International Finance: a Foreign Exchange Regimes

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International Finance (a) Foreign Exchange
Regimes

• Dr. K. Ramakrishnan

Fall 2007
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International Finance Module

• Disclaimer
• This is just a peek into a very important area of
  finance / business.

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International Finance Class

• Todays class (Available on the web so download
  and use, if not done already)
• Forex Regimes.
• International Parity Conditions
• Purchasing Power Parity
• Interest Rate Parity
• Forward Rates as Unbiased Predictors of Future
  Spot Rates
• International Investment Flows
• Managing International Risk (for Info. Brealeys
  PowerPoint)

4
International Finance Forex Session

• Ill focus class-time on concepts / calculations
• Information type materials available on the
  site and wont devote class time to that.

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Forex Regimes - review

• Background Legal tender in one country may not
  be acceptable in another, absent convertibility
  and confidence in its quality/value.
• Purchasing Power of currency vital. If it
  decreases in the country, it will also outside.
• Govt... policies may range from fixed rates to
  free floating and a whole gamut of options
  within these extremes.
• ..(see next slide)

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Foreign Exchange Regimes

• Policies Range from
• Fixed (Managed/Dirty Float)Free Float
• Declare and defend a par value..
• Deliberate Choice
• Forex market huge, less regulated,
  de-centralized
• Countries have limited ability to fix rates.
  Need actions taken in the real economy - trade,
  capital flows etc.
• Choice of Regimes and Implications
• Size, scale of economy open-ness issues
• Dependence on foreign capital flows.
• Balance of payments - issues.
• Enforcement Implications.

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Forex Regimes

• Govt... policies may range from fixed rates to
  free floating (gamut of options within these
  extremes.)
• FIXED RATE regime Govts. declare defend a
  Par value or price
• intervening as needed to accomplish this.
• need reserves or access to Forex
• mechanisms to limit / manage investment trade
  flows.
• Monitoring mechanisms, enforcement, black markets
  etc..

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Forex Regimes (contd.)

• Free Floating Regimes Markets determine rates.
  What are some implications?
• Prices
• Role of Govt...
• Corporations/ Individuals.
• Predictability / Forecasts.
• Economy.

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Forex - Floating Rate Regime (contd.)

• Philosophy
• Govts. can / should set rates gt Managed Floats
• Govts. cant / shouldn't set rates gt Free Floats
• If rates change due to underlying
  economic/political causes, govt. may be unable to
  maintain target rates without substantial costs /
  dislocations
• For short-term factors, govt. can/may be able to
  smooth the path of rate changes.

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Forex - Managed Rate Regimes

• Rate Fixed v/s Target price based on
  fundamentals
• Implementation
• Peg v/s crawling peg
• Basket of Currencies - choice weight
• Index - eg. SDRs
• Effect Rate impacts economic activity, relative
  competitiveness of Imports v/s Exports sectors,
  and hence wealth transfers.

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Forex. Regimes - Summary

• Choice of regimes has important effects on the
  country and on the expectations from the
  governments.
• Since Forex Markets are huge, it is nearly
  impossible to maintain rates, not justified by
  fundamentals (speculation role)
• Intl co-ordination is important and increasing,
  and major countries consult, co-operate,
  co-ordinate policies.
• Beyond Fixed Rates

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Beyond Fixed Rate Regimes (1 of 2)

• Minimal Govt. intervention gt Free Floating Rate
  Systems
• Fixed Rate systems, obligate the governments to
  intervene and maintain a stated rate.
• Credibility and confidence in government ability
  and willingness to intervene and maintain rates
  is vital. Loss of confidence in government is
  expensive.
• 3 variables
• Forex Rate Variability
• Open Economy (relatively free imports and
  exports, and no CAPITAL FLOW CONSTRAINTS) and
• Monetary Policy Independence.
• Cant control all the 3 elements above. Strict
  fixed rate means that underlying economy will
  need to make the adjustments

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Beyond Fixed Rates ( 2 of 2)

• Govt.. can signal voluntary surrender of monetary
  policy options
• Currency Boards (on-going Argentina experience)
  
