FIN415 / INB 415 Class Web Page, Spring ' 21
Instructor: Maggie Foley, DCOB #263
Jacksonville University
Weekly SCHEDULE,
LINKS, FILES and Questions
Chapter |
Coverage, HW, Supplements -
Required |
References
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Discussion: How to pick stocks (finviz.com) Daily earning announcement: http://www.zacks.com/earnings/earnings-calendar IPO schedule:
http://www.marketwatch.com/tools/ipo-calendar |
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Topic 1: 2020 Review (from worldbank.com) The impact of COVID-19
has drawn numerous comparisons – some to the Global Financial crisis of
2007–2008, others to World War II, and more still to crises we know only from
history books. The full scale of the pandemic will only be known in years to
come, as we collect and analyze the data, adapt and evolve our financing to
meet countries’ needs, and continue our work to end extreme poverty and
promote shared prosperity. For class discussion: ·
Do you think that the Covid-19 crisis is a temporary shock, or a
permanent one? ·
How soon can we recover from this crisis? ·
Comparing with financial crisis of 2008, which one is more severe? ·
Accelerated Economic Downturn
Those restrictions – enacted
to control the spread of the virus, and thus alleviate pressure on strained and
vulnerable health systems – have had an enormous
impact on economic growth. The June
edition of the Global Economic Prospects, put it plainly: “COVID-19 has triggered a global crisis like no other – a global health crisis that, in addition to an enormous
human toll, is leading to the deepest global recession since the Second World
War.” It forecast that the global economy as well as
per capita incomes would shrink this year – pushing
millions into extreme poverty.
Relieving the Debt Burden
This economic fallout is hampering countries’ ability to respond effectively to the pandemic’s health and economic effects. For this reason, in April, the World Bank and IMF called for the suspension of debt-service payments for the poorest countries to allow them to focus resources on fighting the pandemic. The Debt Service Suspension Initiative (DSSI) has enabled these countries to free-up billions of dollars for their COVID-19 response. Yet, as the graph below illustrates, debt service outlays to bilateral creditors will impose a heavy burden for years to come, and quick action to reduce debt will be needed to avoid another lost decade. Impact on Businesses and Jobs
Around the world,
companies – especially micro, small, and medium
enterprises (MSMEs) in the developing world – are
under intense strain, with more than half either in arrears or likely to fall
into arrears shortly. To understand the pressure that COVID-19 is having on
firms’ performance as well as the adjustments they
are having to make, the World Bank and partners have been conducting rapid
COVID-19 Business Pulse Surveys in partnership with client governments. These offer a glimmer of good news. Responses collected between May and August showed that many of these firms were retaining staff, hoping to keep them on board as they ride out the downturn.
Watch this video on Netflix Death to 2020 https://www.youtube.com/watch?v=PZjLujzc858 |
From IMF website, as of April 2020 |
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Topic 2: Multilateral Trade vs. Bilateral Trade What
is MULTILATERALISM? What does MULTILATERALISM mean? MULTILATERALISM meaning
& explanation (youtube)
What
is BILATERAL TRADE? What does BILATERAL TRADE mean? BILATERAL TRADE meaning
& explanation (youtube)
Take away: ·
Multilateral trade agreements strengthen the global economy by
making developing countries competitive. ·
They standardize import and export procedures giving economic
benefits to all member nations. ·
Their complexity helps those that can take advantage of globalization,
while those who cannot often face hardships. ·
For class discussion: Do you agree with the
above points? Why or why not? Multilateral
Trade Agreements With Their Pros, Cons and Examples
5 Pros and 4 Cons to the World's Largest Trade Agreements https://www.thebalance.com/multilateral-trade-agreements-pros-cons-and-examples-3305949 BY REVIEWED BY Updated October 28, 2020 Multilateral trade agreements are commerce treaties among three or
more nations. The agreements reduce tariffs and
make it easier for businesses to import and export. Since they
are among many countries, they are difficult to
negotiate. That same broad scope makes them more robust than other types
of trade agreements once all parties sign. Bilateral agreements are easier to
negotiate but these are only between two countries. They don't have as big an impact on
economic growth as does a multilateral agreement. 5 Advantages ·
Multilateral agreements make all
signatories treat each other equally. No country can give better trade
deals to one country than it does to another. That levels the playing field. It's
especially critical for emerging
market countries. Many of them are smaller in size, making them
less competitive. The Most
Favored Nation Status confers the best trading terms a nation
can get from a trading partner. Developing countries benefit the most from
this trading status. ·
The
second benefit is that it
increases trade for every participant. Their companies enjoy low tariffs. That makes their exports cheaper. ·
The
third benefit is it standardizes
commerce regulations for all the trade partners. Companies save legal
costs since they follow the same rules for each country. ·
The
fourth benefit is that countries can negotiate trade deals with more than one country at a time. Trade
agreements undergo a detailed approval process. Most countries would
prefer to get one agreement ratified covering many countries at once. ·
The
fifth benefit applies to emerging markets. Bilateral trade agreements tend to favor the country with the best
economy. That puts the weaker nation at a disadvantage. But making
emerging markets stronger helps the developed economy over time. As those emerging markets
become developed, their middle class
population increases. That creates new affluent customers for everyone. 4 Disadvantages ·
The
biggest disadvantage of multilateral agreements is that they are complex. That makes them difficult and time consuming to negotiate.
Sometimes the length of negotiation means it won't take place at all. ·
Second,
the details of the negotiations are particular to trade and business
practices. The public often misunderstands them. As a result, they receive lots of press,
controversy, and protests. ·
The
third disadvantage is common to any trade agreement. Some companies and regions
of the country suffer when trade
borders disappear. ·
The
fourth disadvantage falls on a country's small businesses. A multilateral agreement gives a
competitive advantage to giant multi-nationals. They are already familiar
with operating in a global environment. As a result, the small firms can't
compete. They lay off workers to cut costs. Others move their factories to
countries with a lower standard of living. If a region depended on that
industry, it would experience high
unemployment rates. That makes multilateral agreements unpopular. Pros
Cons
Examples Some regional trade
agreements are multilateral. The largest had been the North
American Free Trade Agreement (NAFTA), which was ratified on
January 1, 1994. NAFTA quadrupled trade between the United
States, Canada, and Mexico from its 1993 level to
2018. On July 1, 2020, the U.S.-Mexico-Canada Agreement (USMCA) went
into effect. The USMCA was a new trade agreement between the three countries
that was negotiated under President Donald Trump. The Central American-Dominican
Republic Free Trade Agreement was signed on August 5, 2004. CAFTA-DR
eliminated tariffs on more than 80% of U.S. exports to six countries: Costa
Rica, the Dominican Republic, Guatemala, Honduras, Nicaragua, and El
Salvador. As of November 2019, it had increased
trade by 104%, from $2.44 billion in January 2005 to $4.97 billion. The Trans-Pacific
Partnership would have been bigger than NAFTA.
Negotiations concluded on October 4, 2015. After becoming president, Donald Trump withdrew from the
agreement. He promised to replace it with bilateral
agreements. The TPP was between the United States
and 11 other countries bordering the Pacific Ocean. It would
have removed tariffs and standardized business practices. All global trade
agreements are multilateral. The most successful
one is the General Agreement on Trade and
Tariffs. Twenty-three countries signed GATT in 1947. Its goal was to
reduce tariffs and other trade barriers. In September 1986,
the Uruguay Round began in Punta del Este, Uruguay. It
centered on extending trade agreements to several new areas. These included
services and intellectual property. It also improved trade in agriculture and
textiles. The Uruguay Round led to the creation of the World Trade
Organization. On April 15,
1994, the 123 participating governments signed the agreement creating the WTO
in Marrakesh, Morocco. The
WTO assumed management of future global multilateral negotiations. The WTO's first project
was the Doha round
of trade agreements in 2001. That was a
multilateral trade agreement among all WTO members. Developing countries
would allow imports of financial services, particularly banking. In so
doing, they would have to modernize their markets. In return, the developed
countries would reduce farm subsidies. That would boost the growth
of developing countries that were good at producing food. Farm lobbies in the United
States and the European
Union doomed Doha negotiations. They refused to agree
to lower subsidies or accept increased foreign competition. The WTO abandoned
the Doha round in July 2008. On December 7, 2013, WTO
representatives agreed to the so-called Bali package. All countries
agreed to streamline customs standards and reduce red tape to expedite
trade flows. Food security is an issue. India wants to subsidize food so
it could stockpile it to distribute in case of famine. Other countries worry
that India may dump the cheap food in the global market to gain market share. |
Rust Belt https://www.investopedia.com/terms/r/rust-belt.asp By JAMES CHEN Updated Aug 25, 2020 What Is the Rust Belt? The Rust Belt is a
colloquial term used to describe the geographic region stretching from New
York through the Midwest that was once dominated by the coal
industry, steel production, and manufacturing. The Rust Belt became
an industrial hub due to its proximity to the Great Lakes, canals, and
rivers, which allowed companies to access raw materials and ship
out finished products. The region received the
name Rust Belt in the late 1970s, after a sharp decline in
industrial work left many factories abandoned and desolate, causing
increased rust from exposure to the elements. It is also referred to as the
Manufacturing Belt and the Factory Belt. KEY TAKEAWAYS
Understanding the Rust Belt The term Rust Belt is often
used in a derogatory sense to describe parts of the country that have seen an
economic decline—typically very drastic. The rust belt region represents
the deindustrialization of an area, which is often accompanied by fewer
high-paying jobs and high poverty rates. The result has been a change in the
urban landscape as the local population has moved to other areas of the
country in search of work. Although there is no
definitive boundary, the states that are considered in the Rust Belt–at least
partly–include the following:
There are other states in
the U.S. that have also experienced declines in manufacturing, such as states
in the deep south, but they are not usually considered part of the Rust Belt.
The region was home to some of America's most prominent industries, such as
steel production and automobile manufacturing. Once recognized as the
industrial heartland, the region has experienced a sharp downturn in
industrial activity from the increased cost of domestic labor, competition
from overseas, technology advancements replacing workers, and
the capital intensive nature of manufacturing. Poverty in the Rust Belt Blue-collar jobs have
increasingly moved overseas, forcing local governments to rethink the type of
manufacturing businesses that can succeed in the area. While some cities
managed to adopt new technologies, others still struggle with rising poverty
levels and declining populations. Below are the poverty rates
from the U.S. Census Bureau as of 2018 for each of the Rust Belt
states listed above. Poverty Rates in the Rust Belt. Investopedia There are other U.S. states
that have high poverty rates, such as Kentucky (16.9%), Louisiana (18.6%),
and Alabama (16.8%). However, the rust belt states have–at a minimum–a
double-digit percentage of their population in poverty.1 History of the Rust Belt Before being known as the
Rust Belt, the area was generally known as the country's Factory, Steel, or
Manufacturing Belt. This area, once a booming hub of economic activity,
represented a great portion of U.S. industrial growth and development. The natural resources that
were found in the area led to its prosperity—namely coal and iron ore—along
with labor and ready access to transport by available waterways. This led to the
rise in coal and steel plants, which later spawned the weapons, automotive,
and auto parts industries. People seeking employment began moving to the
area, which was dominated by both the coal and steel industries, changing the
overall landscape of the region. But that began to change
between the 1950s and 1970s. Many manufacturers were still using
expensive and outdated equipment and machinery and were saddled with the high
costs of domestic labor and materials. To compensate, a good portion of them
began looking elsewhere for cheaper steel and labor—namely from foreign
sources—which would ultimately lead to the collapse of the region. There is no definitive
boundary for the Rust Belt, but it generally includes the area from New York
through the Midwest. Decline of the Rust Belt Most research suggests the
Rust Belt started to falter in the late 1970s, but the decline may have
started earlier, notably in the 1950s, when the region's dominant industries
faced minimal competition. Powerful labor unions in the automotive
and steel manufacturing sectors ensured labor competition stayed to a
minimum. As a result, many of the established companies had very little
incentive to innovate or expand productivity. This came back to haunt the
region when the United States opened trade overseas and shifted manufacturing
production to the south. By the 1980s, the Rust Belt
faced competitive pressure—domestically and overseas—and had to ratchet
down wages and prices. Operating in a monopolistic fashion for an
extended period of time played an instrumental role in the downfall of the
Rust Belt. This shows that competitive pressure in productivity and labor
markets are important to incentivize firms to innovate. However, when
those incentives are weak, it can drive resources to more prosperous regions
of the country. The region's population also
showed a rapid decline. What was once a hub for immigrants from the rest of
the country and abroad, led to an exodus of people out of the area. Thousands
of well-paying blue-collar jobs were eliminated, forcing people to move away
in search of employment and better living conditions. Politics and the Rust Belt The term Rust Belt is
generally attributed to Walter Mondale, who referred to this part of the
country when he was the Democratic presidential candidate in 1984. Attacking
President Ronald Reagan, Mondale claimed his opponent's policies were ruining
what he called the Rust Bowl. He was misquoted by the media as saying
the rust belt, and the term stuck. Since then, the term has consistently been
used to describe the area's economic decline. From a policy perspective,
addressing the specific needs of the Rust Belt states was a political
imperative for both parties during the 2016 election. Many believe the
national government can find a solution to help this failing region succeed
again. |
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Part II In class exercise – convert currencies back and forth If
the dollar is pegged to gold at US $1800 = 1 ounce of gold and the British pound
is pegged to gold at Ł1200 = 1 ounce of gold. What should be the exchange
rate between US$ and British Ł? How much can you make without any risk if the
exchange rate is 1Ł = 2$? Assume that your initial investment is $1800. What
about the exchange rate set at 1Ł =
1.2$? What about your initial investment is Ł1200? Solution: 1Ł = 2$ (note that the exchange
rate is set at 1Ł = 1.5$ since $1800 = Ł1500=1 ounce of gold č $1.5=1Ł). č With $1800, you can buy 1 ounce
of gold at US $1800 = 1 ounce of gold. čWith one ounce of gold, you
can sell it in UK at Ł1200 = 1 ounce of gold, so you can get back Ł1200 č convert Ł to $ at $2=1Ł as
given č get back Ł1200 * 2$/Ł =
$2400 > $1800, initial investment č you could make a profit of
$600 ($2400 - $1800=$600) č Yes. 1Ł = 1.2$ (note that the exchange
rate is set at 1Ł = 1.5$ since $1800 = Ł1500=1 ounce of gold č $1.5=1Ł). č With $1800, you can buy
either 1 ounce of gold at US $1800 = 1 ounce of gold. č With one ounce of gold, you can sell it in UK at Ł1200 =
1 ounce of gold, so you can get back Ł1200 č convert Ł to $ at $1.2=1Ł
as given č get back Ł1200 * 1.2$/Ł =
$1440 < $1800 č you will lose $360 ($1440
- $1800=$-360)č No. č So should convert to Ł first
and then buy gold in UK č With $1800, you can
convert to Ł1500 ($1800 / (1.2$/Ł = Ł1500 ). č buy gold in UK at Ł1200 =
1 ounce of gold, so you can get back Ł1500/Ł1200 = 1.25 ounce of gold č Sell gold in US at
US $1800 = 1 ounce of gold č So get back 1.25 ounce of
gold * $1800 = $2250 > $1800 č you will make a profit of
$450 ($2250 - $1800=$450) č Yes. Homework (due with first midterm
exam) 1. If the dollar is pegged to gold at US $1800 = 1 ounce
of gold and the British pound is pegged to gold at €1500 = 1 ounce of gold.
What should be the exchange rate between US$ and Euro €? How much can you
make without any risk if the exchange rate is 1€ = 1.5$? Assume that your
initial investment is $1800. (answer: $1.2/euro, $450) 2. Multilateral trade vs. bilateral trade: Which side do
you support? Why? |
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Chapter 2 Chapter 2 (PPT) Let’s watch this video together. Imports, Exports, and Exchange Rates:
Crash Course Economics #15 ·
Topic 1-
What is BOP? The balance of payment of a country contains two accounts:
current and capital. The current account records
exports and imports of goods and services as well as unilateral transfers,
whereas the capital account records purchase
and sale transactions of foreign assets and liabilities during a particular
year. ·
What is the current account? Balance of
payments: Current account (video, Khan academy)
As the name implies, the current account considers goods and
services currently being produced. The current account deals with short-term transactions known
as actual transactions, as they have a real impact on income, output and
employment levels of a country through the movement of goods and services in
the economy. It consists of visible trade (export and import of goods), invisible trade (export
and import of services), unilateral transfers, and investment income (income from
factors such as land or foreign shares). The credit and debit of foreign exchangedue
to these transactions are also recorded in the balance of current account. The
resulting balance of the current account is approximated as the sum total of balance of trade. https://www.bea.gov/data/intl-trade-investment/international-transactions
The
U.S. current account deficit narrowed by $1.1 billion, or 0.9 percent, to
$124.1 billion in the third quarter of 2019, according to statistics from the
U.S. Bureau of Economic Analysis. The revised second quarter deficit was
$125.2 billion. The third quarter deficit was 2.3 percent of current dollar
gross domestic product, down less than 0.1 percent from the second quarter.
