate stood at 3600 R/$.S. bonds. Volatility of return realized by a U. T/F 34. positively or negatively to the covariance of the foreign interest rate with the percentage change in foreign currency exchange rate. stocks. investor investing in foreign stocks. dollar.S. hedge fund.S. contributed to severe devaluation of currencies in the South East Asian economies during 1996-97 currency crisis. 36. What will be the realized return to the U. investor is related: positively to the volatility of foreign interest rates. How much had the Rupiah devalued (revalued) in percentage term? 35. hedge fund investing in Japanese Nikkei index. The yen was at 127¥/$ at the beginning and at 109¥/$ by the end of the year. T/F 29. bonds. T/F 30. volatility of foreign currency. explain why? 68 77 .S.S. In the previous question assume Euro devalues to $. Consider a U.

(1979) and Obstfeld (1986) who argues that currency crises can occur in a country with sound economic fundamentals due to the self-fulfilling prophecy modeled by Diamond and Dybvig.6% for currency and macro risk factors for the loans denominated in U. in Sea Island. 4 Here the interest rate risk in dollars and pounds is defined as the variance of the underlying interest rates. 7 See for exampleKrugman. 2 On the other hand when the state of the economy falters shaking consumer confidence. Furman and Stiglitz (1998).5% plus spread of 2. 3 See Whitt (1998). 7 countries are in a system with a pegged exchange rate allowing +/. which could lead to investors panic and financial crises in the extreme see Radlet and Sachs (1998a. who reaches similar conclusion. 2002. thereby reducing economic activities and producing weak economic fundamentals.End Notes: 1 The Atlanta Fed eighth annual conference on financial markets: financial crises October 17–19. dollar. eight countries maintain a currency board with an implicit legislative requirement to maintain a specific currency at fixed exchange rate provided that the monetary policy of the country is strictly in line with the policy of the currency to which it is pegged to. while assuming zero co-variance between the pound interest rate and percentage change in the exchange rate. 8 countries are in a system of crawling pegs allowing periodic adjustment to the central rate to which it is pegged to.1 percent fluctuation around the central (2001) Development Economic research Group World Bank. 6 See Kowai et. while U. Georgia. 9 See for example: McKinnon and Pill (1996) and Krugman (1998a). 14 Wall Street Journal January 11.S. 10 Nominal interest rate averaged 16% in Thailand during 1991-96. 5 Federal Reserve Bank of Atlanta conference on: Financial Crises 1999. 1998b). Atlanta. 8 The Link between banking and currency crisis is documented in a study by Kaminsky and Reinhart (1999). 11 The return on invested capital according to OECD (1998) estimate was below cost of capital for two thirds of Korean Chaebol prior to collapse of Korean Won. 1999. 25 countries maintain a managed float and more than 48 countries have independent float. 12 See Radlet and Sachs (1998) and Chang and Velasco for supporting evidence.S risk free rate was 4. 13 According to International Financial Statistics of the International Monetary Fund more than 38 countries are in a system of exchange rate arrangement similar to the Euro zone. 69 78 . 1983).

The foreign currency exchange market is the largest and least regulated market. TRANSACTIONS AND RATES Foreign Exchange Markets The foreign exchange market is the complex network of global over the counter (OTC) institutions and structures that facilitates: exchange of one currency for another (transfer of purchasing power). Unlike the stock and 62 79 . Market and Transaction Spot Outright Forward Forward Rate Agreement FRA an Approximation Hedging with FRA Syndication of Euro Credit Loans Foreign Exchange Swaps Forward/ Forward Swap Foreign Exchange Market Functions Foreign Exchange Quotations Arbitrage in the Foreign Exchange Market Major Players in the Foreign Exchange Market Triangular Arbitrage Speculative Transactions Settlement Risk Spot Rate and the Law of One price The Big Mac index Central Bank Intervention Relative Version of Purchasing Power Parity Exchange Rate Pass-through Spot Exchange Rate and Nominal Interest Rate Forward Exchange Rate and Covered Interest Parity Forward Premium or Discount for Selected Currencies International Parity Relationship Macro Determinants of the Exchange Rate Real Exchange Rate Real Exchange Rate and East Asian Currency crisis End Notes FOREIGN EXCHANGE MARKETS. management of exchange rate risk (transfer of foreign exchange risk) from hedgers to risk arbitrageurs and exchange rate determination.Chapter 3 Foreign Exchange Rate Dynamics: Managing Exposure Chapter outline: Foreign Exchange Rate.

63 80 . outright forward and swaps markets far exceeds the volume of the daily stocks and bonds traded in the organized exchanges worldwide. Credit derivatives. forward and swaps. credit default swaps (single- name or multi-name). accounted for more than $51 trillion by 2007. FX swaps. currency swaps and options was in excess of $57 trillion in 2007. On the other hand interest rate contracts: forward rate agreements (FRAs). The volume of daily transactions in the spot.commodity markets. interest rate swaps and options have notional principal of over $388 trillion. it operates with no supervisory or regulatory oversight. The amount of foreign exchange contracts: outright forward.

Moscow. 81 . The market is relatively thin when trading begins in the Far East and is far more liquid when the last hours of trading in Europe coincide with trading in the United States due to differences in the time zones. Singapore and other East Asian countries. Western Europe. Australia to Tokyo. Exhibit 3. Chicago and San Francisco. New York.1: Global Positions in OTC Derivatives The foreign exchange market is geographically dispersed around the globe extending from Sydney.

dollar makes up 45. 82 65 . Exhibit 3. respectively .2. and 43.2: Currency distribution of reported foreign exchange market turnover The U. 44.1 The Euro and Japanese yen are the second and third currency as the percentage of total in the period of 1995-98 in terms of their respective position in the global foreign exchange market activity.S.The proportion of the individual currency daily turnover in the global foreign exchange market is shown in Exhibit 3.5 percent of shares of total daily turnover of the global foreign exchange market activity for the 2001 through 2007 periods.

while foreign exchange swap transactions have surpassed the other two transactions with a growth rate of 79 percent as reported by the Bank for International Settlement. Spot Transactions: A spot transaction involves the exchange of one currency for another.3: Global Foreign Exchange Turnover Source: Bank for International Settlements. Average daily turnover has grown by 59 percent between 2004 and 2007 for spot transactions. Spot transactions 83 66 . dollar with the Japanese yen at an agreed exchange rate to be settled in cash in two business days between two counter parties.Foreign Exchange Transactions A foreign exchange market is composed of spot. the U. Exhibit 3. For outright forward transactions over the same period the growth rate is 73 percent. outright forward and swaps transactions. $382 and $1. daily foreign exchange market turnover by types of transaction as reported by the Bank for International Settlements in 1992 through 2007 is depicted in Exhibit 3. outright forward and swaps was $1.005.3. For example. Average daily turnover for spot. The global.714 billion by 2007.S.

The un-hedged payoff is risky and depends on the value of the yen when it is converted to U.S. however. the British £ with the euro at the forward exchange rate determined today for the delivery to take place for cash settlement in more than two business days. The foreign exchange dealer in New York has quoted the pound as follows: $1.40 In 31 days Nissan delivers the yen and receives $2. The Bank has the following quote for 31days yen forward: 121.40 yen is locked in and Nissan will receive $2.40 ¥/$.25 percent of all transactions in the foreign exchange (FOREX) market are outright forward contracts.8595 million at the maturity of the forward contract as illustrated in Table 3. for example.1.S.32-122. dollars. dollar in two business days to settle the spot transaction at the ask rate of $1.24 million U. the hedged pay-off at the ask price of 122. The foreign exchange dealer’s profit from the above spread in dollar terms is $30. Outright Forward: This over the counter transaction involves the exchange of one currency.5210-$1.8595 million at the ask price of 122.000.5240.5240 Kodak pays $15.accounts for nearly 31 percent of all transactions in the foreign currency exchange market in 2007. Nearly 11. 84 67 . For example Kodak needs to pay £10 million to a British supplier in a spot transaction. Example: Hedging with Forward Contract: Nissan manufacturing enters into a forward contract with the Bank of America today to sell 350 million yen at a forward price determined today and Nissan will deliver yen in 31 days to the Bank of America.

9 e l 2.40 the hedged position with an over the counter forward contract provides more dollars for the receivable denominated in foreign currency as shown in Exhibit 3.859477 115 3.845528 2.866503 2.1 2.4.65 120 122 124 126 128 130 132 Yen per Dollar unhedged forward hedge 85 68 .7 2.4 2.859477 121 2.8 c e R r 2.Table 3.755906 2.692308 2.95 2.75 a ll o D 2.40 yen/$.86 The payoff on an un-hedged position could be higher or lower depending on the exchange rate prevailing on the maturity of the yen receivable.85 b a iv e 2.822581 2.043478 $2.859477 124 2.1: Forward Hedging yen/$ Un-hedged Forward hedge 123 2.892562 2.859477 130 2.859477 122.4: Forward Hedge and Unhedged Positions 2. however. Exhibit 3.859477 122.859477 2. at the exchange rate above 122.859477 127 2. It is possible for the un- hedged position to provide more dollar receivables at the exchange rate below the forward rate ask price of 122.

To manufacture a forward rate.S. companies that obtain a large chunk of their revenues in foreign currency engage in hedging to protect against swings in exchange rates that may erode their earnings.1 Where Rl .term rate has to be set equal to the geometric average of the short-term rate has to be equal to the geometric average of a 60-day rate and 30-day forward rate prevailing 30 days hence. simple approximation in the Equation 3.25 5 7/8 – 6 90-days 6 1/4 – 6 3/8 6 ½ – 6 5/8 5 4/8 – 5 5/8 6 1/4 – 6 3/8 The 30 days forward rate prevailing in 60 days in dollar and other currencies can be estimated using an approximation as follows: Ninety-day fixed rate borrowing can be defined as the average of the 60-days rate and the 30. the long. However.The following excerpt from The Wall Street Journal provides an interesting story of the changing corporate expectations and the strategy they follow for hedging their receivables or payables denominated in foreign Approximation: Consider the quotes in the inter-bank Euro-currency interest rates for dollar. Swiss Franc and Euro as follows: US dollar UK sterling Swiss franc Euro 30-days 5 3/4 – 5 7/8 5 5/8 – 5 6/8 4 7/8 – 5 5.00.00 and ¥135.00 by mid- year and some instead expect the Japanese currency to hold in a trading range of between ¥120. For example. “Companies "are not as concerned" now that the yen will slip towards ¥ forward rate 60-days hence. 86 69 .” Forward Rate Agreement (FRA) . pound. U.50 – 5 5/8 60-days 6 – 6 1/8 6 1/8 – 6 1/4 5 1/8 – the long term rate. a 90. Woolfolk added. Rs . mainly by buying forward or option contracts that insure against currency movements beyond specific levels.1 provides a useful framework for estimating forward rates as follows: Rl = (Sm* Rs + Fm*F)/(Sm + Fm) the short term rate.

is the forward rate. However. The bank selling FRA is guaranteeing the 30-day forward at 7. Fm is the forward rate maturity Sm is the short term rate maturity 90-day rate = (60 * 60-day rate + 30 * 30-day forward rate) /90 6 3/8 = (60* 6 + 30* 30-day forward) /90 30-days forward rate = 7. The buyer of FRA is indirectly guaranteed the rate at 7.F.27 percent during the same time periods. The total daily transaction in the over the counter. inter-bank market for FRA was $209 and $362 billion dollar as of 2004 and 2007. if the actual rate exceeds the agreed rate say by 1.5 percent in 60 days the losing party. and as a percentage of total 11 and 11.125 percent in the above example. respectively.125 percent in 60 days.5 percent more 87 70 . in this case the buyer of the FRA gets compensated by the present value of the difference in 60 days and the buyer of the FRA has to pay at the spot 1.125% The forward rate is produced schematically as follows: Borrow at ask rate of 6 3/8 for 90 days Or Luck at FRA Rate for 30 days Invest for 60 days at Bid Invest at an unknown rate for 30-days? Hedging with FRA: The forward rate agreement is an over the counter instrument to hedge the interest rate risk.

