Review Chapters 19 to 23

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Review Chapters 19 to 23
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Chapter 19 -

• Balance of Payments Accounting
• Main points
• Credits and debits
• Four categories and balances
• Current account and National Income Equation

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Credits and Debits

• Credit brings currency into the country NOW
• Debit currency leave the country NOW
• Categories
• Current Account
• Capital Account
• Long-term Financial Transactions
• Short-term Financial Transactions
• Official Reserve Transactions

4
Current Account

• Exports of Goods
• Imports of Goods
• Merchandise trade balance
• Exports of Services
• Imports of Services
• Balance on goods and services
• Factor income receipts from abroad
• Factor income payments abroad
• Balance on goods, services and investment income
• Unilateral transfers received
• Unilateral transfers made
• I Current Account Balance

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Capital Account

• II Net increase in foreign long-term assets at
  home
• Net increase in long-term assets abroad
• II Balance on current account and long-term
  assets (Basic Balance)
• III Net increase in foreign short-term assets
• Net increase in short-term assets abroad
• III Official reserve transaction balance (Overall
  Balance)
• IV Net increase in foreign short-term official
  reserve assets
• Net increase in official reserve assets
  abroad
• Zero

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Classify as credit or debit, and category for
Canada put in statement

• A British company takes over a Canadian company,
  paying Canadian stockholders 300 in Canadian
  dollars (British chequing account in Can)
• Mike, from Canmore (Alberta), buys stock in
  Microsoft (Mikes US account in Canada)
• Bill Gates gives U of M 200 million dollars for
  Aids research (Gates account in Can)
• Michelle buys US at her branch of the TD bank,
  using 4200 Canadian for the purchase. (no
  central bank transaction here)
• Richard, from Florida, visits Canada to escape
  the hot summer. He spends 2000 Canadian (from
  acc in Ca)
• Chuntai, from Winnipeg, downloads C200 worth of
  music from the US, and he actually pays for it!
  (acc in US in US)

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Current Account National Income

• Recall Y C I G (X-M)
• And Y C S T
• Therefore,
• (X-M) I G S T or
• (X-M) S (T G) - I
• If (T-G) S gt I , we have a surplus
• If Sgt (T G) I , we have ?
• rearrange this equation to determine all
  combinations that give surplus or deficit on the
  Current Account.

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More concepts

• Autonomous items in BoP main transaction that
  occurs, independent
• Accomodating item transaction that occurs
  because of main transaction (example, all the
  payments from bank accounts)
• Financial account (capital account) categories 2
  to 4
• What does it mean to be a net debtor to the world?

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Chapter 20 Foreign Exchange markets (we are
necessarily going to skip important parts)

• Demand for and supply of foreign exchange
• price movements and terminology
• Spot and forward and futures markets
• Arbitrage
• Measures of the spot rate
• NEER
• RER
• PPP
• Combining foreign exchange market with financial
  markets

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Foreign Exchange markets

• Demand for and supply of foreign exchange
• exports and imports of goods services
• financial transactions (loans, stock purchases,
  sales)
• speculation and hedging
• Market banks around the world, financial
  institutions, insurance companies

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Time dimension

• Current market / price of foreign exchange
• SPOT market / price
• Future market / price of foreign exchange
• Forward market / price (bought sold through
  most banks, brokers)
• Futures price (futures market, set amounts,
  formal Exchange, posted prices)

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The Basic Foreign Exchange Market
e/
S
e
eeq
D
D
Euros ()
Qeq
Q
13
Recall

• If the price of the foreign currency rises
  (appreciates), our currency has depreciated
• If the price of the foreign currency falls, our
  currency has appreciated

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Arbitrage

• Arbitrage is the act of buying and selling
  something in two different markets and making a
  profit from it.
• With many different currencies, the most common
  kind of arbitrage is triangular arbitrage
• this occurs when an actor in the exchange market
  can use trade between three currencies to make a
  profit

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Arbitrage

• If I can use US dollars, sell them to buy euros,
  sell euros and buy yen, then sell yen and buy US
  dollars, and make a profit, I have succeeded at
  triangular arbitrage
• Example
• dollar sterling rate 1.50/
• dollar Swiss franc rate is 0.80/Sfr
• and Sfr/ 2 Sfr/
• What would an arbitrageur do?