The U.S. current account deficit widened by
$17.2 billion, or 10.6 percent, to $178.5 billion in the third quarter of
2020, according to statistics released by the U.S. Bureau of Economic
Analysis. The revised second quarter deficit was $161.4 billion. The third
quarter deficit was 3.4 percent of current dollar gross domestic product, up
from 3.3 percent in the second quarter. For Details, please read the following article. EMBARGOED UNTIL RELEASE AT 8:30 A.M. EST, Friday, December 18,
2020 BEA 20-66 U.S. International Transactions, Third Quarter 2020
Current
Account Deficit Widens by 10.6 Percent in Third Quarter
Current Account Balance, Third Quarter The U.S. current account deficit,
which reflects the combined balances on trade in goods and services and
income flows between U.S. residents and residents of other countries, widened
by $17.2 billion, or 10.6 percent, to $178.5 billion in the third quarter of
2020, according to statistics released by the U.S. Bureau of Economic
Analysis. The revised second quarter deficit was $161.4 billion. The third quarter
deficit was 3.4 percent of current dollar gross domestic product, up from 3.3
percent in the second quarter. The $17.2 billion
widening of the current account deficit in the third quarter mostly reflected
an expanded deficit on goods that was partly offset by an expanded surplus on
primary income. Coronavirus (COVID-19)
Impact on Third Quarter 2020 International Transactions All major categories
of current account transactions increased in the third quarter of 2020
following notable declines in the second quarter, reflecting the resumption
of trade and other business activities that were postponed or restricted due
to COVID-19. In the financial account, most of the currency swaps between the
U.S. Federal Reserve System and foreign central banks that remained at the
end of the second quarter were ended in the third quarter, contributing to
the continued U.S. withdrawal of deposit assets abroad and the continued U.S.
repayment of deposit and loan liabilities. A record level of net shipments of
U.S. currency abroad to meet the demand for U.S. currency by foreign residents
increased U.S. currency liabilities, partly offsetting the net repayment of
U.S. deposit liabilities. The full economic effects of the COVID-19 pandemic
cannot be quantified in the statistics because the impacts are generally
embedded in source data and cannot be separately identified. For more
information on the impact of COVID-19 on the statistics, see the technical note that accompanies this
release. Current Account Transactions (tables 1-5) Exports of goods and
services to, and income received from, foreign residents increased $99.4
billion, to $796.0 billion, in the third quarter. Imports of goods and
services from, and income paid to, foreign residents increased $116.6
billion, to $974.5 billion. Trade
in Goods (table 2) Exports
of goods increased $68.4 billion, to $357.1 billion, and imports of goods increased
$94.4 billion, to $602.7 billion. The increases in both exports and imports
reflected increases in all major categories, led by automotive vehicles,
parts, and engines, mainly parts and engines and passenger cars. Trade
in Services (table 3) Exports
of services increased $2.8 billion, to $164.8 billion, mainly
reflecting an increase in charges for the use of intellectual property,
mostly licenses for the use of outcomes of research and development, that was
partly offset by a decrease in travel, primarily education-related travel. Imports of services increased
$6.5 billion, to $107.7 billion, mainly reflecting increases in charges for
the use of intellectual property, mostly licenses for the use of outcomes of
research and development; in transport, primarily sea freight transport; and
in travel, primarily other personal travel. Primary
Income (table 4) Receipts
of primary income increased $26.8 billion, to $238.7
billion, and payments of primary income increased
$11.9 billion, to $190.6 billion. The increases in both receipts and payments
mainly reflected increases in direct investment income, primarily earnings. Secondary
Income (table 5) Receipts
of secondary income increased $1.4 billion, to $35.3
billion, reflecting an increase in private transfers, mostly private sector
fines and penalties, that was partly offset by a decrease in general
government transfers, mainly government sector fines and penalties. Payments of secondary income increased
$3.7 billion, to $73.5 billion, reflecting increases in private transfers,
primarily private sector fines and penalties, and in general government
transfers, mostly international cooperation. Capital Account Transactions (table 1) Capital transfer
receipts increased $0.3 billion, to $0.4 billion, in the third quarter,
reflecting the U.S. Department of State’s sale of a property in Hong Kong. Financial Account Transactions (tables 1, 6, 7, and 8) Net financial account
transactions were −$221.1 billion in the third quarter, reflecting net
U.S. borrowing from foreign residents. Financial
Assets (tables 1, 6, 7, and 8) Third quarter
transactions decreased U.S. residents’ foreign financial assets by $73.0
billion. Transactions decreased other investment assets, mostly currency and
deposits, by $288.1 billion. Transactions in deposits included a net
withdrawal by the U.S. Federal Reserve of $203.0 billion from deposits abroad
related to the ending of currency swaps. Transactions increased direct
investment assets, mostly equity, by $71.1 billion; portfolio investment
assets, mostly equity securities, by $142.2 billion; and reserve assets by
$1.8 billion. Liabilities
(tables 1, 6, 7, and 8) Third quarter
transactions increased U.S. liabilities to foreign residents by $172.0 billion.
Transactions increased direct investment liabilities, both equity and debt,
by $70.5 billion and portfolio investment liabilities, mostly equity
securities, by $147.5 billion. Transactions decreased other investment
liabilities, mostly loans, by $46.0 billion. Financial
Derivatives (table 1) Net transactions in
financial derivatives were $24.0 billion in the third quarter, reflecting net
lending to foreign residents.
·
What is the Capital Account
Balance of payments: Capital account (video,
Khan Academy) The capital account is a
record of the inflows and outflows of capital that directly affect a nation’s foreign assets and liabilities. It is concerned with all international trade
transactions between citizens of a given country and
citizens in other countries. The components of the capital account include foreign investment and loans, banking
capital and other forms of capital, as well as monetary movements or changes
in the foreign exchange
reserve. The capital account flow reflects factors such as
commercial borrowings, banking, investments, loans, and capital. In other words, the capital account is concerned with payments
of debts and claims, regardless of the time period. The balance of capital
account also includes all items reflecting changes in stocks. https://fred.stlouisfed.org/tags/series?t=capital+account · The Bottom LineIn economic terms, the current account deals with receipt and
payment in cash as well as non-capital items, and the capital account
reflects sources and utilization of capital. The sum of the current
account and capital account as reflected in the balance of payments will
always be zero; any surplus or deficit in
the current account is matched and canceled out by an equal surplus or
deficit in the capital account. (https://www.investopedia.com/ask/answers/031615/whats-difference-between-current-account-and-capital-account.asp) Top Trading Partners - November 2020
https://www.census.gov/foreign-trade/statistics/highlights/toppartners.html Topic 2: Trade war with China to reduce trade
deficit (current account deficit) For Class Discussion: Has the US won the trade war against China? Can trade war
help reduce the US current account deficit? America v
China: why the trade war won't end soon | The Economist (youtube)
Has the US lost
the trade war with China? (youtube)
US-China trade
deficit skyrockets | DW News (youtube)
Chapter 2 part I (Due with first mid term exam) 1.
About the trade war between US and China and the upcoming one between
US and Germany, what is your opinion? Can the trade wars help reduce the US
current account deficits? 2.
Based on the classroom discussion, and documents posted and available
online, do you think that the trade war against China could help US to reduce
its trade deficit (or current account deficit)? Please be specific. 3. Internet exercises (not
required, information for intereted students only) a. IMF,
world bank and UN are only a few of the major organizations that
track, report and aid international economic and financial
development. Based on information provided in those websites, you could learn
about a country’s economic outlook. IMF: www.imf.org/external/index.htm UN: www.un.org/databases/index.htm World
bank: www.worldbank.org’ Bank
of international settlement: www.bis.org/index.htm b. St.
Louis Federal Reserve provides a large amount of recent open economy
macroeconomic data online. You can track down BOP and GDP data for the major
industrial countries. Recent
international economic data: research.stlouisfed.org/publications Balance
of Payments statistics: research.stlouisfed.org/fred2/categories/125 |
Balance of payments: Current account (video, Khan academy) (FYI)Balance of payments: Capital account (video,
Khan Academy) (FYI) Current
vs. capital accounts: what is the difference (youtube)? From khan academy Reference of useful websites for global economy International Trade
Statistics (PDF) Current Account (BOP) Data – World Bank http://data.worldbank.org/indicator/BN.CAB.XOKA.CD IMF, world bank and UN are only a few of the major organizations
that track, report and aid international economic and
financial development. Using these website, you can summarize the
economic outlook for each country. IMF: www.imf.org/external/index.htm UN: www.un.org/databases/index.htm World bank: www.worldbank.org Bank of international settlement: www.bis.org/index.htm St. Louis Federal Reserve provides a large amount of recent open
economy macroeconomic data online. You can track down BOP and GDP data for
the major industrial countries. Recent international economic data: research.stlouisfed.org/publicaitons/iet Updated May 5, 2019 Current vs. Capital Accounts: An Overview The current and capital accounts represent two halves of a
nation's balance of payments. The current account represents a country's net
income over a period of time, while the capital account records the net
change of assets and liabilities during a particular year. In economic terms, the current account deals with the receipt
and payment in cash as well as non-capital items, while the capital account
reflects sources and utilization of capital. The sum of the current account
and capital account reflected in the balance of payments will always be zero.
Any surplus or deficit in the current account is matched and canceled out by
an equal surplus or deficit in the capital account. KEY
TAKEAWAYS • The current
and capital accounts are two components of a nation's balance of payments. • The current
account is the difference between a country's savings and investments. • A country's
capital account records the net change of assets and liabilities during a
certain period of time. Current
Account The current account deals with a country's short-term
transactions or the difference between its savings and investments. These are
also referred to as actual transactions (as they have a real impact on
income), output and employment levels through the movement of goods and
services in the economy. The current account consists of visible trade (export and
import of goods), invisible trade (export and import of services), unilateral
transfers, and investment income (income from factors such as land or foreign
shares). The credit and debit of foreign exchange from these transactions are
also recorded in the balance of the current account. The resulting balance of
the current account is approximated as the sum total of the balance of trade. Transactions are recorded in the current account in the
following ways: • Exports are
noted as credits in the balance of payments • Imports are
recorded as debits in the balance of payments The current account gives economists and other analysts an idea
of how the country is faring economically. The difference between exports and
imports, or the trade balance, will determine whether a country's current
balance is positive or negative. When it is positive, the current account has
a surplus, making the country a "net lender" to the rest of the
world. A deficit means the current account balance is negative. In this case,
that country is considered a net borrower. If imports decline and exports increase to stronger economies
during a recession, the country's current account deficit drops. But if
exports stagnate as imports grow when the economy grows, the current account
deficit grows. Capital
Account The capital account is a record of the inflows and outflows of
capital that directly affect a nation’s foreign assets and liabilities. It is
concerned with all international trade transactions between citizens of one
country and those in other countries. The components of the capital account include foreign
investment and loans, banking and other forms of capital, as well as monetary
movements or changes in the foreign exchange reserve. The capital account
flow reflects factors such as commercial borrowings, banking, investments,
loans, and capital. A surplus in the capital account means there is an inflow of
money into the country, while a deficit indicates money moving out of the
country. In this case, the country may be increasing its foreign holdings. In other words, the capital account is concerned with payments
of debts and claims, regardless of the time period. The balance of the
capital account also includes all items reflecting changes in stocks. The International Monetary Fund divides capital account into
two categories: The financial account and the capital account. The term capital account is also used in accounting. It is a
general ledger account used to record the contributed capital of corporate
owners as well as their retained earnings. These balances are reported in a
balance sheet's shareholder's equity section. China
won the trade war
https://www.econlib.org/china-won-the-trade-war/ By
Scott Sumner
A year
ago, Tyler
Cowen claimed that President Trump won round
one of the trade war with China: I’m
not entirely convinced we won even the first round of the trade war, although
the claim might be true. The stated goal of President Trump and his advisers
was to reduce the US trade deficit with China. A secondary goal may
have been to slow the growth of China’s economy. A third goal might
have been to weaken the position of Xi Jinping, who has been moving China in
a more repressive and nationalistic direction. Today,
we know that the US failed spectacularly on all three counts. Indeed the
last year has been an unmitigated disaster for Trump administration protectionists.
Today’s Bloomberg has
an article arguing (correctly) that China ended up winning the trade war: The
trade deficit has risen to record levels in 2020: The
goal of slowing the rise of the Chinese economy has also failed. The Chinese
economy (in dollar terms) is now expected to overtake
the US in 2028, five years earlier than
estimated just a year ago. (In PPP terms they overtook us years ago.) And
the prestige of Xi Jinping has risen dramatically relative to the prestige of
President Trump, even before the recent fiasco on Capitol Hill. In
China there’s a widespread view that our botched handling of Covid-19 shows
the superiority of an authoritarian system, at least on questions of public
health. (That’s not my view, as Taiwan did better than China.) The
prestige of America has never been lower. Here’s
what Tyler said a year ago: A third
set of possible benefits relates to the internal power dynamics in the
Chinese Communist Party. For all the talk of his growing power, Chinese
President Xi Jinping has not been having a good year. The situation in Hong
Kong remains volatile, the election in Taiwan did not go the way the Chinese
leadership had hoped, and now the trade war with America has ended, or
perhaps more accurately paused, in ways that could limit China’s future
expansion and international leverage. This trade deal takes Xi down a notch,
not only because it imposes a lot of requirements on China, such as buying
American goods, but because it shows China is susceptible to foreign threats.
. . . It is
too soon to judge the current trade deal a success from an American point of
view. Nevertheless, its potential benefits remain underappreciated, and there
is a good chance they will pay off. It’s
no longer too soon to judge. Perhaps without Covid-19 the outcome would
have been more favorable to the US, but as of today the trade war looks like an
own goal for the US. The correct policy would have been to join the TPP
back in 2017. And increase high skilled immigration from China (including
Hong Kong.) Let’s hope the Biden Administration learns the right lessons. |
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Part II of Chapter 2 --- Evolution of international monetary system Finance: The History of Money (combined) (video, fan to
watch)
Review of history of money: A brief history of money - From gold
to bitcoin and cryptocurrencies (video)
· Bimetallism:
Before 1875 · Classical
Gold Standard: 1875-1914 The Gold Standard Explained in One Minute (video)
§ International
value of currency was determined by its fixed relationship to gold. § Gold was used to
settle international accounts, so the risk of trading with other countries
could be reduced. · Interwar
Period: 1915-1944 § Countries
suspended gold standard during the WWI, to increase money supply and pay for
the war. § Countries relied
on a partial gold standard and partly other countries’ currencies
during the WWII · Bretton Woods
System: 1945-1972 The Bretton Woods Monetary
System (1944 - 1971) Explained in One Minute (video)
§ All currencies
were pegged to US$. § US$ was the only
currency that was backed by gold. § US$ was world
currency at that time. · The
Flexible Exchange Rate Regime: 1973-Present FLOATING AND FIXED EXCHANGE RATE (video)
For class discussion: Do you support returning to gold standard? The Evolution
of US Currency
At times, America may not be the
most popular nation in the world, but one thing is for sure: it is famous for
its green. The greenback has been iconic since its inception. This infographic above misses a few key instances
in US currency history – namely the birth of the
Federal Reserve in 1913 and Nixon ending convertibility to gold in
1971. Both events were catalysts to massive money printing which leaves
the USD with only a fraction of the purchasing power that it once had. Fed’s Powell explains why a return to the
gold standard would be so damaging to the economy JUL 10
2019 Thomas
Franck@TOMWFRANCK KEY POINTS • “If you assigned us [to] stabilize the dollar price of gold, monetary
policy could do that, but the other things would fluctuate, and we wouldn’t
care,” Powell says. • Though Powell distanced himself
from the Fed nomination process, his comments put him at odds with the
writings of Judy Shelton, a current nominee to the central bank. Federal
Reserve Chairman Jerome Powell told Congress on Wednesday that he doesn’t
think a return to the gold standard in the U.S. would be a good idea. “You’ve assigned us the job of two direct,
real economy objectives: maximum employment, stable prices. If you assigned
us [to] stabilize the dollar price of gold, monetary policy could do that,
but the other things would fluctuate, and we wouldn’t care,” Powell said
from Capitol Hill. “We wouldn’t care if unemployment went up or down. That
wouldn’t be our job anymore.” “There
have been plenty of times in fairly recent history where the price of gold
has sent a signal that would be quite negative for either of those goals,” he
said. “No other country uses it,” he added. The Fed is tasked and overseen by Congress to maximize employment and
keep prices stable. Though
Powell was quick to distance himself from the Fed nomination process, his
comments on the gold standard put him at odds with the writings of Judy
Shelton, a current Fed nominee and advocate for monetary policy reforms. Shelton,
who was tapped last week by President Donald Trump to join the Fed’s board,
has written that a return to the gold standard affords the U.S. “an
opportunity to secure continued prominence in global monetary affairs.” “If the appeal of cryptocurrencies is their
capacity to provide a common currency, and to maintain a uniform value for
every issued unit, we need only consult historical experience to ascertain
that these same qualities were achieved through the classical international
gold standard,” she wrote in 2018. The
U.S. first severed the dollar from gold during the Great Depression of the
1930s, when then-president Franklin Roosevelt cut the greenback’s ties with gold, allowing the government to issue
more money and lower interest rates. The U.S. allowed foreign governments
to trade dollars for gold until President Richard Nixon abolished the policy
in 1971. The
choice of Shelton may hint at Trump’s frustration with Fed leaders and the
direction of the central bank’s monetary policy. Trump has argued that higher
interest rates and so-called quantitative tightening have capped GDP growth
and dampened the U.S. position in trade negotiations with China. Mar
27, 2020,04:54pm EDT|30,167 views What If We Had A Gold Standard System,
Right Now? Nathan LewisContributor https://www.forbes.com/sites/nathanlewis/2020/03/27/what-if-we-had-a-gold-standard-right-now/?sh=1bfba3313e58 For most of the 182 years between 1789 and 1971, the
United States embraced the principle of a dollar linked to gold — at first,
at $20.67/oz., and then, after 1933, $35/oz. Nearly every economist today
will tell you that was a terrible policy. We can tell it was a disaster because,
during that time, the United States became the wealthiest and most
prosperous country in the history of the world. This is economist logic. But, even if some economists might agree with the general
principle, they might be particularly hesitant to apply such monetary
discipline right now, in the midst of economic and financial turmoil. This
kind of event is the whole reason why we put up with all the chronic
difficulties of floating currencies, and economic manipulation by central
banks. Isn't it? So, let's ask: What if we were on a gold standard system,
right now? Or, to be a little more specific, what if we had been on a gold
standard system for the last ten years, and continued on one right now, in
the midst of the COVID-19 panic and economic turmoil? In the end, a gold
standard system is just a fixed-value system. The International Monetary Fund
tells us that more than half the countries in the world, today, have some
kind of fixed-value system — they link the value of their currency to
some external standard, typically the dollar, euro, or some other
international currency. They have fixed exchange rates, compared to this
external benchmark. The best of these systems are currency boards, such as is
used by Hong Kong vs. the U.S. dollar, or Bulgaria vs. the euro. If you think of a gold standard as just a "currency board linked to gold,"
you would have the general idea. These currency boards are functioning right
now to keep monetary stability in the midst of a lot of other turmoil. If you
had all the problems of today, plus additional monetary instability as Russia
or Turkey or Korea has been experiencing (or the euro ...), it just piles
more problems on top of each other. Actually, it would
probably be easier to link to gold than the dollar or euro, because gold's
value tends to be stable, while the floating fiat dollar and euro obviously
have floating values, by design. If you are going to link your currency
to something, it is easier to link it to something that moves little, rather
than something that moves a lot. Big dollar moves, such as in 1982, 1985,
1997-98 and 2008, tend to be accompanied by currency turmoil around the
world. But, even within the discipline of a gold standard system,
you could still have a fair amount of leeway regarding central bank activity,
and also various financial supports that arise via the Treasury and Congress. Basically, you could do just about anything that is compatible
with keeping the value of the dollar stable vs. gold. In the pre-1914 era, there was a suite of policies to this
effect, generally known as the "lender of last resort," and
described in Walter Bagehot's book Lombard Street (1873).
