Evolution of International Trade

By : Anup Mahesh Savale

Initial trade among communities
• Communities grew in centers favorable for life • Initial trade among communities was for luxuries • Trade resulted in
– Specialization – Increased scale: enhanced productivity – De-risking – Spread of technology

Resulting in Explosive growth in human Wealth

Origin of Wealth: Eric Beinhocker

International trade accelerated this further

Origin of Wealth: Eric Beinhocker

Why International trade ? • • • • • • Mercantilism Theory of Absolute advantage Theory of Comparative advantage Factor endowment theory International Product life cycle theory Internationalization of Firm

India’s Foreign Exchange reserves
March 31, 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 $ billion 1,799 9,832 19,254 25,186 21,687 26,423 29,367 32,490 38,036 42,281 54,106 75,428

In December 2003, Indian FX reserves crossed $100 b A growth from 2 billion to 100 billion a base for examining Global trade

• Prevailed in 17th and 18th century, Europe • Mercantilism replaced feudalism

– Feudalism emphasis on local economy, self sufficiency and agriculture – Political change – From Feudalism to nationalism – Cultural change –From Salvation to Happiness of man on earth
• Mercantilism: “Fear of goods; hunger for money” • Foreign trade as a means to accumulate treasure and increase the power of the state • Treasure in the form of gold and silver to increase the power of the king and the state • Policy advocated “restricted trade”:

- Restrict imports - Encourage exports, especially manufactured goods - Encourage re-export of goods

- Achieve full employment of both human and natural resources

Similar situation in India in 1991 Imports restricted and exports promoted As India faced an FX crisis Import surcharge, LC margins

Theory of Absolute Advantage
• Propounded by Adam Smith in Wealth of Nations (1776) • Advocated free trade from ‘restricted’ trade • Export a commodity that can be produced at a lower cost compared to the importing country • Import a commodity that is produced by another country at a lower cost • Free trade increases the wealth of a country • Wealth of a country is the wealth of all its citizens not just the king

Tax benefits and Software Technology Parks created in 1994 An application of theory of absolute advantage?

Absolute Advantage illustrated
Country Cost of Production Wine Portugal England Cost ratio Cloth 100(a1) 50(a2) 100/50 2.0 Domestic barter rate 1 wine = 2 cloth 1 wine = .5 cloth

50(b1) 100(b2) 50/100 0.5

• • • •

England has absolute cost advantage in wine Portugal has absolute advantage in cloth England will export wine and import Cloth Portugal will export cloth and import wine Perfect conditions for International trade

Theory of Comparative Advantage
• Propounded by David Ricardo, On the theory of Political Economy and taxation (1817) • Identified fundamental difference between Domestic trade and international trade - Factors of production perfectly mobile within a country but immobile among countries - Goods perfectly mobile within and outside the country • Export goods at which it is comparatively more efficient and import goods at which it is comparatively less efficient

Development of Auto ancillary industry in India

Theory of Comparative advantage
Cost of Proudction for one unit Wine Domestic rates Portugal England 80 120 90I wine = 0.89 cloth 1 cloth =1.125 wine 1001 wine = 01.20 cloth 1 cloth = 0.83 wine Cloth Exchange rate Exchange rate

Portugal has lower cost of production than England for both wine & Cloth Cloth costs more than wine in Portugal Wine cost more than cloth in England Therefore, Portugal will export wine and England will export cloth Exchange rate for Portugal wine and English cloth will be England will pay for a unit of wine a maximum of Portugal will want for a unit of wine a minimum of 1.20 cloth 0.89 cloth

Trade will take place at a price between max. 1.2 cloth to a min. of 0.89 cloth at which both countries benefit from international trade.

Factor Endowment Theory
• Propounded by HECKSCHER – OHLIN (early 20th century) • A country should export goods that uses its most abundant factor of production most intensively • A country should import goods that uses its most scarce factor of production most intensively • Countries with low interest rates and abundant capital will have capital intensive industries meeting global demand • Countries with large labor pool will have labor intensive industries meeting global demand International division of Labor China for manufacturing & India for Services

Leontief paradox
• • Leontief won the noble price for his Input-Output analysis, which formed the basis for testing Factor Endowment theory Leontief analyzed the 1947 US data based on 50 industries 38 industries had international trade Aggregated factors into two –Capital and labor US had more capital employed per worker As per Factor endowment theory US should have exported capital intensive goods and imported labor intensive goods For 1947, US imported goods that had 30% more Capital intensity Second test of 1951 indicated 6% higher capital intensity in imports In 1971 third test indicated 27% higher capital intensity in imports compared to goods exported

Leontief paradox -2
for 1959, data for Japan was tested, Japan was labor intensive but on its total exported capital intensive goods - A split into exports to developed countries 25% and less developed countries 75%revealed that, Japan exports to US followed the Factor endowment theory 1962 data for India tested, Indian exports were labor intensive, but Indian exports to US were capital intensive Leontief Paradox partially explained by Factor Intensity Reversal For e.g.. if agriculture is traded between India and US, in India agriculture is labor intensive, and in US it is capital intensive. If US exports to India, US exports capital intensive goods in line with theory; but India imports labor intensive goods If India exports to US, India exports labor intensive goods in line with theory; but US imports capital intensive goods


Factor Intensity Reversal explains Leontief paradox Factor Endowment theory explains trade

International Product Lifecycle Theory
• Propounded by Raymond Vernon (1960’s) • Product life cycle: Introduction, Growth, Maturity, decline • Introduction: Manufacture for home market & exports begin • Growth: Foreign production starts • Maturity: Foreign producers become competitive in their local markets • Decline: Foreign producers enter home market

Shift of semi-conductor manufacturing from United States to Asia

Internationalization of firms
Stages of Firms evolution I stage II stage III stage IV stage No regular exports Export via overseas agents Establishment of overseas Subsidiary Overseas Production