125 percent. Assuming the money received can be invested at 9.125 percent.375.375 percent. The interest cost will be equal to $76. The losing party.375 percent below the agreed rate and the present value of this amount has to be sent to the seller of the FRA in 60 days. For example. however in 60 days she will receive $16. in this case the buyer of the FRA.540. and international organizations. the dollar denominated loans that are originated in London. sovereign governments. Syndication of Euro credit Loan Euro credit loans are short term or a medium term loan that is extended to multinational corporations.02 ) (30/360)] / (1+09125x30/360) = $16.66. the buyer of the FRA in 30 days will be borrowing at spot at 1. The buyer of the FRA is at locked in at 7. which is exactly equal to interest cost of the loan at 7. the base rate is LIBOR.125 percent and in 60 days the 30-days rate at the spot is 9.95 The buyer of FRA in 60-days will be borrowing $10 million at 9. Example: Assuming the buyer of the FRA wished to borrow $10 million in 60 days for only 30 days and in order to protect himself against rising interest rate buys FRA at 7.041. will receive the present value of the difference in 60 days as follows: Cash received by the losing party = 10M (0.540.125%. If the rate in 60 days falls by 1. the total out of pocket cost of this loan will be equal to $59. The 88 71 .125 percent no matter which way interest rates move.125 percent for 30-days.95 from the seller of the FRA that can be invested at the borrower’s opportunity acquire the capital needed.

Table 3: Participation and Sub-Participation Banks fee Amount of Fee income capital funded 12 sub. . The lead arranger bank Goldman Sachs retains $100 million in its book and spreads the risk and reward proportionally among the sub-participants as illustrated in the following Figure.01 $240 million $2.01 $600 million $6.000 participants 12 sub.625.125.04125 $100 million $4.000 89 72 . Case Study: Consider a multinational corporation who wishes to borrow a $1. The arranger bank books $4. . lending banks form syndication spreading risk and reward for the loan. Since the size of the Euro credit loan is very high.625 million collected from the borrower as shown in Table 3. .25 % $1.25 percent over a 7-year period with an up-front fee of 1.000 participants Arranger .25 billion $15.000 total 1.borrower usually pays say 1-year LIBOR plus a spread that is dependent on credit quality of the borrower.25 percent (origination fee).000 participants 10 sub.100.25 billion jumbo loan in the Eurodollar market at LIBOR plus 1.000.125 million arranger fee of the total up-front fee of $15.01 $310 million $3.400. The lending banks are also transfer interest rate risk to the borrower by pricing the loan at floating rate of LIBOR or any other variable rate index.

That means Goldman Sachs has to put up 8 million of its own capital and borrow remaining $92 million in the interbank market at the cost of 1-year LIBOR.75 percent.25 billion Loan Retains $100 million 12 Sub-participants 10 Sub-participants 12 Sub-participants $50 million each $31 million each $20 million each Questions: 1. What is the return on equity for this bank at the end of second year 90 73 . One of the sub-participating banks is a UAE bank who funded $24 million of the above syndication loan. requiring minimum 8 percent regulatory capital by the bank regulator. How much interest is due to Goldman Sachs by borrower at the end of second year? 2. Participation Process in Syndication of Euro Credit Loan Borrower $1. What is the return on equity for the Goldman Sachs for funding $100 million of the syndication loan? 3. The regulator in the UAE requires 15 percent regulatory capital. The $100 million loan in the Goldman Sachs book is 100 percent risk weighted. Suppose 1-year LIBOR by the end of first year is equal to 3.25 billion Arranger fee Arranger Bank Servicer fee Arranges $1.

then the swap is the forward/forward swap. 30 and 60 day forward rate. can wait and borrow in 60-days by paying the prevailing spot rate or she can enter into foreign exchange swap agreement. Suppose the importer 91 74 . provided that this bank has funding cost at the rate of LIBOR +25 bps (100 basis points is equal to 1 percent)? 4. in two different dates prevailing in the future say 30 and 60 days and at the rate determined today for the respective. at the predetermined exchange rate for cash settlement at the expiration of the contract (the short leg). When the short leg of the swaps is more than 2 business days.000 in 60-days for only 30 days to pay for an outstanding obligations entered with a British supplier. that is. provided that the rate for the long leg is usually different from the rate prevailing at the conclusion of the short leg. for example.000. A FOREX swap can also be described as the portfolio of long and short positions entered into. The above foreign exchange swap described is a spot / forward swap. and reversal of the exchange of the same two currencies at the rate agreed by the two parties at a date in future. Describe how the borrower in the above syndication loan will manage its exposure to interest rate risk. the U. In the over the counter market for forward and swaps any particular date can be arranged with the swap dealer that is usually a major bank. Foreign Exchange Swaps: A contract involving two counterparties to exchange. The importer can buy 30-days FRA in 60-days as of today.S. say three business days known as (long leg). simultaneously. Example: An importer needs £1. in two business days. dollar for the Singapore dollar in principal amount only.

000 pounds for 30 days 60 days from today. The notional principal in the above example is £1. rate of 5.sells £1. This is the implied 30-days forward repo-rate as the importer is selling pounds 90-days forward with the agreement to buy it back in 60-days as follows: (1+ repo-rate)= $1.000 pounds for 30 days at fully collateralized basis at the 92 75 .5210/£ and simultaneously buys £1. which could be higher or lower than the prevailing 30 days rate or could enter into forward/forward swaps that can fix the cost of borrowing today.000 90 days forward at $1.5210/£ after being annualized is the interest rate denominated in dollars.800 and receives $152.36 percent per annum. Haynes pays $152. Haynes can wait and borrow at the current market rate in 60 days.000.S.000. Example: Forward/ Forward Swap.5278/£.5210/£ The actual 30-days rate in 60 days could be higher or lower than 5. the un-hedged position produces availability risk (the risk that the capital may not be easily available) for the importer that is mitigated in the forward/future markets. Haynes enters into a swap agreement by buying 60 days pounds forward at $1.5278/£/$1. By selling forward one essentially is borrowing (financing) and by buying forward one is equivalently lending (investing) at a predetermined rate that fixes (locks) the cost of borrowing.52/£. This swap transaction is borrowing in disguise for 30 days at a fully collateralized basis at the U.36 percent. Foreign exchange swaps make up over 50 percent of all the transactions in the FOREX market.000 and has the use of 100.000 and the ratio of the buying rate of $1.000 60 days forward at $1.000. Haynes Company needs to borrow 100. Furthermore.5280/£ and simultaneously selling 90 days pounds forward for $1.5278/£ and the selling rate of $1.

S. dollar equivalent known as indirect quote or European Terms.5 provides the direct and indirect quotations for Japanese yen and British pound spot.52/£ Swap Dealer Haynes $1. dollar from the perspective of foreign investors. The forward transaction is intended to transfer risk from one party to another. For example. The direct quote provides the value of the foreign currencies from the perspective of the U. 93 76 . 2002. 1-month through 3-months forward rates as of May 17. Exhibit 3. Finally. dollar per foreign currency known as direct quote or foreign currency per U.S.32 percent annualized.S. while indirect quote refers the foreign currency value per U. a swap transaction is essentially financing at a fully collateralized basis. transferring risk is hedging that is intended to reduce the exposure to foreign exchange risk. a spot transaction is intended to transfer purchasing power from one party to another and vice versa.5280/£ Foreign Exchange Market Functions: In the previous section the type of transactions in the foreign exchange market was analyzed.rate of 6. Foreign Exchange Quotations: Foreign exchange daily quotations are reported in the major newspapers for all major currencies worldwide. $1. Each transaction is intended to provide a particular function. Haynes is paying dollars and receiving pounds and the swap dealer is paying pounds and receiving dollars as illustrated in the following figure.S. The currencies are quoted in terms of U. investors in terms of dollar per foreign currency.

5: Foreign Exchange Quotations $/Yen Yen/$ Fri Thu Fri Thu Japan (yen) .6870 .6941 ------------------------------------------------------------------------------------------------------------ Source: Investors Business daily.6896 .Exhibit 3.007814 125.32 127. 6858= 183.6902 6-month forward 1.month forward .007802 125.6876 3-month forward 1.4501 1.4556 1.6863 1.S.72 127.4544 .month forward .007942 . while weaken against the yen in the next 1 through 6 months as of Friday May 16. The dollar is trading at a premium against the pound and at a discount against the yen that is reflected in the indirect quote (European Term) in Exhibit 3.61yen/pound 94 77 .currency exchange rates can be estimated from the perspective of the Japanese investor as yen/$ and British investor as pound/$ as the yen/pound as follows: 125. May 17.4408 .97 3. Cross.5.007839 125. The pound is said to be trading at discount against the U.57 6.4421 1.6858 .4582 1.007954 .007883 124.92 128. The forward exchange rate as a measure of the market consensus of the future exchange rate for the British pound and Japanese yen are indicating that the dollar is expected to strengthen against the pound.008025 .6934 .5 cross.85 Britain (pound ) 1.17 1.007979 .month forward . The consensus for the future exchange (forward) rate may change as new information comes to the market and individuals and institutions evaluate that information and push the exchange rate into the new direction.4570 .month forward 1. 2002 based on current and expected future information.Exchange Rate: Based on the Exhibit 3.4489 . 2002.61 126.92/. dollar in the forward market for 30 to 180 days forward as reflected in the direct quote.

6870=182. 181.72 yen/pound and 179.month forward .007954 .0079403 124. 3-month or 6- month forward yen/$ and 1-month.92 127.0078989 125. Bid and Offer Quotations in the Inter-Bank Market: In the over the counter market for foreign exchange the quotes for the spot and forward transactions are provided by major foreign exchange dealers in terms of the bid (buy) and offer (ask) price on the major currencies in which the dealer is making the market. The spot exchange rate yen per pound should be 183.61.month forward .70 yen/pound The above cross currency exchange rates are the direct quote from the Japanese investor’s perspective and the indirect quote will be the ratio of one over the direct quote.008025 .0078833 125. or 6-month forward pound/$ as follows: 125.99 yen/pound.60 6. the various cross currency forward rates can be calculated as the ratio of the 1-month.0078666 125.6. The currency may be quoted outright with a price that reflects all decimals. 3. The dealer stands to buy at the bid price and simultaneously sell at the offer price earning an arbitrage profit. Exhibit 3. Likewise.61 125.94 Point’s quotations 95 78 .85 3.007979 .6: Spot and forward Quotations for Yen and British Pound in the Inter-Bank Market Offer $/ƒ Bid Bid ƒ/$ Offer Japan (yen) spot . or it may be quoted as point’s quotations as shown in Exhibit 3.32 126. The cross currency forward rates as a forecast of the future rates hinting an appreciation of the yen against the British pound as fewer yen are required to pay for one unit of the British pound.007942 . deviation provides an opportunity for risk-less arbitrage in the currency exchange market.month forward .12 1.72/.72 126.

