ECONOMICS 3150B Lecture 7 October 6, 2005

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ECONOMICS 3150BLecture 7October 6, 2005
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Test on Tuesday, October 11 _at_ 1255-220PMNo
class on Thursday, October 13
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Responsible for Test 1Part 1 Currency
Markets, Exchange rates, Currency markets, Fixed
vs. flexible exchange rates, Common currency
areaReadings chs. 12, 13, 14, 15, 17, 18, 19,
20, 21
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Bank of Canada Balance Sheet

• Assets
• Domestic assets Government of Canada bonds
• Foreign assets Foreign currencies, gold, foreign
  Government Treasury Bills (T-bills)

• Liabilities
• Deposits held by private banks
• Currency in circulation

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Fixed Exchange Rates Policy Effectiveness

• B. of C. committed to maintaining value of
  exchange rate
• Consider case ??
• Traditional D/S model
• ? in D for C, ? in S of C
• In absence of intervention, C depreciates in
  value (E?)
• To keep exchange rate constant, B. of C. either ?
  M ? ?R or intervene directly and buy C (sell
  foreign assets)
• Consider direct intervention requirement for
  foreign asset reserves
• Problem can B. of C. persist in buying C?

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Direct Intervention Sell foreign assets
E
S of C imports

E0

D for C exports
Q(C)
S
D
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Flexible Exchange Rates

• Independent monetary policy not constrained by
  need to keep exchange rate fixed at particular
  level
• Fiscal policy ineffective
• Expansionary policy ?? R ? ? E ?? EX gS and ? IM
  gS ? ? aggregate demand
• Combination of higher interest rates and
  appreciation of C neutralize expansionary
  effects of fiscal policy
• Ignoring effects on P and repercussions on
  aggregate D for gs
• Degree of independence
• US ? M to stimulate economy and reduce UR
  (Canadian policy-makers likely to have same
  objective)
• US actions will lead to appreciation of C (? in
  US GDP ? ? Canadian CU and ? R(US) ? ?Canadian
  CA) which will reduce positive spillover effect
  from US
• flexible rates will require B. of C. to follow
  lead of US Federal Reserve

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Flexible Exchange Rates

• Automatic stabilizer
• Increase in rate of inflation in US
• R(C) R(US) E(e)-E/E ?
• E(e)-E/E ?E(e) ?P(C) - ?P(US)
• Assume ?P(C) ?P(US) ?P(D) ? initially
  ? ?E(e) 0
• Now assume ?P(US) ? ? ?E(e) lt 0 ? E ?
  (appreciation)
• P(C) P(D)?P(US)E1-? ??P(C) ??P(D) (1-
  ?)?P(US) ?E(e)
• ?P(C) ?
• If ?P(US) ? ? ?E ? ? offsetting impact on
  ?P(C)
• With fixed exchange rates
• If ?P(US) ? ? ?P(C) ?

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Dollarization

• Problems with flexible exchange rates
• Effectiveness of independent monetary policy
• Trade costs hedging
• Competitiveness incentives
• Instability of foreign exchange markets
  tendency to overshoot

• Problems with Dollarization
• Loss of independent m.p.
• Loss of automatic stabilizer
• Economic performance and sovereignty

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International Capital Markets

• Group of closely interconnected markets in which
  assets trade
• Foreign exchange markets part of international
  capital markets
• Debt, equity, futures, options, commodities,
  currencies, etc.

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Diversification

• Risk reduction
• Same expected return, lower risk for portfolio
• Higher expected return, same degree of risk
• Risk aversion
• Risks
• Default
• Price variability
• Exchange rate
• Imperfect information
• Insurance markets financial and non-financial
  risks
• Spread risks re-insurance, insurance pools
• Pooling of risks insurance pools
• Derivatives

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Sovereign Debt and Defaults

• Private debt CCAA, ch. 11
• Convert debt into equity
• Convert into new debt with lower face value and
  lower interest rates
• Receive cash for fraction of value at maturity
  (pennies on the dollar)

• Sovereign debt
• Conversion into equity not an option
• Convert into new debt with lower face value and
  lower interest rates
• Defer interest and principal payments, possible
  reduction in interest rate
• Receive cash
• IMF provides new loans to make payments on
  outstanding debt loans generally made with
  conditions (re. macroeconomic policies reduce
  debt, low inflation rate targets microeconomic
  policies privatization, deregulation) ?
  beneficiaries are current creditors