Can we see a parallel in India Companies acquiring companies globally

A major factor influencing trade now: Technology and Wealth Creation
• Wealth = Value in exchange • Capital + Labor + Technology = Wealth or Economic Growth • Capital and Labor are subject to the principle of marginal diminishing return, whereas technology can hold marginal diminishing return • Growth can be led by Technology called Inspiration led growth or by labor / capital called Perspiration led growth

Technology and Growth

Capital deepening = assets used in business Production = used commercially in manufactur In Usage = retail consumption
Source: Solomon, Smith

Evolution of Global Foreign Exchange Markets
J Shankar IISc, MBA –Second Semester January 2007

Evolution of international Forex markets • • • • • • Trade & trade practices Why study evolution of FX markets Milestones of evolution Gold standard or Mint parity theory Gold exchange standard Bretton woods or Exchange rates linked to US$ • Floating rate / market determined

Trade & trade practices
Type of trade Local Deemed Exports Aided Sale Export Movement of Payment in Goods Currency National National International International Local currency Foreign currency Local currency Foreign currency

Why study evolution of FX Markets
• • Often, History repeats itself, especially in moments of crisis or points of inflections Inferences can be drawn from history for e.g. 1. Venue of meeting and power tilts 2. Impact / response of wars / economic upheavals 3. Policy responses to crisis • Study of history is fascinating in itself
Look out for color code as we go along

Milestones of Evolution
• Pre 1870 • 1870 • 1922 (Genoa) • 1944 (Bretton Woods) • 1967 (Rio de Janeiro) - Barter sales of luxuries - Gold Standard / Mint parity - Gold exchange standard - IMF / US$ base - Introduction of SDR

• 1971 (Washington DC) - US$-Gold link breaks • 1973 (OPEC induced) - Market based

Export trade Pre 1870’s
• Pre historic*

– Initial trade between communities was normally for luxuries not indispensable, through barter trade
• Trade in ancient India (Arthashastra)

– Profit margin allowed on imported goods is 10% – Foreign merchants shall not be sued in money disputes unless they are legal persons in the country; their local partners can however be sued
• Trade till 19th century
– Mainly through travelling merchants, who sold the goods they carried and bought back with them local goods that could be used in their native land

* What happened in History, Gordon Childe

1870 -Gold Standard / Mint theory

– – –

Britain -1819 - Resumption Act
After Napoleonic wars (1793-1815) gold conversion resumed Currency notes exchanged to gold at fixed rates Simultaneously repealed restrictions on export of gold coins and bullions from Britain

• • •
1. 2. 3.

Followed by Europe 1870’s, USA -1879 Exchange rate based on underlying gold Principles of Gold standard
Currency value fixed w.r.t gold; Currency issue backed by gold Free trade in gold;

Gold Standard –Theoretical basis
Trade deficit Leads to Less exports More imports Increase in Prices Increases Money supply Imports Gold Trade Surplus Leads to Export Gold Reduce Money Supply Reduction In price More exports Less Imports

1870 -Gold Standard / Mint theory
• Positives
– – free world trade; stable price / exchange / economic growth & peace volatile economy / depression -1890 1907, reduction in money supply leads to recession, lower price does not lead to higher purchases


1914 - I World War, gold conversion suspended in Europe, USA continues Gold conversion

1922 - Genoa Agreement
Background – • Genoa a town in Italy attended by Britain, France, Italy and Japan • Convertibility to gold stopped in 1914; • Fiduciary money gains acceptance; • Gold as settlement currency withdrawn & partial gold standard introduced • I WW result - High inflation / shortages Reasons cited for withdrawal of Mint parity gold production decline; save freight & storage cost - UK economy grew by 5% in 19th century, gold production increased only by 3-4% Results in – • Currency not backed by gold; for international trade gold as settlement currency continues, not for domestic conversion • Sterling as world currency, • London as World trade centre II World War brings this system to a halt

Movement from barter to Gold





Paper money

Gold standard

For Domestic trade

For export trade

1944 - Breton Woods
Background – • US the only country on gold standard; • Left in 1933 at $20.67 and returned in 1934 at $35 • II WW financed by paper money; • Results in high inflation & shortages • 44 countries meet in the town in New Hampshire in US • Harry Dexter White of US Treasury and Lord Keynes of UK present plans Accepted – • Keynesian plan -promote full employment & stable exchange rates, • Central banks to co-operation & aid nations in crisis

International Monetary Fund
IMF formed with 44 member nations– • Fix gold parity for US$ -$35 for 1 troy ounce ; other currency rates fixed w.r.t. US$, • Capital flows can be controlled, • All countries to reach Capital Account Convertibility as soon as possible to promote free trade – US and Canadian $ convertible from 1945 – Europe 1958 - 61, Japan 1964 • Change in parity only for fundamental disequilibrium • Countries with convertible currency cannot change exchange rate
Conditions for IMF membership

International Monetary Fund
• IMF facility to correct disequilibrium – Quota contributed by members -25% in gold; 75% in their own currency -Credit facility -Extended facility 125% of quota 140% of quota

-Standby facility -IMF guarantee for 3-5 year borrowing - General Agreement to borrow -1962
– Agreement for IMF to borrow from Industralised nations for lending to countries in disequilibrium

- Currency swap arrangement -1962
Benefits for IMF members

Triffin’s paradox predicts Collapse of Breton Woods system • 1960’s –Theory “More the US$ is

accepted as international currency of settlement, sure is the failure of this system”
– US$ earns interest; gold does not; but exchange rate is fixed

1967 - Rio de Janeiro
• Impetus - declining International liquidity • 1958-60 - US$ 2b gold shifts from US to Europe • 1960 -1967 12 b gold shifts out of US • March 1968 two tier price for gold announced
– Price for Central banks fixed at $35 – Open market price of 44.36 in Paris

• Introduced SDR or Special Drawing Rights

SDR –Special Drawing Rights
• • • • SDR’s allocated to members based on the global needs to supplement existing reserve assets for liquidity SDR’s initially fixed in terms of gold via US$, later through a basket of currencies SDR’s can be used by the member country to buy foreign currencies for their international trade IMF allocates SDRs to members in proportion to their quotas
– Interest is paid to the member if the SDR held by member is higher than original allotment – Interest is paid by member if the SDR held by the member is lower than original allotment