3.6849784 .6859652 . while quoting the 1.4582 1. The compensations are tied to the performance of individuals in generating arbitrage profit in private banks. .52 6-month forward -131 to .4501 1.128 In the inter-bank market for foreign exchange the dealer may quote outright as $1.4545 .81 to – 54 and – 161 to –128.21 3-month forward -81 to .118 Bid Offer Bid Offer Britain (pound ) spot 1.4582-99 per unit of British pound.54 6-month forward -161 to .6875215 . In this case the dealer is indicating that he is willing to sell pound at $1.6910373 .6896076 6-month forward 1.4471 .4578 . However.6934332 Point’s quotations 1-month forward -26 to .4421 1.4556 1. 1-month forward -20 to . When the point’s quotations are given and it is positive then the dealer is signaling that the points need to be added to the spot rate to arrive at a particular forward rate.4582.4599 and simultaneously buy at the bid price of $1.685777 1. These points have a negative sign signaling deductions from the spot rate to arrive at the respective forward rate of varying maturities.4599 .685777 3-month forward 1. Arbitrage in the Foreign Exchange Market: Temporary deviations in the spot as well as forward rates provide an opportunity for the major foreign exchange dealers and other individuals and corporations to engage in arbitrage. central banks’ foreign exchange dealers with fixed remuneration make the market in millions of dollars in major currencies without being concerned about profit or 96 79 .27 3-month forward -60 to .month forward 1. and 6-month forward in point quotations as –26 to – 21. Major banks around the world have trading divisions with currency traders around the clock making markets in foreign currency exchange for their clients as well as their own account.

Moragan. stability.7. reduced volatility as well as pushing the currency in certain direction against speculative attacks on dollars..P.B.8. The fall in the daily turnover from a high of 1.2 trillion daily trading of the foreign exchange market transactions involving spot. Currency trading by central banks and others account for over 40 percent of the total foreign exchange trading. Goldman Sachs Deutsche Bank Citigroup J.5 to 1.B.e. The central bank dealers buy and sell a particular currency in chunks of $10 to $20 million or more dollars in order to achieve certain objectives. Morgan 0.S.P.00 20.00 40. Major Players in the Foreign Exchange Market: The market share of currency trading and distribution of the major financial institutions is shown in Exhibit 3.7: Foreign Exchange Market Major Players and Distribution of Their Shares Foreign Exchange Market Shares Others Barclays Major FOREX Dealers Bank of America Morgan Stanley State Street U. pounds or yen).loss in a given daily transactions.00 50. (i.2 trillion reflects the growing use of electronic trading in the inter-bank market.00 30.F. This Exhibit shows that J. Citigroup and Deutsche Bank nearly have 30 percent of the $1.00 10. Exhibit 3.00 Percent 97 80 . forward and swap transactions as seen in Exhibit 3.S. Warburg C.

swaps $1.50 $0. an arbitrageur needs to buy pounds and then use pounds to buy the cheap currency yen as 98 81 .85 183.00 1989 1992 1995 1998 2001 Year Source: Euromoney: Bank for International Settlements Triangular Arbitrage: It is possible that the foreign. Exchange Rate Bid Offer Pound/$ .69343 $ /yen 124.forward. Using the dollar. yen/$ and yen/£ is quoted as follows by banks in United Kingdom.69103 .94 Yen/£ 182.70-182.8: Daily Turnovers spot.Source: Euromoney: Bank for International Settlements Exhibit 3.92 The yen appears to be non-aligned as the cross-currency implied exchange rate for the bid and offer price for yen/£ respectively has to be equal to 179. spot or forward exchange rate delivery in the inter-bank market can be out of sync temporarily and arbitrageurs try to align the currency by buying and selling the under-valued or over-valued currency.00 Trillions $0.24.50 $1. Suppose the bid ask price for the pound/$.61 125. United States and Japan.

562/£. a currency trader is expecting pounds to devalue in the next 60 to 90 days based on the private forecast of a weaker pound.00 $1.040. expecting currency to appreciate or depreciate in the near future.000.354.5 £691.77 profit provided that the arbitrageur started with $1million and follows the above process illustrated in the diagram. Had the speculator taken the opposite position that is buying pounds 90 days forward at $1. The loss in this speculative transaction is equal -$32. Start with $1 million $1.57812/£.57812/£ in the next three months against the expectation of the speculator at which time the short seller buys pounds at the spot market at $1.292.the pound is quoted at a premium against the yen in the above cross currency inter-bank market as compared to implied cross exchange rates as illustrated in the following diagram.003.000.292. He sells £2 million 90 days forward at1. For example. Speculative Transactions: Currency market speculative transactions involve buying or selling currency (long or short).030 Sell ¥ for $ at bid Buy ¥with £ at bid Buy £ with $ at bid Direct term European term European term The above triangular arbitrage generates $3. the pound appreciates to $1.562/£ 99 82 .77 ¥126.835.

This eliminates the time lag between the two legs of the FX trade.040 $1. subsidiary in February was $750 million.040. To date.562/£ $1. and with the global launch of the Continuous Linked Settlement (CLS) network in July 2002.57812/£ $/£ Foreign Exchange Loss: The speculative currency trading losses suffered by Allied Irish Bank’s U.and selling the pounds three months later at $1.3 The CLS mechanism allows the two payment legs of the FX trade to be made simultaneously.4 100 83 .2 Settlement Risk Settlement risk is one of the important issues in the FX sector of the over the counter market. the FX payment and collection process is set to be aligned.S. An FX trader at Ireland’s largest bank had taken a huge long position on the yen’s rise in 2001. Exhibit 3. before transaction cost as demonstrated in Exhibit 3. the settlement of the FX trade in different time zones resulted in a delay between the pay and receive legs.5781/£. but when the dollar continued to climb against the yen. the speculator would have realized a profit of $32.9. which lies at the center of FX settlement risk. the losses piled up.9: Profit (Loss) in Speculative Long and Short Position Profit (Loss) Short in £ Long in £ -$32.

micro factors and the type of exchange rate arrangements in place in the respective economy).e.2 is the ratio of the two price indices.. The exchange rate implied in Equation 3. Price in $= Price in £. Any deviations from parity will lead to risk-less arbitrage in a frictionless market. $/£.S. The dynamics of the two baskets in reality are different as each basket has to respond to the underlying fundamentals i.$/£ 3.2 in the above analysis is predicated on the assumption that the price in the respective country is determined in a competitive market and absence of any imperfections i. and U. otherwise.S. is indeed the ratio of the two price indices in dollars and pounds not distorted by market imperfections. Assuming a basket of goods and services is currently priced in the U. is currently priced at $150..Spot Rate and the Law of One price: An exchange rate is the ratio of two prices for an identical basket of goods and services denominated in two different currencies.. The identical purchasing power in dollars and pounds for U. macro economic factors discussed in the previous chapter as well as the factors unique to a particular economy (i.2 is predicated on the assumption that the exchange rate. According to The Law of One Price assets of the same risk class are expected to provide the same rate of return. government intervention and regulatory impediments.K residents in the Equation 3. This is the absolute version of the Purchasing Power Parity. It then follows from The Law of One Price an implied exchange rate of $1. arbitrageurs simultaneously buy inexpensive assets and sell short the overvalued asset and earn risk-less profit. 101 84 .e.2 The spot exchange rate implied $/£ in Equation 3.e.50 per British pound as the ratio of the two baskets of goods and services denominated in dollar and pound.K at £ 100 and the same identical goods and services in U.

which is traded worldwide. when there is deviation from The Law of One Price and arbitrageurs are unable to take advantage of price disparity in different location worldwide. while it is undervalued against the Swiss Franc by 68%.02/$3. The truth is that the price in the market for real assets is not usually determined at least for classes of goods in a competitive environment.15 The dollar appears to be overvalued against most emerging market economies. which ultimately has to be passed on to consumers. the ratio of the prices in the U. According to the Big Mac index the dollar appears to be overvalued against Argentina’s Peso by 15 percent as the price of Big Mac is equal to $3.02 and $3. The price of the burger is usually the simple average of the prices in 120-different locations worldwide. According to The Law of One Price the price of identical basket of goods in this case Big Mac has to be equal in dollar term worldwide.K for the Big Mac is an implied parity exchange rate and as compared to actual exchange rate can provide a rough approximation as to whether a currency is over or undervalued. The government intervenes in the process of price determination or institutes regulatory requirements that impose additional cost on the producer.57 respectively in Argentina and the United States.S and U. For example. ($3. the Big Mac is nontradeable. Unlike gold.57)-1= -.The Big Mac index: The Economist has devised an index of Big Mac burgers denominated in currencies in which there is Burger King Franchise owned by McDonalds Corporation worldwide.10 shows the Big Mac Index for the 2009 period. Exhibit 3. 102 . the British pound by 3% and the Euro area by 29 percent.

supply and demand forces determine the price in the financial market for financial assets such as stocks and bonds competitively. which inversely affect the value of financial assets. However. with central banks reacting to economic fundamentals by changing the short-term interest rates. 103 .

Exhibit 3.10: Big Mac Index 2009 104 .

While.Central Bank Intervention: The foreign exchange market is the market where the price of a currency is determined by supply and demand forces for the independently floating currencies and needs to be distinguished with the stock market. 105 88 . While. dollar without much success by selling dollars to buy other currencies. government intervention in the stock market has been only limited to extreme cases involving events triggering a shut down of the market.S. Central Bank in the period 1982 to 1985 on three occasions attempted to weaken the U. the intervention by an individual Central Bank may prove futile. the dollar index continued to gradually weaken falling below 100 of 1997. The index of dollar continued to appreciate against most major currencies from 1997 through 2002. the central bank intervenes in the foreign exchange market in order to maintain an exchange rate within a desirable range whether or not such attempts proves to be successful or not. Exhibit 3. dollar index against major currencies during 1994-2009 periods. The events of the 1990s and various crises provide evidence in support of the above arguments that intervention by Central Banks usually distorts the currency values for only short periods and economic fundamentals coupled with expectations ultimately determines currency values.11 provides the level of the U. The U. the coordinated policy can prove successful in realigning currency value. There has been some spike in the dollar value as the European Central Bank and Central Bank of Japan undertook significant intervention to keep the dollar from falling below 90 yen.S.S. From the recession of 2001 through to the recession of 2008. the base year.

6 This phenomenon is known as a J-Curve as the trade balance deteriorates following an initial devaluation of currency and later improvement in trade balance as exports become attractive and import price rises after a long delay accompanied by a fall in import volumes as portrayed in the Exhibit 3.S.S. Exhibit 3.11: Trade Weighted Index of U.S. dollar plunged in late 2003 through 2007 the rise in price of imports was unusually slow or weak as foreign exporters tried to cut their profit margins in order to maintain their market shares as pointed out in several studies. Dollar Although the U. exchange rate to import price and volume was delayed for nearly 14 to 18 months following dollar devaluation. 106 89 .12.5 The pass- through from the U.

the merchandise trade balance actually deteriorates following devaluation to lower level at time t1.weighted index of U.Exhibit 3. Exhibit 3. lack of any particular patterns and randomness of the percentage change in the exchange rate is the result of the independently floating exchange rate arrangement of the early 1970s to which U.12: J . 107 90 . data takes nearly 14 to 18 months from the initial devaluation to the improvement in the trade balance as documented by Rosensweig and Koch (1988). currency belongs. Rising volatility.S.S.Curve Merchandise Trade Balance Time Time t 0 Time t1 Time t2 Suppose at time t0 the central bank devalues the currency. dollars against major trading partners from 1973 to 2002. However improvement in the balance is delayed until time t2.13 provides the monthly percentage change in the trade. This long delay for U.S.