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Arbitrage

• If I can use US dollars, sell them to buy euros,
  sell euros and buy yen, then sell yen and buy US
  dollars, and make a profit, I have succeeded at
  triangular arbitrage
• Example
• dollar sterling rate 1.50/
• dollar Swiss franc rate is 0.80/Sfr
• and Sfr/ 2 Sfr/
• an arbitrageur would use to buy 1 ,(need
  1.50), then buy 2 francs, sell francs for and
  get 1.60,making 0.10 profit.

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Measures of the Spot Rate

• Nominal Effective Exchange Rate
• NEER weighted average exchange rate measure
  (weights are exports PLUS imports from each
  country)
• RERcur e/ cur X (U.S. price index cur)
• (Jap. price index cur)
• PPPAbsolute Price Level / Price Level
• PPP /rele /base yr X PI cur/PIcur

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Measures of the Spot Rate

• Example (you do)
• U.S price index 1.08 2004/2000
• Japanese price index 1.02 2004/2000
• Exchange rate yen/ 115.8 2004
• Exchange rate yen 114.3 2000
• RERcur e/ cur X (U.S. price index cur)
• (Jap. price index cur)
• PPPAbsolute Price Level / Price Level
• PPP /rele /base yr X PI cur/PIcur

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Forward and Futures Market

• The forward rate is the exchange rate at a future
  date in time
• If you think the spot rate of a currency at a
  future date will be higher than the posted
  forward rate, you would
• have a long position in the currency,
• buy forward
• buy a futures contract
• buy a call option
• sell a put option

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Forward and Futures Market

• If you think the spot rate of a currency at a
  future date will be lower than the posted forward
  rate, you would
• have a short position
• sell forward
• sell a futures contract
• buy a put option
• sell a call option.

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Reading futures options table
To buy yen in April at 94 cents per 100 yen (9400
basis points per 100 yen) will cost 1.43 basis
points Therefore one contract will
cost 0.0143/ X 12,500,000 1,787.50 To
sell yen in April at 94.5 cents per 100 yen, one
contract would cost 0.0060/ X 12,500,000
750.00
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Foreign Exchange Markets and Financial Markets
Uncovered Interest Rate Parity

• (iNY iLondon) xa
• xa E(e)/e 1
• xa is the percentage expected appreciation of the
  foreign currency
• Because investor is bearing all the risk of
  changes in the exchange rate, this is called
• uncovered interest rate parity (UIP)
• If (iNY iLondon) gt xa , then investments in the
  US are more attractive,
• If (iNY iLondon) lt xa , then investments in
  London are more attractive

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Covered Interest Parity

• As the title of the last few slides suggest, the
  equality
• (iNY iLondon) p
• is called covered interest parity
• Covered interest parity tells us that there is a
  45 degree line that relates the difference in
  interest rates to the forward premium

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Covered Interest Parity
iNY iLondon ()
CIP
p (-)
p ()
iNY iLondon (-)
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Four markets

• The following graph shows how the four markets
  react to an imbalance in the markets such that
  the interest rate in New York is too high
  relative to the interest rate in London and the
  foreign currency premium.
• loanable funds move from London to NY (supply in
  London falls i increases, supply in NY rises i
  falls)
• price of pounds falls today, rises on forward
  market (money will return)

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Four markets
Ss
iNY
iLondon
Ss
Ss
Ss
Ds
s
s
e/fwd
e/
Ss
Ss
Ss
Ds
Ds
Ds
s
s
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Chapter 21 International Financial Markets and
Instruments An Introduction

• This chapter surveys assets
• International bank lending
• International bonds
• Inernational stock markets (and mutual funds)
• Derivatives
• It examined
• history
• size
• how they work

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Bank lending

• International bank lending can occur for many
  reasons
• domestic banks lend to private firms abroad who
  are making real investments
• domestic banks purchase foreign financial
  instruments, if return is higher than at home
• foreign banks may borrow from domestic banks to
  have working balances of domestic currency

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International Bank Lending - terms

• Bank for International Settlements (BIS) BIS acts
  as a clearinghouse for central bank settlements,
  deals with international banking matters, and
  promotes international financial cooperation
• London Interbank Offered Rate (LIBOR) - average
  of the rate of interest that major banks are
  using when lending money to each other
• Gross international bank lending is the sum of
  total cross-border claims and local claims in
  foreign dollars.
• Net international bank lending is this gross
  number, less interbank deposits
• Interbank deposits are deposits by foreign banks
  in home banks and home banks in foreign banks.
  They arent really loans, but exist to facilitate
  international transactions --- they are big