• •

Beginning of the collapse 1967 - Rio de Janeiro
• Special Drawing Rights (SDRs) -Paper gold upto 3 times their own SDRs • SDRs are used in transactions between central banks • Value 1970 -1 SDR = 1 US$ 1974 -linked to 16 currencies currencies • SDR history 1970 US$ 2.95 b US$ 3.4 b 1971 1980 -linked to 5 US$ 2.95 b 1972

• SDR introduced - 1.5% interest on SDRs increased to 5% in 1975

Triffin’s paradox in action: Collapse of Breton Woods
• US gold reserve 1944 26 b of total global stock of 33 b 1958 23 b 1971 10 b • Between 1967-68 20% of gold reserve was taken out of US; price of gold $44.36 per ounce vs.$35 • US gold reserve as % of $ held by other central banks -1963 -100%; 1970 -50%; 1971 -22% • Bundesbank held 18 b $ in 1972, more than the entire US gold reserve

1971 -US stops gold conversion
• US budget deficit 1958 -71 US$ 56 b 1971-73 US$ 60 b • 1958 -71 US had BOP deficit due to -higher return outside US leading to capital outflows -Vietnam war & military commitments • Measures- 1963 -Interest Equilization tax 1965-Voluntary Credit restrain 1968 -Mandatory Credit restrain 1971 –US had $10 b of Gold; UK wanted to convert $3 b of $ it held for gold • August 15, 1971 –US stopped gold convertibility
– 10% import surcharge on imports introduced – 90 days wage and price freeze

1971 - Smithsonian Agreement
• Group of 10 formed in 1962 meet • Temporary regime -2.25% range • US devalues 8.57%; • Yen 17%, Mark 13.5%, FF & UKP 9% up in 1971 • US devalues 11% in 1973 • Arrangement fails due to oil price hike by OPEC in 1974 of 400%

Post 1973 -OPEC influence
• Organisation of Petroleum Exporting Countries • 1973 oil price hike 400%; • 1978 another increase -Japan - hikes local price -surplus BoP US -prevents price hike - deficit BoP • Creates market fiction and total market determined rates • Approach to oil price hike

Market determined prices
• G 7 -US, UK, WG, Japan, France, Italy, Canada • US$ exchange rate 75 DM UKP Yen 2.3 2.0 305 80 1.7 2.3 250 85 3.3 1.1 255 90 1.7 1.7 148 95 1.4 1.6 100 98 1.6795 1.6627 114

• Upto 1980’s trade dominates exchange market • Post 1980’s capital flows influences market

Market determined prices
• Capital flows influenced by Interest rates • Trade flows influenced by Tariffs / trade agreements • Economic sequence or vicious circle Economic activity-> Money quantity ->Interest rates ->Exchange rates ->Economic activity

Evolution of Indian Foreign Exchange Markets
J Shankar IISc, MBA –Second Semester January 2007

Evolution of Indian Rupee
• • • • • • • • • • • Indian Currency: Arcot rupee, started by Nawab of Arcot, later adopted by Europeans and was known as English, French and Dutch arcots; English used them in Madras, Calcutta and Dacca: 171-177 grains of pure silver Sonaut rupee: used in United Provinces; also refers to coins minted three years and older Sicca rupee: used by East India Company from 1793 in Bengal 176 grains of pure silver and total weight of 192 grains Company rupee: introduced by East India Company after 1835 1835 Act of Imperial Government: standard rupee for all part of India under British control: 180 grains of metal; 165 silver Paper currency Act of 1861: a legal tender paper currency: notes of Rs.10, 20, 50,100, 500, 1000 and 10,000 declared unlimited legal tender in their circles 5 rupee note in 1891, 1 rupee note in 1940 1903: Rs.10 and higher notes declared universal legal tender 1935 Reserve Bank of India set up as central bank 1947 India joins IMF: Indian rupee = 30.225 cents of US$ April 1957, decimal coinage system introduced

Evolution of Indian FX markets
• Founder-member of IMF • 1947 INR -US$ = 3.31; INR-UKP =13.33 • 1949 INR-US$ = 4.75; INR -UKP =13.33
– 75% of Commonwealth countries followed devaluation – Pakistan did not devalue; India stopped payment; Pak followed devaluation in 1955

• Wars in 1962 & 1965-66
6.6.66 -57.5% devaluation; US$ =7.5, UKP 21

• 1967 -US$ 7.5; UKP =18 (Pound re-valued) • 1971 -Pegged to UKP in a band of 2.25% range

Evolution of Indian FX Markets
• 1975 - INR pegged to basket of currencies • 1978 -banks permitted intra day positions • 1979 -RBI ups margin to 5% from 2.25% • 1981 -Reuters services permitted in India • 1987 -RBI sells US$ as well as Rupee; till 1987, pound was the only currency • 1991 -LC Margins (200%), devaluation & Exim scripts for export subsidies

Evolution of Indian FX Markets
• 1992 -LERMS (Exim scripts withdrawn & dual rate introduce) Official $ rate Rs.26 • US$ replaces UKP as intervening currency • 1993 -Unified exchange rate introduced; Direct quote instead of indirect quote • 1994 -August, current account convertibility • 1995 -Sodhani committee report • 1997 -Tarapore committee report

Sodhani committee recommendations -1995
• To develop FX markets in India • Forward Covers based on Projections • Banks overnight currency limits of Rs.15 cr. to be replaced • Interbank borrowing to be excluded for reserve requirements • RBI to act through both spot and swap markets • Corporates to be permitted to sell options

Sodhani committee recommendations -1995

• Accounting norms for derivatives, both for dealers and end-users • Corporates to have Board approved Exchange Risk Policy and authorisation levels

Tarapore Committee recommendations -1997
• June 1997, Road map for Capital Account Convertibility • Pre-requisites to be achieved by 2000: – Gross Fiscal deficit to 3.5% from 4.5%, currently around 5% – Inflation at 3%-5%, currently in 4-6% – NPA in banks at 5%, – CRR at 3%

