International Finance Synthesis PDF

Table des matières 1. The exchange rate and the history of IMS...................................................................................... 3 1.1. Definition (nominal, effective, …)....................................................................................................

Table des matières 1. The exchange rate and the history of IMS...................................................................................... 3 1.1. Definition (nominal, effective, …)............................................................................................................ 3 1.1.1. Bilateral exchange rate – Two conversion.................................................................................................. 3 1.1.2. Multilateral exchange rate – Nominal Effective Exchange Rate (NEER)..................................................... 4 1.1.3. Exchange rate regimes................................................................................................................................ 4 1.1.4. Balance sheet of the Central Bank.............................................................................................................. 5 1.1.5. Exchange rate and national accounting...................................................................................................... 6 1.2. History of the International Monetary System (ISM)................................................................................ 7 1.2.1. What is an international monetary system? What is the aim?................................................................... 7 1.2.2. What systems have been practiced?.......................................................................................................... 7 1.2.3. What is the actual state-of-art?................................................................................................................ 12 1.3. European Monetary System.................................................................................................................. 13 1.3.1. What about the history?........................................................................................................................... 13 1.3.2. The EMS-1 (à lire)...................................................................................................................................... 13 1.3.3. EMS-2 (à lire)............................................................................................................................................. 15 1.3.4. How Does EMS-2 Differ From EMS-1?...................................................................................................... 16 1.3.5. A revival of the EMS?................................................................................................................................ 16 1.4. Main Theoretical relationships.............................................................................................................. 17 1.4.1. Uncovered interest rate parity.................................................................................................................. 17 1.4.2. Purchasing power parity (PPP).................................................................................................................. 19 1.5. The Dornbush-Fisher model.................................................................................................................. 22 1.5.1. Close economy model: IS-LM (recall)........................................................................................................ 22 1.5.2. Summary:.................................................................................................................................................. 25 1.5.3. Open Economy model – Mundel Fleming................................................................................................. 26 1.5.4. The Dornbusch-Fisher Model.................................................................................................................... 27 1.6. Exercises.............................................................................................................................................. 30 1.6.1. Exercise 1................................................................................................................................................... 30 1.6.2. Exercise 2................................................................................................................................................... 31 1.6.3. Exercise 3................................................................................................................................................... 33 2. Models – When monetary policy meets exchange rate (What’s the link between monetary policy and exchange rate? )............................................................................................................................ 35 2.1. Monetary policies and the exchange rate.............................................................................................. 35 2.2. Overshooting of the exchange rate....................................................................................................... 37 2.3. Exercises.............................................................................................................................................. 40 2.3.1. Exercise 1................................................................................................................................................... 40 2.3.2. Exercise 2................................................................................................................................................... 40 2.3.3. Exercise 3................................................................................................................................................... 41 2.4. Summary.............................................................................................................................................. 42 2.5. Currency crises..................................................................................................................................... 