Another set of solutions resolved the Panic of 1907, without ever leaving the
gold standard. The Federal Reserve was explicitly designed to operate on a
gold standard system; and mostly did so for the first 58 years of its
existence, until 1971. Others have argued that a functional "free
banking" system, as Canada had in the pre-1914 era, would allow private
banks to take on a lot of these functions, without the need for a central
bank to do so. What could the
Federal Reserve do today, while still adhering to the gold standard? First: It could
expand the monetary base, by any amount necessary, that meets an increase in
demand to hold cash (base money). Quite commonly,
when things get dicey, people want to hold more cash. Individuals might
withdraw banknotes from banks. Banks themselves tend to hold more "bank
reserves" (deposits) at the Federal Reserve — the banker's equivalent of
a safe full of banknotes. This has happened, for example, during every major
war. During the Great Depression, the Federal Reserve expanded its balance
sheet by a huge amount, as banks increased their bank reserve holdings in the
face of uncertainty. Nevertheless, the dollar's value remained at its $35/oz.
parity. Federal
Reserve Liabilities 1917-1941. NATHAN LEWIS Second: The
Federal Reserve could extend loans to certain entities - banks, or
corporations - as long as this lending is consistent with the maintenance of
the currency's value at its gold parity.
In the pre-1914 era, this was done via the "discount window." One
way this could come about is by swapping government debt for direct lending.
For example, the Federal Reserve could extend $1.0 trillion of loans to banks
and corporations, and also reduce its Treasury bond holdings by $1.0
trillion. This would not expand the monetary base. But, it might do a lot to
help corporations with funding issues. What the Federal
Reserve would not be able to do is: expand the "money supply"
(monetary base) to an excessive amount — an amount that tended to cause the
currency's value to fall due to oversupply, compared to its gold parity. Now we come to a wide variety of actions that are not
really related to the Federal Reserve, but rather, to the Treasury and
Congress. In 1933, a big change was Deposit Insurance. The Federal
Government insured bank accounts. It helped stop a banking panic at the time.
This is a controversial policy even today, and some think it exacerbated the
Savings and Loan Crisis of the 1980s, not to mention more issues in 2008.
But, nevertheless, it didn't have anything to do with the Federal Reserve. In 2009, the stock market bottomed when there was a rule
change that allowed banks to "mark to model" rather than "mark
to market." Banks could just say: "We are solvent, we
promise." It worked. Today, Congress has been making funds available to
guarantee business lending, and for a wide variety of purposes that should
help maintain financial calm. Whether this is a good idea or not will be
debated for a long time I am sure. But, it has nothing to do with the Federal
Reserve. All of these actions are entirely compatible with the gold standard. What about interest rates? Don't we want the Federal
Reserve to cut rates when things get iffy? In the 1930s, interest rates were
set by market forces. Given the economic turmoil of the time, government bond
rates, and especially bill rates, were very low. The yield on government
bills spent nearly the whole decade of
the 1930s near 0%. Markets lower "risk-free" rates
automatically, during times of economic distress, when you just allow them to
function without molestation. Every bond trader already knows this. U.S.
interest rates, 1919-1941 NATHAN LEWIS When we go down
the list of all the things that the Federal Reserve, the Treasury, Congress
and other regulatory bodies could do, while also adhering to the gold
standard, we find that there is really not much left. It turns out that many
of the things that supposedly justify floating currencies, are also possible
with a gold standard system. Homework of chapter
2 part ii (due with the first midterm exam) ·
Do you support returning to gold standard? Why or why not? ·
Do you believe that bitcoin would be the future currency? Why or why
not? |
Why Does the Price of
Bitcoin Keep Going Up? Breaking
down the reasons that Bitcoin's price keeps rising • By
LUKE CONWAY Updated Dec 17, 2020 https://www.investopedia.com/why-does-bitcoin-keep-going-up-5092683 As
of December 16, Bitcoin has increased by about 195% year-to-date, topping
$23,000, but what is driving this meteoric rise? The reasons for its
appreciation vary, but Bitcoin has grown from what was once considered a scam
by many into something that has matured into a viable investment made by
famous billionaire investors, large institutions, and retail investors alike.
Why are these investors so bullish on Bitcoin even after it has surpassed
all-time highs? KEY
TAKEAWAYS • Inflation and the lowering purchasing power amidst massive
stimulus spending is driving people to store-of-value assets, including
Bitcoin. • Bitcoin's mining reward halving
mechanism further proves its scarcity and merit as a store-of-value asset. • Institutional adoption as both an investment and as a service they
can provide shows strong confidence in the future of Bitcoin and
cryptocurrency. • The infrastructure built around cryptocurrency and Bitcoin has shown
immense maturity over recent years making it easier and far safer to invest
than ever before. Inflation and the Lowering
Purchasing Power of the Dollar Since
the gold standard was removed in 1971 by Richard Nixon the amount of
circulating dollars has steadily increased. Between the year 1975 and just
before the coronavirus hit, the total money supply has increased from $273.4
billion to over $4 trillion as of March 9, 2020. Since that date, the total
money supply has gone from $4 trillion to over $6.5 trillion as of November
30, 2020, largely due to coronavirus related stimulus bills. Total
money supply (https://fred.stlouisfed.org/series/M1). Congress
is currently in talks to pass another stimulus bill of nearly $1 trillion,
aimed to help those suffering from the coronavirus. Should this new stimulus
bill be passed it would mean that since the onset of coronavirus, around 50%
of the world's total supply of US dollars will have been printed in 2020. While
there are certainly people suffering from a lack of jobs and businesses
shutting down, the increase in money supply has significant long-term
implications for the purchasing power of the dollar. Purchasing
power of the dollar since 1970 (https://fred.stlouisfed.org/series/CUUR0000SA0R). The
stimulus spending has led many to fear far greater inflation rates, and
rightfully so. To hedge against this
inflation investors have sought assets that either maintain value or
appreciate in value. Over the course of 2020, this search for a
store-of-value asset to hedge against inflation has brought them to Bitcoin.
Why? There
are many assets that are considered a store-of-value. Perhaps the most common
assets that come to mind are precious metals like gold or other things that
have a limited supply. With gold, we
know that it is a scarce resource, but we cannot verify with complete
certainty how much exists. And, while it may seem far fetched, gold
exists outside of earth and may one day be obtainable via asteroid mining as
technology advances. Why this Matters to Bitcoin This
is where Bitcoin differentiates itself. It is written into Bitcoin’s code how
many will ever exist. We can verify
with certainty how many exist now and how many will exist in the future. This
makes Bitcoin the only asset on the planet that we can prove has a finite and
fixed supply. In
Investopedia’s Express podcast with editor-in-chief Caleb Silver, Michael
Sonnenshein, a board member of the Grayscale Bitcoin Trust, said: “The amount of fiscal stimulus that has been injected into
the system in the wake of the COVID pandemic to stimulate the economy and get
things moving again, I think has really caused investors to think about what
constitutes a store of value, what constitutes an inflation hedge and how
they should protect their portfolios.” Sonnenshein
elaborated further saying: “It's important that
investors think about that. And I
think a lot of them are actually thinking about the juxtaposition between
digital currencies, like Bitcoin, which have verifiable scarcity and thinking
about that in the context of Fiat currencies, like the US dollar which
seemingly are being printed unlimitedly.” Part of Bitcoin’s price appreciation can certainly be attributed to fears
of inflation and its use as a hedge against it.
With further money printing on the horizon from stimulus packages, as well as
talks of student loan forgiveness from the Biden administration, it is fair
to say that inflation will continue, making the case for store-of-value
assets more compelling. The Halving To
further understand why Bitcoin has a verifiable finite limit to its quantity
it is important to understand the mechanism built into its code known as the
Halving. Every 210,000 blocks that are mined, or about every four years, the
reward given to miners for processing Bitcoin transactions is reduced in
half. In
other words, built into Bitcoin is a synthetic form of inflation because a
reward of Bitcoin given to a miner adds new Bitcoin into circulation. The
rate of this inflation is cut in half every four years and this will continue
until all 21 million Bitcoin is released to the market. Currently, there are
18.5 million Bitcoins in circulation, or about 88.4% of Bitcoin’s total
supply. Why is this important? As
discussed before, the rising inflation and growing quantity of the US dollar
lower its value over time. With gold, there is a somewhat steady rate of new
gold mined from the earth each year, which keeps its rate of inflation
relatively consistent. With
Bitcoin, each halving increases the assets stock-to-flow ratio. A
stock-to-flow ratio means the currently available stock circulating in the
market relative to the newly flowing stock being added to circulation each
year. Because we know that every four years the stock-to-flow ratio, or current
circulation relative to new supply, doubles, this metric can be plotted into
the future. Since
Bitcoin’s inception, its price has followed extremely
close to its growing stock-to-flow ratio. Each halving Bitcoin has
experienced a massive bull market that has absolutely crushed its previous
all-time high. The
first halving, which occurred in November of 2012, saw an increase from about
$12 to nearly $1,150 within a year. The second Bitcoin halving occurred in
July of 2016. The price at that halving was about $650 and by December 17th,
2017, Bitcoin's price had soared to just under $20,000. The price then fell
over the course of a year from this peak down to around $3,200, a price
nearly 400% higher than Its pre-halving price. Bitcoin’s
third having just occurred on May 11th, 2020 and its price has since
increased by nearly 120%. https://www.lookintobitcoin.com/charts/stock-to-flow-model/. Bitcoin’s
price increase can also be attributed to its stock-to-flow ratio and
deflation. Should Bitcoin continue on this trajectory as it has in the past,
investors are looking at significant upside in both the near and long-term
future. Theoretically, this price
could rise to at least $100,000 sometime in 2021 based on the stock-to-flow
model shown above. Some
investment firms have made Bitcoin price predictions based on these
fundamental analysis and scarcity models. In a leaked CitiFX Technicals analysis Tom Fitzpatrick, the managing
director at US Citibank, called for a $318,000 Bitcoin sometime in 2021. Live
on Bloomberg Scott Minerd, the Chief Investment Officer of Guggenheim Global
called for a $400,000 Bitcoin based on their “fundamental
work.” Institutional
Adoption As
discussed, the narrative of Bitcoin as a store of value has increased
substantially in 2020, but not just with retail investors. A number of
institutions, both public and private, have been accumulating Bitcoin instead
of holding cash in their treasuries. Recent
investors include Square (SQ), MicroStrategy (MSTR), and most recently the
insurance giant MassMutual, among many others. In total, 938,098 Bitcoin now
valued at the time of writing at $19,450,247,760 has been purchased by
companies, most of which has been accumulated this year. The largest
accumulator has been from Grayscale’s Bitcoin Trust which now holds 546,544
Bitcoin. Investments of this
magnitude suggest strong confidence among these institutional investors that
the asset will be a good hedge against inflation as well as provide solid
price appreciation over time. Aside
from companies flat out buying Bitcoin, many companies are now beginning to
provide services for them. PayPal (PYPL), for example, has decided to allow
crypto access to its over 360 million active users. Fidelity Digital Assets,
which launched back in October 2018, has provided custodial services for
cryptocurrencies for some time, but they are now allowing clients to pledge
bitcoin as collateral in a transaction. The CBOE and the CME Group (CME) plan
to launch cryptocurrency products next year. The number of banks,
broker-dealers, and other institutions looking to add such products are too
many to name, but in the same way that a company must have confidence in an
investment, it must also have confidence that the products that they sell
have value. Central banks and
governments around the world are also now considering the potential of a
central bank digital currency (CBDC). While these are not cryptocurrencies as
they are not decentralized, and core control over supply and rules is in the
hands of the banks or governments, they still show the government’s
recognition of the necessity for a more advanced payment system than paper
cash provides. This further lends merit to the concept
of cryptocurrencies and their convenience in general. Maturity From
its initial primary use as a method to purchase drugs online to a new
monetary medium that provides provable scarcity and ultimate transparency
with its immutable ledger, Bitcoin has come a long way since its release in
2009. Even after the realization that Bitcoin and its blockchain tech could
be used for way more than just the silk road, it was still near impossible
for the average person to get involved in previous years. Wallets, keys,
exchanges, the on-ramp was confusing and complicated. Today,
access is easier than ever. Licensed
and regulated exchanges that are easy to use are abundant in the US.
Custodial services from legacy financial institutions that people are used to
are available for the less tech-savvy. Derivatives and blockchain-related
ETFs allow those interested in investing but fearful of volatility to become
involved. The number of places that Bitcoin and other cryptocurrencies are
accepted as payment is growing rapidly. In
Investopedia;s Express podcast, Grayscale’s Sonnenshein said “the market today has just developed so much more from
where we were back then (2017 peak), we've really seen the development of a
two-sided market derivatives options, lending and borrowing futures markets.
It's just a much more robust 24 hour two-sided market that is starting to act
more and more mature with every day that passes.” Along
with all of this, the confidence showcased by large institutional players by
both their offering of crypto-related products as well as blatant investment
into Bitcoin speaks volumes. 99Bitcoins, a site that tallies the number of
times an article has declared Bitcoin as dead, now tallies Bitcoin at 386
deaths, with its most recent death being November 18th, 2020 and the oldest
death being October 15th, 2010. With Bitcoin smashing through its
all-time-high and having more infrastructure and institutional investment
than ever, it doesn’t seem to be going anywhere. |
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In class exercise: 1.
If U.S.
imports > exports, then the supply of dollars > the demand of
the dollars in the foreign exchange market, ceteris paribus. True/False?
Solution: Import means using $ (spending $, or out flow of $) to buy foreign goods č In the FX market, supply of $ increases č So when supply increases and assume that demand is unchanged, the value of $ will drop 2. If Japan exports > imports, then yen would appreciate against other currencies. True/False? Solution: Export means selling domestic products for yen ( in flow of yen from importers who will pay yen for the goods made in Japan; there is an increased demand for yen) č In the FX market, demand of yen increases č So when demand increases and assume that supply is unchanged, the value of yen will rise. 3. If the interest rate rises in the U.S., ceteris paribus, then capital will flow out of the U.S. True/False? Solution: Interest rate rises č
financial market will become more attractive to foreign investors č
capital will flow in,
not flow out. |
|
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Chapter 3 International Financial Market/ References: Go to www.forex.com and
set up a practice account and you can trade with $50,000 virtue money. Visit http://www.dailyfx.com/to
get daily foreign exchange market news. Part I: international financial centers Financial Hubs Today https://www.valuewalk.com/2020/04/top-10-biggest-financial-centers-world/
For detail, visit https://www.longfinance.net/media/documents/GFCI_27_Full_Report_2020.03.26_v1.1_.pdf British
think tank Z/Yen Group and the China Development Institute have published the
27th edition of the Global Financial
Centres Index. The tanking compares the competitiveness of the world’s
leading financial cities. Since 2007, the financial center ranking publishes
twice a year. It
compares the competitiveness of financial cities based on a survey of more
than 29,000 people worldwide. It also considers more than a hundred indices
from the World Bank, the Economist Intelligence Unit, and the Organization
for Economic Co-operation and Development (OECD). The financial hubs rankings include these five key areas -
infrastructure, human capital, business environment, financial sector
development, and reputation & general factors. Top 10 Financial Centers in
the World These
are the top ten biggest financial centers in the world, according to the 27th
financial center rankings. ·
10-
Los Angeles Los
Angeles is not just about glitz and glamour. It has also emerged as a global
business and finance hub. Los Angeles jumped from 19th place in 2017 to 13th
spot last year. It occupies the 10th spot with a score of 723 in the latest
ranking. ·
9-
Geneva The
Swiss city made a huge jump, from the 26th spot in last year’s GFCI. Geneva
currently scores 729 to occupy the 9th spot in the latest GFCI report. The
Swiss hub is one of the most livable and most expensive locations on the
planet. Geneva is home to several financial institutions, asset management
firms, and watchmakers. ·
8-
San Francisco Even
though San Francisco’s score declined from 736 to
732, its ranking jumped from 12th to 8th. Every financial headquarter except
Geneva witnessed a decline in its score compared to last year. San Francisco is a major technology and
financial hub. It is home to many large financial institutions and venture
capital firms. ·
7-
Beijing This
year, Beijing took 7th place, unchanged from last year even though its score
declined from 748 to 734. Beijing has
often is described as the “Billionaire Capital of the World”. Beijing’s
Financial Street is lined with headquarters of the People’s Bank of China,
large state-run banks, and insurance companies. ·
6-
Hong Kong (HK) HK
is one of the most significant financial locations in Asia. Since last year,
the city has suffered a little due to pro-democracy protests, which disrupted
the transit, retail, and tourism in HK. The Special Administrative Region of
China has a high concentration of banking and financial institutions. ·
5-
Singapore Singapore
slipped from 4th to 5th place this year, but it is still one of the world’s
most business-friendly countries. The island-nation has transformed its
economy on the back of hard work and political stability. Singapore is a leading destination for
wealth management and insurance firms. ·
4-
Shanghai Shanghai is home to the
world’s fourth-largest exchange with a market cap of over $4 trillion.