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International bank lending

• There are 3 components to bank lending
• domestic bank loans in domestic currency to
  nonresidents (traditional)
• (German bank lending Euros to US firm for
  purchase of German exports)
• domestic bank loans in foreign currency to
  nonresidents (eurocurrency)
• (German bank lends dollars to US firm to buy
  Saudi oil)
• domestic bank loans in foreign currency to
  domestic residents (eurocurrency)
• (German bank lending dollars to German firm to
  buy Saudi oil)

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Other major assets

• Bonds, Eurobonds
• Bonds have a face value or maturity value which
  is the value of the bond at the maturity date.
• For example, a bond may have a value of 5,000
  upon redemption at maturity.
• Bonds will also have interest payments, or a
  coupon rate which are usually paid yearly.
• For example, a 1,000 bond paying 5 coupon rate
  will yield an annual payment of 50.
• Stocks
• Mutual funds

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Financial linkages

• There are six financial markets linked with the
  inclusion of eurocurrencies
• We now have 6 prices to consider
• Interest rates
• U.S. interest rate (in US)
• U.K. interest rate (in UK)
• eurodollar interest rate
• eurosterling interest rate
• Exchange rates
• spot rate (dollars/pound)
• forward exchange rate (dollars/pound)

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International financial derivatives

• maturity mismatching borrow and loan for
  different periods
• future rate agreements forward purchase of
  fixed rate loan
• eurodollar interest rate swaps swapping fixed
  or flexible loan, or floating based on LIBOR with
  different based interest rate
• eurodollar cross-currency interest rate swaps -
  3 with different currencies involved

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continued

• eurodollar interest rate futures Set future
  purchases on margins in recognized exchanges (1
  mil basis point margins)
• eurodollar interest rates options (options on
  forward interest rates)
• options on swaps (just what it says)
• equity financial derivatives

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1. Maturity mismatching

• To hedge against a change in interest rate, a
  financial institution can acquire two or more
  financial contracts whose maturities overlap.
• Borrow short term and deposit long term to lock
  in current interest rate for later deposit
• Deposit short term and borrow long term to lock
  in current interest rate for later loan.

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2. Future Rate Agreements (FRA)

• Example
• Oly-west wants to borrow 1 mil in 6 months for a
  one-year period.
• They purchase a forward rate agreement at 5.5 .
  (the contract is for the rate, and there is a
  fee)
• If the market rate in 6 months is above
• 5.5 the seller pays Oly-west the difference
  between the two rates. (If rate is 5.7 seller
  pays 0.002X 1 mil. 2000)

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3. Eurodollar interest rate swaps

• This is similar to forward rate agreements,
  except
• there are two different kinds of interest rates
  for a number of time periods in the future
• it can involve two floating rates, one relative
  to LIBOR, another relative to a specific basket
  of currencies (floating-floating swap)

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4. Eurodollar cross-currency interest rate swaps

• This is similar to interest rate swap, but also
  includes currency swap.
• A holder of a fixed rate loan in one currency can
  change it for a floating rate in another
  currency.
• Or it can exchange a floating rate in one
  currency for a floating rate in a different
  currency.
• This one hedges the currency as well as the
  interest rate.

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5. Eurodollar interest rate futures

• These are similar to interest forward rate
  agreements, but with the same types of
  distinctions we see in future exchange rate
  agreements.
• they are transacted on organized exchanges (CME)
• they are for fixed periods (3rd Wed. of month)
• they are for fixed amounts
• gains and losses are paid daily in a margin
  account

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6. Eurodollar interest rate options

• Like exchange rate contracts, there is also an
  options market for interest rates
• Up until now, all contracts require an exchange
  to be made, whether the interest rate moves in a
  favourable direction or not.
• Again, as in exchange rate contracts, actors can
  participate in this option market by
• buying a call option
• selling a call option
• buying a put option
• selling a put option

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7. Options on swaps

• As financial instruments, caps were very
  successful.
• The market next introduced options on swaps
• It is, as the name implies, an option to swap
  interest rates
• purchaser of a call option to swap (swaption)
  has the right to receive a fixed rate in a swap
  and pay a floating rate.
• purchaser will exercise option if fixed rate is
  above floating rate

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8. Equity financial derivative

• So far, we have talked about derivatives of the
  exchange and interest rate markets
• In an equity swap, an investor can swap the
  returns on a currently owned equity to another
  investor for a price
• With international markets, investors in one
  country can buy and hold equities and agree to
  pay investors in another country the gains and
  losses for an agents fee.