44 2.5.1. What’s a currency or financial crisis?........................................................................................................ 44 2.5.2. Is financial crises a growing problem?...................................................................................................... 44 2.5.3. Sources of the currency crises................................................................................................................... 45 2.5.4. How to cure a financial crisis?................................................................................................................... 46 2.5.5. Brazil 98 currency crisis............................................................................................................................. 46 3. Measuring exchange rate misalignment....................................................................................... 49 3.1. The exchange rate movements............................................................................................................. 49 3.1.1. Deterministic Trend................................................................................................................................... 49 3.1.2. Moving Average........................................................................................................................................ 50 3.1.3. Hodrick-Prescott Filter.............................................................................................................................. 50 3.1.4. End-Point Bias........................................................................................................................................... 51 3.2. Exchange rate misalignments................................................................................................................ 52 1  3.2.1. PPP (Penn)................................................................................................................................................. 52 3.2.2. Macroeconomic Balance Approach – CGER/EBA (IMF)............................................................................ 53 3.3. Forecasting exchange rate.................................................................................................................... 56 3.3.1. Using the deterministic trend................................................................................................................... 56 3.3.2. Using the stochastic trend......................................................................................................................... 56 3.3.3. Using the moving average......................................................................................................................... 56 4. Exchange rate and the firm.......................................................................................................... 59 4.1. Balance sheet Approach....................................................................................................................... 59 4.1.1. Description of the Mic-Mac link................................................................................................................ 59 4.1.2. The currency risk....................................................................................................................................... 59 4.1.3. The exposure............................................................................................................................................. 60 4.2. Foreign Exchange rates (FX) markets and Hedging strategies................................................................. 61 4.2.1. Spot Markets (reminder)........................................................................................................................... 61 4.2.2. Triangular arbitrage................................................................................................................................... 62 4.2.3. Hedging can be performed on the Foreign Exchange market.................................................................. 63 4.3. Exercises.............................................................................................................................................. 70 4.3.1. Exercise 1................................................................................................................................................... 70 4.3.2. Exercise 2 – Future contract...................................................................................................................... 70 4.3.3. Exercise 3 – Option contract (optional).................................................................................................... 71 5. Exam........................................................................................................................................... 72 2 1. The exchange rate and the history of IMS 1.1. Definition 1 coin and 1 banknote. 20 $ “In God, we trust”  this banknote has no physical value So, what gives the value? It is not the value but the trust in it. The Central Bank prints banknotes and says “With the 20 dollars, you have the capacity to buy, to eat, to spend the value of 20 dollars”. That’s a liability that I have. The printing of the money is just a trust, a liability that I have at the Central Bank or at The Federal Reserve Bank. In the middle edge, it was not necessary to write “In God, we trust” because the coins were in gold. The weight of gold corresponded to a value, a purchasing value. The Central Bank provides us with currency. They print sheet of paper and tell us that with it we can purchase things. If tomorrow, the Central Bank changes the value of the sheet of paper, we can lose purchasing power (=inflation) or we can gain purchasing power (=deflation). If the Central Bank says yesterday you could buy a dinner with 20$ and today only a coffee, that’s what we call the inflation. The exchange rate is the corresponding money of € for $ (= conversion). We have 20 dollars and we want to have it in euros. We make this conversion thanks to the exchange rate (today: 1€ = 1.19$). The nominal exchange rate is the price of one currency expressed in terms of another currency. Who is fixing the exchange rate? The market is fixing the exchange rate. Who is fixing the value of the Chinese’s exchange rate? There is a bilateral agreement between Europe and China to fix the value. 