Experts predict Shanghai will become the world’s biggest financial hubs
within a decade. In the latest ranking, its score (740) is just one point
behind Tokyo. ·
3-
Tokyo Tokyo
is the world’s third-biggest financial center with a score of 741 with many
top banking, insurance, and financial services firms located in the city. The Tokyo Stock Exchange is the
third-largest in the world, behind only NYSE and Nasdaq. With a rich
human capital, Tokyo is both a costly and healthy business environment. ·
2-
London Despite Brexit, London is
the second biggest financial center on the planet with a score of 742. London
has been a global financial hub since the London Stock Exchange was founded
in 1698. However, the city’s economic prospects don’t look promising because
businesses move their offices and investments to other cities in Europe due
to Brexit. London could fall behind many other cities in the coming years. ·
New
York New
York retains the title of the world’s leading financial hub. It is home to many of the world’s largest
banks, insurance companies, hedge funds, credit rating agencies, and private
equity firms. Two of the world’s largest stock exchanges by market
capitalization – New York Stock Exchange and Nasdaq – are based in New York. It’s a global city with a mix of
various cultures. Where are Financial Centers
Heading? The
rapid rise of business hubs like London seemed invertible all until Brexit.
Additionally, COVID-19 has dramatically impacted the acceptance of working
for home, well beyond the business sector. Since 2020 due to factors such as
coronavirus, it appears that in-person meetings are becoming less vital. Also, recent events such as Brexit and
HK’s “merger” with China
could complicate these two cities’ rankings and ratings for the business
environment. However, it may surprise you that a recent rating has London
catching up on New York regarding financial sector development and other
metrics. FAQs ·
What is the financial district of London
called? Located
in London’s heart, Canary Warf and “the Square Mile” is one of the biggest finance hubs on earth. ·
Why is New York the financial capital? New
York is considered the place for finance due to its having the largest stock
exchanges in the city, the New York Stock exchange, and the NASDAQ. The city
has become a hub for wall street due to its attraction of human capital and
funding. ·
How did Hong Kong become a financial center? Under
the treaty of Nanking in 1842, China ceded the city to the British. HK
quickly became a center for financial sector development due to a robust
financial environment and reputation. Additionally, after the communists took
over China, many vital industries went over to British ruled HK as an
intermediary to China. ·
Which
is the biggest financial market in the world? The currency market is the
biggest by size and liquidity. FX trading volume beats stocks by a massive 28
to 1 level. Summary The
world is rapidly changing before our eyes. The list of top business hubs is becoming more Asian and less
European and North American dominated.
However, if the coronavirus pandemic teaches us anything it’s that the future
is unclear, it would be foolish to bet against hubs like New York City
vanishing anytime soon. • London. London has been a leading international financial centre
since the 19th century, acting as a centre of lending and investment around
the world. English contract law was adopted widely for international finance,
with legal services provided in London. Financial institutions located there
provided services internationally such as Lloyd's of London (founded 1686) for insurance and the Baltic
Exchange (founded 1744) for shipping. During the 20th century London
played an important role in the development of new financial products such as
the Eurodollar and Eurobonds in the 1960s, international asset management and
international equities trading in the 1980s, and derivatives in the 1990s. London
continues to maintain a leading position as a financial centre in the 21st
century, and maintains the largest trade surplus in financial services around
the world. However, like New York, it faces new competitors including
fast-rising eastern financial centres such as Hong Kong and Shanghai. London is the largest centre for
derivatives markets, foreign exchange
markets, money markets, issuance of international debt securities, international insurance, trading in gold, silver and base metals
through the London bullion market and London Metal Exchange, and international bank lending. London benefits from its position between
the Asia and U.S. time zones, and has
benefited from its location within the European Union, though this may end
following the outcome of the Brexit referendum of 2016 and the decision of
the United Kingdom to leave the European Union. As well as the London
Stock Exchange, the Bank of England, the second oldest central bank, and the European Banking Authority are in London,
although the EBA is moving to Paris in March 2019 after Brexit. Economics of Brexit (2020
Update) I A Level and IB Economics
(youtube) • Tokyo. One report suggests that Japanese authorities are working
on plans to transform Tokyo but have met with mixed success, noting that
"initial drafts suggest that Japan's economic specialists are having
trouble figuring out the secret of the Western financial centres'
success." Efforts include more English-speaking restaurants and services
a/nd the building of many new office buildings in Tokyo, but more powerful
stimuli such as lower taxes have been neglected and a relative aversion to
finance remains prevalent in Japan. Tokyo emerged as a major financial centre
in the 1980s as the Japanese economy became one of the largest in the
world. As a financial centre, Tokyo
has good links with New York City and London. • Hong Kong. As a financial centre, Hong Kong has strong links with
London and New York City. It developed
its financial services industry while a British territory and its present
legal system, defined in Hong Kong Basic Law, is based on English law. In
1997, Hong Kong became a Special Administrative Region of the People's
Republic of China, retaining its laws and a high degree of autonomy for at
least 50 years after the transfer. Most
of the world's 100 largest banks have a presence in the city. Hong Kong is a leading location for initial
public offerings, competing with New York City, and also for merger and acquisition
activity • Singapore. With its strong links with London, Singapore has developed into the Asia
region's largest centre for foreign exchange and commodity trading, as well
as a growing wealth management hub. Other than Tokyo, it is one of the main centres for fixed
income trading in Asia. However, the market capitalisation of its stock
exchange has been falling since 2014 and several major companies plan to
delist. (https://en.wikipedia.org/wiki/Financial_centre) For Discussion: Do we need so many financial centers in Asia? Is London Losing Its Global Standing After Brexit and Covid-19? (video) How Brexit
disruption will change London's financial centres l FT
(youtube)
Post-Brexit
trade deal: 'The City of London will find ways of thriving in the future
(youtube)
Homework of
chapter 3 part I (due with the third midterm exam) ·
Will London lose its financial hub status to a EU city such as
Frankfurt? Why or why not? |
Brexit Is Nipping at London’s Role as a Financial Powerhouse Britain and the European Union don’t trust each other much,
and global banks are caught in the middle. https://www.nytimes.com/2020/11/27/business/brexit-london-financial-center.html Updated Dec. 24, 2020 LONDON — For Britain, its exit from the European
Union is supposed to be the start of a new era as a “Global Britain,” an
open, inviting and far-reaching country. For the European Union, Brexit is an
opportunity to repatriate some business from across the English Channel and
further bolster the continent’s economic standing in the world. And for the City of London, a large hub for international
banks, asset managers, insurance firms and hedge funds, Brexit is a political
headache. Britain’s financial center has been caught in the middle of
these two agendas, leaving the future of the City’s relationship with the
rest of Europe fractured and uncertain. Britain left the free trade
bloc at the end of January but immediately entered into an 11-month
transition period that has kept everything unchanged. What comes after Dec.
31, when this transition period expires, is being negotiated down to the
wire. Hanging in the balance are things like fishing quotas, long lines for
customs checks at ports and disruption to automakers and other manufacturers
that have fine-tuned a “just in time” supply chain. But the global financial firms with big operations in London already know
they will lose the biggest benefit of Britain’s E.U. membership: the ability
to easily offer services to clients across the region from a single base,
known as passporting. This has allowed a bank in London to provide loans
to a business in Venice or trade bonds for a company in Madrid. One impact of Brexit:
British banks are informing many customers in Europe that their accounts must
be closed. After Jan. 1, that won’t be
so simple. The ability of firms in
Britain to offer financial services in the European Union will depend on
whether E.U. policymakers determine that Britain’s new regulations are close
enough to their own to be trusted — a critical concept known as equivalence. The problem is that some
very common banking activities — taking deposits and making loans to companies
and individuals, for example - don’t qualify for equivalence. The result will
be a patchwork arrangement with large holes. That’s why thousands of people, primarily Brits, living in Europe who
have British bank accounts have recently been told their accounts will be
closed. To ease the transition Britain decided to copy some of the
European Union’s regulations. In turn, it hoped that the European Union would
allow firms in Britain to keep doing business in the bloc. In early November,
Britain’s chancellor of the Exchequer said his government would accept the
E.U. rules in a number of areas, including capital requirements and credit
ratings agencies. But the European Union
hasn’t reciprocated. The bruised feelings raised by Britain’s divorce from the
bloc continue to influence relations between the two. Officials in Brussels
say they are wary that, over time, Britain will exploit its independence and
weaken the restrictions on risk and other rules that banks don’t like. That lack of a deal “should
not be the starting gun for a race to deregulate,” Joachim Wuermeling, who is
in charge of bank supervision at the Bundesbank, Germany’s central bank, said
last month. This has led to a political stalemate, in which London and
Brussels remain at odds on several key pieces of financial regulation and
unwilling to give market access to each other. One such rule allows investment firms to offer their services
and trade financial securities across borders to clients in the European
Union, under a piece of regulation called Mifid II. The bloc is updating its
rules for cross-border securities trading and won’t grant Britain a stamp of
approval until the revision is completed in the middle of next year. That stance spurred an
outraged response from none other than the governor of the Bank of England,
Andrew Bailey, who in September complained to members of Parliament about
Brussels’s behavior. “I just do not see how we
can have an equivalence process where the E.U. essentially says, ‘We’re not
even going to judge equivalence at the moment, because our rules are going to
change,’” Mr. Bailey said. “What does that mean, really? It means that they
think this is a rule‑taking process.” (The accusation of “rule-taking”
is often the ultimate put-down in these talks, meaning that one side is
dictating rules to the other.) The disharmony is
underscored by the fact that, unlike the rules that governed pre-Brexit,
these regulatory decisions are made unilaterally and can be revoked with
short notice. The lack of agreements mean London will lose financial jobs as
a result of Brexit. Even before the year-end deadline, E.U.
regulations are compelling banks to shift workers, and capital, to the
continent. The movement of decision makers is important: In the event of a
crisis, Europe’s bank overseers don’t want critical people to be somewhere
offshore, even if it’s London. Overall, since mid-2016,
financial firms have shifted $1.6 trillion in assets out of Britain,
according to EY. But the process hasn’t been
completed. It has been delayed by the pandemic, which has made it difficult
for people to move and some corporate clients have been more concerned with
keeping their business afloat than signing new contracts. “Some banks and their
customers apparently want to wait until the last minute to make the actual
transfers,” Mr. Wuermeling of the Bundesbank said. “They would be well
advised to act now.” JPMorgan has asked about 200
employees to move from London to other European cities, mainly Paris and
Frankfurt, before the end of the year. Another 100 workers are expected to
move next year. JPMorgan also plans to move about 200 billion euros in assets
to Frankfurt. Goldman Sachs plans to transfer between $40 billion and $60
billion from its British operations to its German subsidiary by the end of
the year. That unit held just $3.6 billion at the end of 2019, according to
company filings. All told, lenders with
German licenses will move assets worth about 400 billion euros, or $475
billion, to the Continent because of Brexit, according to the Bundesbank.
That will more than double the banks’ assets in the European Union. The Bundesbank expects banks
that have sought German licenses because of Brexit to bring in 2,500
employees, some of whom may be located in other cities like Milan or
Amsterdam. That’s hardly the mass migration to the continent predicted a few
years ago. (Estimates reached as high as 75,000 jobs relocating out of London
to the rest of Europe.) Still, the moves keep alive a question that has been posed
since the Brexit vote in 2016: Could another European capital unseat London
as the region’s dominant financial center? So far there has been no single big winner. Money has
scattered to Frankfurt, Luxembourg, Dublin and Paris. “London will remain by far the most dominant player,” said
Michael Grote, a professor at the Frankfurt School of Finance &
Management who has studied the effect of Brexit on financial services. Next year, Britain’s financial sector is still expected to be
one of the largest in the world: The amount of money it manages is about 10
times the size of the British economy. The business that actually relates to
clients in the European Union, and would be threatened by regulatory discord,
is relatively small. “Not that much business in
London and the United Kingdom’s financial center actually depends on
equivalence,” Alex Brazier, the Bank of England’s head of financial stability
strategy and risk, told members of Parliament in September. About 10 percent
of the City’s Ł300 billion in annual revenue from finance and insurance comes
from clients in the European Union, he said. Of that about a third, or Ł10
billion, is from activities that could continue under equivalence rules, he
added. While London won’t lose its status as the financial capital of
Europe, its primacy will be eroded. The market for financial services will
become more fragmented. Andrew Gray, the head of
Brexit at PwC, said that dispersal of
financial services around the Continent would create more friction in the
system, adding to costs. “There is economy of scale of having it in London,”
he said. “You lose that economy of scale.” Eshe Nelson reported from London and Jack
Ewing from Frankfurt. Michael J. de la Merced contributed reporting from
London. |
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Chapter 3 - Part II: Floating exchange rate system vs.
fixed exchange rate system For Discussion: · US is using
floating exchange rate system. What is the advantage and disadvantage of this
system? DO we need Cheap $ or strong $? · Chinese
currency is pegged to US$. What is the advantage and disadvantage of this
system? What about let it float, instead of holding its value at a fixed
rate? Can Chinese government control its currency? How? Is cheap RMB always
better than Strong RMB, to Chinese government? · Germany
is part of the Euro Zone. Can Germany manipulate Euro? · Who
are the major players in the FX market? · As
compared with stock market, FX market is more volatile or less? Why? A - set a fixed exchange rate between its currency and
another while allowing capital to flow freely across its borders, B - allow capital to flow freely and set
its own monetary policy, or C - set its own monetary policy and
maintain a fixed exchange rate. The Impossible Trinity or "The Trilemma", in
which two policy positions are possible. If a nation were to adopt position
a, for example, then it would maintain a fixed exchange rate and allow free
capital flows, the consequence of which would be loss of monetary
sovereignty. The Impossible Trinity - 60 Second Adventures in Economics (5/6)
(video)
The impossible trinity (also
known as the trilemma) is a concept in international economics which states
that it is impossible to have all three of the following at the same time: • a fixed foreign exchange rate • free capital movement (absence of capital controls) • an independent monetary policy It
is both a hypothesis based on the uncovered interest rate parity condition,
and a finding from empirical studies where governments that have tried to
simultaneously pursue all three goals have failed. The concept was developed
independently by both John Marcus Fleming in 1962 and Robert Alexander
Mundell in different articles between 1960 and 1963. Policy
choices According to the impossible
trinity, a central bank can only pursue two of the above-mentioned three
policies simultaneously. To see why, consider this
example: Assume
that world interest rate is at 5%. If the home central bank tries to set
domestic interest rate at a rate lower than 5%, for example at 2%, there will
be a depreciation pressure on the home currency, because investors would want
to sell their low yielding domestic currency and buy higher yielding foreign
currency. If the central bank also wants to have free capital flows, the only
way the central bank could prevent depreciation of the home currency is to
sell its foreign currency reserves. Since foreign currency reserves of a
central bank are limited, once the reserves are depleted, the domestic
currency will depreciate. Hence,
all three of the policy objectives mentioned above cannot be pursued
simultaneously. A central bank has to forgo one of the three objectives.
Therefore, a central bank has three policy combination options. Options In
terms of the diagram above (Oxelheim, 1990), the options are: • Option (a): A stable exchange rate and free capital flows (but not an
independent monetary policy because setting a domestic interest rate that is
different from the world interest rate would undermine a stable exchange rate
due to appreciation or depreciation pressure on the domestic currency). • Option (b): An independent monetary policy and free
capital flows (but not a stable exchange rate). • Option (c): A stable exchange rate and independent
monetary policy (but no free capital flows, which would require the use of
capital controls. Currently,
Eurozone members have chosen the first
option (a) while most other countries have opted for the second one (b).