The exchange rate in practice is the ratio of the prices of unidentical products produced in two different countries.12 Percentage Change in the Value of Trade Weighted Index of U. direct or indirect. soybean. They are oil. to its own producers with the exception of oil.03 0.S. Suppose U. Exhibit 3. the U.04 -0.S provides a direct subsidy to dairy and soybean producers and indirect subsidy to steel producers in the form of giving them protection from cheaper steel produced overseas by imposing a tariff and quota on steel imported from other countries. Some products are uniquely produced in one market and not produced at all in other markets due to technological constraints. However.02 -0. does not provide any subsidy. Dollar 1973-2002 0.05 0. milk and chicken.04 0. which is 91 108 .01 -0.K. Some prices are very competitive in one market. Example: Assume there are only five products produced in United States and United Kingdom.03 -0.02 0.05 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 The set of all prices for all goods and services in the real and financial markets that make up the price index are determined uniquely in each sub-segment of the market subject to the constraint imposed by the environment in which they operate. while the same product produced elsewhere is not.01 0 -0. steel.

The lower price for dairy products in the U. interest rates and other factors such as competition and institutional arrangements on the exchange rate. The higher price for steel in the U. Relative Version of Purchasing Power Parity: In this context. Having recognized the imperfections induced by government actions in distorting prices. The implied exchange rate based on the Law of One Price has to be equal to the ratio of $157. is distorted and does not take into account the true cost of production.indirectly subsidized. requiring 10 percent more pounds in order to purchase the same basket of goods. consumers also experience a loss of purchasing power in dollars by 5 percent. is also distorted by giving local producers an opportunity to raise their price to match the higher price of steel produced elsewhere. while the identical basket in the U.S requires $157.4318/£. as they need $157.K in this scenario is due to higher inflation relative to the United States. assuming prices are rising at a faster rate in the U. and U. The U. Therefore.50 that used to cost $150 one year earlier. which is induced by imposition of a tariff.S.S (provided that the exchange rate adjusts to a new equilibrium as predicated by the PPP) as British goods become relatively more attractive as import prices fall and export prices go up (pass through is complete) due to 109 92 . However.S.K is distorted leading to a distorted exchange rate between dollars and pounds. let us analyze the impact of inflation. than the U.S.K.S.50 to acquire the same basket of goods and services that only used to cost $150 domestically.K to the U.S. the price index in the U.50/£110 or $1. there will be a transfer of purchasing power from the U. requiring £110 to acquire the same basket of goods and services that used to cost £100 one year ago in an earlier example. The loss of purchasing power in the U.

relative loss of purchasing power by the U.K resident and relative gain of purchasing

power by the U.S. resident buying cheaper imports as illustrated in Exhibit 3.14.

Exhibit 3.14 Relative Version of PPP

Time 0 U.S Time 1
$150 5% Inflation $157.50

$1.50/£ $1.4318/£
£100 10% £110

Foreign exchange markets therefore transfer purchasing power between two countries

as spot and the expected future exchange rate changes due to changing economic

fundamentals and changes in expectations. The relative PPP holds when the implied

exchange rate derived is the ratio of the prices at time 1 (future price) in the above exhibit

denominated in dollars and pounds, that is $1.4318/£. Therefore it follows from Exhibit

3.13, that the expected or future exchange rate S1 is related to current spot rate S0 times

the ratio of one plus the respective inflation rates Π$ , Πf in the U.S and the U.K, that is

the expected exchange rate S1 is as defined in Equation 3.3 as follows:

S1 = S0 (1+Π$) / (1+ Πf) 3.3

S1= $1.50/£. (1+. 05)/(1+. 10) = $1.4318/£

The approximate version of the relative PPP implies that, the percentage change in the

exchange rate is equal to inflation differentials as shown in the Equation 3.4.

(S1- S0)/ S0 = (Π$ ¯ Πf) 3.4


Where, S1 and S0 are the direct quote spot rates at time 1 and zero and Π$ and Πf are the

inflation rates in dollars and foreign currency, respectively. The graphical representation

of the above approximation in Equation 3.4 is provided in Exhibit 3.15.

Exhibit 3.15 Parity Relationship

(S1- S0)/ S0

PPP Line



-5% (Π$ ¯ Πf)

Inflation differentials


The PPP line is the locus of all points where the percentage change in direct quote

exchange rates is identical to the inflation differential denominated in dollars and foreign

currency. Deviations from the parity line provide an opportunity to buy goods and

services from the country whose currency has not appreciated or depreciated according to

the inflation differentials and the violation of The Law of One Price. For example points

to the left of PPP line such as A where inflation differentials are positive say 3 percent

(U.S. rate is higher than foreign rate by 3 percent), while foreign currency has

appreciated by 4 percent against dollar that is ((S1- S0)/ S0 = 4%).


The above scenario makes foreign goods and services more expensive for the U.S. to

purchase and likewise U.S. goods and services becomes attractive for foreigners to

purchase until the parity is restored i.e. U.S. dollar appreciates against foreign currency

by 1 percent to maintain parity. The loss of purchasing power by U.S. residents in buying

foreign goods and services in the above scenario persuades them to withhold buying

expensive imports. The gain in purchasing power of the foreign individuals due to the

fact that their currency buys more of the U.S. dollar induces them to purchase more

goods and services imported from the U.S. The higher demand for U.S. goods and

services leads to a greater demand for dollars and its appreciation. To the left of PPP line

purchasing power transfers from the U.S. to foreign countries continues until the

exchange rate parity is restored.

To the right of the PPP line such as B, there is a transfer of purchasing power from

foreign countries to the U.S. as foreign currency fails to appreciate by the amount of the

inflation differential making foreign goods and services relatively more attractive for the

U.S. to buy. This scenario continues until parity is achieved and there is no transfer of

purchasing power from one country to the other. Most evidence tends to reject the

relative version of the PPP in the short run, while providing some support for it in the

long term.7

Exchange Rate Pass-through: The relative version of the PPP requires that the change

in price be reflected immediately in the exchange rate. The fact is that the price changes

are not reflected in exchange rate and the pass through is incomplete. The competition

and agency relationship that defines the contractual relationship between exporter and

importer and currency denomination of imports affects the degree of the pass-through.


Absorb all of the increase in import price by cutting its profit margin and or cost. The pass-through is incomplete and the degree of pass through as the ratio of the change in U. at this price Lexus might lose business to competing cars and therefore.5 million yen.S. the current spot is 100¥/$. price and the change in the exchange rate or . 100% pass-through. Absorb none of the increase in import price and passes all of the increase to exporter. is only increased by 6 percent while the yen appreciated by 11.16 provides the yen per dollar index over the 1970 to 2009 period as reported by Federal Reserve Bank of Saint Louis. partial pass- through. Japan’s multinational corporations at times of rising yen value have cut their base price in yen in order to maintain their share of market in the U.000 to $38. The pass-through from the exchange rate to import price has been partial as major Japanese multinational companies such as Sony.11 percent. The yen continued to revalue against the U.For example.889 in a complete pass-through.S. under 100%.S.S. Absorb some of the increase and pass the remaining to the importer. Assuming yen appreciates to 90¥/$. Example: Suppose Lexus is priced at 3. Exhibit 3. 1. Mitsubishi.06/. Komatsu. 2. Toyota and others have absorbed some of the increase in import price since.S. zero pass-through. The price in the U. the dollar price of the Lexus will rise from $35. 3. However. in a complete pass through the price of Japanese import 113 96 . and Europe. is 54 percent. 1111. the price in the U. An exporter has three options as far as how much of the increase in import price due to its own currency appreciation it is willing to absorb. dollar until mid 1995 reaching nearly 80 yen per dollar. may go up to $37.100.

imports is denominated in dollars. Furthermore.S. imports are acquired in contracts that fix prices in dollar terms for extended periods that delay the pass-through from exchange rates to import prices. U.S.S.price would have been extremely uncompetitive. Exhibit 3. manufacturing industries during the sample period 1980-91 as shown 114 97 .8 Yang (1997) has provided new evidence in favor of the partial exchange rate pass- through in the U. nearly 77 percent appreciation. The International Monetary Fund reports that nearly 70 percent of U.16: Yen/$ over time The invoicing practice also helps to explain the partial pass-through. The yen revalued in nominal terms from 358 ¥/$ in 1971 to 80 ¥/$ by the mid 90s. For example. 48 percent of Japanese exports were not denominated in yen in 1986 according to IMF (1987).

058 percent of the change in the price.S dollar 0. The average coefficients for all industries is equal to 42 percent.S.68 percent reveals. 115 98 .in Exhibit 3.32 of the increase in price by cutting cost or profit margins. It looks like U. apparel faces tough competition from their southern neighbors as the small coefficient of pass-through of 10. The industries with products that are highly capital intensive (specialized products) are able to pass through the greater proportion of the change in price due to change in exchange rate to the importer. implying that for every one percent change in the U. The coefficients for the complete pass-through are expected to be equal to unity and zero for no pass-through. For example.S.17. The Pass-through coefficient is as high as 88 percent for Stone. and Concrete products and as low as 8 percent for lumber and wood products.042 percent of the change is passed to the importer and the manufacturer absorbs 0. apparels absorb nearly 89. U. while industries in which there is stiff competition from other producers overseas find it difficult to pass-through the change in exchange rate to the price they charge the importer. Glass.

the evidence is to the contrary and real rate differentials are significant and the market is far from the” textbook “definition of perfectly competitive.3583 38 Measurement instruments 0. competitive.S. capital market the real return on the capital after adjusting for the change in exchange rate and inflation has to be the same across the globe. is interest sensitive.3914 37 Transportation equipment 0.Exhibit 3.7559 36 Electrical and electronic machinery 0.17: Pass-through coefficient for selected industries Industry Code (SIC) Industry Pass-Through Coefficient 20 Food and kindred products 0.3576 28 Chemicals and allied products 0.8843 33 Primary metal industries 0. except electrical 0.2765 Average 0.5312 30 Rubber and plastic products 0.0812 25 Furniture and fixtures 0.4205 Spot Exchange Rate and Nominal Interest Rate: The capital account. However.3138 35 Machinery. Invoking The Law of One Price requires that the terminal (future) value of the investment in dollar and euro 99 116 . which is the financing vehicle for the current account.2485 22 Textile mill products 0.1068 24 Lumber and wood products 0. and Euro zone are expected to be 4 and 5 percent respectively next year and current spot rate is $1/ euro. Assuming a frictionless.3144 32 Stone. concrete products 0.7256 39 Miscellaneous manufacturing 0.9 Example: Assume nominal interest rates in the U. glass.5318 31 Leather products 0. Capital moves from one location to another not only at the expectation of the higher yield but also promise of the higher returns.3124 23 Apparels 0.2123 34 Fabricated metal products 0.

investor converts $100 to 100 euro at the current spot rate and invests the euro at 5 percent. The International Fisher Parity (IFP) is maintained provided that the expected future exchange rate is equal to the ratio of the two investments as illustrated in Exhibit 3.9905/euro at the expected future exchange and will be equal to $104.S.9905/euro U. which is identical to the investment at home at the home rate of 4 percent. Let us start with $100 equal to 100 Euro in Exhibit 3. dollars at $.S.18: International Fisher Parity Time 0 U.18. In the above example if a U. In the above scenario regardless of the currency of chosen the return realized in dollars and Euros will be the same at 4 percent for a U.18.K 100 5% Interest 105 Euro Euro rate The exchange rate S1 is the ratio of the future value of two investments denominated in dollars and Euros at the respective expected interest rate of 4 and 5 percent at time identical in future i.e. Exhibit 3. It then follows that the expected spot rate in the future S1 is the ratio of two present values (the current spot rate 117 100 . the proceeds of 105 Euros will convert to U. there should be parity in dollar and euro returns. investor trying to take advantage of higher nominal interest rate in foreign currency.S.S Time 1 $100 4% Interest $104 rate S0 = $1/euro S1= $.

