Foreign Exchange Market PDF

Introduction The foreign exchange market is where the various national currencies are bought and sold. Exchange rate definitions The exchange rate is the price of one currency in terms of another. Specifically, we have 2 equivalent definitions: Unit of foreign currency per unit of domestic...

Introduction The foreign exchange market is where the various national currencies are bought and sold. Exchange rate definitions The exchange rate is the price of one currency in terms of another. Specifically, we have 2 equivalent definitions: Unit of foreign currency per unit of domestic currency → how many of foreign units I need to buy ONE unit of domestic currency. Unit of domestic currency per unit of foreign currency→ how many domestic units of currency I need to buy ONE unit of foreign currency (most used) The bid rate is the rate at which a bank will buy a currency, while the offer rate is the rate at which the bank will sell its currency in exchange for dollars. The difference is known as the bid-offer spread and represents the gross profit margin of the bank. Characteristics and participants of the foreign exchange market Exchange rates are treated like “normal securities” (they represent the price of one currency with respect to another). As all financial securities, we have “offer prices”. There is an offer price for each currency, but the mostly used one is the dollar $. Since $ is so heavily traded, it is cheaper for a EU dealer to buy USD with € and then sell $ to buy Pesos, rather than buying Pesos with €. Participants in the market: Retail clients→ businesses, investors, MNCs, etc: they buy / sell orders Commercial banks→ they buy / sell orders from retail clients and buy / sell currencies on their own account. Distinction to be made: o Dealer→ trades for himself and keeps the liquidity in the market. He does market making. Only 20/22 banks have this power (since it is very risky): JP Morgan, Deutsche Bank, Credit Agricole, Lazar, Nomura, etc). Dealers can only work for themselves and others (like brokers) by having someone else manage a part of their portfolio devoted to broking. o Other commercial banks→ mere intermediaries Foreign exchange brokers→ they collect buy / sell quotations from many banks and try to obtain the most favourable quotation quickly and at low cost. They take orders and execute them at that price. They do not trade for themselves. Only disadvantage→ brokerage fee. Central banks→ they buy units of currency for securities denominated in a currency, or vice versa (securities for currency). They thus exchange currencies and securities to influence the rate. Arbitrage in the foreign exchange market Arbitrage is the exploitation of price differentials for riskless guaranteed profits. There are two types: 1.) Financial centre arbitrage→ it ensures that the exchange rate is the same everywhere for the same currency (same dollar – pound rate in Ney York and London) 2.) Cross currency arbitrage→ it ensures that if $/£ = 1.35 and $/€ = 1.21, then €/£ = 1.108 in order to avoid illegal actions. (1.108 = 1.35 / 1.21) The spot and forward exchange rate Two types: 1.) Spot exchange rate→ it is the quotation for immediate delivery. We pay that price for immediate delivery of currency. 2.) Forward exchange rate→ quotation for contracts agreed upon today for a delivery of the currency in a later time (ex: 3 months), when the physical transaction occurs. There is another sub-distinction: Forward contracts→ NOT standardized: they are tailor made on the specific needs. The quantity to be exchange is not pre-defined, as well as all the conditions in the contract. It is NOT NECESSARILY listed in a market Future contracts → standardized contract: the quantity associated to each contract is specified. Ex: contract A gives the possibility to exchange 100€. They are listed in the market. Advantages and disadvantages of forward and future contracts: Forward contracts o Advantages→ give more flexibility (not constraint to size of contracts) and they have no standardized MATURITY (1 month, 2 months, etc like in a future contract). They are typically more stable. o Disadvantages→ can be at risk if one of the 2 does not follow the engagement of delivery of the agreed amount of currency. Ex: one party may refuse or give less amount. Therefore, contracts mature but risks not to be EXECUTED. Future contracts o Disadvantage→ they can be too volatile o Advantage→ future contracts are listed on official markets, therefore