By contrast, Harvard economist Dani Rodrik advocates the use of the third
option (c) in his book The Globalization Paradox, emphasising that world GDP
grew fastest during the Bretton Woods era when capital controls were accepted
in mainstream economics. Rodrik also argues that the expansion of financial globalization and the free movement of
capital flows are the reason why economic crises have become more frequent in
both developing and advanced economies alike. Rodrik has also developed
the "political trilemma of the world economy", where
"democracy, national sovereignty and global economic integration are
mutually incompatible: we can combine any two of the three, but never have
all three simultaneously and in full." (from
Wikipedia)
Understanding Forex Quotes ---- https://www.investopedia.com/terms/c/currencypair.asp
Understanding
Forex Quotes by Investopedia
When a
currency is quoted, it is done in relation to another currency, so that the
value of one is reflected through the value of another. Therefore, if you are
trying to determine the exchange rate between the U.S. dollar (USD) and the
Japanese yen (JPY), the forex quote would look like this:
This is referred to as a currency
pair. The currency to the left of
the slash is the base currency,
while the currency on the right is called the quote or
counter currency. The base currency (in this case, the U.S. dollar) is always
equal to one unit (in this case, US$1), and the quoted currency (in this
case, the Japanese yen) is what that one base unit is equivalent to in the
other currency. The quote means that US$1 = 119.50 Japanese yen. In other
words, US$1 can buy 119.50 Japanese yen. The forex quote includes the
currency abbreviations for the currencies in question. Direct Currency Quote vs. Indirect Currency Quote There are two ways to quote a currency pair, either directly or indirectly. A direct currency quote is
simply a currency pair in which the domestic
currency is the quoted currency; while an indirect quote, is a
currency pair where the domestic
currency is the base currency. So if you were looking at the Canadian
dollar as the domestic currency and U.S. dollar as the foreign currency, a
direct quote would be USD/CAD, while an indirect quote would be CAD/USD. The
direct quote varies the domestic currency, and the base, or foreign currency,
remains fixed at one unit. In the
indirect quote, on the other hand, the foreign currency is variable and
the domestic currency is fixed at one unit. ·
Direct currency quote:
foreign currency / domestic currency, such as JPY / USD (one JPY for
how many USD) ·
Indirect currency quote: domestic currency / foreign currency,
such as USD/JPY (one USD for how many JPY) For
example, if Canada is the domestic currency, a direct quote would be 1.18
USD/CAD and means that USD$1 will purchase C$1.18. The indirect quote for
this would be the inverse (1/1.18), 0.85 CAD/USD, which means with C$1, you
can purchase US$0.85. In the forex spot market,
most currencies are traded against the U.S. dollar, and the U.S. dollar is
frequently the base currency in the currency pair. In these cases, it is
called a direct quote. This would apply to the
above USD/JPY currency pair, which indicates that US$1 is equal to 119.50
Japanese yen. However,
not all currencies have the U.S. dollar as the base. The Queen's currencies -
those currencies that historically have had a tie with Britain, such as the
British pound, Australian Dollar and New Zealand dollar - are all quoted as
the base currency against the U.S. dollar. The euro is quoted the same way as
well. In these cases, the U.S. dollar is the counter currency, and the
exchange rate is referred to as an indirect quote. This is why the EUR/USD quote
is given as 1.25, for example, because it means that one euro is the
equivalent of 1.25 U.S. dollars. Most currency exchange rates
are quoted out to four digits after the decimal place,
with the exception of the Japanese yen (JPY), which is quoted out to two
decimal places. Cross
Currency ( You can find the cross exchange rates
at www.forex.com) When a currency quote is
given without the U.S. dollar as one of its components, this is called a
cross currency. The most common cross currency pairs are
the EUR/GBP, EUR/CHF and EUR/JPY. These currency pairs expand the trading
possibilities in the forex market, but it is important to note that they do
not have as much of a following (for example, not as actively traded) as
pairs that include the U.S. dollar, which also are called the majors. (For
more on cross currency, see Make The Currency Cross Your Boss.) (https://www.investopedia.com/university/forexmarket/forex2.asp) Summary: USD
/ JPY =
119.50 č 1 US$ = 119.5 YEN, to US residents
this is an indirect quote; to a
Japanese, it is a direct quote. JPY
/ USD =
1/119.50 č 1 YEN = (1/119.5)$, to US residents
this is a direct quote; to a
Japanese, it is a indirect quote. Direct quote = 1/(indirect quote) or indirect quote = 1/ (direct quote) *** Inverse relationship Part IV: what is BID and ASK price on Forex Forex: Bid and Ask
(video)
Bid and Ask The bid price is used when selling a currency
pair (going short)
and reflects how much of the quoted currency will be obtained when selling
one unit of the base currency, or how much the market will pay for the quoted
currency in relation to the base currency. The quote
before the slash is the bid price, and the two
digits after the slash represent the ask price (only the last two digits of
the full price are typically quoted). Note that the bid price is always smaller than the ask price.
Let's look at an example:
If you want to buy this currency pair, this
means that you intend to buy the base currency and are therefore looking at
the ask price to see how much (in Canadian dollars) the market will charge
for U.S. dollars. According to
the ask price, you can buy one U.S. dollar with 1.2005 Canadian dollars. However, in order to sell this currency pair, or
sell the base currency in exchange for the quoted currency, you would look at
the bid price. It tells you
that the market will buy US$1 base currency (you will be selling the market
the base currency) for a price equivalent to 1.2000 Canadian dollars, which
is the quoted currency. Whichever currency is quoted first (the base currency) is
always the one in which the transaction is being conducted. You either buy or
sell the base currency. Depending on what currency you want to use to buy or
sell the base with, you refer to the corresponding currency pair spot exchange rate
to determine the price. (https://www.investopedia.com/university/forexmarket/forex2.asp) In class exercise: 1.
1) You just arrived at
Toronto airport. How much is $1,000 in CAD? Solution: č USD/CAD=1.2000/05č base is USD č sell $ at bid price: 1$=1.2CAD, So with $1,000, you can convert it to $1,000 * 1.2 CAD/$ =
1,200 CAD 2) The next day, you plan to leave Canada. How many $ in 1,200
CAD? $1,000 or less? Solution: č now you want to buy $: 1$ = 1.25 CAD, so with 1,200 CAD, you
can convert it to 1200 CAD / 1.25 CAD/$ = $960 Exercise II: GBP/USD = 1.5200/1.6000 Meanwhile, the bid rate is
quoted as 0.625 Ł/$ and the ask rate is quoted as 0.6579 Ł/$. USD/GBP = 0.6250 /0.6579 If you convert it to Ł and
then convert it back to $, what will happen? Answer: Sell at bid and buy at ask price (ask is
always higher than bid so you buy high and sell low, since you are dealing
with the bank). $1000č at London, sell $1000 at bid rate, if you use USD/GBP quote, since $ is the base currency. đ $1000 * 0.625 GBP/$ = 625 GBP đ When leaving London, how many $ back from 625 GBP? đ Now buy $ at ask rate đ 625 GBP / 0.6579 GBP/$ = 625 / 0.6579=$950 <$1000, you will lose some money in this transaction due to bid ask spread. Exercise
III: Suppose the spot ask
exchange rate is $1.90 = Ł1.00 (note that base currency here is Ł) and the spot bid exchange
rate is $1.89 = Ł1.00 (another way to quote the curry should be: USD/GBP =
(1/1.9)/(1/1.89) = 0.5263/91) If you were to buy $1,000,000 worth of Ł
and then sell them 10 minutes later, how much of your $1,000,000 would be
lost by the bid-ask spread? (Hint: You buy at ask and sell at bid) GBP at $1.60 /Ł and buy $ at
0.6579 Ł/$. So $1000 / 1.6
$/Ł * 0.6579 Ł/$ = $950 Exercise
IV: The
dollar-euro exchange rate is $1.25 = €1.00 and the
dollar-yen exchange rate is Ą100 = $1.00. What is the euro-yen cross rate? (answer: Ą125 = €1.00) Exercise
V: The
AUD/$ spot exchange rate is AUD1.60/$ and the SF/$ is SF1.25/$. The AUD/SF cross exchange rate is: (answer: 1.2800) Exercise VI: Suppose that
the current exchange rate is €0.80 = $1.00. The direct quote, from the U.S.
perspective is which of the following? a) €1.00 = $1.25 b)
€0.80 = $1.00 c)
Ł1.00 = $1.80 Exercise VII:
If the $/Ł bid and ask prices are $1.50 and $1.51, respectively, the
corresponding Ł/$ bid and ask prices are: a)
Ł0.6667 and
Ł0.6623 b)
$1.51 and $1.50 c)
Ł0.6623 and
Ł0.6667 Answer: $/Ł bid and ask prices are $1.50 and $1.51 č Ł/$ is the inverse of $/Ł and bid is less than ask.
Ł/$ bid = 1/1.51 č 1$ = (1/1.51) Ł = Ł0.6623 ------ bid price Ł/$ ask = 1/1.50 č 1$ = (1/1.50) Ł = Ł0.6667 ------ ask price Exercise VIII:
The dollar-euro exchange rate is $1.25 = €1.00 and the dollar-yen exchange
rate is Ą100 = $1.00. What is the euro-yen cross rate? a) Ą125 = €1.00 b) Ą1.00 = €125 c) Ą1.00 = €0.80 Answer:
Ą/€: 1.25$ = 1€ č 1$= (1/1.25) € č 1$ = 0.8€ 1$ = 100 Ą č 0.8€ = 100 Ą č €1.00 = Ą125 Exercise IX:
The AUD/$ spot exchange rate is AUD1.60/$ and the SF/$ is SF1.25/$. The AUD/SF cross exchange rate is: a.
0.7813 b.
2.0000 c.
1.2800 d.
0.3500 Answer:
AUD/SF: AUD1.60/$ č 1$ = 1.6AUD SF1.25/$ č 1$ = 1.25SF So, 1.6AUD = 1.25SF č(1.6/1.25)AUD= 1 SF č 1 SF = 1.28 AUD HOMEWORK Part I - CHAPTER 3 (Due with first mid term exam) 1.
Bid/Ask Spread Compute
the bid/ask percentage spread for Mexican peso retail transactions in which
the ask rate is $.11 and the bid rate is $.10. HINT: BID ASK SPREAD = (ASK-BID)/ASK (Answer: 9.09%) 2.
Indirect Exchange Rate If
the direct exchange rate of the euro is worth $1.25, what is the indirect
rate of the euro? That is, what is the value of a dollar in euros? (Answer:
0.8€) 3. Suppose the spot bid exchange rate is $1.50 = Ł1.00 and the spot ask
exchange rate is $1.6 = Ł1.00. If you were to buy $16,000,000 worth of Ł and
then sell them five minutes later, how much of your $16,000,000 would be “eaten” by the bid-ask spread? 3.
Cross Exchange Rate Assume
Poland currency (the zloty) is worth $.17 and the Japanese yen is worth $.008.
What is the cross rate of the zloty with respect to yen? That is, how many
yen equal a zloty? (Answer: 21.25Ą) 4.
Foreign Exchange You
just came back from Canada, where the Canadian dollar was worth $.70. You
still have C$200 from your trip and could exchange them for dollars at the
airport, but the airport foreign exchange desk will only buy them for $.60.
Next week, you will be going to Mexico and will need pesos. The airport
foreign exchange desk will sell you pesos for $.10 per peso. You met a tourist
at the airport who is from Mexico and is on his way to Canada. He is willing
to buy your C$200 for 1,300 pesos. Should you accept the offer or cash the
Canadian dollars in at the airport? Explain. (Answer: You can only get $1,200
peso if you accept the offer in the airport) 5.
Do you think that LIBOR will cease to exist? Why or why not? (please refer to the paper posted on class
website.) 6. Why are euro Libor
rates negative?
(please refer to the paper posted on class website.) Part V: LIBOR, Eurodollar, Eurobond What is US
dollar LIBOR? (What is LIBOR? Video, and
other video (Libor, khan academy) The London Interbank Offered Rate (LIBOR)
is an interest rate based on the average interest rates at which a large number
of international banks in London lend money to one another. The official LIBOR rates are calculated
on a daily basis and made public at 11:00 (London Time) by the ICE Benchmark
Administration (IBA). We publish the LIBOR rates on this website with a delay
(we are not allowed to publish realtime LIBOR rates).
|
Euro
LIBOR |
02-12-2021 |
02-11-2021 |
02-10-2021 |
02-09-2021 |
02-08-2021 |
-0.58529 % |
-0.58200 % |
-0.58543 % |
-0.58486 % |
-0.58586 % |
|
-0.57529 % |
-0.57500 % |
-0.57886 % |
-0.58014 % |
-0.58071 % |
|
- |
- |
- |
- |
- |
|
-0.58029 % |
-0.58000 % |
-0.58086 % |
-0.57929 % |
-0.57929 % |
|
-0.56014 % |
-0.55557 % |
-0.55414 % |
-0.55114 % |
-0.55400 % |
|
-0.55043 % |
-0.55014 % |
-0.54643 % |
-0.54400 % |
-0.53786 % |
|
- |
- |
- |
- |
- |
|
- |
- |
- |
- |
- |
|
-0.54271 % |
-0.54186 % |
-0.54057 % |
-0.54057 % |
-0.53914 % |
|
- |
- |
- |
- |
- |
|
- |
- |
- |
- |
- |
|
- |
- |
- |
- |
- |
|
- |
- |
- |
- |
- |
|
- |
- |
- |
- |
- |
|
-0.50043 % |
-0.50043 % |
-0.50129 % |
-0.49929 % |
-0.49514 % |
The London Interbank Offered Rate is the average interest rate at
which leading banks borrow funds from other banks in the London market. LIBOR
is the most widely used global "benchmark" or reference rate for
short term interest rates.
For
discussion:
·
Why are euro Libor rates
negative?
A negative deposit rate is intended to encourage lenders to do something more useful with their money than park it with the ECB. It's also designed to help weaken the euro to provide some assistance to eurozone exporters, and, hopefully, spur prices at home by making imports more expensive
Your opinion?
·
When did Japan start negative interest rates?
The Bank of Japan adopted a negative rate in
January 2016, mostly to fend off an unwelcome yen spike from hurting an
export-reliant economy. It charges 0.1 percent interest on a
portion of excess reserves financial institutions park with the BOJ.
Your
opinion?
·
Will interest rates go negative in the
US?
As worries over the economic fallout from the COVID-19 crisis have
intensified, investors have priced in negative policy rates in
the United States. Your opinion?
Eurodollar
-- Eurodollar explained (video)
The term eurodollar refers to U.S.
dollar-denominated deposits at foreign banks or at the overseas branches of
American banks. By being located outside the
United States, eurodollars escape regulation by the Federal Reserve
Board, including reserve requirements. Dollar-denominated deposits not
subject to U.S. banking regulations were originally held almost exclusively
in Europe, hence the name eurodollar. They are also widely held in branches
located in the Bahamas and the Cayman Islands.
·
Between LIBOR USD
rate and US interest rate for similar terms, there should not be any
discrepancies. Right?
A eurobond is denominated in a currency other than the home
currency of the country or market in which it is issued. These bonds are
frequently grouped together by the currency in which they are denominated,
such as eurodollar or euroyen bonds. Issuance is usually handled by an international syndicate of financial
institutions on behalf of the borrower, one of which may underwrite the bond,
thus guaranteeing purchase of the entire issue. https://www.investopedia.com/terms/e/eurobond.asp
Why are interest rates negative in
Europe?
Ever since eurozone
interest rates turned negative in 2014, a debate has raged about whether
or not this makes economic sense. DW explains how they came about and why the
monetary policy tool is a double-edged sword.
For anyone in need
of money, Germany seems to be a paradise on earth these days. Not only
can the country's government effectively get paid for borrowing
money, consumers too can enjoy a money-for-nothing rate environment,
provided they are considered solvent enough.
Lenders are giving
out one-year €1000 ($1100) loans for as low as -0.5%, meaning you have to pay
back only €995, while a €250,000 mortgage can be taken out for about
0.52% for 10 years.
The other side of the coin is, however, that savers get no returns at all on their
money, and banks are considering punishing those who hold more than
€100,000 in their accounts by passing on the negative interest
rates imposed on them by the European Central Bank.
Crisis mode
The era of ultra-low
and finally negative interest rates in Europe began when the ECB was battling
the global financial crisis triggered by the collapse of US bank Lehman
Brothers in 2008, and the European sovereign debt crisis that followed in
2010.
The immediate financial shocks of those crises have been
overcome, but a decade later their
effects on the real economy, including low inflation and subdued growth,
continue to rankle, requiring further unconventional policy measures such
as negative interest rates.
A trigger for the ECB to cut its deposit rate in
September to a record low of -0.5% was a renewed drop in the eurozone inflation rate to 1% in August, well below
the central bank's target. Moreover, the bank had to revise downward its
growth projections for this year and next, predicting growth at
just above 1% — below what
is considered the bloc's natural potential.
"The Governing
Council now expects the key ECB interest rates to remain at their present or lower
levels until it has seen the inflation outlook robustly converge to a level
sufficiently close to, but below, 2%," the ECB said, and its
president, Mario Draghi, added that "now it is high time for the fiscal
policy to take charge" of promoting growth.
A negative deposit
rate is intended to encourage lenders to do something more useful with their
money than park it with the ECB. It's also designed to help weaken the euro
to provide some assistance to eurozone exporters, and, hopefully, spur prices at home by
making imports more expensive. Higher state spending, meanwhile, is aimed at
boosting economic activity, which after a decade of only moderate growth is
currently stalling or even receding.
Structural problems
Apart from the euro
area, Switzerland, Denmark, Sweden and Japan have also allowed rates to fall
below zero. Interestingly
enough though, when negative rates first appeared, investors and economists
assumed they were a response to idiosyncratic events, such as the
eurozone sovereign debt crisis — an emergency that required temporary central
bank easing.
Today, however, it is hard to blame negative rates on a
specific "event," except maybe if you believe that Donald Trump's
trade wars will deal a devastating blow to global growth.
Instead, the investors, economists and policymakers are
increasingly pointing to long-term
structural explanations for the shift to negative rates. They cite
demographics, saying that aging developed world populations may be
suppressing demand. It is also speculated that technological innovation may
be dragging prices down.
