18. Capital Flows and the FX Market

Currency Market Quotes

• Traders quote the nominal exchange rate in the currency market, representing the price of one currency relative to another

Real Exchange Rate Calculation

• Comparing goods prices in two countries over time, along with the quoted foreign exchange rate, allows the calculation of the real exchange rate
• The real exchange rate is used to compare comsumption costs between two markets in conjuction with the foreign exchange rate (nominal exchange rate)

Retail Foreign Exchange Market

• The retail foreign exchange market includes transactions by households and small institutions
• These transactions may involve tourism, cross-border investment, or speculative trading

Sell Side of Foreign Exchange Markets

• Multinational banks that deal in currencies make up the sell side of the foreign exchange markets
• They act as primary dealers in currencies and originators of forward foreign exchange contracts
• Firms and investors that require foreign currencies or hedge risks are on the buy side

Crawling Bands and Exchange Rate Transition

• Crawling bands are most likely used when transitioning toward floating exchange rates in exchange rate regimes
• When managing exchange rates within crawling bands, the margin around a target exchange rate goes up over time
• This is used in the move from fixed to freely floating exchange rates

Forward Exchange Rate Defined

• A forward exchange rate is when two parties agree to trade a specific amount of one currency for another at a future date
• A spot exchange rate transaction occurs immediately
• A real exchange rate adjusts for relative inflation rates between two countries

Government Objectives and Capital Restriction

• Governments can reduce domestic assets and protect industries by imposing capital restrictions
• Other objectives include maintaining fixed exchange rates, and keeping domestic interest rates low

Trade Deficits Analysis: The Absorption Approach

• The absorption approach to trade deficits suggests that currency devaluation offers only a temporary improvement if the economy doesn't have excess capacity
• Long-term improvement requires either a smaller fiscal deficit or a larger excess of domestic savings over domestic investment

Narrowing Trade Deficits: The Marshall-Lerner Condition

• The Marshall-Lerner condition's approach suggests that a country's ability to narrow a trade deficit by devaluing its currency depends on the elasticity of demand for imports and exports
• The absorption approach implies national saving must increase relative to domestic investment for a currency devaluation to narrow a trade deficit

Nominal Exchange Rate Changes & Consumption Baskets

• If there are no changes in the price representative consumption basket in two currency area over the measurement period, changes in the nominal exchange rate are equal to changes in the real exchange rate
• Real interest rate = nominal interest rate × ratio of consumption basket (index) price levels of 2 countries
• Fisher relation for two countries: (1 + Rnominal A)/(1 + Rnominal B) = (1 + Rreal A) [1 + E(inflationA )] / (1+ Rreal B)[1 + E(inflationB )]

Real Exchange Rate Calculation (Example)

• Real Exchange Rate = 0.75 BDE/TOL × 110/105 = 0.79 BDE/TOL

"Real Money Accounts" in Foreign Exchange

• Insurance companies are commonly considered "real money accounts"
• Real money accounts in foreign exchange markets are buy-side investors that do not use derivatives
• Mutual funds and pension funds can be classified as real money accounts
• Hedge funds typically use derivatives
• Central banks may intervene, and usually do not act as investors

Balance of Payments and the Absorption Approach

• The elasticities of demand for exports and imports are key needed to move a country's balance of payments towards surplus
• The decreasing domestic expenditure relative to income is equivalent to increasing domestic savings

Government Objectives for Capital Restriction

• A government that imposes restrictions on capital flows into or out of its country is most likely trying to reduce the volatility of domestic asset prices

Factors Related to Differences in Real and Nominal Exchange Rates

• The ratio of the two countries’ price levels causes the difference between country D's nominal and real exchange rates with Country F
• Real exchange rate (D/F) = nominal exchange rate (D/F) × CPIF/ CPID

Exchange Rate Regimes and Currency Control

• A country can participate without giving up its own currency when using a target zone or conventional fixed peg
• Formal dollarization or a monetary union means a country does not have its own currency
• Currency Boards, conventional fixed pegs, target zones, and crawling pegs use another currency or a basket of currencies

Conventional Fixed Peg Arrangement

• Akor's exchange rate againsnt eh currnecy to which it pegs may flucturate around the peg rate by ±1%

Target Zone Regime

• In a target zone of a central bank, a monetary policy goal of a stable exchange rate with the euro has deviations of no more than 3% from its current exchange rate

Exchange Rate Appreciation

• EUR has appreciated 2.19% relative to the CNY if the exchange rate for Chinese yuan (CNY) per euro (EUR) changed from CNY/EUR 8.1588 to CNY/EUR 8.3378 over a 3-month period
• The percentage change in the CNY is [(1 / 8.3378) / (1 / 8.1588)] – 1 = –0.0215 = –2.15%.

J-Curve Effect and Trade Deficits

• The J-curve effect describes currency depreciation that increases a country's trade deficit increase over time
• Import and export contracts may be fixed in foreign currency units, and only reflect the rate change over time, currency depreciation should decrease a trade deficit in the long run

Forward Market Participants

• Long-term investors are least likely to participate in the forward market
• Forward contracts are for 30, 90, 180, and 360-day periods making them short-term choices
• Hedgers use forward contracts to protect the home currency value of foreign currency

Calculating Currency Appreciation/Depreciation

• The British Pound (GBP) has appreciated againsnt eh AUD by10.1%
• GBP (1.6300 / 1.4800 −1 = 10.1%) since The exchange rate for Australian dollars per British pound (AUD/GBP) was 1.4800 five years ago and is 1.6300

EUR/JPY Exchange Rate Changes

• Value of the EUR has Appreciated by 5.1% because the exchange rates are quoted with the EUR as the base currency, the percentage change is simply 103.00 / 98.00 − 1 = 5.1%.

Leveraged Accounts in Foreign Exchange

• Leveraged accounts in the foreign exchange market refer to investment accounts that use derivatives

CAD and U.S. Goods

• The CAD appreciated and Canadians will find U.S. goods cheaper
• because the CAD is now more expensive in terms of USD

Real Exchange Rate Decrease Factors

• Other things equal increase in the domestic price levels

Governmental Capital Restrictions: Objectives

• A common objective of capital restrictions is to keep domestic interest rates low