6. Suppose the expected interest rate in dollars and pounds will be 4. In this example assuming we invest £100 and its dollar equivalent $145. The current spot rate is $1. The crucial assumption in the maintenance of the IFP is predicated on the equality of the real interest rates worldwide as well as nominal interest rates to be an unbiased predictor of future inflation.82 in the respective currency as shown in Exhibit 3. Forward Exchange Rate and Covered Interest Parity: There is a great deal of empirical evidence in support of or against the efficiency of the foreign exchange for forward rates.5. The parity exists when the forward rate is the rational expectation of all individuals and embodies no risk premium over time.4582/£ which is the ratio of two identical baskets of goods and services denominated in dollars and foreign currency and priced today (ratio of two present values).of S0 times the ratio of the one plus nominal interest rate denominated in dollars and foreign currency) as expressed in the Equation 3. The forward interest rate parity (IRP) relationship as illustrated in Exhibit 3. the forward rate has to be equal to the ratio of two future values denominated in dollars and pounds.5 Where.5 and 6 percent respectively in one period in future.19 is defined as the ratio of two future values denominated in dollars and foreign currency in Equation 3. R$ and Rf are the interest rates in dollars and foreign currency.19. S1= S0 (1+R$) / (1+Rf) 3. 118 101 . Invoking rational expectations and zero risk premiums.10 The real rate of interest is related to productivity of labor and capital and there are vast sectoral differences in a given economy’s labor productivity as well as differences worldwide.

19 Forward Interest Rate Parity $145. The forward premium or discount (F– S0)/ S0 in direct quote and in equilibrium has to be equal approximately to interest rates differential in Equation 3. The forward pound in the above exhibit is at a discount of approximately –1.6 Where the parameters are as defined previously.82 U.Exhibit 3. fewer dollars are required to buy the pound and the interest rates differential is also –1.20.S.7 as follows: (F– S0)/ S0  (R$ – Rf) 3.5 percent as illustrated in the Interest rate parity IRP relationship below in Exhibit 3.4376/£ £106 £100 6% £106 U.7 The forward premium or discount (S0 – F)/ F is in the European term and may need to be annualized.K F= S0 (1+R$) / (1+Rf) 3.5 percent since.5% $152.4582/£ F=$1.A $152.38 4. 119 102 .38 S0 =$1.

In Exhibit 3.19 suppose the actual quoted forward exchange rate is equal to $1.82 to buy £100) there will be $6.Exhibit 3. the points to the right of IRP line such as Y refer to a situation where the forward premium or discount in foreign currency is below the interest rate differential in 120 103 .20: IRP Relationship (F– S0)/ S0 IRP Line X Y -1.5 % The IRP line is the locus of all points that are in equilibrium where the forward premium or discount has to be equal to the interest rate differential and any temporary deviations results in a risk-less arbitrage. However.5 percent and borrowing $145.5% ( R$ – Rf) -1. any point to the left of the IRP line such as X indicates that the forward premium or discount in foreign currency exceeds the interest rate differential in dollars and foreign currency and investors realize risk-less arbitrage profit by borrowing dollars and investing in foreign currency and selling foreign currency forward. For example. The forward pound is at a premium.62 risk-less arbitrage profit for following the strategy just described.50/£. Other things remaining the same (interest rates differential of –1.

38 that is identical to the future value of the investment had the investor’s invested in the bond denominated in U.K as they see the higher rate that is contaminated with higher inflation and covered interest parity (CIP) arbitrage will be a zero net present value investment for them. Example: Suppose the interest differential in dollars and Swiss francs is 4 percent per annum (U. dollars and sell dollars forward for a risk-less arbitrage profit. The risk-less arbitrage profit in a competitive capital market has to be equal to zero. 000. would not be fooled by higher nominal interest rates in the U.35 provided that the arbitrageur borrowed SF1.00 at 3 percent. with spot rate at $0.S.4376/£.S.dollars and foreign currency and it pays to borrow foreign currency and invest in U. 121 104 . and Swiss interest rates are 7 and 3 percent respectively) and SF is at a 1. dollars.S.6419/SF. realizing exactly $152.S. There is deviation from parity and following the strategy just described above will result in a risk-less arbitrage profit of SF25. As seen in the above exhibit assuming U. Interest rate parity as an equilibrium relationship between forward premium or discount and interest rate differentials requires two crucial assumptions as follows: Rational Expectations Absence of Risk Premium Rational expectations: This assumption requires that investors in the U.S investors convert dollars for pounds at the spot rate and invest the proceeds in pound denominated bonds at 6 percent interest and sell pounds one year forward today in order to hedge against foreign exchange rate risk at the forward rate of $1.164.4 percent premium against the dollar.000.633/SF and one year forward in SF is $0.

It is likely that the uncertainty will be largest when exchange rates change dramatically compared to their recent historical trend. Not only will they have temporary problems forecasting the exchange rate without systematic error. All three observations for yen are to the left of the IRP line and as demonstrated earlier it pays off to borrow dollars and buy yen while. pound and Spanish Peseta as of September 10. but they are also likely to demand risk premia because of it. 122 . dollar as the three forward rates are at a premium exceeding the interest rate differential.21 provides the observed behavior of forward premium or discount and interest rate differentials between the U. investing in yen at the Japanese yen rate and selling yen forward for risk-less arbitrage profit.S.11 Forward Premium or Discount for Selected Currencies: Exhibit 3. dollar and yen. Since deviations from parity are relatively small. 1998. the large institutional investors will be able to take advantage of small deviations to make arbitrage profit. the actions of currency speculators can be expected to lead to deviation from the CIP simply because speculators are still in the process of adapting to the change.Absence of Risk Premium: This assumption requires that the forward rate does not embody a risk premium constant or time varying. where as the larger bid and ask spread in the inter-bank market makes it almost impossible for the small investors to benefit from such events. The Japanese yen appears to be over-valued against the U.S. In such an environment. Uncertainty about the future course of the exchange rate can account for observed deviations from the covered interest parity hypothesis. that the forward rate does not deviate from the ratio of the two futures value as is seen in the above exhibit.

2) 1.9 (-1.9) 1.2 (1.Exhibit 3.8) 1.4 (5. The Financial Times.8 (5.6) 1.6 (1.7) -1.22 as follows: S0 = $1/euro S1= $0.5% Πf = 3. the international parity relationships can be illustrated in Exhibit 3.5 (5) -1. The forward market for foreign exchange for 1-month peseta and pound and three- month Spanish pesetas appears to be in line with the interest parity relationship.9903/euro R$ = 4% Rf = 5% Π$ = 2.year Forward 4.9 (-1.21: Forward Premium (discount) and Interest Rates Differential Yen Pound S/peseta 1-Month Forward 5.8 (-1.2 (1.Month Forward 4.2) 3.22: International Parity Relationship -1 Percentage change exchange rate Interest rate Forward premium -1 differential or discount -1 -1 Nominal Inflation differential -1 123 106 . International Parity Relationship: Assuming the following parameters.5) Source: The figures are interest rate differential and forward premium (discount) in the parentheses versus US dollar September 10 1998.5% Exhibit 3.3) -1.9903/euro F= $0.

economy where production takes place is related to the financial sector where production is financed. and the right hand side is the amount of money M supplied to the economy and the velocity turnover of money V. The inflation differentials as defined in the equation 3.S. The percentage change in price index of P is the rate of the inflation in the economy and is determined in Equation 3.10 124 107 .9. μ q and μ v are respectively the growth rate of monetary aggregates. Macro Determinants of the Exchange Rate: Using the framework from the quantity theory of money.9 Where Π$ is the rate of inflation in $. therefore international parity ex-ante is in line with its theoretical counterpart. the real sector of the U.5 percent in both dollars and Euros and percentage changes in exchange rate and forward premium or discount is identical.8 Where the left hand side defines the total nominal output as the product of price index P and output Q in an economy. The PPP can be used to link the real sector to the financial sector into the monetary approach to exchange rate determination as shown in the Equation 3. V 3. μ m.10 between any two countries will be equal to: Π $ ¯ Π f = ( μ m ¯ μ mf ) ¯ ( μ q ¯ μ qf) + ( μv ¯ μvf ) 3. The euro is at a 1 percent discount against the dollar due to 1 percent higher nominal interest rate that is reflected in the inflation differential of 1 percent. Π$ = μ m ¯ μ q + μ v 3. growth rate of the GDP and percentage change in velocity. Q = M . The real interest rate is 1. P.8.

Real Exchange Rate: The nominal exchange rate adjusted for the respective inflation rates in two different economies provides a measure of the economy’s real cost of producing goods for consumption and goods for export over the given period. The real exchange rate Er is defined as the nominal exchange rate En adjusted for the inflation differentials in two economies as illustrated in the Equation 3.11 Where Pf and P$ are the price index in foreign currency and dollars respectively.75 % Growth rate of GDP£ = 3.Example: Suppose the growth rate of money supply.12.K are provided as follows Growth rate of money supply $ = 6 % Growth rate of money supply £ = 8. GDP and changes in the velocity for the U.S.5 % Growth rate of GDP $= 2.S. Since nominal exchange rate is the ratio of the price index denominated in dollars and foreign currency. and the U. Er = En (Pf / P$) 3.11.12 125 108 . Er = (P$ /Pf ) (Pf / P$) = 1 3.K will be equal to –1/2 percent and the dollar expected to revalue by ½ percent against the pound assuming PPP holds. P$ /Pf.25 % Change in velocity $ = 1% Change in velocity £ = 1/2 % Using the above information the inflation differentials between the U. it then follows that the real exchange rate has to be constant and equal to unity as shown in 3. and the U.

5 133.1 119.2 121.3 157.1 110.6 122.7 89.6 119. Real exchange rates can be viewed as a measure of an economy’s true competitiveness as compared to other economies.4 116.6 96.5 Source: Author’s own estimates.8 102.0 144.5 106.6 103.0 1996 100.0 100.0 100.7 107.7 94.3 1997 101. Real exchange rate is by no means constant and deviates from unity substantially for all of the currencies in the sample periods.4 119.5 134.S.8 107.S.2 109.7 107.6 106.8 140.8 104.1 150.5 and 10.2 103. At times when the U.4 119.0 1998 108.8 128.4 115.8 114. the cost of producing exports rises.5 1992 89.3 110.3 2000 109.8 126109 . which makes U.2 125.2 114.S dollar and British Pound appear to have appreciated in real terms by 34.6 99.1 104.0 129.4 129.9 111.3 103.4 121.4 1995 100.8 89. The U.23 provides preliminary evidence of the behavior of the real exchange rate for the several major currencies over the period 1989 to 1998 with 1995 as the base year with real exchange rate at 1 or 100 percent.9 100.3 123.5 118. Japanese exports before and after the base period 1995 appear to be extremely uncompetitive as the real exchange rate appreciated by 33. Exhibit 3.0 119.5 129. Exhibit 3.S.0 100.S 1989 86.9 101.2 123. exports uncompetitive in the world market.0 100.8 93.3 140.0 100.3 1990 85.1 112.4 113.3 124.5 105. exports were relatively more competitive prior to the base year of 1995 as compared to years following 1995 making exports extremely uncompetitive as reflected in widening the current account deficits. U.23: Real Exchange Rates for Major Currencies COUNTRY NAME Canada France Germany Japan Singapore U.K U.6 134.1 103.3 113.0 1999 109.4 104.2 1993 95.6 104.6 percent respectively between 1995 the base year through the 2001 period.7 120.0 100.2 114.7 1994 102.4 118. real exchange rate index set at 100 for 1995.5 120.9 85.4 112.7 1991 82.0 136. real exchange rate appreciates against all other currencies.2 2001 113.

percent relative to the base year in 2001. Japanese real exchange rate in the year 1989

appears to have appreciated by 50 percent as compared to the base year making exports

very uncompetitive as reflected in the decade of recession in Japan and falling equity

prices. The widening trade deficit in the U.S. in the 1990s and 2000 to 2001 (see Exhibit

2.3) may be attributed to the appreciation of the real exchange rate making U.S. goods

relatively expensive for the trading partners.