Tarapore committee recommendations -1997
• Balance of Payment, cover +3 month debt service held in reserve minimum -6 months import export to be $26b $22b -3 month import + 1 month

$24b -short term debt + portfolio

money at 60%, any increase at 70% (current level) min 40%

$31b -NFE assets to Currency ratio

Role of RBI in CAC environment
• NREER as indicator for intervention Real Effective Exchange Rate • Intervention to maintain +/- 5% of REER Direct -purchase / sale in FX market -Interest rate signalling Pronouncement / Direction Recommendatory Indirect Noise level indication / Neutral

1998 -Back to regulated market
• Backdrop: Asian currency crisis • January 16, 98 INR-US$ touches 40.40

– RBI announces: – REPO rates 7% to 9% – CRR increase 10% to 10.5% – Banks -square /near square position – Import surcharge increased 15% -30% Rupee drops to 37.70 vs. US$

1998 -Back to regulated market
• August 19, 98 INR-US$ touches 43.60 – RBI announces: – CRR rates increased 10% to 11% – Repo rates from 5% to 8% – Forward contracts on imports cancellation and rebooking banned – Banks to report peak intra day position Dec 16, 1997 forward cover for loans could not be cancelled & rebooked

2003 and onwards - Problems of Plenty • Options in Indian rupee introduced • Norms for forward covers liberalized • Permission given for covers in excess of documentary evidence based on specific RBI approvals • Norms for Acquisition liberalized, acquisition upto net worth permitted

Second Tarapore Committee on Fuller Capital Account Convertibility
• • • Five year time table 2006-11, in 3 phase First phase 2006-07, Second 2001-09, third phase 2009-11 For Individuals:
– Freely remit up to $50,000 in P-1, and $200,000 in P-3 – Residents can have foreign currency accounts overseas – Foregin individuals can invest in stocks through PMS & MF – Retention of 100% of inward remittance in EEFC a/c for all exchange earners

For Business
– MF can invest up to $3 b in P-1, and $5 b in P-3 – PMS to be allowed to invest in Overseas market – ECB upper limit to be raised gradually, end use restriction to be removed – No ceiling on long term or rupee denominated ECB’s – Companies can invest up to 4 times their capital in overseas subsidiaries / JV in P3

Second Tarapore Committee on Fuller Capital Account Convertibility
• For Banks: – – – – – • – – – – – – – P-3 can raise up to 100% of their capital through ECB RBI to evolve policies to allow on case by case Industrial houses to hold equity in Indian banks or promote new banks Encouragement to Institutions to set up private banks Government holding in state owned banks to 33% A single banking law for all banks including PSU banks Ban on participatory notes Non residents to access FNCR (B), NR (E) RA deposits FIIs to set aside reserves in volatile times Banks must consolidate PSU’s must reign in borrowing Reign in Small savings and unfunded pensions Center and State should graduate from the present system of computing financial deficit to a new measure of public sector borrowing requirements (PSBR)


Theories of Exchange rate determination
J Shankar IISc, MBA –Second Semester January 2007

Why study Exchange rate theories?
• Need to take decisions involving transactions in which Foreign exchange rate is a critical input
– Exchange rates fluctuate in a broad range – Transactions like exports, imports, investments, loans, project investments are affected – Often decision is vitiated by exchange rate moves

Forecasting can be for different time horizons
Time horizon Short time –intra day Medium term – days to months Long term – beyond 3/6 months Dominant force Technical / Speculative Cyclical Structural Analytical tool used Sentiment factors / Technical views Technical factors / Fundamental views Fundamental views

All three factors are present in all markets, They are more critical in Foreign exchange markets

Topics we will cover in this class
• Basic Economic concepts • Exchange rate theories – Purchasing Power Parity – Balance of Payment – Interest rate differentials – Real Interest rate differentials

Price -Volume relationship



Demand Volume
Law of diminishing marginal utility

Interest - Money relationship



Investments Volume of Money

Domestic currency value -Volume of business relationship


Domestic Currency


Depreciates Decrease

Exports Volume of Business

What determines domestic currency value?

• Origin -16th century Spain, 1920 Gustav Cassel • Concept - One price for one commodity
Undervalued DC Exports Increase

Overvalued DC

Imports Increase

Correction in Value

Concept originally came up in 16th Century in Europe

One price for one commodity -some conditions
• • Commodity under question tradable There are no trade barriers to arbitrage and trade • • There are no transaction cost The goods traded are homogenous

Big Mac theory and PPP

Innovative and Imaginative use by Economist

Big MAC in practice
• Big Mac theory (in 1986) – 66 countries; only local items used; – Has not reflected current exchange rate – Robert Cumby (1993) researched that 70% gap bridged in 1 year Country DC Price PPP Ex rate % • US 2.53 • India 47 18.5 37.7 (57) • Indonesia 4600 1818 3605 (50) • S. Korea 2300 909 1060 (14) • Singapore 3.00 1.19 1.58 (25)
November 21, 1997 (during Asian Currency crisis)

PPP -Stage 2
• Evolution in PPP concepts Law of One price Basket of commodities

Inflation differentials -REER

PPP -Stage 2
• Absolute PPP –equilibrium exchange rate of two countries determined by ratio of the two countries price level • Relative PPP –focuses on change in price levels rather than absolute levels

Problems in PPP
• Calculate PPP -CPI, WPI, Wage index, Export PI, • Basket of Currency -Europe -Mortgage • Base Period -International – 1973 –floating exchange rate, 1980 –US current account in balance, formation of Euro
– National -1991, 1995, 1996, 1998, 2001

1999 –

• Elasticity of demand Food low Specialised low high high


Income high High Mfg.

