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INTERNATIONAL FINANCE 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 curr...

INTERNATIONAL FINANCE 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). 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.  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  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, 𝑀𝑑1 increases as I would like to have more money to perform transactions. As interest rate (i) goes up, I’ll invest more, and 𝑀𝑑1 will 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.