there are many WARRANTIES, such as clearing houses→ contracts are not bilateral, the cleaning house is an agent which has the obligation to execute the contract. If A does not execute it, it must deal with the clearing house, which will law suit it. Nominal, real, and effective exchange rates There is an additional distinction: 1.) Nominal exchange rate→ what prevails in the market at a given date (S). It does NOT consider the “relative purchasing power of domestic and foreign entities” (we do not consider the difference in purchasing power). It is for “paper money”-  Appreciation and depreciation of the nominal exchange rate does not imply that the currency becomes less or more competitive on international markets. 𝑃 2.) Real exchange rate→ RER = 𝑆 ∗ 𝑃∗ S = spot exchange rate (nominal) P = domestic price level P* = foreign country price level Here, we consider the differences in the price level between countries. It is for “physical goods” → if 2 countries produce homogeneous goods, how many good of country A do I need to buy one good of country B? EXAMPLE: a real appreciation of the pound makes the UK goods more expensive for US residents as they will have to spend more to purchase the original basket of UK goods 3.) Effective exchange rate→ it is the measures of whether the currency is appreciating of depreciating against a basket of foreign goods, not only one single currency. a. Nominal effective exchange rate→ 1 currency exchanged versus a basket of currencies. b. Real effective exchange rate→ domestic price level versus the price level associated to the basket of currencies of countries. EXAMPLE: UK trades 70% with EU and 30% with USA. In the effective exchange rate, US $ has a 30% weight and EU € a 70% weight. If both foreign (€ and $) currencies appreciate, more weight is attached to €. A simple model of the determination of the spot exchange rate The exchange rate (price) of a currency can be analysed like any other price using the tools of demand and supply. As if fluctuates, demand and supply vary. The demand for foreign exchange The demand for currencies is a derived demand as currencies are demanded not for an intrinsic value but for what they can buy. Typically, as a currency appreciate against others, the price of the country’s exports to others increases. The curve slopes downward: when the exchange rate € appreciates, you need more dollars to buy one unit of €, and thus $ depreciates. Therefore, domestic goods are less competitive (EU) and we have less demand for domestic currency. On the contrary, when € depreciates, it is cheaper to buy EU goods and demand for euro increases. Shifts in demand can depend on exogenous factors: a rise in income, change in foreign taste in favour of domestic goods and rise in price of foreign goods will increase demand (red). Opposite actions will decrease demand (green). Increase in the demand for domestic currency→ appreciation Decrease in the demand for domestic currency→ depreciation The supply for foreign exchange If € appreciates, the cost of foreign imports decreases (we increase its demand) and we reduce the demand for EU goods. Thus, we increase the demand for $, which are purchased by increasing the amounts of € supplied (supply is upward sloped). It can shift for: Change in domestic taste for foreign gods (taste increases = red) Change in income (higher domestic income = red) Increase in the domestic supply→ depreciation Decrease in domestic supply→ appreciation The spot exchange rate is determined by the intersection (equilibrium) of the supply and demand for the currency. Yet is the exchange rate free to fluctuate as the market of commodities is? NO→ it has constraints. Alternative exchange rate regimes Three of them: Pegged exchange rate→ with the 1948 Bretton Woods conference a pegged exchange rate system against the USD emerged. Flexible/ floating exchange rate→ exchange rate is free to fluctuate (as commodities), and it moves to clear up the excess demand and supply. EXAMPLE: an increase in the demand for UK exports increases the demand for pounds, and thus appreciated the £.  