Industrial RM low Non specialised High

• Tradable and non tradable goods

Balance of Payment theory
• Conceived in 1930’s by Joan Robinson • Long run equilibrium exchange rate is rate at which internal & external balance is achieved • Internal balance -full employment • External balance -targeted level for current account balance

Equilibrium Exchange rate
• Long term equilibrium exchange rate – Attainment of internal and external balance – Internal balance = attainment of full employment
• Full employment = Strong demand for goods produced in economy

– External balance = attainment of some targeted level for the current account balance
• External balance = Long term balance in current account, a result of exchange rate led trade flows

Logical movements
Trade inflows or exports Less Trade outflows or imports Equals Current account balance

• Depreciating currency increases exports and reduces imports resulting in net inflows: – Depreciating currency = net trade inflows

Logical movements
Trade inflows or exports Less Trade outflows or imports Equals Current account balance

• Appreciating currency decreases exports and increases imports resulting in net outflows: – Appreciating currency = net trade outflows

Logical movements

• Internal balance = full employment • To reach Full employment = there must be demand for Domestic output
– Domestic output = Local demand + Exports

• Domestic currency value can be used to reach full employment • How? • How does Domestic currency value affect employment?

Some observations

• Internal balance and external balance can be achieved at a point of time; • During most occasions: the position will be tilting towards either Internal balance or external balance

IB & EB Equilibrium rate
Appreciates CA deficit

Weak demand CA deficit

Strong demand CA deficit

DC Value

Weak demand CA Surplus


D demand Strong
CA surplus



Depreciates CA Surplus
Weak demand

Real domestic demand

Strong demand

Evolution of BOP theory
• Initial concept - Balance of Trade -Current Account Focus • Current concept - Balance of Payment: both trade & capital flows • Sustained Current account deficit not feasible due to debt trap
Trade deficit CA deficit Debt service External debt

Real interest rate differentials
• Components of interest Incentive + Risk premium + inflation • Risk premium eliminated by Sovereign risk; but country risk cannot be eliminated • High inflation indicates domestic competitiveness weak, weak currency • Exchange rate movement = Real interest rate differentials

Interest rate differentials
• Zero Capital mobility Income = Savings + Consumption Savings = Investment Consumption Current Account balance = Nil Income = Savings +

• Capital account mobility

Savings is not equal to Investment

Current Account balance = Capital flow

Interest rate differentials -2

• Current Account balance Negative = Capital Inflow into economy Surplus =Capital outflow from economy • Capital flows influenced by Interest rates • With free flow of capital, interest rate differentials bridged by capital flows

If you were the decision makes, what type of currency would you like for your country? • An appreciating currency or • A depreciating currency And why?

Fiscal and Monetary policies: A look at Mundell Fleming models J Shankar IISc, MBA –Second Semester January 2007

Mundell-Fleming Model
• • • • Robert Mundell (1963) & J Marcus Fleming (1962) Analyze impact of Fiscal / Monetary policy on exchange rates Importance of capital mobility Classification of economy Capital mobility -nil, low, high, perfect Exchange rate -Fixed, Floating

Mundell-Fleming Model -assumptions
• MF model is based on an open economy this is too small to influence the interest rate in the rest of the world • Price is assumed to be fixed in the short run and equilibrium level of output is below full employment level • Model assumes exports /imports will rise in response to a

change in value of the domestic currency

M-F transmission mechanism

Inc. In Money Supply

Inc. in Dom. Economic Activity

Trade balance Deficit Dom. Currency depreciation Capital Outflow

Decline in Dom. Interest Rate

Impact of expansionary Monetary policy
Fixed Exchange rate • Money Increase = Domestic demand =Imports attractive due to fixed Ex. Rate • Foreign exchange reserves are drained; fastest where there is perfect mobility and slowest with zero mobility, • Capital moves out in anticipation of currency depreciation Capital Mobility FE Res. D.Prdn D Int. • Zero Modest loss No change No

• Low • High

large loss

No change extensive loss

No change No

No change


• Perfect

Only trade led drain to trade deficit + capital outflow

Infinite loss

No change.

No change

Impact of expansionary Monetary policy
Floating exchange rate • Money Increase = Interest rate decline =Capital outflow =Currency depreciation = higher exports • Higher freedom for capital flow, faster the currency depreciates, faster it depreciates higher the domestic production increase Mobility D.Cur D.Prdn D Int. • Zero Small dep. Small inc.
Large dec.

• Low • High

large dep.

large inc. larger dep.

Small dec. larger inc. No change

smaller dec. largest dep. Largest inc.

• Perfect

Trade and capital flows balance to some extent

M-F transmission mechanism
• Fiscal policy is the policy with regard to Government spending

Inc. In Govt. Spending/ Investment

Inc. in Dom. Economic Activity

Trade balance Deficit

Increase in Dom. Interest Rate

Impact On Balance of Payment*

Capital inflow

*If trade dominates, currency depreciates If capital inflows dominate currency appreciates

Impact of Expansionary fiscal Policy
Fixed Exchange rate
Zero mobility • Increased govt. investment met by imports • Increase in Interest rate does not translate to capital inflows due to Zero mobility • Hence, no impact on domestic production In Perfect mobility • Domestic expansion financed by capital inflows; output has multiplier impact of investment; no change in interest rate as increased demand met by foreign inflows

Capital Mobility • Zero • Low • High • Perfect
Smaller inc.

FE Res.
large loss small loss

small inc.

D Int.
large inc. Small inc. large inc. No change

No change

small gain large gain larger inc.

Impact of Expansionary fiscal Policy
Floating exchange rate • In Zero mobility, policy induced demand is met by imports, BOP deficit leads to currency depreciation leading to higher exports; high interest rates does not attract capital inflows due to no mobility • In perfect mobility, policy induced demand brings in capital inflows leading to exchange rate appreciation and reduces export competitiveness Capital Mobility • Zero • Low • High • Perfect D.Cur D Int. large dep. large inc. Large inc. small dep. small inc. Small inc. small app. smaller inc.smaller inc. large app. No change No change D.Prdn

Combined impact of Monetary / Fiscal policy
In situations of high capital mobility
Expansionary Monetary Policy Expansionary Fiscal Policy Restrictive Fiscal Policy Ambiguous Restrictive Monetary Policy Domestic Currency Appreciates Ambiguous