Others argue for secular stagnation, which is when low demand
and a reluctance to invest create a self-reinforcing downward loop. Or simply
put, thanks to the central banks'
flooding of markets with cheap money, there're just not enough
opportunities around to put it to any profitable use.
When is the time to say enough?
So the question is for how long can a negative rate
environment continue before it hurts the real economy?
Research published in August by economists from the US
Treasury Department, the University of Bath, the University of Sharjah and
Bangor University found "robust" evidence that bank lending growth is already weaker in countries with negative
rates.
With interest rates so low in Europe, the return on loans or other debt is not matching the risk for
commercial banks, leaving more expensive equity financing as the sole source
of funding. That increases the
overall cost of project financing so that potentially growth-enhancing
projects never get off the ground.
Furthermore, the Association of German Banks has estimated
that European lenders pay €7.5 billion
a year for their excess deposits with the ECB. By contrast, US banks still
earn billions from the US Fed for their holdings due to a positive rate
environment.
"It is a remarkable burden for banks who find it more or
less impossible to convey this cost to retail savers," the director of
the association, Volker Hofmann, said.
This means there are also limits to how much of the burden the
banks can transfer to retail savers by introducing negative as that
could prompt depositors to avoid being charged by choosing to hold
physical cash instead.
Despite the downsides, US investment bank JPMorgan estimates
that Europe may face "another
eight years" of negative interest rates.
"Monetary policy
may be able to prolong the current [business] cycle, but ultimately we do not
think it can prevent recession," Bob Michele, global head of fixed
income at the bank's asset management arm, said in a note in September. He
questions whether the ECB is "doing enough to get ahead of the
curve" with a recent rate cut and its relaunch of asset purchases, and
demands a "decisive shift from monetary to fiscal policy."
Why Negative Interest Rates Are Still Not Working in Japan
By SEAN ROSS, updated Dec
13, 2020
The Bank of Japan (BOJ)
keeps trying to print Japan back to economic prosperity, and it is not
letting 25 years of failed stimulus policies get in its way. Negative interest rates were announced by
the BOJ in January 2016 as the latest iteration in monetary experimentation.
Six months later, the Japanese economy showed no growth, and it's bond market
was a mess. Conditions deteriorated so far that the Bank of
Tokyo-Mitsubishi UFJ Ltd., Japan's largest private bank, announced in June
2016 that it wanted to leave the Japanese bond markets because BOJ
interventions had made them unstable.
While these economic woes
present major problems for prime minister Yoshihide Suga and BOJ Governor
Haruhiko Kuroda, they can serve as a cautionary tale for the rest of the
world. Wherever they have been tried, chronically
low-interest rates and huge monetary expansions have failed to promote real
economic growth. Quantitative easing (QE) did not achieve its stated
objectives in the United States or the European Union (EU), and chronic
low-interest rates have been unable to revive Japan's once-thriving economy.
Why Japan Went Negative
There are two reasons why central
banks impose artificially low-interest rates. The first reason is to encourage borrowing, spending, and investment.
Modern central banks operate under the assumption that savings are
pernicious unless they immediately translate into new business investment.
When interest rates drop to near zero, the central bank wants the public to
take your money out of savings accounts and either spend it or invest it.
This is based on the circular flow of income model and the paradox of thrift.
Negative interest rate policy (NIRP)
is a last-ditch attempt to generate spending, investment, and modest
inflation.
The second reason for
adopting low-interest rates is much more practical and far less advertised. When national governments are in severe
debt, low-interest rates make it easier for them to afford interest payments.
An ineffective low-rate policy from a central bank often follows years of
deficit spending by a central government.
No country has proven less
effective with low-interest-rate policies or high national debt than Japan.
By the time the BOJ announced its NIRP, the Japanese government's rate was
well over 200% of gross domestic product (GDP). Japan's debt woes began in
the early 1990s, after Japanese real estate and stock market bubbles burst
and caused a steep recession. Over the next decade, the BOJ cut interest
rates from 6% to 0.25%, and the Japanese government tried nine separate
fiscal stimulus packages. The BOJ deployed its first quantitative easing in
1997, another round between 2001 and 2004, and quantitative and qualitative
monetary easing (QQE) in 2013. Despite these efforts, Japan has had almost no
economic growth over the past 25 years.
Why Negative Interest Rates
Do Not Work
The Bank of Japan is not
alone. Central banks have tried negative rates on reserve deposits in Sweden,
Switzerland, Denmark, and the EU. As of July 2016, none had measurably
improved economic performance. It seems that monetary authorities may be out
of ammunition.
Globally, there is more than
$12 trillion in government bonds
trading at negative rates. This does little for indebted government, and
even less to make businesses more productive or to help low-income households
afford more goods and services. Super-low
interest rates do not improve the capital stock or improve education and
training for labor. Negative
interest rates might incentivize banks to withdraw reserve deposits, but they
do not create any more creditworthy borrowers or attractive business
investments. Japan's NIRP certainly did not make asset markets more
rational. By May 2016, the BOJ was a top 10 shareholder in 90% of the stocks
listed on the Nikkei 225.
There appears to be a
disconnect between standard macroeconomic theory by which borrowers,
investors, and business managers react fluidly to monetary policy and the
real world. The historical record does not kindly reflect governments and
banks that have tried to print and manipulate money into prosperity. This may
be because currency, as a commodity, does not generate an increased standard
of living. Only more and better goods and services can do this, and it should
be clear that circulating more bills is not the best way to make more or
better things.
LIBOR is ending. Is your company ready? (FYI)
Benchmark interest rates
such as the London Interbank Offered Rate (LIBOR) are a core component of
global financial markets, influencing borrowing and lending for all types of
companies. LIBOR is calculated by submissions from various leading banks that
estimate the rate that would be charged to borrow from other banks. It is
used pervasively in various types of contracts, with the current contracts that
reference LIBOR measuring in the trillions.
In July 2017, the UK
Financial Conduct Authority announced that it would no longer compel Panel
Banks to participate in the LIBOR submission process after the end of 2021. On the surface, this may appear to be a
problem for just the financial sector, but many companies have been surprised
at the breadth of their LIBOR exposure outside of financial instruments. The benchmark rate is used in contracts
across functions, internal processes, and systems, including in lease
contracts, accounts receivable contacts, procurement contracts, transfer
pricing processes, intercompany funding contacts, and pension plan assets.
Given the lack of visibility into and
potential breadth of exposure, as well as the diversity of impacted
stakeholders and functions, it is imperative that business leaders take
action.
Switching to preferred alternative rates
The Secured Overnight Financing
Rate (SOFR) is expected to be the preferred alternative reference
rate for US dollar financial products after 2021. Other jurisdictions are
also eliminating IBOR rates and will adopt replacement rates as follows:
·
The Bank
of England formed the Risk Free Rate Working Group, which recommended a
reformed Sterling Overnight Index Average (SONIA) as the alternative
unsecured risk-free rate for the Pound Sterling (GBP) LIBOR market.
·
The
European Central Bank (ECB) formed the Working Group on Euro
Risk-free Rates, which recommended the Euro Short-Term Rate (€STR)
unsecured rate to replace EONIA
·
The
Swiss National Bank selected the Swiss Average Rate Overnight (SARON),
a secured reference rate based on data from the Swiss Franc repo market, as
an alternative to CHF LIBOR.
·
The
Bank of Japan formed a working group that ultimately
recommended the Tokyo Overnight
Average Rate (TONAR) as an unsecured overnight rate replacement.
Although Panel Banks will
continue to participate in the LIBOR submission process until the end of
2021, market participants are actively preparing for the transition by
identifying exposures, understanding the impact of those exposures, and
taking action to modify both direct LIBOR references and contractual fallback
provisions that will be triggered if LIBOR ceases to exist.
Seven challenges for businesses to get ahead of
before LIBOR reform
1.
Identifying LIBOR
references in contracts
2.
Operations may need to
change
3.
Interest rate
management
4.
Liquidity management
5.
Accounting and tax
6.
Debt management
7.
Investment management
LIBOR’s end for insurers:
finding opportunity during the switch to new reference rates (FYI)
Ready or not, the end of the
London Interbank Offered Rate (LIBOR) is coming, and it’s a very big deal.
Roughly US$350 trillion in financial contracts
have interest rates that are tied to LIBOR benchmarks—for now. But the
LIBOR benchmark is scheduled to go away at the end of 2021, and its impending
end has set in motion an overhaul in the world’s financial infrastructure.
It’s a very big deal, with implications for your business, processes, and
technology.
For insurers,
there are some particular risks ahead:
·
Long-dated liabilities that can extend 30 years or more, making
flexibility essential in pricing products and hedging with long-dated derivatives
or other financial products.
·
Decentralized regulation under which they answer to
multiple state regulators in the US and different national and regional
supervisors around the world.
·
Sub-sector level vulnerabilities: stemming from their
different roles depending on whether they are providers of life insurance and
annuities, primary insurers, reinsurers, property and casualty insurers, or
specialty firms.
In the US, many financial
instruments now tied to USD LIBOR will be pegged instead to the Secured
Overnight Financing Rate (SOFR), an alternative reference rate (ARR)
calculated using US treasury repo transactions. In the UK, they’ll be linked
to a different ARR: the Sterling Overnight Index Average (SONIA). Other
countries and markets have recommended their own replacement benchmarks for
use once LIBOR has been phased out.
Some insurers
hope for a LIBOR transition delay. Don’t count on it.
Given the pandemic’s
economic effects and how much work many insurers still have to do to move
away from LIBOR, some companies seem to still be gambling that LIBOR’s
cessation will be delayed. But COVID-19 can no longer be seen as a novel;
rather, it has to be viewed as a sad-but-lasting feature of our economy that
we all must adapt to. In that spirit, regulators and industry working groups
are sending clear messages that COVID-19
will not delay LIBOR’s retirement. If anything, they’re actively
sharing best practices and coalescing around
approaches to accelerate the transition. They’re
also setting timelines for transition milestones, such as those published by the Alternative Reference Rates
Committee (ARRC) for moving to SOFR.
The pace of progress remains uneven across the insurance industry.
We’ve seen that insurers with in-house asset management units tend to be more
likely to be taking proactive steps given their responsibility for
transitioning out of LIBOR-based instruments. But virtually all insurers face
operational and economic risks if they don’t have a solid plan in place for
adopting ARRs. Firms that use third-party asset managers, for example, are
responsible for customer communications around those assets and must
coordinate the transition with their vendors as deadlines begin to compress.
We expect the ARRC’s
guidance will help senior management take a closer look at the LIBOR
transition and give a boost to internal collaboration. The coming transition
is fundamentally about risk management—which is the defining purpose of the
insurance industry. By making it a strategic priority and continuing to
recalibrate efforts as necessary, insurance companies can turn the risks of
moving away from LIBOR into opportunities for growth.
Insurers could face challenges across multiple
aspects of their business
1.
Hedging assets, liabilities
2.
Pricing products
3.
Gauging risks
4.
Operational challenges
5.
Additional challenges
Hedging
assets, liabilities
·
Term structure: Insurers that use volatility hedges and interest rate swaps to
offset timing between their assets and liabilities may have some major
changes ahead. SOFR currently has a
limited term structure. This may prove particularly problematic for firms
that offer annuities, life, long-term care, disability insurance, and long-dated
casualty coverages.
·
Declining liquidity: As ARRs gain popularity, LIBOR-based markets will likely see liquidity drying up for some
asset classes. This could drive volatility and push up
hedging costs, especially for longer-dated liabilities without adequate
transition plans in place. A liquidity slump may also disrupt hedging and
risk measurement by altering asset valuations. Many property and casualty
insurers favor shorter-dated assets and so are especially vulnerable to
losses from volatility or a slump of liquidity at the short end of the yield
curve.
·
Valuation: In a move designed to build liquidity in SOFR, this
fall, the major central counterparty
clearing houses (CCPs) will change the way they value cleared derivatives by
switching the discount rate they apply when calculating present value. In
mid-October 2020, LCH Group and CME
Group will take a coordinated step to switch from discounting cash flows with
the US Effective Fed Funds Rate to SOFR. Some market participants could receive basis swaps and/or cash
compensation as part of an attempt to keep the transition value neutral, and
there may be operational considerations for insurers as they book these basis
swaps or cash payments. The National Association of Insurance
Commissioners’ (NAIC) Statutory Accounting Principles Working Group has
determined that these basis swaps should be classified and reported as
derivatives used for hedging and therefore are considered admitted assets
under SSAP 86.
https://www.pwc.com/us/en/industries/financial-services/library/libor-end-insurance.html
Chapter 4 Exchange
Rate Determination
Part I: What determines the
strength of a currency?
Currency value is determined by demand and supply, if not
manipulated by the government.
Q: What factors
determine the strength of a currency?
A: Currency trading is complicated by the
fact that there are so many factors involved. Not only are there a number of country-specific variables
that go into determining a currency's strength, but there are also other
benchmarks--other currencies, for example, as well as commodities--against
which a currency's strength can be measured.
However, three
crucial factors are as follows:
1.
Interest rates. High interest rates help promote a strong
currency, because foreign investors can get a higher return by investing in
that country. However, the level of interest rates is
relative. You've probably noticed that interest rates on CDs, savings accounts and money market
accounts are very low right now. So are U.S. Treasury
bond rates and the U.S. federal funds rate.
Ordinarily, this would weaken the U.S. dollar, except for the fact that
interest rates behind other major world currencies are also low.
3.
Stability. A strong government with a
well-established rule of law and a history of constructive economic policies
are the type of things that attract investment and thus promote a strong
currency. In the case of the U.S. dollar, its strength is further augmented
by the fact that commodities are generally traded in dollars, and many
countries use the dollar as a reserve currency.
Speaking
of stability, that is probably what governments seek for their currencies,
more so than strength. A strong
currency makes a country's exports more expensive, hurting that nation's
trade competitiveness. On the other hand, a weak currency makes imports more
expensive, boosting domestic inflation. So the ideal course is to aim down
the middle and avoid destabilizing fluctuations.
http://www.investopedia.com/video/play/main-factors-influence-exchange-rates/ (VIDEO)
Please also read the following article to learn
more about how changes in demand and supply work on exchange rate.
The foreign exchange market involves firms, households, and
investors who demand and supply currencies coming together through their
banks and the key foreign exchange dealers. Figure 1 (a) offers an example
for the exchange rate between the U.S. dollar and the Mexican peso. The vertical axis shows the exchange rate
for U.S. dollars, which in this case is measured in pesos. The horizontal axis shows the quantity of
U.S. dollars being traded in the foreign exchange market each day. The demand
curve (D) for U.S. dollars intersects with the supply curve (S) of U.S.
dollars at the equilibrium point (E), which is an exchange rate of 10 pesos
per dollar and a total volume of $8.5 billion.
Figure 1. Demand and Supply for the U.S. Dollar and Mexican Peso
Exchange Rate. (a) The quantity measured on the horizontal axis is in U.S.
dollars, and the exchange rate on the vertical axis is the price of U.S.
dollars measured in Mexican pesos. (b) The quantity measured on the
horizontal axis is in Mexican pesos, while the price on the vertical axis is
the price of pesos measured in U.S. dollars. In both graphs, the equilibrium
exchange rate occurs at point E, at the intersection of the demand curve (D)
and the supply curve (S).
Figure 1 (b)
presents the same demand and supply information from the perspective of the
Mexican peso. The vertical axis shows the exchange rate for Mexican pesos,
which is measured in U.S. dollars. The horizontal axis shows the quantity of
Mexican pesos traded in the foreign exchange market. The demand curve (D) for
Mexican pesos intersects with the supply
curve (S) of Mexican pesos at the equilibrium point (E),
which is an exchange rate of 10 cents in U.S. currency for each Mexican peso
and a total volume of 85 billion pesos. Note
that the two exchange rates are inverses: 10 pesos per dollar is the same as
10 cents per peso (or $0.10 per peso). In the actual foreign exchange
market, almost all of the trading for Mexican pesos is done for U.S. dollars.
What factors would cause the demand or supply to shift, thus leading to a
change in the equilibrium
exchange rate? The answer to this question is discussed in
the following section.
One reason to demand a currency on the foreign exchange market
is the belief that the value of the currency is about to increase. One reason
to supply a currency—that is, sell it on the foreign
exchange market—is the expectation that the value of
the currency is about to decline. For
example, imagine that a leading business newspaper, like the Wall Street Journal or
the Financial Times,
runs an article predicting that the Mexican peso will appreciate in value.
The likely effects of such an article are illustrated in Figure 2. Demand for the Mexican peso
shifts to the right, from D0 to
D1, as investors
become eager to purchase pesos. Conversely, the supply of pesos shifts to the
left, from S0 to
S1, because
investors will be less willing to give them up. The result is that the
equilibrium exchange rate rises from 10 cents/peso to 12 cents/peso and the
equilibrium exchange rate rises from 85 billion to 90 billion pesos as the
equilibrium moves from E0 to
E1.
Figure 2. Exchange Rate Market for Mexican Peso Reacts to
Expectations about Future Exchange Rates. An announcement that the peso exchange rate is likely to strengthen
in the future will lead to greater demand for the peso in the present from
investors who wish to benefit from the appreciation. Similarly, it will make
investors less likely to supply pesos to the foreign exchange market. Both
the shift of demand to the right and the shift of supply to the left cause an
immediate appreciation in the exchange rate.
Figure 2 also
illustrates some peculiar traits of supply and demand diagrams in the foreign
exchange market. In contrast to all the other cases of supply and demand you
have considered, in the foreign
exchange market, supply
and demand typically both move at the same time. Groups of participants
in the foreign exchange market like firms and investors include some who are
buyers and some who are sellers. An expectation of a future shift in the
exchange rate affects both buyers and sellers—that
is, it affects both demand and supply for a currency.