1.1.1. Bilateral exchange rate – Two conversion  E= price of home currency in terms of foreign currency, 1 EUR = $1.35 = 1/R  R= Price of foreign currency in terms of home currency, $1 = 1/1.35 = 0.74 EUR Before, 1€ worth 1,35$ and now, 1€ worth 1,19$. What does that change in the exchange rate value between last month and today (2018) means? We can say that dollar is getting stronger than EUR. Now, I get less dollars for 1€. EUR is getting weaker and we call that a depreciation. If the EUR depreciates, that means that the dollar appreciates. If I am an investor and I invest in Europe, I’m unhappy. If I am an investor and I invest in the US, I’m happy. The appreciation of the exchange rate provides us an extra return. People who had invested in Europe are sad since they faced a lost. Do we prefer certainty or uncertainty? Normally, if we are a risk cover, we prefer certainty. Mots of investors don’t like risk because they want to be certain about their returns or at least more or less sure about it. However, the higher the risk is, higher the potential gain is. In this course, we will say that if E is going up that means that we face a depreciation and in contrary, when E is going down then we are in front of an appreciation. (1$ - 1/1,19€, if the exchange rate goes down, € appreciates and $ depreciates.) If the EUR appreciates that means the purchasing power of my dollar in Europe will be less. European citizens will be richer and have higher purchasing power. The CB must guarantee the purchasing power of the citizens and thus, they should monitor inflation. The first objective of the CB is to control inflation. Otherwise, the banknotes worth nothing. Ex. The most products we are buying are imported. When you import goods, you pay in foreign currency. If we want to buy a car in the US, we pay it in dollars. 3 A change of even a small percentage of the exchange rate has a direct impact/change on our purchasing power. What can we observe (on the left)? The variation isn’t stable at all. The variation from 0.9 to 1.6 is huge. If we had invested 1 million EUR in 2002 (0.9) in dollar and 6 years after you sell them back, the benefit will be 1 million dollars. The exchange rate is very volatile. In 2014, it was 1,38 and now it is 1,19. It represents a 20% variation. 20% is nice as a return. What about the emerging countries (on the right)? In March 2014, all those countries exchange rate against the dollar collapse. All the emerging countries collapsed. 1.1.2. Multilateral exchange rate – Nominal Effective Exchange Rate (NEER) The NEER (expressed as an index) consists of a weighted average of various bilateral nominal exchange rates, with the weights reflecting their relative importance in international trade. You know the strength of your currency vis-à-vis your all trading partners. It shows the effective exchange rate  Broad: all the trading partners of the US  Major: main partners of the US How is the NEER calculated? Choice of currency basket  Actual and potential competitors in domestic and foreign markets  May exclude: o Currency that are linked o Non-convertible currencies o High inflation currencies Choice of weights  many options are available like bilateral trade weights (import weights, export weights and overall trade weights), … The value of the dollars when we take into account all trading partners (= blue line) of the US. It is more a macro approach but in a firm, we don’t care about that we just want a bilateral measure. FRED is a bank data base provided by the Federal Bank of Luis. 1.1.3. Exchange rate regimes We have several exchange rate regimes; fixed (where two governments decide to fix the parity) and flexible (where the market is fixing the value). If the demand is higher than the supply, the price is increasing. If the supply is larger than the demand, the price is decreasing. If the world is asking a lot of dollar, that means that the world is exporting a lot from the US. There is a demand for dollar. If a country is exporting a lot, there is higher demand for this currency. Automatically, the price will go up. 4 On the contrary, if I import a lot, the demand for my currency is going down. If the demand is going down, the price is going down. The market defines the flexible exchange rate. What is the extreme case of fixed exchange rate? It is when the two currencies have the same value, we call that the currency union or the dollarization. There are some countries in the world where they use dollar. They renounce to their own monetary policies to give more credibility in their country currency. That’s the case of dollarization. It’s the case for the Ecuador or the Zimbabwe. Currency board: this is the regime of the Eastern European countries (Poland, Hungary). We have a panel of exchange rate regimes determination, which go from currency union to floating exchange rate like we can see on the previous picture. 1.1.4. Balance sheet of the Central Bank The liabilities of the Central Bank are there to provide us currency. Liability depends on something which is the foreign currency and the domestic credit to the economy that are set in the assets part of the Central Bank balance sheet. Those two represent the reserve of the Central Bank, that’s what backs-up now the CB (before it was gold). We need to have counterpart to produce the currency and the currency is used to develop the country. The monetary basis (MB) is equal to the total of assets which is equal to the total of demand. The money supply is the monetary basis times a multiplier. If we have cashless money. 