Domestic Currency Depreciates

• Restrictive fiscal policy = policy inducted demand reduction leads to capital outflows leading to DC depreciation • Expansionary monetary policy = increased imports & capital outflows • Expansionary monetary policy negates Expansionary fiscal policy

Combined impact of Monetary / Fiscal policy
In situations of Low capital mobility
Expansionary Monetary Policy Expansionary Fiscal Policy Restrictive Fiscal Policy Domestic Currency Depreciates Restrictive Monetary Policy Ambiguous Domestic Currency Appreciates


• Restrictive fiscal policy = Policy inducted demand reduction leads to reduction in imports • Restrictive monetary policy = Decrease in domestic demand leading to current account improvement • Expansionary fiscal policy negates Restrictive monetary policy

Euro: the birth of a new currency

J Shankar IISc, MBA –Second Semester January 2007

EURO seen as it happened

Genesis of Euro What is Euro Global implications of Euro

Genesis of Euro
1958, Treaty of Rome Balanced development of economic activity, created European Investment Bank 1972, Bale agreement, “The Snake” Currency fluctuation 2.25% 1973, European Monetary Co-op Fund 1979, European Monetary System European Currency Unit (ECU)

Genesis of Euro -2
1987, Single European Act frontier free market by 1992 1990, First phase of EMU in effect Free capital flows 1990, UK joins EMS Jan 1, 93 Free capital flows begin Jan 1, 94 European Monetary Institute 1995 Date for single currency fixed -1999 Dec 1995, Currency named “Euro”

Genesis of Euro -3
May 1, 1998 Participating countries fixed Exchange rate between them fixed Jan 1, 1999 Euro & Domestic Currency co-exist, Euro = 1.1740 US$ 1999-2001 No compulsion no prohibition

Jan 1, 2002 Euro replaces DC as legal tender

What is Euro?
Eligibility criteria for joining Euro Inflation <1.5% of average of lowest three countries Budget deficit <3% of GDP Total public debt <60% of GDP LT interest rates <2% of the average of lowest three countries Currency stability within EMS band for 2 years

What is Euro?
Austria -schillings Belgium -francs Holland -Gilders Finland -markka France -Franc Germany -Mark Ireland -Punts Italy -Lira Luxemburg francs Portugal escudos Spain -pesos 13.7603 } 40.3399 } 2.20371 } 5.94573 } 6.55957 } EURO =US$1.1740 1.95583 } .787564 } 1936.21 } 40.3399 } 200.482 } 166.386 }

What does it mean?
Domestic currency -> Euro

Euro effective from January 4, 1999 Euro & Domestic Currency co-exist “No compulsion, no prohibition” Upto January 3, 2002 After January 3, 2002 only Euro

Immediate Implications
In the 11 countries, who are part of Euroland One currency will exist One interest rate One exchange rate -w.r.t Foreign Currencies Central banks give their Monetary powers to European Central Bank

Global Implications of Euro
GDP in US$t Population in m Unemployment Debt market US$ t 5 Savings rate 4% Global % Exports 12.2% 15.6% Balance of trade -ve +ve US 8.1 270 5% Japan 4.0 140 3.5% 3.3 12% +ve Euro 6.3 290 11.75% 5 9.8%

Euro vs. US$
EURO balance sheet + Trade surplus + Higher unemployment + Higher savings + Larger market - Cultural barriers - Survival of Euro a ? - Capital markets - Technology & innovation

• European Monetary Union Tarapore Committee report • Basis for the two PPP = Inflation & REER BoP = Budgetary deficit, Reserve levels IRD = Interest rate range & inflation

Market convention: Forex Markets

J Shankar IISc, MBA –Second Semester January 2007

FX markets and Hedge Instruments
• Contract of sale -some key issues • FX Market & market players • Forward Contracts • Currency Futures • Pricing difference between Forward Contracts and Futures • Swaps • Options

Contract of Sale -Some key concepts
• Price -currency value of commodity • Factors affecting the price, independent of the market conditions Delivery schedule Terms of Payment

• Price in any market denotes a delivery schedule & terms of payment defined by convention or Law

What are FX market practices

Market quotes available
• Business Line, February 9, 2007
– Money and Banking page

• Inter-bank rate on February 8th :Thursday
– US$ Opened 44.13/1350, close 44.12/1250, previous close 44.12

• Traveler Rates issued by Thomas Cook on 7th :
– US$ Buying rate: 44.75, Selling rate 48.05

• Exchange rates of SBI on 7th
– US$ Export or buying rate: 44.08, Import or selling rate: 44.17

What are these different rates?

FX Markets
• Works from Monday to Friday • INR-US$ market

– 9.00 AM to 4.30 PM; 5.00 PM for banks
• Cross currencies

– Round the clock market (Monday to Friday); due to trading across the globe – Hong Kong – Frankfurt –New York –San Francisco
• Market convention is “Two way quotes” • Spread (difference between buying rate and selling rate) also called bid –ask rate reflects the liquidity of the market

A typical market quote
Market Quotes at 5.00 PM on 08/02/2007 Currency EXPORT RATES SPOT RATES TT US$ Euro

IMPORT RATES 3m SPOT RATES TT 1m Bill 44.20 57.44 86.92 36.46 28.83 44.37 57.74 87.25 36.74 28.98 44.74 58.37 87.94 37.35 29.32 3m


Bill 44.07 57.25 86.55 36.34 28.73 44.18 57.33 86.80 36.40 28.76 44.57 57.90 87.55 36.86 29.06

44.08 57.26 86.67 36.35 28.74

44.17 57.40 86.86 36.44 28.81

Yen (100) Sing $

Inter US$ bank rate –Rs. 44.13

FX Markets –Some more practices

• Inter-bank rate, Customer rate, card rate
– Inter bank rate – for trade between banks – Customer rate – a spread over inter bank rate (based on volume, credit risk, size of transaction and relationship) – Card rate – fixed rate for the day for small value transactions; say below $10,000 – An area for negotiation; – Small value transactions can be bunched