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Chapter 22 Monetary Portfolio Balance
Approach to the BoP

• Monetary approach to BoP exchange rate
• Portfolio balance Approach
• Exchange rate overshooting
• Emphasis on money and financial assets as driving
  force of exchange rate movements
• Look at effect of macro variables on demand for
  money and bonds, examine effects on exchange
  rate.
• Look at effect of Ms on asset markets
• examine the dual effect of short-run, long-run
  through overshooting

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Money Supply

• First, basic equations
• Ms a(BRC) a(DRIR)
• Ms Money supply
• BR reserves of commercial banks (depository
  institutions)
• C currency held by the nonbank public
• a the money multiplier
• DR domestic reserves CB assets
• IR international reserves CB assets

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Money Demand

• The demand for money equation is
• -
  - ?
• L f(Y, P, i, W, E(p), O)
• The demand for liquidity (money is a liquid asset
  because it can be easily transferred) depends on
• income
• prices
• interest rate
• wealth,
• expected prices
• other things

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Monetary Approach to the Balance of Payments

• Effect of an increase in interest rate i
• If i increases, people want to hold less money,
• Ms gt Md
• Prices increase, currency depreciates

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Monetary Approach to the Balance of Payments

• The simple Monetary model crude monetary model
• Assume full employment.
• Ms kPY
• Y is fixed because there is full employment.
• If Ms rises, P rises proportionally.
• An expansion in the money supply will increase
  prices (inflation), causing a BoP deficit which
  will continue until prices stabilize at a higher
  level. (The effect is on current account)

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Two-Country Framework.

• The exchange rate equation
• e kBYBMsA
• 
  
  --------------------------------------------
• kAYAMsB
• tells us about the effect of money supply
  changes and income changes on the exchange rate,
  all else equal
• if MSA gt MSB then e rises, or country As
  currency depreciates
• if YA gt YB (and MS doesnt change), then country
  As currency appreciates.

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Portfolio Balance Approach to BoP and Exchange
Rates

• Emphasizes
• integration of financial markets across
  countries, people hold both domestic and foreign
  assets
• domestic and foreign assets are imperfect
  substitutes (there is a risk premium to holding
  foreign asset
• asset holders change portfolio in response to
  expected relative returns
• expectations are rational. People use all
  available information to form expectations.

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Money demand

• - - -
• L f(id , if , xa, Yd , Pd , Wd )
• (id , if ) if either interest rate rises, people
  will shift from money to interest-bearing asset
• (xa) if there is an expected appreciation of the
  foreign currency, there will be lower demand for
  money as people buy foreign bonds
• (Y , P ) If income or price rise, so does the
  transaction demand for money.
• (Wd) Similarly, people with greater wealth also
  want more cash on hand.

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Domestic asset demand

• - - - -
• Bd f(id , if , xa, Yd , Pd , Wd )
• if the home interest rate rises, people will
  purchase more domestic bonds
• if foreign interest rate rises, people will
  demand more foreign bonds and fewer domestic
  bonds
• if there is an expected appreciation of the
  foreign currency, there will be lower demand for
  domestic bonds as people buy foreign bonds
• If income or price rise, so does the transaction
  demand for money, and so people hold fewer bonds.
• If wealth increases, (all else equal) people buy
  more of every asset.

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Foreign asset demand

• - - -
• eBf f(id , if , xa, Yd , Pd , Wd )
• a rise in home interest rate decreases demand for
  foreign bonds
• a rise in foreign interest rate increases demand
  for foreign bonds
• an expected appreciation of the foreign currency
  raises the return from and demand for foreign
  bonds
• If income or price rise, so does the transaction
  demand for money, and so people hold fewer bonds.
• If wealth increases, (all else equal) people buy
  more of every asset.

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You should try toLook at effect of changes in

• Y, i, if , P, W, Yf on demand for each asset and
  consequently on the exchange rate or Balance of
  Payments
• Ms, supply of bonds.