𝑀 𝑆 = 𝑀𝐵 ∗ 𝑘 where k is the money multiplier. If we have a country which is exporting a lot, the trade balance (EX-IM) is positive. What does it mean for the foreign currency? There is an inflow of foreign reserves (FR) and thus the foreign reserves increase just like the foreign currency. Imagine you are at fixed exchange rate, so the value of the currency doesn’t change. If the foreign currency increases, the money supply increases automatically. So, when the trade balance increase, the money supply will automatically increase too when we are under fixed exchange rate. The Central Bank has to limit inflation. The money demand comes from the people. The CB can control the money supply, they can increase or decrease in order adjust the inflation. When inflation is too high, they decrease money supply to make the currency stronger and then the value of the money increase and we don’t need that much money anymore. When inflation is too low, they increase money supply to make the currency more present. If we are under fixed exchange rate, we cannot control money supply. As a result, when we have fixed exchange rate, we are losing monetary policy. Only the trade balance determines the MS. The Belgian monetary policy is done by the ECB and thus National Banks are losing their power. When we are under flexible exchange rate, the value of the exchange rate is changing such that if we export more than what we import, we have more demand for our currency, then our currency will appreciate until the trade balance is equilibrated. If we are under flexible exchange rate, we are freezing the movement in the foreign currency. Here, with floating exchange rate, we can control monetary policy (adjust the monetary policy). You have the trade balance but you also have the movement of capital corresponding to the investment flows (=Capital Account). 5  1.1.5. Exchange rate and national accounting Current Account + Capital Account = Trade Balance + Capital Account = Balance of Payments  Under flexible exchange rate, Balance of Payment (BoP) = 0  Under fixed exchange rate, Balance of payment (BoP) ≠ 0 and corresponds to the inflows or outflows in reserve. Ex. The Chinese have a surplus in the BoP and thus there is a lot of investments and they are exporting a lot. They have an accumulation of reserves (=inflow). If they let all that things in, then the money supply, will increase and thus activities will go up just like inflation. Chinese people don’t want to much inflation and thus they are controlling the monetary policy. Ex. Situation in Greece it’s the opposite. They are importing a lot and thus the BoP is negative and thus they are losing reserves (=outflows). As a result, money supply is decreasing just like activities. BIG PROBLEM! There is one case called currency crisis, it happens when we are losing reserves and when we don’t have any reserves anymore. When the stock of reserves is equal to 0, it is the crisis. An investor likes certainty, so it’s favourable to have fixed exchange rate for the investors. 6  1.2. History of the International Monetary System (ISM) 1.2.1. What is an international monetary system? What is the aim? Any set of institution that, from a monetary point of view, facilitates international movements of goods and capital and thus (1) provides sufficient liquidity (if necessary) and (2) creates solutions for adjustment problems (external balance). Exchange rate arrangements are the core of an international monetary system. If we don’t have enough money or liquidity in circulation, then we cannot stimulate activities. Global imbalances: some countries (such as China, India…) are accumulating reserves just like Germany, Finland and the Netherlands. We have moved from the G7 to the G20, but why those new countries have been invited? The answer is to pay because they have reserves. 1.2.2. What systems have been practiced? 1.2.2.1. Floating exchange rates A system in which each country is responsible for its own currency only: floating exchange rates. The value of the exchange rate is determined by the market. Exchange rates can take any value and therefore exchange rates can serve to solve adjustment problems (automatic stabilizers). Governments are not constrained by whatever rule of the game in their exchange rate/monetary policy. External balance is automatically reached and exchange rate policy can serve internal balance. There are no specific liquidity problems. 1.2.2.2. Fixed exchange rate systems A system with more or less cooperation.  Policy coordination (G7) 1.2.2.2.1. N-System  Gold Standard (1870 – 1914) All the currencies are backup by gold. Gold is the only reserve currency. The CB had huge reserves of gold. The exchange rate was fixed in order to maintain the stability of the system. The balance of payment of some countries are positive or negative. From time to time, there were boats full of gold shipping from countries with deficit to countries with a surplus. The value of each currency was fixed in terms of gold. Ex. 1 DM = 0.2 units of gold and $1= 0.4 units of gold. Then, 2 DM = $1 so this fixes exchange rates and we call that the Mint Parity. Fluctuation margins correspond to gold points. Those are the costs of shipping an amount of gold to one unit of the foreign currency between the two monetary centres. At one point, all transactions are done through the weak currency while reserves are kept through the strong currency. Bimetallism  Greshaw Law: the bad currency is kicking out the good one. Bimetallism: you have silver and gold, silver has less value than gold. Save the strong currency and trade with the weak one. Balance of payment disequilibria were settled by shipping of gold. If:  BOP0 - gold inflows (gold import points) As the quantity of gold is limited, a deficit could not go on forever. Automatic adjustment mechanism = Price-Specie- Flow 7 What’s the mechanism of Gold Standard? One country like Belgium is in deficit in his Balance of Payment and its reserves are decreasing. If the reserves are decreasing, the money supply also decreases. If money supply decreases, that means that there is less money in circulation and thus prices are going down. If the prices are going down, we are more competitive. Given the fact that we are more competitive, we can export more and import less and so, the BoP will improve. There is an automatic adjustment. This mechanism is called Price-Specie-Flow and discovered by David Hume. BOP