Potential for smart risk less profit in negotiating costs

FX Markets –Some more practices
• Spot, TOM, Cash prices – Spot -2 working days from transaction day or t+2 – TOM – T+1 (NPV of cash flow considering Risk free rate) – Cash price – T (NPV of cash flow considering Risk free rate) - Used for Cash flow management / interest cost management • Quote on Dec 1 (Friday), Spot date Dec 5, TOM date 4
– Spot rate – Cash /Spot discount – TOM/Spot discount – Call money rate 44.6550 00.0065 (for 4 days) 00.0015 (for 1 day) 06.10%

• •

Cash Spot discount % TOM/Spot discount %

1.33% 1.23%

Potential for smart risk less profit in negotiating costs

FX Markets –Spot, TOM and Cash
FX Settlement volumes February 3rd 2006 US$ Trade Type # of TradesMillion Cash TOM Spot Forward



55 136 1790 32

844 37332 1467 64931 3558 157104 180 8073

• Imports and exports or trade flows (including services) • Borrowing and lending or financial flows • Investment flows • Speculation
Earlier Business Line used to report on FX volumes for the day

FX Markets –Some more practices
• Bill rate and TT rate – Bill rate further processing required in the bank (includes processing charges) – TT rate –further work required is minimal – Since the difference is a service charge, can be negotiated based on the bargaining position of the customer – In the SBI quote, difference between Bill rate and TT rate is
• For exports Re.0.01, for $100,000 you pay Rs.1000 • For imports Re.0.03, for $100,000 you pay Rs.3000 – For transactions where you have forward cover, the forward cover rate applies and not the bill rate or TT rate
Potential for smart risk less profit in negotiating costs

Factors considered in selecting FX banker
• • Trust: will give your the best rate and make your profit from volumes instead of margin; banks fix spread over inter bank rate Infrastructure: Communication facilities, do you have access to your dealing room, can you execute large value transactions, are you reachable 25 by 7, 365 days; SBI –Pound sterling Nov 1988 For cross currencies: Do you have overseas offices, can you execute overnight orders, keep client informed on markets moves Can you innovate new instruments and structures; most foreign banks FX banking goes with other banking facilities like borrowing, investments and Non fund based business; integrated approach; share of fund businesss Provides access to your research views and are able to add value to customers trading strategy: Most foreign banks get their economist to visit large clients and discuss their view with the treasury teams Often the person makes the difference

• • •

FX Market Players and Instruments

J Shankar IISc, MBA –Second Semester January 2007

FX Market Players
• Hedgers • Speculators • Arbitrageurs • Central Bank “as a player”

• • • • • • Have an exposure Enter market for risk reduction Will take delivery Incidental to their primary business Affected by market liquidity May or may not have a view on price movements • Examples –Consumers & Investors
Need: Price that will be traded in the future

• • • • • • • • Create an exposure Increases risk; risk-reward critical Will not take delivery Benefits from low liquidity Enters market because of price view Primary business is market operations Examples -Hedge Funds, Margin players, Banks play this role to provide liquidity to their customers: Difference between inter-bank rate and card rate is the reward for this

A price that he expects will trade in the future

• No primary exposure • Minimal exposure taken • Risk-free profits; source of profit market information • Does not take delivery • Exist because of illiquidity • No view on price • Primary Business is market operations
Looks out for differences in Prices in different markets

What is a derivative
• • • A cost effective method of finding a tradeable future price Derivatives name arises from the fact that the price is derived from the spot market Fundamental basis for derived price is the cost of holding

Key is cost effective method

Cost of holding
• Spot price + cost of holding - interest cost - holding cost (warehousing cost) - transaction cost

Methods of finding the future price or Derivative instruments
• Forward Contract • Futures • Swaps • Options

Forward Contract
• A contract for sale or purchase of for delivery and payment beyond the market norms / conventions • Difference between spot & forward price is discount or premium • Premium = Forward price minus spot price • Discount = Spot price minus forward price • Over the counter market • Settlement mainly through delivery • No margin or immediate payment required
Most popular instrument in the Indian FX market

Forward Rate
Forward rate = S ((1+(rdxt) /
(1 rf xt ) +


S = Spot rate rd = Domestic interest rate rf = Foreign currency interest rate t - the life of the forward contrac C = transaction cost of bid-ask spread in FX markets and bid ask spread in Money markets • Since Indian Rupee is not fully convertible, the forward rate is not determined only by interest rate differential but also expectation of spot movement

Example of Forward Contracts

Forward Price (INR -US$) (bid rates) 44.6550 0.0791 0.2333 0.4688

Premium / (discount)

Spot price 1/12/06 1 month premium 3 month premium 6 month premium Interest Rates

2.09% 2.12% 2.11%

Source: Mecklai Financial & Commercial Services

Period 6 month

INR 6.80%

US$ 5.33%

Differential 1.47%

Indian Rupee is not a convertible currency

Example of Forward Contracts

Forward Price (US$- Premium / (discount) Euro) Bid price 1.3257 0.0020 0.0056 0.0104 Euro 3.74% US$ 5.33% Differential 1.49% 1.78% 1.71% 1.57%

Spot price 1/12/06 1 month premium 3 month premium 6 month premium Interest Rates

Period 6 month

Euro and US$ are convertible currency

• Traded in an Exchange • Standardised terms Quantity Delivery period Terms of settlement Trading through members Margin stipulation

Terms in Futures Markets
• Basis = difference between cash price and future price • Contango =Future prices > cash price • Backwardation =Future price < cash price or Future price < cash price plus cost of carry • Cost of Carry = cash price + financing cost + carrying cost

Evolution of Futures Market
• 1919 -Eggs • 1921 commodities -corn, wheat, oats, rye • 1947 metals -copper • 1972 currencies -DM, Yen • 1975 Gold • 1977 Treasury Bonds • 1983 Crude oil
Future market in Indian rupee not yet introduced in India

Difference between Forward Contract & Futures
• FEATURE Size Delivery OTC Spread Broking fee Optional Mandatory 1% -doFORWARD FUTURE Tailor-made Standard -doExchange Margin Settlement by Delivery over 90% < Price Commission