Canada appears to have gained relative competitiveness as is evidenced by the

relatively smaller increase in its real exchange rate 13.5 percent as opposed to 34 percent

compared to its main trading partner the United States. France and Germany’s exports

appear to be relatively more competitive than that of the U.S. as their respective real

exchange rate appreciated by nearly 19 and 23 percent between 1995 and 1998,

respectively. The real exchange rate remains over 100 for all the years proceeding the

base year of 1995 for both countries implying that their exports remained relatively

uncompetitive particularly that of Germany’s. Exhibit 3.24 provides a graphical

representation of the real exchange rate for the selected countries.


E x h i b i t 3 . 2 4 : R e a l E x c h a n g e R a t e s o f I n d u s tr i a l C o u n t ri e s 1 9 8 9 -2 0 0 1

18 0 .0

16 0 .0

14 0 .0

R 12 0 .0
a 10 0 .0
l 8 0 .0
6 0 .0

4 0 .0

2 0 .0

0 .0

1 98 9 19 90 1 99 1 19 92 1 9 93 1 99 4 19 95 1 99 6 19 9 7 1 9 98 1 99 9 20 00

T i m e (Y e a r )

The real effective exchange rate for a sample of emerging economies is presented in

Exhibit 3.25. Malaysia’s ringget after suffering devaluation in excess of 35 percent in the

1997 Asian crises appears to have appreciated by 54 percent in real terms relative the

base year through 2001. Venezuela’s real exchange rate has appreciated by nearly 274

percent relative to the base year through 2001, thereby making exports prohibitively


Exhibit 3.25: Real Exchange Rate for selected Emerging Economies

NAME Bolivia Chile China Malaysia Venezuela
1989 51.0 60.3 40.0 110.5 11.1
1990 59.4 64.3 58.5 110.9 19.9
1991 64.0 75.3 64.1 109.9 25.0
1992 74.7 81.6 63.9 100.3 30.3
1993 84.4 93.0 62.0 102.2 38.3
1994 91.6 97.5 85.3 103.7 53.6
1995 100.0 100.0 100.0 100.0 100.0
1996 96.7 99.6 94.6 100.3 121.5
1997 106.9 101.9 98.8 112.0 188.5
1998 108.3 112.1 101.6 151.3 231.6


1999 121.1 126.8 102.8 151.2 283.3
2000 127.2 134.4 102.2 154.8 342.1
2001 139.4 158.9 101.6 154.1 373.9
Source: Author’s own estimates.

Chile and Bolivia have had their real exchange rate appreciate by 39.4 and 58.9 percent

respectively over the 1989 to 2001 periods. China, equipped with relatively cheap labor

and an extremely inexpensive currency exchange rate, has enjoyed growth in exports and

as the success story of 90s is on the verge of becoming an economic super power in the

21 century.

Real Exchange Rate and East Asian Currency crisis: Corsetti et al (1999) have

provided the estimate of the real exchange rate relative to the U.S. dollar for South East

Asian economies with 1990 as the base year and real rates for all countries set at 100. My

own estimates of the real exchange rates for 8 South East Asian economies is presented

in Exhibit 3.26 with the Taiwan excluded as the IFS database does not provide any data

for this economy. With the exception of Hong Kong and Singapore all other countries

experienced significant appreciation in their real exchange rates. For example Korea,

Indonesia, Malaysia, Philippines and Thailand’s real exchange rate appreciated by 131.8,

134.5, 43.6, 37.9 and 81 percent respectively between 1990 and 1997 (see Exhibit 3.26).

These countries saw an erosion of their competitiveness in exports and bore the brunt of

the crises in the currency market with the collapse of their currency and ensuing fallout in

the financial and the banking sector.

Exhibit 3.26: Real Exchange Rate Indices for East Asian Economies 1991to 2009


37 79.42 115.10 137.36 118.93 122.65 123.38 105.24 92.79 109.20 100.75 94.18 99. 1990=100 China relative to Korea.96 160.85 137.09 100.23 91.95 80.71 93. with a base year of 1990 i.92 115.36 111.53 87.24 118.04 89.16 97.28 103.98 128.24 113.36 101.49 130.83 89.14 133.27 93.67 86.66 121. Singapore and Hong Kong were not as hard hit as the other countries in the 1997 Crisis.45 2005 135.63 112.60 101.21 92.87 81.24 1997 106.51 133.66 94.47 92.23 2006 125.80 117.80 109.52 112.88 1994 93.20 73.33 90.79 105.30 100.63 104.83 143.90 132.86 1999 122.46 94.96 97.68 172.59 112.77 90.97 91.69 105.18 2008 108.32 93.75 91.48 93.91 119.86 92.34 96. 113 130 .78 1995 89.68 93.92 116.13 115.12 105.09 147.PR China Country Thailand Malaysia Singapore Indonesia Philippines (mainland) Korea Hong Kong Taiwan Japan 1990 100 100 100 100 100 100 100 100 100 100 1991 98.08 74.02 85.80 127.99 82.86 99.75 116.56 139.57 70.41 92.94 1992 96.95 124.52 111.24 72.04 107.80 115.29 100.43 110.89 88.40 123.48 95.59 2002 145.36 117.74 111.41 73.83 130.89 139.80 82.78 105.68 132.23 74.58 94.88 131.16 130.70 118.60 78.34 102.15 105.09 119.e.48 1993 96.81 140.02 134.51 135.54 104.49 91.93 96.67 98.78 123.23 1998 132. United States Department of Agriculture.36 69.83 80.90 144.30 2009 108. which may be due to surplus in their current account and the build up of their foreign reserve as compared to other countries in the region that had significant deficits and dwindling foreign exchange reserves.56 114.88 1996 88.36 101.17 94. Indonesia and Thailand enjoyed a comparative advantage in this period over its trading partners in the region in the form of cheap labor and relatively inexpensive currency.93 84.06 82.61 96.43 102.20 100.83 111.94 133.46 120.66 2003 140.78 155.56 135.58 135.30 132.52 138.43 89.05 135.13 118.69 2000 132.36 144.87 88.02 104.01 87.86 103.74 114.78 94.31 108. thereby capturing export markets lost by others in the erosion of their competitiveness particularly the steel market at the expense of Korea and the apparel market to the detriment of Indonesia and Malaysia.91 112.83 194.73 Source: Author’s own estimates using annual real exchange rates from the Economic Research Service.84 107.02 120.72 112.20 99.06 103.55 91.86 76.34 2001 148.88 161.77 85.92 2004 136.31 79.02 97.48 122.85 132.42 103.31 98.43 2007 113.17 93.71 102.93 105. South China.15 68.62 103.73 93.73 128.25 111.78 138.48 249.09 98.

Appreciative friends and family persuaded him to go into business during the 1980s. 131 114 . although the local congressman had already blandly assured his constituents that business could proceed as usual. At the same time—presumably to head off protests from both Canadians and their erstwhile customers—the U. “A lot of them. The new U.S. Trade Representative gave assurances that exceptions could be made in cases of hardship. he headed down the hall.” He scorned even hardwood-solids-and-veneers construction. Lytle-Lamm thought glumly. (After all. the management of Real-Wood had not felt much concern about foreign exchange risk. Real-Wood Furniture. it was not to be. Inc. they simply had other priorities. Because imported wood had until recently constituted only a small part of the firm’s costs—skilled labor was by far the largest—and because it negotiated long- term contracts.S administration had just announced a 27 percent tariff on imported Canadian lumber. Its founder—a civil engineer with the U. when her new boss. ) However.” With that. lower-cost Canadian mills to meet its needs. as she started back toward her office. Bureau of Reclamation—had built furniture and cabinets in his suburban Spokane garage beginning in the 1970s. Still awed by the prospect of “doing it for real. “Whatever you’re doing can wait.” Mary S. she soon realized that whatever it was. What’s going on?” Waved to a seat without introduction. only three weeks earlier and had hoped to feel her way gradually into the job of financial analyst. Because the firm’s founders and senior managers still did not think of themselves as business professionals. How they could be obtained and how they would work was not yet clear. Real-Wood had bought most of its raw materials—wood solids— locally. Real-Wood Furniture began as a hobby. she had joined Real-Wood Furniture. it seemed urgent. doing finance in class and doing it with real money—other people’s. at that—are two very different things!) Evidently. Accordingly. more capital-intensive. that had just changed. by Lee Sarver “Well. the director of Accounting and Finance stuck his head through her door at about 10:30.” she had been trying to determine the most efficient and business-like arrangement for the objects on her desk. ostensibly to protect domestic mills from “unfair” competition. These were the events that had precipitated today’s unplanned meeting of the management of Real-Wood with the firm’s bankers and other outside advisors. For years. as the firm’s market grew. “More new faces. (The founder and chairman still never missed an opportunity to sneer about “sawdust-and-glue boards with a photo of wood stuck on. there goes my weekend.” she thought. The firm’s managers were not naïve. competition sharpened and cost-control became an issue. Real-Wood had relied increasingly on newer. while maintaining relationships with long-time suppliers. Mary reached the conference room only a few steps behind him and stopped dead.S. Inc. they had recently begun hiring people with formal training like Mary and her boss. With a mint-shiny MBA from Pacific Northwest University. and by 1996 the firm—which sold to decorators and independent shops as far away as northern California—had grown to 120 employees. with more attention to convenience and quality than to cost. As it turned out. Grab a notepad and come along.