• Common Currency eg. European Currency Union
  and Effects
• Dollarization
• Details of these policy choices follow. Each has
  its own costs benefits

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Currency Boards - (background)

• Widely introduced in British colonies (19th
  century)
• Hong Kong, reintroduced currency board (1983)
• In 1991 Argentina and 1992 Estonia adopted
  currency board arrangements.
• Urged adoption in Mexico, Russia, and Ukraine

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Currency Board (logic and operations)

• Reasons
• Disenchantment with Central Banks susceptibility
  to political pressure to finance deficits
• Central Banks use of discretion
• Currency Boards essentially are
• Monetary rule equating Change in Monetary Base to
  the BOP Surplus or Deficit
• Credible defense of Fixed Exchange rate while
  giving up Monetary sovereignty

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Currency Board Advantages / Disadvantages

• Advantages
• assurance of convertibility at fixed exchange
  rate,
• pressure to maintain macroeconomic discipline,
• the provision of a built-in mechanism for balance
  of payments adjustment, and,
• so, the maintenance of confidence.
• Disadvantages include loss of ability
• to tailor monetary policy to a country's own
  situation and
• to use changes in the exchange rate to adjust
  balance of payments.
• May facilitate Capital Flight (Indonesia)

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Currency Boards - examples
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The Euro

• Economic Integration of Europe
• Since 1992, relatively free movement of goods and
  people across national borders
• Creation of supra-national bodies (court,
  parliament, now Europe Central Bank)
• Monetary Union and Single Currency
• Introduced the Euro - outside the control of
  any one individual country
• Implications

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International Parity Conditions

• Money Forex Markets are related, and with
  appropriate transactions, one can create
  synthetic contracts to give same cash flows.
• Contracts with same cash flows will sell for same
  price - else arbitrage possible.
• Basic Relationships
• a) Fisher Effect Nominal rates in a country
  real rates expected inflation.
  (internationally too!)
• b) P.P.P. Arbitrage in goods market creates one
  price world-wide for products.

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International PARITY Conditions

• Expectations, Hard to Measure

Actual, Can TRADE
SF
Predictive
Expected Difference in INFLATION Rates
Difference in Interest Rates



IRP
PPP
Predictive
Difference between SPOT and FORWARD rates

Expected Change in Spot Rate
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International Parity Conditions

• PPP
• absolute form law of one price
• relative form permits existing dis-equilibrium
  but relates future changes in inflation to
  changes in spot forex rates.
• Goods Arbitrage relatively high transactions
  costs, greater market segmentation possibilities,
  and hence PPP may work only in the long term.

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International Parity Conditions

• IRP
• In eqbm., expected real return on capital is the
  same across different countries (else, capital
  flows from low to high return countries)
• Covered Interest Arbitrage relatively low
  transactions costs, lower market segmentation
  possibilities, and hence IRP expected to work
  even in short term.

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Covered Interest Arbitrage

• Borrowing in one currency, converting Spot into
  another, and lending that currency is equivalent
  to a forward market transaction.
• Example
• a) Opportunities may be few and of short
  duration.
• b) Unless arbitrage is disabled, will work.

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An example

• Spot rate for Indian Re. is 48.50 / US.
• Interest rates
• India 10 per annum
• US 4 per annum
• What should the 3 month forward rate have to be?
  Why?
• If you are quoted 3 month rate of 48.75 Re/, can
  you arbitrage? Exact Steps?

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Covered Interest Arbitrage

• All such transactions involve bridging markets.
  Two money markets (Re and ) where one can
  borrow or lend and two forex markets (Spot
  and Forward) where one can buy or sell a
  currency.
• Given any 3 of the rates, the 4th is uniquely
  determined. If that rate does not hold, then we
  have Arbitrage possibilities.
• For our purpose (understanding the logic and
  developing a framework) we ignore transactions
  costs, bid-ask spreads and assume same borrowing
  and lending rates. the only compromise is that
  in real life with these factored in, there is
  more leeway for rates to vary a bit.

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Next - Foreign Investments!

• Do keep working!
• Dr. Ram
• www.usd.edu/kramakr
• 605-677-5549 (Direct - work)
• 605-677-5455 (Dept.)