Where to use Future and Forward
• Forward contract for known cash flows; • For uncertain cash flows Futures • Futures prices can be different from forward prices due to
– Credit risk priced in forward contract, risk in futures covered through margin – Since forward contract is not marked mark to market, cash flow is not influenced till the date of the expiry

Derivative Instruments in FX markets

J Shankar IISc, MBA –Second Semester February 2007

What is a derivative
• • • A cost effective method of finding a tradeable future price Derivatives name arises from the fact that the price is derived from the spot market Fundamental basis for derived price is the cost of holding

Key is cost effective method

Cost of holding
• Spot price + cost of holding - interest cost - holding cost (warehousing cost) - transaction cost

Methods of finding the future price or Derivative instruments
• Forward Contract • Futures • Swaps • Options

A contract obtained for a price paid that gives the holder the right but not the obligation to conduct a trade with the counterparty, on terms specified in the contract Writer of option –receives premium and undertakes the obligation Buyer of option –pays premium and buys the right but not the obligation Put Option –right to sell Call option –right to buy

Similar to a general insurance contract

Inputs to Option Pricing
Current Price or Spot price Strike Price or price for exercise Tenor or period for which option required Interest rate –risk free rate of interest of both domestic • Dividend yield of the stock, benefit from holding the asset; for FX options risk free rate of interest of foreign currency • Volatility –computed as standard deviation of daily percentage changes in spot prices • • • •

Specific components of Option
• Premium –consideration paid to the writer of option • Strike Price – price for exercise at the point of exercise, • Tenor –life of option • Exchange traded options are of short duration normally less than one year • In Indian markets - Stock Index Option is an European Option - Individual stock options are an American Option - INR options are European Option

Some terminologies explained

Value of an option
• Intrinsic value of an option – Gain to holder on immediate exercise of option – = Market price – Exercise price for Call option – = Exercise price – Market price for Put option Does a option have value if it has no intrinsic value? Where does this value come from? – Time value of option • Volatility value • Interest value or Risk free rate • Dividends – Fair value of an option considers both the Intrinsic value + the time value of an option Option premium value can never exceed spot price

• •

Classification of options based on exercise price
Classification based on Intrinsic value • At the Money option
– Exercise price = Spot price

• In the Money option
– Call option: Spot price > Exercise price – Put option: Exercise Price > Spot price

• Out of Money options
– Call option: Exercise price > Spot price – Put option: Spot price > Exercise Price

• Zero price options are typically Out of Money Options

Typical Option quotes for FX
OPTION PRICES (US$/INR) Months ATM Call Put 1 month 44.32 0.21 0.21 3 month 44.59 0.38 0.38 6 month 44.90 0.53 0.53 12 month 44.54 0.74 0.74

Quote of Mecklai Financial & Commercial Services Ltd February 20, 2007

Option specific terms used
• Delta = Change in Option price to change in spot price – Used by writers of option to determine the amount for hedging in spot market – Call options have delta in the range 0 to +1 – Put options have delta in the range 0 to -1 – Higher the delta, greater the probability of option expiring ITM Gama =rate of change in Delta to change in spot price Theta =rate of change in Option value w.r.t. time – For the holder indicates the rate at which option looses value over time, or decay value; for the writer of the option it is value accruing to him; – theta does not have a linear relationship with time but square root of time; – The loss is more closer to the date of expiration (Slog over)

• •

Option specific terms used
• Lamda :Change in premium to change in volatility • Volatility is an input that is person dependent • 3 types of volatility
– Historical volatility: computed based on daily price moves – Forward looking volatility: computed by adjusting historical volatility by an amplifier or reducer – Implied volatility: is worked back from premium

• Writers of Options believe volatility will decrease going forward compared to implied volatility in their option pricing model

Benefits of using option
• Cost paid upfront, no further cost involved for buyer of options, hence can be factored in by the hedgers • •   Potential for upside not capped, hence benefit unlimited Option strategy based on view Bullish (believes prices will increase)- buy call option Bearish (believes prices will fall) –buy put option Writer of option has an unlimited liability Writer benefits only if the option expires without being exercised or the difference between exercise price and spot market on date of exercise is lower than the premium received by him

Use of a call option or right to buy
• • Hedgers will buy call options, if they are Bullish or expects prices to go up or wants to cap their costs Speculators will write call options, if If they are bearish or expects market to be flat; collects premium upfront for a risk that he is taking

Uses of a Put option or right to sell
• Hedgers with an uncertain sales price - Will buy put option to protect against price drop  Speculators will write put option - if he is bullish or expects price to go up

Forward to Forward (combination of two forward contracts)
• A simultaneous purchase and sale of forward contract for different periods • To fix the premium without fixing the spot rate, Spot rate fixed before the expiry of first contract • Used in Indian markets before it was banned in 1990’s • To take a view on interest rate / expectation down the line without fixing spot rate

Exotic forwards (combination of forwards with Options)
• Range Forwards defines a range, with high and low (European) • Layered Forwards defines a range, with high and low (American)

Instrument variants to reduce the forward premium cost

What is a Swap?
• • • • • • • Swap is an exchange of benefits derived from holding an assets Two types of swaps –Currency swap and Interest swaps Intermediary –Market maker Assumes credit risk for a spread Swaps are settled by payment / receipt of difference Reference to a specific public rate Documentation format is ISDA prescribed (International Securities Dealers Association)

The first Swaps
• First Currency swap in 1981 between World Bank and IBM
– Exchange principal and fixed interest for interest and fixed interest in another currency – Value of swap priced through interest – Interest rates used –T Bill, LIBOR, CP rates

• CAPS –for lender Upside is fixed or for borrower downside is fixed • Floors – for lender downside is fixed or for borrower upside is fixed • Collar –that has both a Cap and a floor

Pricing for a Swap
Based on NPV Initial NPV of a Swap is Zero Exchange rate is determined by the Yield Curve If the yield curve is flat, fixed interest will be close to floating interest rates • If the yield curve is normal, sloping up left to right, swap rate is fixed such that - Fixed interest is higher than floating - Steeper the curve, higher the rate fixed • • • •

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