since Real-Wood had just finished a new curing facility. “The simplest thing for us to do is nothing. with some numbers and the notation. At this point. Several of the Canadian mills supplying Real-Wood had joined together to offer the firm delivery of a large shipment of assorted hardwoods before the effective date of the tariff. However important. Eventually. there was no way the proposed shipment could be worked in to the production schedule anytime soon. Besides. That’s your department.” answered Mary’s boss “but it still seems like a long shot. Pierpont. she found a single hand-written sheet on her desk (See Exhibit 1). After all. “Sorry to put you on the spot. in fact. “Maybe I will have a weekend. with payment of 2. who was present at the meeting.5 million Canadian dollars (CD) due then. buy the Canadian dollars when we need them. that was. “Right.) Mary’s boss confirmed that Real-Wood’s cash balance could be stretched to cover the approximately 1. they offered to consolidate several orders—some not due for almost a year—for delivery in 90 days at most. since she had spent the time thumbing through her old class notes (now yogurt-stained). Heck. you know those people.6 million US dollars (USD) necessary. let’s take delivery of the wood. announced that the lenders he represented were more than willing to provide the financing.” In response to several pairs of raised eyebrows: “For example. However. Morgan J. Work out our alternatives. In the foreground was a particular deal. they might generate enough volume to get a good rate.” 132 115 . But what I do know we can do today—and for exactly how much—is hedge.” Pierpont smiled without humor. if the wood could not be sold or bartered to other firms. perhaps even until an exception was obtained or policy changed again. it would have to be stored. Several alternatives were discussed. after all. merely the background to this meeting. how much can happen in the space of 90 days?” The purchasing manager jumped in. (Insurance for this surge in inventory would be covered for a year under the blanket policy the firm purchased when construction began.” He looked in her direction and everyone else’s glance followed his. and get on with building furniture. Mary?” ***** Mary’s self-confidence returned during lunch. “And Mary can figure out the best course. I got these from Morgan. we can buy Canadian dollars forward. maybe we can. Good luck. Let’s take care of this before quitting time today. “Or we can buy Canadian dollar futures. Such a large delivery would help the firm to postpone facing the costs of the tariff.4–1. if they had to bear the exchange risk—assuming that they would even discuss it— he countered. we can even borrow Canadian dollars and park them in a CD for 90 days. if they’ve made a number of similar proposals to other customers.” said the production manager. “But they approached us! After all. All eyes were on her.” Mary opened a new spreadsheet and grinned. at that. When she returned to her office. Right. Morgan can get us a quote or we can shop around. “Maybe we can negotiate a price in US dollars!” When Mary’s boss observed that the Canadians would surely raise their asking price. Essentially. they have the most to lose from the tariff. Even the latter course was feasible. Morgan?” Pierpont nodded. the deal was approved and the real issue became exactly how the firm should structure the transaction. the firm’s lead banker. “I mean. everyone realized it had become time for the firm to analyze its international position from a strategic perspective.” “Well.

b.a. Is political risk confined exclusively to international transactions? c.a. in general. United States 1. Chapter 3 Questions & Problems: 133 116 . In what sense does failure to hedge constitute speculation? c. a. spot 1. Distinguish spot and forward rates. Questions 1. Calculate the corresponding direct/indirect quotations. How does hedging resemble diversification? How does it differ? 5. What is the relationship between inflation and interest rates in one country? b.5783 Canadian dollar. According to the Exhibit 1. Canada 2. What risk does Real-Wood face specifically? 2. is exchange risk? b. a. What does the forward rate imply about the expected future spot rate? 8. If a Big Mac costs $1. Evaluate Real-Wood’s alternatives. a. 3-month rate. what should it cost (on average) in Canada? 7. a. Do only less-sophisticated governments of the Third World pose political risk? 3. Distinguish hedging and speculation. What is Purchasing Power Parity? b. 6. If CIRP does not hold. a.99 (on average) in the United States.5728 Canadian dollar. What is Covered Interest Rate Parity (CIRP)? b. Are the exchange rates in Exhibit 1. What is the relationship between inflation and interest rates between two countries? 9. a. What is political risk? b. a.70% p. What is meant by a forward premium or discount? c. Could Real-Wood profit by not hedging? 4. b. Exhibit 1 Foreign Exchange Rates Canadian dollar. where can you earn the best return? 10. a. direct or indirect quotations? b.5828 Money Market Rates 3-month rate.83% p. 4-month futures 1. does CIRP hold between Canada and the United States? c. 3-month forward 1. What.

7134 1. T/F 2. Your firm is trying to buy 200 million yen in the market.79 How much in dollars does the firm pay to buy the required yen? 4.7120 1. T/F 6. A forward contract is for delivery of the underlying commodity in more than two business days in future at a price determined today.7192 90-day forward 1.5 million pounds at the exchange rate quoted above. What is the dealer profit in the previous question? 5. Forward transactions are approximately 10 percent of all foreign exchange transactions.7184 30-day forward 1. The foreign exchange market is the largest and least regulated market in the world.8001 180-day 1. 134 117 .7843/£ $1.83/£. T/F 8. T/F 11. Nissan manufacturing plans to buy 1. T/F 10.8066 a) How much in dollars does Nissan pay in 180 days to secure 1.1.5 million pounds 180 days forward on July 6. Three types of transactions takes place in the foreign exchange markets. 2005 at an exchange rate quoted below: Bid offer Spot rate 1. A swap transaction is a portfolio of two offsetting forward transactions at prices determined today. A foreign exchange swap is a financing means at a fully collateralized basis.7156 1.8017 forward 1-year forward 1.5 million pounds? b) If the exchange rate in 180 days is $1. how much in foreign exchange losses will Nissan experience? 12.7892/£ How much in dollars does the treasurer pay to fulfill its obligations? 7. The spot price quoted per dollar is as follows: Bid Offer 122.63/£. 3. Discuss each transaction using an example.34 123. The pound is quoted at: Bid Offer $1. T/F 9.7198 1.7178 1. In the previous question suppose Nissan plans to sell 1. Vanity’s treasurer has to buy 125 million pounds to pay for the imports. A foreign exchange swap is borrowing and lending simultaneously at the known forward exchange rates. how much in foreign exchange gains will Nissan experience? c) If the exchange rate in 180 days is $1.

5 million pounds 90-day forward? b) If the exchange rate in 180 days is $1.5 million 150-day forward at the current prevailing150-day forward exchange rate of $1. is there an arbitrage profit if you had $1 million to start? Verify that arbitrage profit is $31. if the quoted cross exchange rate is 210.83/£. T/F 14.25 percent. In 6 months 3- month interest rate is 5. A Nashville importer of fine silks from the UK needs £1. The foreign exchange market performs all of the following functions except: a) Transfer risk b) Transfer purchasing power c) Financing at a fully collateralized basis d) None of the above 18. 118. 6 months from today.5756/£ Point quotations 1-month forward 14-30 3-month forward 43-68 6-month forward 77-99 a) What is the bid/offer rate for the 1.5 million in 90 days for only 60 days. a) How much in dollars does Nissan receive in 180 days for selling 1. and 6-month forward? b) If you wish to sell £2.5712/£ $1.63/£. 20. how much in foreign exchange gains (losses) will Nissan experience? c) If the exchange rate in 180 days is $1. A Foreign exchange swap is a portfolio of a long and a short position entered into simultaneously by two counterparties at predetermined rates and dates in the future.5 million 3 months forward. T/F 17. 125 ¥/$ $1. will there be an arbitrage profit if you had $1 million to start? 21.06-97. A 6X9 FRA is offered by a financial institution at 4 percent. Given the following quotes estimate cross exchange rate between yen/pound. In the interbank market for foreign exchange a dealer has quoted outright yen/$ as.6015/£ and simultaneously buy £1. A forward rate agreement (FRA) is an OTC contract of varying maturities used to hedge interest rate risk. Agilan treasurer plans to borrow $20 million for three months. T/F 15.6098/£. In question 18. how much in dollars would you receive? 135 118 .1 percent for a 60-day loan.250. In the previous question if yen/pound is 200¥/£. In the previous question the forward/forward swap locks the importer’s financing of £1. What is the bid/ask price? 22. how much in foreign exchange gains (losses) will Nissan experience? 13.5 million at an annualized rate of 3. What is the implied 60- day forward repo rate? 16. What rates does Agilan treasurer pay and receive in 6 months? 14. enters into a swap agreement to sell £1. 3.5 million 90-day forward at an exchange rate of $1. A dealer in New York has the following quotes: Bid offer Spot $1.50¥/£.65/£ 19.

Suppose BMW Z7 is priced at €60. how much is the arbitrage profit? c) Which currency is over (undervalued)? 24. Gold price is $408/oz in New York and £235/oz in London. c) If you wish to buy £2.78/£. The Euro appreciates from $1. The pass-through coefficient of 0. What will be the dollar price of the BMW in a complete pass-through? In the event the dollar price of the BMW is equal to $62.S.52 a) What is the yen/pound implied cross exchange bid/offer rate? b) Suppose a dealer is offering yen/pound at 162¥/£.6325 by the expiration of the futures contract. T/F 33.26 107. How much profit or loss does the trader experience? 25. how much in dollars would you pay? 23.6378 Japanese Yen . What is the implied exchange rate assuming law of one price holds? 27.60. Pass-through coefficient is expected to be equal to zero in a complete pass-through. what is the degree of pass-through? 34. is $2.6376 . A trader in Hong Kong buys 8 contracts on 3-month pound futures at $1. Given the following quotations.5 million 6 months forward.56 million or its pound equivalent? How much in profits would you realize in the above scenario? 28. and the actual dollar/€ exchange rate is $1. A real exchange rate is equal to the nominal exchange rate adjusted for the inflation differential between two countries.000.28. How much profit or loss does the trader experience? 26. T/F 35.72 for instrumentation means what? 36. In the previous question if the actual exchange rate is $1. what would you do to profit if you had $3. Other things remaining the same.S. In the previous question suppose the trader shorts 8 contracts.20 to $1. and by how much? 29.0093 . Assuming the merchandise trade balance deteriorates following devaluation. Which currency is overvalued (undervalued).5 percent against dollars. is $2. In question 28 the implied exchange rate from the law of one price is equal to……. 31. The actual dollar/rubles exchange rate is $. and by how much? 32. The pound devalues to $1.10/R.5 rubles.90 in 2004.28. Which currency is overvalued (undervalued). The price of a Big Mac in local currency in Germany is €2. T/F 136 119 .500 following Euro’s appreciation to $1.0095 105. The price of a Big Mac in local currency in Russia is 14.5678 1. this phenomenon produces a J-curve as imports remain inelastic for some time.5683 . A Big Mac in the U. T/F 30. identify an arbitrage opportunity assuming you have $3 million to start: American term European term Bid Offer Bid Offer British pounds 1. A Big Mac in the U. Each contract is for delivery of 62.6732.500 units of pounds. In the previous question Euro is overvalued by 13.4.23/€..

dollar has depreciated and Cadillac appreciated. 37. one could say that the U. the price of a unit of foreign currency in terms of European economic currency. T F 11. The Canadian dollar nominal exchange rate is C$1. and Canada’s inflation rates are 2.S. given that neither currency is the dollar. T F 8. the dollar will depreciate in value. Currency Exchange risk refers to fluctuations of the exchange rate of one currency with that of its trading partners. T F 3. Cross-currency is the product of two indirect quotes. An increase in real interest rate in Japan “Ceteris Paribus” leads to depreciation of Japan’s trading partners’ currency. T/F True-False Questions 1.75 and dollars per rupee is equal to $ . 38. T F 2. Increase in aggregate income in Japan relative to its trading partners causes depreciation of the Japanese yen.S.5 and 4 percent respectively.56/ pound to $1. The exchange rate is a relative price.000 to $25. estimate the real exchange rate. If the Deutsch Mark (DM) rises from $.S. T F 9. dollar is said to have depreciated. T F 7.68.50/ DM. If the British pound falls from $1. dollar has depreciated and DM appreciated.24/$. “3 DM are equal to $1. The real exchange rate is viewed as a measure of an economy’s true competitiveness as compared to other economies. one could say that the U. The world price of the dollar is determined by the U. then lira/ per rupee will be 1010. If world demand for the dollar exceeds the world supply of dollars. T F 6.35/ DM to $.S. T F 5. Assuming U. If lira per dollar is equal to 1300. T F 10. the U. T F 4.S. Central Bank’s trading partners worldwide. In the quotation.45/ pound. T F 137 120 .” the unit of account is the Deutsch Mark and currency being priced is the dollar. If the price of a Cadillac rises from $22.000.777/ rupee. T F 12.