Fixed exchange rate→ exchange rates are fixed by central banks and move quantity of money to keep it as such (ex: selling and buying bonds1). EXAMPLE: if appreciation is considered as dangerous as it would hit the economy’ exports, the bank intervenes to depreciate the currency. How? Two ways: o Non-sterilized intervention→ buying/ selling of bonds and currencies affects the money supply and the interest rate. How? It occurs preventively when there are pressures that the value of the exchange rate will shift. o Sterilized intervention→ buying/ selling of bonds and currencies does NOT affect the money supply and interest rate. How? It occurs after that non-intervention has allowed fluctuations to increase / decrease money supply and interest rate. Sterilized interventions risk overshooting the inflation target as, raising / decreasing the interest rate, will tend to increase / decrease the attractiveness of the currency shifting demand again (MS and i return to the levels before the market intervention) Why do sterilized interventions exist? They aim at having a psychological impact on market participants whilst sticking to its monetary and interest rate targets. Our regime: dirty float regime What is our regime? A perfectly flexible exchange rate has existed for a short time after 1971 (Nixon Shock). Before WW2 exchange rate were fixed because they were all anchored to the Gold Standard. Now, we live in a regime of managed exchange rate (dirty float)→ central banks are free to correct the behaviour of exchange rates. Thus, increasing the demand for €, we have an increase of the exchange rate. On the contrary, with supply shocks the domestic exchange rate increases. (go over the LM-IS model) Money demand and money supply in fixed exchange rates 1st image→ demand shock. 2nd image→ supply shock 1 One specific type of bond are “consols” = perpetual bond which pays interest with no maturity date where the principal is not paid at a specific date, but the bondholder receives periodic interest payments for as long as the bond exists.  In both cases, the graph of demand and supply for currency looks at such. In the first case (demand shock), E will initially reach where S1 and D2 cross, with a higher E. The CB will rise the domestic money supply and re-low E (from Ms1 to Ms2). In the second case (supply shock), E will initially reach where S2 and D1 cross, with a lower level. The CB will reduce the money supply and raise E (from Ms2 to Ms1). Money demand→ 𝑴𝒅𝟏 = 𝑳 ( 𝒚, 𝒊) ∗ 𝑷 y = aggregate income i = nominal interest rate P = price level As income (y) rises, 𝑀𝑑1increases as I would like to have more money to perform transactions. As interest rate (i) goes up, I’ll invest more, and 𝑀𝑑1will decrease (I keep less liquidity). Money supply → managed by the Central Bank according to Assets (bonds B, foreign reserves F), and Liabilities (monetary base H = cash money). The CB creates money through open market operations = selling and purchase of government bonds / foreign reserves. To increase the monetary base H, I buy bonds B through money printed M (money printed). Assets will increase, bonds B increase, and liabilities will increase (H increases). We go from 𝑀𝑠1 to 𝑀𝑠2 , while i decreases. If H were to increase, and i were to remain fixed, we would h→ theave excess supply of money. To clear it up, the interest rate (“price of money”) decreases, so people are incentivized to switch from bonds to liquidity. The Leon Walras Law Why can we focus on the money market without discussing whether the equilibrium suits the bond market? Thanks to the Leon Walras Law→ “general equilibrium theory”, where if n – 1 market are in equilibrium, all the n markets will be in equilibrium. If money market is in equilibrium, then also the bond market will be. In fact, price of money = price of bonds = interest rate. The determination of the forward exchange rate: interest rate parity condition Covered Interest Parity Condition How does the exchange rate accommodate in response to changes in interest rate? Consider that: F = 1-year forward exchange rate, S = spot exchange rate, i = 1-year domestic (UK) interest rate, i* = 1-year foreign (USA) interest rate.  If we invest 1 £ at i, after 3 months we get: 1 ( 1 + i) = 1 + i if we exchange 1£ in S $ and we invest in i*, after 3 months we get: S ( 1 + i*). The final sum (after 3 𝑆 ( 1+ 𝑖 ∗ ) months) can be converted back in £ as: 𝐹 = 𝐹 (forward rate). In equilibrium, these will be equal, as there are NO arbitrage opportunities. Therefore: 𝑆 1+𝑖 = ( 1 + 𝑖 ∗) 𝐹 This is the Covered Interest Parity Condition: it must be thus EQUAL to invest in the two countries to avoid arbitrage opportunities. This formula can be mathematically rearranged as: If F differs from what has been predicted from the last equation, there would be arbitrage opportunities. Numerical example: to understand why CIP must be used to calculate the forward exchange rate (ex: $1.29/1£), let’s see what would happen F was different than the calculated one (ex: $1.25/1£), with i* = 0.02, i = 0.06, and S = $1.35/1£: A UK investor with £100 could have £106 by the end of the year A UK investor selling £ spot to $ at 1.35 (thus obtaining 135$, which become 137.7$ at the end of the year with an interest rate of 0.02) while simultaneously buying £ forward at 1.25 (thus selling 137.7$ at the end of the year in pounds, giving him 110.16£). Only if the forward exchange rate is $1.29/1£ would he get 106£ in both methods. Approximated Covered Parity Condition Approximating (1 + i) to 1, we get the approximate version of the CIP, which equals to: 𝐹−𝑆 = 𝑖∗ − 𝑖 𝑆 This can be read as such: if the domestic interest rate is lower than the foreign interest rate, then the domestic currency will be at t forward premium by an equivalent percentage on an annualized basis. The forward currency should be depreciated with respect to the spot, in order to compensate for the higher level of return earned by investing in foreign currency.  𝐹−𝑆 𝑖∗ = 𝑖 + represents the effective return on a foreign investment. 𝑆 Participants of the forward exchange market The forward exchange markets is where buyers and sellers agree to exchange currencies a some specified date in the future. What are the participants? 1.) Hedgers→ usually firms that want to protect against exchange rate fluctuations that imply exchange rate risk (exchange risk = risk of loss due to adverse movements). Why to join this market? Because a forward exchange contract ensures that the amount of currency paid in the future, not touched by fluctuations. Why not to do it now to avoid uncertainties? Because firms might not have the money 2.) Arbitrageurs→ usually banks that aim at riskless profit due to discrepancies between interest rate and “forward discounts” / “forward premium” a. Forward premium→ forward exchange rate appreciation compared to spot (F > S) b. Forward discount→ forward exchange rate depreciation compared to spot (F < S) Their presence ensures that the so-called Covered Interest Parity (CIP) condition holds, 3.) Speculators→ they are agents who hope to make a profit by accepting exchange rate risk, believing that the future sport rate will be different to the quoted forward rate. The interaction of traders, hedgers, arbitrageurs, and speculators F is determined by the interaction of these agents. Fundamental condition: for every forward purchase there must be a forward sale of the currency so that the excess demand for the currency sums to zero 𝑁𝐷𝐻 + 𝑁𝐷𝐴 + 𝑁𝐷𝑆 = 0 NDH = net demand of hedgers, NDA = net demand of arbitrageurs, NDS = net demand of speculators. Graphically: AA= forward exchange rate consistent with CIP. Since £ is at forward discount, the interest rate in UK is > then in USA. Dh is the hedgers’ net demand in the forward market. Ds is the demand for forward speculators ($1.22/1£ represents their average forecast = they will be net sellers of pounds if the rate is above 1.22, because they expect to sell pounds at greater price in the future). Uncovered Interest Rate Parity Conditions (UIRPC) In all the previous equations, called covered conditions, everything was known (S, i, i*, F), as they are all listed in the market. If we miss one of them, we define the uncovered interest rate parity condition. If we don’t have information on F, we will have expectations (E) about the future spot rate value. The expectation is defined as 𝐸𝑡 𝑆𝑡+1 and we replace it instead of F in the equation to get (t = time): 𝐸𝑡 𝑆𝑡+1 − 𝑆𝑡 𝑖𝑡∗ − 𝑖𝑡 = 𝑆𝑡 1 + 𝑖𝑡 Everyone’s expectations will be different in this case, a subjective speculation. THIS EQUATION IS YET VALID ONLY IN T+1, NOT 1 DAY BEFORE, NOT 1 DAY AFTER. THAT’S BECAUSE THE CONVERGENCE OF FORWARD AND SPOT RATES OCCURS ONLY WHEN THE INFORMATION BECOMES AVAILABLE IN THE MARKET. 𝐸𝑡 𝑆𝑡+1 − 𝑆𝑡 This can be rewritten as: 𝑖𝑡∗ = 𝑖𝑡 + , which directly infers the expected value of the future spot 𝑆𝑡 exchange rate. If F = 𝐸𝑡 𝑆𝑡+1, the interest rate parity condition delivers the same results. 