ECONOMICS 3150B

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ECONOMICS 3150B

• Fall 2005
• Professor Lazar
• Office N205J
• flazar_at_yorku.ca
• 736-5068

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Lecture 2 September 13
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Link to Lecture Notes

• http//dept.econ.yorku.ca/flazar/3150/3150B-F05.ht
  m

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No class on September 15
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Balance of Payments

• Transactions resulting in payments to foreigners
  (conversion of C into foreign currencies)
  enters B. of P. as debit (-ve) purchase/import
  of goods, services, assets
• Transactions resulting in receipts from
  foreigners (conversion of foreign currencies into
  C) enters as credit (ve) sale/export of goods,
  services, assets
• Current Account transactions involving
  goods/services
• Merchandise trade
• Services tourism, transportation, financial
  services, business services, investment income
• Sum of all current accounts 0

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• Capital Account transactions involving assets
• Short-term ( lt 1 year)
• Long-term ( 1 year) direct investment
• Capital inflow credit in capital account
  Cerebus invests 250 M in Air Canada
• Capital outflow debit in capital account TD
  acquires US bank
• Official reserve transactions by central banks
  official settlement balance
• Unilateral transfers repatriation of income
  foreign aid
• Sum of all accounts 0 (equilibrium in foreign
  exchange markets)
• Debits ? supply of Canadian
• Credits ? demand for Canadian

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National Income Accounts

• Y (GNP) C I G EX IM
• Current account balance (CU) EX IM
• Y (C I G) CU
• Y lt (C I G) ? CU lt 0
• Domestic demand gt domestic production (case of
  US)
• CU ? net foreign wealth
• CU lt 0, ? US borrows from foreigners ? CA gt 0
• Net foreign debt ?
• CU gt 0, ? Canada lends (invests) to (in)
  foreigners ? CA lt 0
• Net foreign debt ?

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Savings and the Current Account

• SP (private savings) Y TR T C
• SG (government savings) T (TR G)
• SG gt (lt) 0 ? government surplus (deficit) -- ? (
  ? ) government bonds outstanding
• S SP SG Y C G I CU
• S gt 0 ? I CU gt 0
• Building up capital stock and/or acquiring
  foreign wealth (assets)
• S lt 0 ? I CU lt 0
• Building up foreign debt to finance investment,
  current consumption or government spending
• CU SP I SG
• If SG ?, CU also may ? (if SP and I do not
  change)
• Twin deficits CU lt 0 and SG lt 0

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Exchange Rate Markets

• Large Number of exchange rates
• Most important for Canada E US/Can
  E1/E
• As of 10/09/05 E 0.8503 E 1.176
• Depreciation (appreciation) ? E (? E )
• Exchange rates between Canadian dollar and other
  currencies e.g. Euro, pound, yen, peso, rupee,
  ruble, HK dollar, etc.
• Direct vs. cross exchange rates, e.g Can and
  Euro (Euros/C)
• Direct 0.6844
• Cross E(Euros/US) 0.85030.8049 0.6844

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Exchange Rate Markets

• Other exchange rates (as of 06/09/05) relative
  to C
• Australia 1.096
• Britain 0.4579
• Euro 0.6734
• India Rupee 36.52
• Japan Yen 92.23
• Philippines Peso 45.55
• South Korea Won 858.9
• Singapore 1.418
• Switzerland Franc 1.042
• Thailand Baht 34.58

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Revaluations of Exchange Rates and Impacts on
Relative Prices

• Prices of comparable Canadian and US goods
  expressed in same currency
• PCE PUS
• ? PCE/PUS
• Depreciation (appreciation) ?? ? ( ? )
• Example Bombardier selling Q400 to Horizon Air
• Price set in C or US?
• Set in US (US 20 M) no foreign exchange risk
  for Horizon Air
• Delivery in 6 months
• _at_ current E Bombardier will receive C23.5 M
• If C depreciates by 5 (E 0.808), Bombardier
  will receive C24.8M
• If C appreciates by 5 (E 0.893), Bombardier
  will receive C22.4M
• Implications for profit margins, pricing?

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Foreign Exchange Markets

• Participants
• Commercial banks
• Corporations
• Non-bank financial institutions
• Hedge funds
• Foreign exchange dealers
• Central banks
• Exchange rates spot, forward
• Rates move together
• Futures, options (call and put)

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Links between Spot and Forward Rates

• Covered interest rate parity
• Invest C1 for one year in Government of Canada
  bond at interest rate of R(1,C) 1 1R(1,C) ?
  C
• Invest C1 for one year in US Government bond at
  interest rate of R(1, US) 1E1R(1,US) ? US
  ? convert into C at end of year at spot exchange
  rate at that time (speculate) or enter into
  forward contract at beginning of year at forward
  rate of F
• For investor to be indifferent between two
  investments and not speculate 1R(1,C)
  E1R(1,US) /F
• ? R(1,C) E1R(1,US) F/F ? R(1,US)
  (E-F)/F ? R(1,US) (F-E)/E
• Covered return
• Forward premium on C when F gt E ? R(1,US) gt
  R(1,C)
• Forward discount on C when F lt E ? R(1,US) lt
  R(1,C)

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Hedging

• Eliminate foreign exchange risks resulting from
  possible revaluation of exchange rate
• Consider case of Bombardier selling RJs to
  Skywest 10 deliveries per year
• Consider exchange rate risk in first year
  assume that all planes are delivered at end of
  year and fully paid for at that time cost per
  plane US30 M
• Bombardier to receive US300 M at end of first
  year
• Foreign exchange rate risk How many C will
  Bombardier receive at end of year? Depends on
  value of spot rate at that time
• At current spot rate (E0.8503), US 300 M yields
  C353 M
• If C appreciates during year, US300 M yields
  less than C353 M
• If C depreciates, US300M yields more than 353
  M

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Hedging

• Options for Bombardier
• Speculate maximum exposure depends upon degree
  of appreciation
• Hedge avoid exposure
• Hedging options
• Forward contract lock in forward rate F(1) ?
  Bombardier will receive with certainty at end of
  year 300 M/F(1)
• Bombardier foregoes possibility of gaining from
  depreciation
• One-year futures contract
• One-year put option to sell US300 M and receive
  C ?? most costly form of hedging but allows
  Bombardier to gain from depreciation of C

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Demand for Financial Assets

• Relative expected rates of return returns on
  financial assets denominated in different
  currencies must be compared in the same currency
• Risk variability of expected return, default
  risk and expected losses in case of default
• Comparison of expected return for same degree of
  risk
• Diversification of portfolio to reduce overall
  risk for portfolio
• Liquidity cost/speed of converting asset into
  cash
• Precautionary motive for holding liquid assets