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Offshore Banking and Eurocurrencies

• Offshore banking
• Business conducted by the foreign branches,
  subsidiaries of a bank outside the home country
  of the bank
• Eurocurrencies
• Bank deposits denominated in a currency other
  than the domestic currency of the country in
  which the bank or its foreign operations reside
• Offshore currencies
• Typical Eurocurrency deposit is non-negotiable
  time deposit with fixed term to maturity ranging
  from overnight to 5 years
• US deposits in a bank in Canada (Canadian, US,
  other) part of Eurodollars Eurodollars US
  deposits in banks outside US
• C deposits in a bank outside of Canada
  (Canadian, other)
• Eurobanks banks that trade in market for
  Eurocurrencies take deposits, make loans
• Most Eurocurrency trading occurs in non-European
  centers

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Rapid Growth of International Banking

• Reduction in trade costs ? growth in
  international trade
• Hedging currency risks
• Liberalization of capital markets
• Growth of MNEs -- banks have followed corporate
  customers abroad
• Circumvent restrictive domestic government
  regulations on financial activity reserve
  requirements, interest rate ceilings, deposit
  insurance
• Political factors desire by some depositors to
  hold currencies outside jurisdiction of countries
  that issue them freezing accounts

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Creation of Eurocurrencies

• Bombardier sells US 30 M RJ to Comair, Delta
  Airline subsidiary Delta pays initial deposit
  of US 3 M by check drawn on US bank (Chase)
• Options for Bombardier
• Convert to C at current spot rate (E)
• Keep US (required for purchases of engines,
  avionics, consulting services, etc.)
• Buy US TBs
• Buy CD from US bank
• Buy Euro-US dollar deposit from Royal Bank branch
  in Montreal
• Only this option leads to creation of Eurodollar
  deposit no change in US money supply

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Creation of Euro-US Dollars

• Bombardier
• Asset US Deposit with RB (Montreal)
• Liability US customer advances
• Comair
• Asset US customer advance
• Liability US loan from Chase
• Chase (Atlanta)
• Asset US Loan to Comair
• Asset -US deposits with Fed

• Royal Bank (Montreal)
• Asset US Deposit with DB (Frankfurt)
• Liability US Deposit of Bombardier
• Deutsche Bank (Frankfurt)
• Asset US Deposit with Citi (NY)
• Liability US Deposit of RB
• Citi (NY)
• Asset US deposits with Fed
• Liability US Deposit of DB

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Vulnerabilities

• Inter-bank lending (as in preceding example)
  hierarchy of banks
• Offshore bank in turn lends to another bank
  interest rate on Eurodollar deposits increase as
  the money moves up the hierarchy of banks
• At top of the hierarchy, much greater default
  risk than at bottom
• If bank or ultimate borrower at top defaults,
  default could create domino effect Royals
  exposure may be much different because of
  interbank lending

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Counter-Party Risks

• Derivatives
• Call option right to buy a fixed amount of a
  financial assets at a pre-determined price at a
  pre-determined future date
• Exercise option What is counter-party (seller of
  option) has disappeared?
• Interest rate/currency swaps

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Swaps and Comparative Advantage

• Two companies
• A (US multinational) can borrow medium-term
  (5-year bonds) at 100 basis points above US
  Government bonds (4.19) and 150 basis points
  above Government of Canada bonds (3.65)
• B (Canadian multinational) can borrow medium-term
  at 200 basis points above US Government bonds and
  100 basis points above Government of Canada bonds
• B has comparative advantage in Canada, A in US
• A US to Canada 23 Canada to US 32
• B US to Canada 21 Canada to US 12
• A needs to hedge against Canadian revenues B
  needs to hedge against US revenues
• in absence of swap agreement, A issues debt in
  Canada at 5.15, B issues debt in US at 6.19

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Swaps and Comparative Advantage (Contd)

• Swap agreement for five years
• A issues debt in US at 5.19, B Issues debt in
  Canada initially at 4.65 (identical principal
  amounts involved)
• A and B swap interest payments
• Net interest rate for A 5.19 - 5.19 4.65
  4.65 in Canadian
• Net interest rate for B 4.65 4.65 - 5.19
  5.19 in US
• Counter-party risk A or B defaults
• Swap market financial institutions operate as
  intermediaries between floating-rate and fixed
  rate payers, and between payers in different
  currencies