The shifts in demand and
supply curves both cause the exchange rate to shift in the same direction; in
this example, they both make the peso exchange rate stronger. However, the
shifts in demand and supply work in opposing directions on the quantity
traded. In this example, the rising demand for pesos is causing the quantity
to rise while the falling supply of pesos is causing quantity to fall. In
this specific example, the result is a higher quantity. But in other cases,
the result could be that quantity remains unchanged or declines.
This example also helps to
explain why exchange rates often move
quite substantially in a short period of a few weeks or months. When
investors expect a country’s currency to strengthen
in the future, they buy the currency and cause it to appreciate immediately.
The appreciation of the currency can lead other investors to believe that
future appreciation is likely—and thus lead to even
further appreciation. Similarly, a fear that a currency might weaken quickly
leads to an actual weakening
of the currency, which often reinforces the belief that the currency is going
to weaken further. Thus, beliefs about the future path of exchange rates
can be self-reinforcing, at least for a time, and a large share of the
trading in foreign exchange markets involves dealers trying to outguess each
other on what direction exchange rates will move next.
In class exercise
(refer to PPT for answers)
Think about
the changes in demand and supply when the following changes occur. And draw
demand and supply curve to explain.
· Inflation goes up č currency
demand high or low? č currency value up or down?
· Real interest rate goes up
č currency
demand high or low? č currency value up or down?
· Domestic residents’ income goes up č currency demand high or low? č currency value up or down?
· Current account goes up č currency demand high or low? č currency value up or down?
· Public debt goes up č currency demand high or low? č currency value up or down?
· Recession or crisis č currency demand high or low? č currency value up or down?
· Other accidental events č currency demand high or low? č currency value up or down?
Note:
·
For the each of the scenarios above, can you draw the demand and supply curve?*
·
If not yet, please watch the following
video. Supply and demand curves in foreign exchange by Khan Academy
(video)
Top Economic Factors That Depreciate
the US Dollar
By
JAMES MCWHINNEY, updated Aug 10, 2020
https://www.investopedia.com/articles/forex/051115/top-economic-factors-depreciate-us.asp
Currency depreciation, in
the context of the U.S. dollar, refers to the decline in value of the dollar
relative to another currency. For
example, if one U.S. dollar can be exchanged for one Canadian dollar, the
currencies are described as being at parity. If the exchange rate moves and
one U.S. dollar can now be exchanged for 0.85 Canadian dollar, the U.S.
dollar has lost value relative to its Canadian counterpart and has therefore
depreciated against it.
A variety of economic
factors can contribute to depreciating the U.S. dollar. These include
monetary policy, rising prices or inflation, demand for currency, economic
growth, and export prices.
KEY TAKEAWAYS
• Currency depreciation, in the context of the U.S.
dollar, refers to the decline in value of the dollar relative to another
currency.
• Easy monetary policy by the Fed can weaken the dollar
when investment capital flees the U.S. as investors search elsewhere for
higher yield.
• Declining economic growth and corporate profits can
cause investors to take their money elsewhere.
Monetary
Policy
In
the United States, the Federal Reserve (the country’s central bank, usually
just called the Fed) implements monetary policies to either increase or
decrease interest rates. For example, if the Fed lowers interest rates or
implements quantitative easing measures such as the purchase of bonds, it is
said to be “easing.” Easing
occurs when central banks reduce interest rates, encouraging investors to
borrow money. Those borrowed dollars eventually get spent by consumers and
businesses and stimulate the U.S. economy.
However,
the implementation of what is known as “easy” monetary
policy weakens the dollar, which can lead to depreciation. Since the U.S. dollar is a fiat currency,
meaning that it is not backed by any tangible commodity (gold or silver), it
can be created out of thin air. When more money is created, the law of supply
and demand kicks in, making existing money less valuable.
Also,
investors often seek out the highest yielding investments, meaning the
highest interest rates. If the Fed
cuts rates, U.S. Treasuries, which are bonds, tend to follow suit and their
yields fall. With lower rates in the U.S., investors transfer their money out
of the U.S. and into other countries that offer higher interest rates. The
result is a weakening of the dollar versus the currencies of the
higher-yielding countries.
Inflation
Inflation
is the pace of rising prices in an economy. There is an inverse relationship
between the U.S. inflation rate versus its' trading partners and currency
depreciation or appreciation. Relatively speaking, higher inflation depreciates currency because inflation means that
the cost of the goods and services are rising. Those goods then cost more for
other nations to purchase. Rising prices can decrease demand. Conversely,
imported goods become more attractive to consumers in the higher inflation
country to purchase.
Demand
for Currency
When
a country’s currency is in demand, the currency stays strong. One of the ways a currency remains in
demand is if the country exports products that other countries want to buy
and demands payment in its own currency. While the U.S. does not export more than it imports, it has found
another way to create an artificially high global demand for U.S. dollars.
The U.S. dollar is what is
known as a reserve
currency. Reserve currencies are used by nations across the world to
purchase desired commodities, such as oil and gold.
When sellers of these commodities demand payment in the reserve currency, an
artificial demand for that currency is created, keeping it stronger than it
might otherwise have been.
In the United States, there
are fears that China’s growing interest in attaining reserve currency status
for the yuan will reduce demand for the U.S. dollars. Similar concerns
surround the idea that oil-producing nations will no longer demand payment in
U.S. dollars. Any reduction in the artificial demand for U.S. dollars is
likely to depreciate the dollar.
Slowing
Growth
Strong economies tend to
have strong currencies. Weak economies tend to have weak currencies. Declining
growth and corporate profits can cause investors to take their money elsewhere.
Reduced investor interest in a particular country can weaken its currency. As
currency speculators see or anticipate the weakening, they can bet against
the currency, causing it to weaken further.
Falling
Export Prices
When prices for a key export
product fall, currency can depreciate. For
example, the Canadian dollar (known as the loonie) weakens when oil prices
drop because oil is a major export product for Canada.
What
About Trade Balances?
Nations
are like people. Some of them spend more than they earn. This, as every good
investor knows, is a bad idea because it produces debt. In the case of the
United States, the country imports more than it exports, and has done so for
decades.
One of the ways the United
States finances its profligate ways is by issuing debt.
China and Japan, two countries that
export a significant amount of goods to the United States, help finance U.S.
deficit spending by loaning it massive amounts of money. In exchange for the
loans, the United States issues U.S. Treasury securities (essentially IOUs)
and pays interest to the nations that hold those securities. It's possible
that someday, those debts will come due and the lenders will want their money
back. If lenders believe the debt level is unsustainable, theorists believe
the dollar will weaken. However,
since there's a healthy demand for Treasuries, the U.S. typically issues new
bonds to pay off any of the foreign-held bonds that are coming due. Trade
balances are also impacted by export prices, inflation, and other variables.
The balance of trade changes as a result of other economic factors, but it
does not cause those factors.
A
Complex Equation
A number of other factors
that can contribute to dollar depreciation include political instability
(either in a particular nation or sometimes in its neighbors), investor
behavior (risk aversion), and weakening macroeconomic fundamentals. There
is a complex relationship between all of these factors, so it can be
difficult to cite a single factor that will drive currency depreciation in
isolation.
For example, central bank
policy is considered to be a significant driver of currency depreciation. If
the U.S. Federal Reserve implements low-interest rates and unique
quantitative easing programs, one would expect the value of the dollar to
weaken significantly. However, if other nations implement even more
significant easing measures or investors expect U.S. easing measures to stop
and foreign central banks efforts to increase, the strength of the dollar may
actually rise.
Accordingly,
the various factors that can drive currency depreciation must be taken into
consideration relative to all of the other factors. These challenges present
formidable obstacles to investors who speculate in the currency markets, as
was seen when the value of the Swiss franc suddenly collapsed in 2015 as a
result of that nation’s central bank making a surprise move to weaken the
currency.
Depreciation: Good or Bad?
The
question of whether currency depreciation is good or bad largely depends on
perspective. If you are the chief executive officer of a company that exports
its products, currency depreciation is good for you. When your nation’s
currency is weak relative to the currency in your export market, demand for
your products will rise because the price for them has fallen for consumers
in your target market.
On
the other hand, if your firm imports raw materials to produce your finished
products, currency depreciation is bad news. A weaker currency means that it
will cost you more to obtain the raw materials, which will force you to
either increase the prices of your finished products (potentially leading to
reduced demand for them) or lower your profit margins.
A
similar dynamic is in place for consumers. A weak dollar makes it more
expensive to take that European vacation or buy that new imported car. It can
also lead to unemployment if your employer’s business suffers because the
rising cost of imported raw materials hurts business and forces layoffs. On
the other hand, if your employer’s business surges due to increasing demand
from foreign buyers, it can mean higher wages and better job security.
The
Bottom Line
A
large number of factors influence currency value. Whether the U.S. dollar depreciates
in relation to another currency depends on the monetary policies of both
nations, trade balances, inflation rates, investor confidence, political
stability, and reserve currency status. Economists, market watchers,
politicians, and business leaders carefully monitor the ever-changing mix of
economic factors in an effort to determine how the dollar reacts.
Part II: Fixed exchange rate vs.
floating exchange rate
The impossible trinity, also
called the Mundell-Fleming trilemma or simply the trilemma, expresses the
limited options available to countries in setting monetary policy.
According to this theory, a country
cannot achieve the free flow of capital, a fixed exchange rate and
independent monetary policy simultaneously. By pursuing any two of these
options, it necessarily closes off the third.
BREAKING DOWN Trilemma
The theory of the
policy trilemma is frequently credited to the economists Robert Mundell and
Marcus Fleming, who independently described the relationships among exchange
rates, capital flows and monetary policy in the 1960s. Maurice Obstfeld, who
became chief economist at the IMF in
2015, presented the model they developed as a "trilemma" in a 1997
pape. According to the trilemma model, a country has three options. It can
A - set a fixed exchange rate between
its currency and another while allowing capital to flow freely
across its borders,
B - allow capital to flow freely and set its
own monetary policy, or
C - set its own monetary policy and maintain a fixed
exchange rate.
The country cannot,
however, fix exchange rates, allow capital to flow freely and maintain monetary policy
sovereignty. For example, Country X links its currency, the X pound, to
the Y franc at a one-to-one ratio. This is effective if both Country X and
Country Y's central banks maintain a policy rate of 3%. But if Country Y
raises interest rates to combat rising inflation, investors would
spot an opportunity for arbitrage. X pounds would flood over the border
to buy Y francs and earn the higher interest rate.
Y francs would in effect become worth more than X pounds.
Thus, either Country X abandons the currency peg and allows the X pound to
fall, raises its policy rate to match Country Y's policy
rate abandoning monetary policy independence or it sets
up capital controls to keep X pounds in the country.
Real-world examples of these trade-offs include the
eurozone where countries have opted for side A of the triangle: they
forfeit monetary policy control to the European Central Bank but
maintain a single currency (in effect a one-to-one peg coupled with free capital flow).
The difficulties of maintaining a monetary union across economies as
different as Germany and Greece have become clear as the latter has
repeatedly appeared poised to drop out of the currency bloc.
Following World War II, the
wealthy opted for side C under the Bretton Woods system, which pegged
currencies to the dollar but allowed them to set their own interest rates.
Cross-border capital flows were so small that the system held for a couple of
decades – the exception being Mundell's native
Canada, a situation that gave him special insight into the tensions
inherent in the system. Today, most
countries allow their currencies to float, meaning they opt for side B.
For class discussion:
Find your country’s exchange rate system from
https://en.wikipedia.org/wiki/List_of_countries_by_exchange_rate_regime
Explain why or why not it is a right choice based on the “impossible
trinity”.
For fixed exchange rate regime, the country has to give up
free capital flow.
For pure floating exchange rate regime, the country has to
give up fixed exchange rate.
For counties in the euro zone, each country has to give up its
monetary policy.
Please refer to the following paper for
classifications of exchange rate regimes
Exchange Rate Regimes from
http://www.imf.org/external/np/mfd/er/2004/eng/0604.htm (IMF, fyi)
Do you think that investing in foreign currency is a good
idea? ----- very risky and unpredictable, but very liquid. What else?
In your view, what is the best currency to trade this year?
Why? Do you like the following recommendations?
Analysis of the Best Currency Pairs to Trade
• USD/EUR – This can be
considered the most popular currency pair. In addition, it has the lowest
spread among modern world Forex brokers. This currency pair is associated
with basic technical analysis. The best thing about this currency pair is
that it is not too volatile. If you are not in a position to take any risks,
you can think of selecting this as your best Forex pair to trade, without it
causing you too much doubt in your mind. You can also find a lot of
information on this currency pair, which can help prevent you from making
rookie mistakes.
• USD/GBP – Profitable pips and possible large jumps have
contributed a lot towards the popularity of this currency pair. However, you
need to keep in mind that higher profits come along with a greater risk. This
is a currency pair that can be grouped into the volatile currencycategory.
However, many traders prefer to select this as their best currency pair to
trade, since they are able to find plenty of market analysis information
online.
• USD/JPY – This is another popular currency pair that can
be seen regularly in the world of Forex trading. It is associated with low
spreads, and you can usually follow a smooth trend in comparison with other
currency pairs. It also has the potential to deliver exciting, profitable
opportunities for traders.
Special Pairs (Or Exotic Currency Pairs)
Typically the best pair for
you is the one that you are most knowledgeable about. It can be extremely useful for you to trade the currency from your
own country, if it is not included in the majors, of course. This is only
true if your local currency has some nice volatility too. In general, knowing
your country's political and economical issues results in additional
knowledge which you can base your trades on.
You can find such
information through economic announcements in our Forex calendar, which also
lists predictions and forecasts concerning these announcements. It is also
recommended to consider trading the pairs that contain your local currency
(also known as 'exotic pairs'). In most cases, your local currency pair will
be quoted against USD, so you would need to stay informed about this currency
as well.
• From https://admiralmarkets.com/education/articles/forex-basics/what-are-the-best-currency-pairs-to-trade
Currency Carry Trades 101 https://www.investopedia.com/articles/forex/07/carry_trade.asp
(video)
By KATHY LIEN, Reviewed By
GORDON SCOTT , Updated Jan 14, 2021
Benefiting
from the Carry Trade
Whether you invest in stocks, bonds,
commodities or currencies, it is likely that you have heard of the carry
trade. This strategy has generated positive average returns since the 1980s,
but only in the past decade has it become popular among individual investors
and traders.
For the better part of the last 10 years,
the carry trade was a one-way trade that headed north with no major
retracements. However, in 2008, carry traders learned that gravity always
regains control as the trade collapsed, erasing seven years worth of gains in
three months.
Yet, the profits made between 2000-2007
have many forex traders hoping that the carry trade will one day return. For
those of you who are still befuddled by what a carry trade is and why the
hysteria surrounding the trade has extended beyond the currency market,
welcome to Carry Trades 101. We will explore how a carry trade is structured,
when it works when it doesn't and the different ways that short- and long-term
investors can apply the strategy.
KEY TAKEAWAYS
·
A currency carry trade
is a strategy that involves borrowing
from a low interest rate currency and to fund purchasing a currency that
provides a rate.
·
A trader using this
strategy attempts to capture the
difference between the rates, which can be substantial depending on the
amount of leverage used.
·
The carry trade is one
of the most popular trading strategies in the forex market.
·
Still, carry trades can
be risky since they are often highly leveraged and over-crowded.
Carry Trade
The carry trade is one of the most popular
trading strategies in the currency market. Mechanically, putting on a carry trade involves nothing more than buying
a high yielding currency and funding it with a low yielding currency, similar
to the adage "buy low, sell high."
The most popular carry trades involve buying currency pairs like the Australian
dollar/Japanese yen and New Zealand dollar/Japanese yen because the interest
rate spreads of these currency pairs are very high. The first step in
putting together a carry trade is to find out which currency offers a high
yield and which one offers a low yield.
The interest rates for the most liquid
currencies in the world are updated regularly updated on FXStreet.
With these interest rates in mind, you can
mix and match the currencies with the highest and lowest yields. Interest
rates can be changed at any time so forex traders should stay on top of these
rates by visiting the websites of their respective central banks.
Since
New Zealand and Australia have the highest yields on our list while Japan has
the lowest, it is hardly surprising that AUD/JPY is the poster child of the
carry trades. Currencies are traded in
pairs so all an investor needs to do to put on a carry trade is to buy
NZD/JPY or AUD/JPY through a forex trading platform with a forex broker.
The Japanese yen's low borrowing cost is a
unique attribute that has also been capitalized by equity and commodity
traders around the world. Over the past decade, investors in other markets
have started to put on their own versions of the carry trade by shorting the yen and buying the U.S. or
Chinese stocks, for example. This
had once fueled a huge speculative bubble in both markets and is the reason
why there has been a strong correlation between the carry trades and stocks.
The Mechanics of Earning Interest
One of the cornerstones of the carry trade
strategy is the ability to earn interest. The income is accrued every day for
long carry trades with triple rollover given on Wednesday to account for
Saturday and Sunday rolls.
Why This Strategy Is So Popular
Between January 2000 and May 2007, the
Australian dollar/Japanese yen currency pair (AUD/JPY) offered an average
annual interest of 5.14%. For most people, this return is a pittance, but in
a market where leverage is as high as 200:1, even the use of five- to
10-times leverage can make that return extremely extravagant. Investors earn
this return even if the currency pair fails to move one penny. However, with
so many people addicted to the carry trades, the currency almost never stays
stationary. For example, between February and April of 2010, the AUD/USD
exchange rate gained nearly 10%. Between January 2001 and December 2007, the
value of the AUD/USD increased approximately 70%.