𝐸𝑡 𝑆𝑡+1 − 𝑆𝑡 If F (NOT EQUAL) 𝐸𝑡 𝑆𝑡+1 , it will be true that 𝑖𝑡∗ − 𝑖𝑡 − (𝑁𝑂𝑇 𝐸𝑄𝑈𝐴𝐿)0 → we need to find a 𝑆𝑡 way to make this equation equal to zero. That can be done thanks to the risk premium. Risk premium In equation 19 we have the uncovered condition on the LHD, and the risk premium on the RHS. Its numerator is the difference between F and the expected spot exchange rate: If they are equal, the risk premium is 0→ the uncovered interest parity condition is valid with no risk If they are not equal, the risk premium is > 0→ the UIRPC doesn’t hold Balance of payments It is a statistical record of the transactions that a given economy realizes with the foreign economies and sectors (between residents and the rest of the world). All transactions are recorded, both physical (good and services) and financial (money, securities, etc). “Residents” refers to whoever is resident in the country in which is located (also MNCs with additional hubs), expect for IOs, which are always treated as foreigners. Yet, it might be that we don’t have physical transfers of goods and services. In this case we deal with unilateral transfers (ex: a gift from one country to another, like a damage compensation). This will be recorded as well. Statistics are based on reliable sampling techniques that estimate the actual transactions. Also, there is a standardized format facilitating intercountry comparisons. The structure of the balance of payments The balance of payments always “balances”, following the double-entry logic of bookkeeping (for each transaction, we have a double record). Receiving currency from the rest of the world is recorded as a credit (plus), whereas payments towards abroad are recorded as debit (minus). There are 3 (5) main sections. The division occurs since the “current account” refers to income flows, the “capital and financial account” refers to changes in assets and liabilities of the private and non-central- bank sector, while the “settlement account” refers to changes of the central bank. Current account o Trade balance→ we only have the record of physical goods. It is the difference between exports and imports. Exports are recorded as credits; imports are recorded as debits. 𝑇𝐵𝑡 = 𝐸𝑋𝑃𝑡 − 𝐼𝑀𝑃𝑡 o Current account balance → it is the sum of the “trade balance” (visible balance) and the “invisible balance”, composed by services + dividends, interest, profit. Here, unilateral transfers are recorded, and they are considered as a fall in domestic income (debt) Net balance for exports in services and payments due for services + unilateral payments = transactions for which there is not a counterbalance 𝐶𝐴𝑡 = 𝑇𝐵𝑡 + services (current account = trade balance + services) Capital and financial account→ everything about financial transactions and movement of capital. Additional items referring to investing and borrowing activities are included. Capital inflows are credit (increase in liabilities to foreigners), while capital outflows are recorded as debits (decrease in liabilities to foreigners). The two parts of the balance of payment (current account and capital/ financial account) are linked together. Ex: through imports we obtain of goods, but money goes out. Settlement account→ it indicates the transactions implemented by the central bank. It includes two sources: o Rises and falls in foreign exchange reserves o Borrowing funds or repayments of loans to IOs  If the CB purchases its currency, then its foreign reserves fall, and this is recorded as a plus. If it sells its currency, and its foreign reserves increase, it is recorded as a minus. If the CB borrows funds from the IMF, this increases its liabilities, and it is recorded as a plus. If the CB pays back the loan, this decreases the liabilities, and it is recorded as a minus. 𝐶𝐴 + 𝐾𝐴 = 𝑏𝑎𝑙𝑎𝑛𝑐𝑒. If this balance is positive (surplus), the CB buys foreign reserves (-) so that the balance of payments is equal to 0. If the balance is negative (deficit), the CB sells foreign reserves (+), so that the balance of payments is equal to 0. Other ways to balance it are: repayment OR borrowing of loans to/ from IOs; self-adjustment of the surplus/deficit in a world of flexible exchange rate, were in case of a surplus the exchange rate increases, goods become less competitive, and demand lowers (vice versa for deficit). Therefore, buying foreign reserves implies that your currency is strong. Trade surplus→ excess of demand→ positive settlement of payments → buy foreign reserves→ “-“ in the settlement balance → accumulation of foreign reserves. The opposite is true in case of trade deficit (ex: USA). o Statistical error→ discrepancies can occur between the items of BoP. Why? All transactions are impossible to be recorded (due to underreported transactions to avoid taxes) OR “leads and lags” might lead to goods being shipped abroad but with delayed payments. thus, if the balance is not 0, this is the result of some adjusted via the statistical error. Surplus or deficit? The