Under the gold standard. The U. a supplier of another currency.S. An individual or institution in the foreign exchange market is a demander of one currency while. However. T F 24. was not obligated to convert various currencies into gold upon demand except the U. T F 22. Based on purchasing power parity (PPP). The forward rate is indicating appreciation of the U. T F 17. the exchange rate is determined by market supply and demand forces. 60-day. T F 16. there will be less incentive to substitute the more expensive foreign goods for domestic ones. T F 18.55. Increasing inflation in Japan relative to its trading partners causes appreciation of the Japanese yen. the currency is said to be trading at a premium. The British pound’s current. dollar respectively. which was convertible to gold at the price of $35/ per ounce of gold. T F 21.58 per U. the U. dollar. the Central Bank intervenes in the market to support or devalue its own home currency relative to other currencies. was the first country to adhere to the gold standard. T F 15.S. An increase in the U. bonds sold in Japan are known as Yankee bonds. As deflation makes domestic goods less expensive.S. T F 26. T F 14. dollar. deficit will continue to put downward pressure on the value of the U.S.57.S.13. . In the Bretton Woods agreement (1944-1971). U. If the spot rate is greater than the forward rate. A revaluation is an attempt by a country to depreciate its currency relative to its trading partners. T F 138 . However. Under the current floating rate system. T F 25. T F 19. from time to time.S. T F 23.S. The collection of accounts receivable denominated at a weakening currency should be accelerated. at the same time. the change in exchange rate between two currencies is related to the change in price inflation of the home country relative to its trading partners. dollar relative to the pound. . 30-day. T F 20. the exchange rate was pegged between countries.50. the rate is expected to fall (depreciate) in the future. and .S. and 90-day forward are equal to .

dollar.593. A Mercedes 300 costs 30. The Canadian dollar is equal to $0.S.00 B. all of the above 28.333/ $ U. What is the cross rate between Italian lira and Swiss franc? A.400 and U. B. goods in question are traded internationally 122 139 .S. none of the above 33. $16. $16. What is the indirect quote for Canadian dollar per U.S.S.S.142.S. $16. $19. capital market D.84 C. $17. $19.178. 1. dollar is equal to 1.75/ $ U. What is the equivalent in U. C. dollars? A.75.50 D.75 U. Purchasing power parity holds if: A. the law of one price is not violated B.S.75 DM) gives a car importer from West Germany an instant saving of: A. suppose DM per U.S. dollar.S. none of the above 29.250. depreciation of Deutsch Mark (1. What is the equivalent in U.300.50 to 1. dollar becomes 1.000 Deutsch Marks. In problem 31. 1.736. dollars for the car? A.68/ Fr. 1. $2.172. dollar per Swiss franc is $.600.S D. none of the above 31. What distinguishes international financial management from that of domestic finance? A. currency exchange B.99 C. dollar? A. 800 lira/Swiss franc C. 650 lira/Swiss franc 30. Assume 1. 952 lira/Swiss franc B.200 lira/Swiss franc D.63 32.5 DM per U.00 D. $2. 1. tax consideration C.00 C.S.493. $25.00 B.Multiple –Choice Questions 27.180. In previous problem.85 D.00 B.25/ $ U. $2. Assume Italian lira per U.

S. 1.309 Canadian dollar per U. none of the above 38.50 to 1.65. 1.48 DM/ $U. prices adjust in the long run for differences in quality D.S. 10 percent D. the percentage change in discount rate is equal to the rate of change in inflation C. 1.S. a decrease in inflation B. If inflation is expected to be 5% in Canada and 10% for U. D. respectively in U. $ D. an increase in real interest C. The spot Canadian dollar per U.S. none of the above 39. Based on purchasing power parity: A.27 Canadian $ per U.S.28 Canadian $ per U.193 Canadian $ per U. $ D. none of the above 37. 5 percent B. a decrease in aggregate income 123 140 .S. and West Germany of . 1.S.5428 DM/ $U.08.S. $ C. the percentage change in exchange rate is equal to the ratio of relative price changes of two countries B. In the previous problem.S.S. C.25/ $U. what exchange rate does this imply if the PPP is to hold? A.S. 1. 1. dollar C.S. none of the above 36.25 Canadian/ U. all of the above hold 34. the percentage change in exchange risk is equal to the rate of change in inflation D. C.$ B.50 DM/ $ if PPP is to hold? A. dollar is equal to 1. the percentage change in real interest rate is equal to rate of change in exchange risk 35. What is the one year forward rate assuming current spot rate of 1. next year. and Canada? A. 1. 1. what happens to exchange rate if inflation is expected to be 5% or 10%. $ B.S. what rate of inflation does PPP imply for West Germany? A. respectively.S.20 Canadian $ per U. 1. In the previous question. 8 percent C. Deutsch Mark per dollar rises from 1.05 and .47 DM/$U. All of the following factors can lead to appreciation of home currency except: A..S. B. Assuming zero inflation in the U. assume the expected inflation one year from now in U. a decrease in real interest D.

50/ pound 45.70. A and C are true 42.5/ DM B. If the spot rate for the Japanese yen is greater than the forward rate.000 pounds in problem__? 124 141 . DM/ pound.155/ French franc C. both A and C 41. dollar C.60. dollar is depreciating relative to Swiss franc D. Japanese yen is expected to appreciate in value C. Japanese yen is expected to depreciate in value D. How many French francs should be supplied in the Currency Exchange Market in order to buy 200.S.S. Compute the equivalent indirect quotes from the following direct quotes: A. all of the above 43. the market expects the value of DM to rise D.000 British pounds per car. What happens if the cross rate between DM and French franc is equal to 3FF/ per DM? 47.63. U. $. This implies: A. dollar B. and 90-day forward for the Swiss franc.S. How much should the importer pay in terms of local currency in problem__? 48. to forego collection of receivables D. What is the cross rate between DM and French franc. Japanese yen is selling at premium B. and $. 60-day. to be selling at discount B. Swiss franc is appreciating relative to U. respectively.40. to stretch collection of receivables B.000 cases of wine at 50 French francs. the currency is said: A. $. The spot. $. B or C Problems 44. and French franc/ pound in the previous problem? 46. If accounts receivable is dominated by a strengthening currency it pays off: A. Swiss franc is depreciating relative to U. to be selling at premium C.65. A French car dealer buys 2 Rolls Royce at 100. this implies: A. to expedite collection of receivables C. If spot rate for Deutsch Mark (DM) is less than the forward rate. A German importer buys 200. $1. are $. 30-day. $.

If we assume zero inflation in West Germany. Putnam. payable in French francs in 60 days. 3. Cassel Gustav "Abnormal Deviators in International Exchange” Economic Journal December 1918. edited by J.697-703.9 French francs per U. Cumby. Bhandari and B. On June 20.S. On July 20. In the previous problem assume on July 20 the exchange rate was 192 yen/ per U. "The Choice of an Invoice Currency in International Transactions. wine producer undertake to hedge his position? References Bilson.S. a test of Fisher-hypothesis. In July 1985. one DM was selling for 2. One year later. what rate of inflation does PPP imply France? 51. $.000 cases of wine at a price of 200 French francs. 413-415. the U. What annual exchange rate profit (loss) will the holder of Japanese yen make? 53. The French spot and 60-day forward rate is 7 and 6. June 1981. If inflation of 3 and 10 percent is expected to prevail in West Germany and U. the exchange rate was 206 yen/ per $.S. What transaction should the U. The current exchange rate between the Deutsch Mark and U. R and M. A California wine producer will buy 10.49. Obstfield "A Note on Exchange Rate Expectations and Nominal Interest differentials. Massachusetts Institute of Technology Press. what will be the exchange rate if the purchasing power parity is maintained? 50. J. 1983. 125 142 . pp.. What is the annual exchange rate profit (loss) by investors holding Japanese yen? 52.S.2 French francs were equal to one DM. "Journal of Finance.5 DM/ $. / Japan exchange rate was 200 yen/ per $.. dollar." In Economic Interdependence and Flexible Exchange Rates.S. dollar is 3. 384-401.S.5 French francs. pp.

Catherine. Homaifar Ghassem and Joachim Zietz “Official Intervention in the Foreign Exchange Market and the Random Walk Behavior of Exchange rates. 48.Frankel. 1345-1357. December 1982. "Tests of Three Parity Conditions: Distinguishing Risk Premia and Systematic Forecast Errors. 348-357. pp." Journal of Finance 1984. "Are real interest Rates equal across countries. Paul. Mishkin. June 1996. Krugman. "In search of The Exchange Risk Premium a Six Currency Test Assuming mean-variance optimization. "Purchasing Power Parity as an Explanation of Long-term changes in Exchange Rates. Richard C." Journal of International Money and Finance. 1997. pp. pp." National Bureau of Economic Research Working Paper no." An International Investigation of Parity Conditions. "Journal of International Money and Finance. Taylor "Real Exchange Rule Behavior: the recent float from the perceptive of the past two centuries. "Prices. H." Journal of Money. F.” Economia Internationale. 255-274. Marston. August 1971. Profit Margins and Exchange Rates. 3 (August 1995): 359-373. "Pricing to Market When the Exchange Rate Changes. J and M. Gaillot." Federal Reserves Bulletin 72 (June 1986): 336-379. Mann. Lothiar. 126 143 ." Journal of Political Economy. 1926 (May 1986). Vol. J. pp. No.1345-57. Credit and Banking.

S. Pp 2-16. Koch. Zietz Joachim and Ghassem. Vol. Zietz Joachim and Ghassem.” Weltwirtschaftliches Archive. Vol. 4 (1995): 789-791. July/August 1988. No. 131. 127 144 .” Economic Review Federal Reserve Bank of Atlanta. J and P. “The U. 3 (1994): 461-475. Homaifar “Exchange Rate Uncertainty and the Efficiency of the Forward Market for Foreign Exchange. No. Dollar and the delayed J-curve.Rosensweig. Homaifar “Exchange rate Uncertainty and the Efficiency of the forward Market for Foreign Exchange: A Reply. 130.” Weltwirtsschaftliches archive.

head of trading at Standard Chartered Singapore. 10 Schwebach and Zorn (1997) provide a simple algorithm challenging the Fisher nominal interest rate as sums of the real rate and inflation premium (constant). 128 145 . Frankel (1982) Mishkin (1984) Cumby (1988) and Marston (1997) for a classic study of real interest rate differentials and deviation on uncovered interest parity.End Notes: 1 Central Bank Survey of Foreign Exchange and Derivatives Activity 1998. Notes Daniel Koh. 4 Euromoney. 3 With the launch of new CLS network. Assuming uncertain inflation the authors provide an alternative algorithm consistent with observed behavior and why nominal interest rate is not an unbiased predictor of future inflation. 5 See for example Mann (1986). 1995) who find evidence particularly for the German Mark and Swiss Franc in the time period from 1976-84 that their respective forward rates were close to the theoretical values. “members can settle trades and net positions in each 24-hour period through its payment-versus-payment process in the books of a central entity”. March 2002. March 2002. Basle May 1999. CLS Bank International. 9 See Cumby and Obstfeld (1981). p 2-15 6 The evidence of delayed reaction of the change in exchange rate and the import price and volume is documented in a study by Rosensweig and Koch (1988) Economic Review July /August 1988. Krugman and Baldwin (1987). 11 See Zietz and Homaifar (1994. p 2-15 7 See for example the classic study by Gailliot (1971) and Lothian and Taylor (1996) 8 See Bilson (1983). and Rosensweig and Koch (1988) Economic Review July /August 1988. one of the member banks. 2 Euromoney. Bank for International Settlements.