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Exchange Rate Overshooting

• The interaction of a fast moving asset market and
  sticky prices cause overshooting
• Asset market equilibrium inverse relationship
  between prices and the exchange (P and e) rate
  P Md and so home currency appreciates
• Goods market equilibrium positive long-run
  relationship between P and e, P country is less
  competitive, e rises (home currency depreciates)

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Goods market - PPP

• e

P
A
A
L
E
P2
E
P1
G
A
A
e
e2
e3
e1
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Chapter 23 Price Adjustment Mechanism

• This chapter examines the REAL economy
• changes in traded goods and services in response
  to exchange rate changes (expenditure switching)
• important consideration of the conditions under
  which market reactions lead to a return to
  equilibrium
• examine adjustment mechanism under fixed exchange
  rates
• consider short-run and long-run how does the
  foreign sector lead to changes in home prices?

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Price Adjustment

• The supply of home currency is a derived supply
• it is derived from our demand for imports
• If our demand is inelastic our supply of currency
  curve slopes downward
• (similarly, the supply of foreign currency is a
  derived supply, based on foreign countrys demand
  for exports from us)

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Downward Sloping supply curve demand elasticity

• The important measures to determine stability are
  elasticities of demand (imports and exports)
• Elasiticity of demand is
• percentage change in quantity demanded
• percentage change in price
• Without calculus (called arc elasticity)
• ?arc (Q2-Q1)/(Q1Q2)/2
• (P2-P1)/(P1P2)/2

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Elasticity of demand and supply

• If the elasticity of demand for dollars is
  greater than one, then the supply of is
  downward sloping
• If the elasticity of demand for dollars is less
  than one, then the supply of is upward sloping.
• The next two graphs illustrate the connection
  between the demand for and the supply of .
• Recall the price of is e/ which is the
  reciprocal of the price of .

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Elasticity along straight line demand curve and
corresponding supply
e/
e/
S
? gt 1
a
c
? 1
b
b
c
a
? lt 1
D
0
0


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Stability vs. Instability

• The Marshall-Learner condition is
• (X/M)?Dx ?Dm gt 1
• If this condition is satisfied, then a
  depreciation triggered by a deficit will lead to
  a return to balance in the balance of payments.
• If there is a trade deficit, the demand for the
  countrys exports may be only slightly inelastic,
  but the condition may still not be satisfied.

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Price adjustment over time

• Given a deficit, currency will depreciate
• people reduce demand for imports, and the demand
  for exports increase
• How much?
• in the short-run, elasticities for supply and
  demand are smaller than long run elasticities
• in short-run, adjustment is too small, and so
  deficit will worsen
• in long-run adjustment is usually enough to
  reduce deficit

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Some actual elasticities

• Table 3, p. 572

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Short-run and long-run equilibrium

• In the short-run, there is an excess demand for
  foreign exchange. However, the short-run
  adjustment will lead to a larger deficit.
• Over time, the curves move and change shape. The
  supply becomes elastic and demand becomes more
  elastic.
• The short-run vs long run movements result in a
  j-curve that can be used to describe the movement
  of the currency over time.

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Graphical analysis
DG S(SR)
SG S(SR)
SG S
e
eeq
e0
DG S
0
Foreign Exchange
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Exchange rate pass-through J-Curve
(X-M) ()
Point of depreciation
(X-M) f(e, time)
Time
(--)
Note, there is a small deficit which triggers
depreciation. Then the deficit gets worse before
improving.
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Exchange Rate Pass-Through

• An important concept in the price adjustment
  mechanism is exchange rate pass-through
• If a 10 depreciation in a currency leads to a
  10 increase in import prices, then pass-through
  is complete.
• If it leads to a smaller percent change in
  prices, then there is not complete exchange rate
  pass-through
• For the US, exchange rate pass-through was as low
  as 22 in the 1990s, meaning a depreciation
  would have little effect on raising import prices.

69
Fixed exchange ratehow it works

• Assume three things
• currency is convertible to gold, gold is mobile
  both within and across countries
• the money supply is allowed to change in response
  to changes in gold holdings in a country
• prices and wages are flexible upward and downward.

70
Price adjustment under fixed exchange rate
Surplus

• If a country has a balance of payments surplus
• The central bank buys foreign currency to supply
  home currency needed for purchases.
• Then reserves flow into the country. (gold or
  foreign exchange)
• Home money supply increases
• Wages and prices rise, decreasing home
  competitiveness