overall balance of payments always balances, but not necessarily each individual account does. The trade account and current account A surplus entails that a country is earning more than it is spending, whereas a deficit entails that a country is spending more than it is earning. The basic balance The basic balance represents the current account balance plus the net balance on long-term capital flows. Having an overall basic balance deficit is not always a bad thing:  - Countries might have a current account deficit that is reinforced by a large long-term capital outflow that will yield future profits Having an overall basic balance surplus is not always a good thing: - Long-term borrowing will lead to future interest, profits, and dividends to be paid back abroad, worsening the current account deficit The main problem lies with classifying the short- and long-term capital flows. Usually, long-term capital flows are of at least 12 months to maturity, but this can be easily switched through investors’ actions. Anyway, the basic balance is relevant if one counts net foreign direct investment (FDI) as the long-term capital account balance. A country with a current account deficit AND a positive net FDI can prosper in the future. The settlements balance The autonomous items are the current and financial / capital account transactions including errors, while the accommodating items are transactions undertaken by monetary authorities as indicated in the settlement balance. - In floating exchange rates→ exchange rate movements make domestically produced goods and services more or less attractive and clean up the balance (surplus→ stronger currency→ appreciation→ depression of trade balance→ equilibrium) - In fixed exchange rates→ settlement balance equals to the amount of reserves that has to be exchanges in order to maintain the equilibrium The net international investment position and the balance of payments Investing abroad allows to increase the external financial assets. The net international investment position is the difference between a country’s ownership of financial assets and its financial liabilities to foreign residents. If NIIP > 0, the country is a creditor nation (external assets > external liabilities). A current account deficit worsens the NIIP. NIIP is also affected by: Changes in external financial assets and liabilities (if foreign stocks increase in value, NIIP increases) fluctuations in exchange rate (if US $ depreciates by 10%, the foreign assets in € are worth more, improving NIIP) USA is currently a net debtor nation, while Germany, China, and Japan are creditor (countries running deficits need to finance by selling foreign assets). Does US current account deficit matter? US spends more than it earns. Its NIIP is affected by: 1.) size of US current account (+ deficit = - NIIP) 2.) change in currency values of US assets 3.) change in dollar exchange rate (depreciation of $ = greater value of € dominated assets of USA, improving NIIP) Japan and China have been large purchasers of US dollar Treasury securities, which allows US to run the deficit. Yet, should purchase cease, it would be difficult for USA to attract the capital inflow required to finance its economy. Positions differ on its deficit: Cooper→ USA is highly productive = foreign investors are ensured of high and reliable returns. Also, US strategy of foreign investment generates high value McKinnon→ $ is used for trade as a reference, and thus its demand will remain strong Roubini and Setser→ US hardly finances its deficit since it is consuming a disproportionate amount of the world’s savings How to correct the US current account deficit? There are various mechanisms: - Rise in US interest rates→ more private savings and less private investment - Depreciation of dollar→ increase in US exports - Tax rises and less government expenditure - Increase in economic growth of Asia and EU→ increase in demand of US exports What are the risks? Foreign countries risk losses if US interest rates rise and/or dollar depreciates + threat of protectionism when US deficit grows, as foreigners’ surpluses might lead to US protectionist responses. USA risks that in the long run the increasing debt will increase the interest payments it has to make, implying less money available for goods and services + the deficit slows the economic growth (since it would further increase the deficit) + greater probability of recession in the future + risk of loss of confidence of the foreign investors.