Low Volatility, Risk Friendly
Carry
trades also perform well in low volatility environments because traders are
more willing to take on risk. What the carry traders are looking for is the yield—any capital appreciation is just a bonus.
Therefore, most carry traders, especially the big hedge funds that have a lot
of money at stake, are perfectly happy if the currency does not move one
penny, because they will still earn the leveraged yield.
As
long as the currency doesn't fall, carry traders will essentially get paid
while they wait. Also, traders and investors are more comfortable with taking
on risk in low volatility environments.
If It Were Only This Easy!
An effective carry trade strategy does not
simply involve going long a currency with the highest yield and shorting a
currency with the lowest yield. While
the current level of the interest rate is important, what is even more
important is the future direction of interest rates. For example, the
U.S. dollar could appreciate against the Australian dollar if the U.S.
central bank raises interest rates at a time when the Australian central bank
is done tightening. Also, carry trades only work when the markets are
complacent or optimistic.
Uncertainty, concern, and fear can cause
investors to unwind their carry trades. The 45% sell-off in currency pairs such
as the AUD/JPY and NZD/JPY in 2008 was triggered by the Subprime turned
Global Financial Crisis. Since carry trades are often leveraged investments,
the actual losses were probably much greater.
Benefiting from the Carry Trade
The
carry trade is a long-term strategy that is far more suitable for investors than traders
because investors will revel in the fact that they will only need to check
price quotes a few times a week rather than a few times a day. True, carry
traders, including the leading banks on Wall Street, will hold their
positions for months (if not years) at a time. The cornerstone of the carry
trade strategy is to get paid while you wait, so waiting is actually a good
thing.
Part III: Will $
collapse?
U.S. Dollar Will Crash in 2021,
Senior Yale Economist Warns
September
25, 2020 UTC: 2:48 PM. September 27, 2020 UTC: 1:00 PM. by Simon Chandler
• Yale University’s Stephen Roach has
predicted the U.S. dollar’s demise in 2021.
• Roach points to the growing current account deficit and the
declining net-national savings rate as
the two main factors pushing the dollar down.
• The dollar has declined against most major currencies over the past
six months. Other analysts are also predicting a sharp loss of value.
The U.S. dollar will crash
in value by the end of 2021, according to
senior Yale University economist Stephen Roach. He also said the probability of a double-dip recession is now over 50%.
Roach
echoed similar warnings in June, describing a 35% crash as “virtually inevitable.” But now he sees the indicators of collapse–the U.S.
current-account deficit and a decline in savings–as
much worse than before.
His
dire warnings have become increasingly credible over the past few months. The dollar has weakened repeatedly
against G10 currencies; other analysts and currency forecasters have also
predicted its downfall.
Stephen Roach: U.S. Dollar
Will Crash
Things
are going from bad to worse for the already weakened U.S. dollar. Speaking to
CNBC, Yale University senior fellow Roach said the following:
We’ve
got data that’s confirmed both the saving and current account dynamic in a
much more dramatic fashion than even I was looking for.
Roach
argues that both of these factors will push the dollar much lower:
The
current account deficit in the United States …
suffered a record deterioration in the second quarter. The so-called
net-national savings rate, which is the sum of savings of individuals,
businesses and the government sector, also recorded a record decline in the second
quarter.
He
noted that the savings rate has entered negative territory for the first time
since the global financial crisis. This means there’s a glut of spending,
with the excess supply of dollars raising the risk of inflation.
The
U.S. current account deficit widened by 52.9% to $170.5 billion in Q2, which
is 3.5% of GDP. | Source: Bureau of Economic Analysis
Roach
thinks a crash is inevitable, given the “laws” of economics:
Lacking in saving and
wanting to grow, we run these current account deficits to borrow surplus
saving, and that always pushes the currencies lower.
The dollar is not immune to that time honored adjustment.
The net-national savings
rate fell to -1% in Q2 2020. |
Source: Federal Reserve Bank of St. Louis
Signs
of Weakening
Roach’s
forecast is becoming more credible by the day. The U.S. Dollar Index–which tracks the value
of the dollar against a basket of currencies–has
declined from $102.82 on March 16 to $94.60 today.
The
U.S. Dollar Index has declined by around 8% from its March peak. | Source:
Yahoo!
The
dollar has also declined against G10 currencies over the past few months. The
Australian dollar and New Zealand dollar are up 20% and 14%, respectively,
against the greenback over the past six months. The pound is 10% up, while
the euro is 8% higher.
The
Chinese renminbi (yellow), Japanese yen (green), euro (red), British pound
(blue), New Zealand dollar (purple), and Australian dollar (brown) are all up
on the U.S. dollar over past half-year. | Source: Yahoo!
Other
analysts besides Roach are also predicting a U.S. dollar crash. As early as
April, UBS predicted a steep decline in H2 2020. Its head of Asia-Pacific
equities, Hartmut Issel, said at the time, “the
dollar does not have too much to offer anymore.”
A
Reuters poll of currency forecasters published in July saw the euro rising against the dollar into 2021.
NAB Group’s Gavin Friend told Reuters:
The dollar rises in two
instances: when you see risk off or when there is a situation where the U.S.
is leading the global recovery, and we don’t think that’s going to be the
case anytime soon.
Things look very bad for the
dollar. And the longer the coronavirus pandemic continues, the likelier it
will be that its status as the world’s reserve
currency will be tarnished.
Goldman Sachs Says Dollar
Could Fall by 6% in 2021 (youtube)
Ray Dalio’s
Dollar Crash Prediction. Here’s How It Will Happen (youtube)
Part IV: In Class
Exercise
Class
Exercise1:
Chicago
bank expects the exchange rate of the NZ$ to appreciate from $0.50 to $0.52
in 30 days.
— Chicago bank can borrow $20m on a short
term basis.
— Currency
Lending
Rate Borrowing rate
$ 6.72% 7.20%
NZ$ 6.48% 6.96%
Question:
If Chicago bank anticipate NZ$ to appreciate, how shall it trade? (refer to
ppt)
Answer:
◦ NZ$ will appreciate, so you should buy
NZ$ now and sell later. Borrow $ŕ convert to NZ$
today ŕ lend it for 30 days ŕ
convert to $ 30 days later ŕpayback the $ loan.
◦ Convert the borrowed $ to NZ$ today.
So your NZ$ worth: $20m / 0.50 $/NZ$=40m NZ$.
◦ Lend NZ$ for 6.48% * 30/360=0.54% and
get
40m NZ$ *(1+0.54%)=40,216,000 NZ$ 30 days
lateč at new rate $0.52/1NZ$, 40,216,000 NZ$ equals t
40,216,000 NZ$*$0.52/1NZ$ = $20,912,320
◦ Your borrowed $20m should be paid back
for
20m
*(1+7.2%* 30/360)=$20.12m.
◦ So the profit is:
$20,912,320
- $20.12m =$792,320, a pure profit from thin air!
Class
Exercise 2:
Blue
Demon Bank expects that the Mexican peso will depreciate against the dollar
from its spot rate of $.15 to $.14 in 10 days. The following interbank
lending and borrowing rates exist:
Lending Rate Borrowing Rate
U.S. dollar 8.0%
8.3%
Mexican peso 8.5%
8.7%
Assume that Blue Demon Bank has a
borrowing capacity of either $10 million or 70 million pesos in the interbank
market, depending on which currency it wants to borrow.
a. How could Blue Demon Bank
attempt to capitalize on its expectations without using deposited funds?
Estimate the profits that could be generated from this strategy.
b. Assume all the preceding information
with this exception: Blue Demon Bank expects the peso to appreciate from its
present spot rate of $.15 to $.17 in 30 days. How could it attempt to
capitalize on its expectations without using deposited funds? Estimate the
profits that could be generated from this strategy.
Answer:
Part
a: Blue Demon Bank can capitalize on its expectations about pesos (MXP) as
follows:
1. Borrow MXP70 million
2. Convert the MXP70 million to dollars:
a. MXP70,000,000 ×
$.15 = $10,500,000
3. Lend the dollars through the
interbank market at 8.0% annualized over a 10 day period. The amount
accumulated in 10 days is:
a. $10,500,000 ×
[1 + (8% × 10/360)] = $10,500,000 ×
[1.002222] = $10,523,333
4. Convert the Peso back to $ at $.14 /
peso:
a. $10,523,333 / $.14 / MXP = MXP
75,166,664
5. Repay the peso loan. The repayment
amount on the peso loan is:
a. MXP70,000,000 ×
[1 + (8.7% × 10/360)] = 70,000,000 ×
[1.002417]=MXP70,169,167
6. The arbitrage profit is:
a. MXP 75,166,664 - MXP70,169,167 = MXP 4,997,497
7. Convert back to at $0.14 / MXP
a. We get back MXP 4,997,497 * $0.14 / MXP = $699,649.6
(solution)
Part
b: Blue Demon Bank can capitalize on its expectations as follows:
1. Borrow $10 million
2. Convert the $10 million to pesos
(MXP):
a. $10,000,000/$.15 = MXP66,666,667
3. Lend the pesos through the interbank
market at 8.5% annualized over a 30 day period. The amount accumulated in 30
days is:
a. MXP66,666,667 ×
[1 + (8.5% × 30/360)] = 66,666,667 ×
[1.007083] = MXP67,138,889
4. Repay the dollar loan. The repayment
amount on the dollar loan is:
a. $10,000,000 ×
[1 + (8.3% × 30/360)] = $10,000,000 ×
[1.006917] = $10,069,170
5. Convert the pesos to dollars to repay
the loan. The amount of dollars to be received in 30 days (based on the
expected spot rate of $.17) is:
a. MXP67,138,889 ×
$.17 = $11,413,611
HW 3 (chapter 4) (Due with first mid
term)
Question 1. Choose between increase / decrease.
US Inflation goes up, $ will
________increase / decrease____________in value__.
US Real interest rate goes up, $ will
________increase / decrease___________ in value__.
US Current account goes up, $ will
________increase / decrease________ in value__.
US Recession or crisis, $ will
________increase / decrease________ in value__.
For each scenario, please draw a
demand and supply curve to support your conclusion.
- please
refer to the PPT of this chapter for how to draw demand and supply
curver Chapter 4 PPT
Question 2: DO you think the US$ will
collapse in the near future? Why or why not?
Question 3: What is currency carry
trade? Do you have a plan to carry on a currency carry trade?
Question 4: Suppose you observe the
following exchange rates: €1 = $.7; Ł1 = $1.40; and €2.20 = Ł1.00. Starting with $1,000,000, how can you make
money?(Answer: get Ł first. Your profit is $100,000)
Question 5:
Assume you have Ł1000 and bid rate is
1.60$/Ł and ask rate is 1.66$/Ł. If you convert it to Ł and then convert it
back to $, what will happen? (Answer: $963.86 and lose $36.14. Sell low and
buy high here. So sell Ł at bid and buy Ł at ask )
Question 6:
Suppose you start with $100 and buy
stock for Ł50 when the exchange rate is Ł1 = $2. One year later, the stock
rises to Ł60. You are happy with your 20 percent return on the stock, but
when you sell the stock and exchange your Ł60 for dollars, you find that the
pound has fallen to Ł1 = $1.75. What is your return to your initial
investment of $100? (Answer: 5%)
Question 7:
Baylor Bank believes the New Zealand
dollar will depreciate over the next five days from $.52 to $.5. The
following annual interest rates apply:
Currency
Lending Rate
Borrowing Rate
Dollars
5.50% 5.80%
New Zealand dollar (NZ$) 4.80% 5.25%
Baylor Bank has the capacity to borrow either NZ$11 million or $5
million. If Baylor Bank’s forecast if correct, what will
its dollar profit be from speculation over the five day period (assuming it
does not use any of its existing consumer deposits to capitalize on its
expectations)? (Answer: 0.44 million NZ$ profit) 5.
Jul 29, 2020,01:44pm EDT|38,633 views
Will The Dollar Collapse? (FYI)
Brad McMillanContributor
We’ve once again reached that point in the cycle where the dollar has started to decline. As a result, the doomsayers have come out of the woodwork. And it’s really no wonder. The headlines have a lot to say about the dollar’s downward movement in recent months, as it has certainly dropped in value from March 2020 to present. But while the dollar is down from its recent peak, it is still above the levels we saw through most of 2019 (which, remember, was a good year). So, do we need to worry about the risk of its collapse?
Dollar Spiked When Pandemic Hit
The real story here is not the dollar’s recent decline. Instead, it is the spike in the dollar’s value when the pandemic hit around the globe in March. Why? Everyone wanted dollars when risks started to rise, which is why the value went up. The decline since then has everything to do with things looking less risky in the rest of the world—and nothing to do with the U.S. looking shaky. If anything, the dollar in 2020 shows just how much of a commanding position it still has.
The Past 10 Years
If we think about the value of the dollar over the past 10 years, the story is much the same. Over that time period, the dollar has remained at its highest level, except for the past couple of pandemic months. In fact, the dollar has gotten steadily more valuable as the U.S. economy has continued to outperform most of the rest of the world. In that time, we have seen spikes and reversals before, and this is just the latest round.
The Past 20 Years
Now, that does not mean the
dollar always goes up. In the past 20
years, the dollar went from roughly where it is now, then down significantly,
and then back up with several significant bounces along the way.
A lot has happened over that two-decade period, including the financial crisis, the pandemic, and many smaller crises. The dollar has responded, in different ways, to the news by varying significantly in value. The headlines and the fluctuations in the dollar’s value are real. This makes sense, as the dollar (like any currency) is a financial asset. As such, its value will change in response to economic conditions. We see the same thing in stocks, bonds, and other currencies, for the same reasons.
The Dollar as Amazon
If you think of currencies as stocks, you could think of the dollar as being the Amazon of the currency world. Like Amazon’s stock, sometimes it is worth more—and sometimes less. Volatility in a currency’s value does not mean the currency will collapse any more than a drop in Amazon’s share price means the company is going away.
In fact, the Amazon comparison is a good one for more than the stock price. Amazon is a dominant presence in its market, with deep market share, substantial commitments from shoppers, and an established range of services and infrastructure that makes it hard to dethrone. Walmart, another behemoth, has been trying for years—and losing ground. It is hard to shake the dominant player, and it takes a concerted attack, by a product that is at least as good, for many years. If Amazon eventually cedes its dominance, it will be years from now, and everyone will see it coming.
So, think of the dollar as Amazon, with a deep and commanding presence in its market, deep market share, substantial commitments from users, and an established array of services and infrastructure that makes it hard to unseat. In this comparison, Walmart is China, which has been working very hard to replace the leader over a period of years but with limited success. And, the comparison continues, in that if China eventually does manage to replace the dollar, it will be years from now—and we will see it coming well ahead of time.
Because of this reality, the incentive to change away from the dollar is even less. Recently, I was asked whether the Saudis would be switching away from the dollar for the oil markets any time soon, as that could break the dollar’s hold on the world economy. Setting aside for the moment the fact that Saudi Arabia remains dependent on the U.S. for military security (which it is very aware of), oil is a very global market, with trading around the world, and all denominated in dollars. For the Saudis to abandon the dollar would require a whole new global trading architecture. Once again, it could happen. But we would see it coming, and it would be neither cheap nor easy. Once again, Amazon benefits from inertia.
So, Will the Dollar Collapse?
This is not the first round of
“will the dollar collapse,” and it certainly won’t be the last. The dollar will not collapse now and will
very likely not collapse any time soon. If it does, we will see it coming—but
it is not coming now.
https://www.forbes.com/sites/bradmcmillan/2020/07/29/will-the-dollar-collapse/?sh=35f285b1450b
First
Mid Term Exam on Thursday (3/4/2021) starting at 1:00 pm on blackboard
collaborate under “First Mid Term Exam” Folder in the left column
Chapter 5 Currency
Derivatives
Let’s watch the following videos to
understand how the forward and future markets work.
Forward contract introduction
(video, khan academy)
Futures introduction (video, khan
academy)
For class discussion:
·
What is margin account?
·
What is mark to market?
·
What is initial margin?
·
What is maintenance margin?
·
What is margin call?
·
How is margin call triggered?
·
What will happen after a margin call is received?
·
How can forward contract and futures contract help reduce risk?
·
Why does margin account value change constantly?
·
What does “mark to market” mean?
1. Difference
between the two?
Forward contract:
· Privately
negotiated;
· Non-transferable;
· customized
term;
· carried
credit default risk;
· fully
dependent on counterparty;
· Unregulated.
Future contract:
· Quoted
in public market
· Actively
traded
· Standardized
contract
· Regulated
· No
counterparty risk
(FYI)
F = forward rate
S = spot rate
r1 = simple interest rate of the term currency
r2 = simple interest rate of the base currency
T = tenor (calculated to the appropriate day count conversion)
2. Future market
Margin account and margin call
CME (Chicago Merchandise Exchange)
http://www.cmegroup.com/trading/fx/#majors
|
||||||||||
Product |
Code |
Contract |
Last |
Change |
Chart |
Open |
High |
Low |
Globex
Voll |
|
6EH0 |
MAR 2020 |
1.0823 |
+0.00095 |
1.0822 |
1.0824 |
1.0822 |
734 |
|||
E7H0 |
MAR 2020 |
1.08230 |
+0.00090 |
1.08230 |
1.08250 |
1.08230 |
32 |
|||
6JH0 |
MAR 2020 |
0.008997 |
+0.0000225 |
0.009003 |
0.009003 |
0.0089945 |
1,688 |
|||
J7H0 |
MAR 2020 |
0.0089970 |
+0.0000220 |
0.0089980 |
0.0090010 |
0.0089970 |
85 |
|||
6AH0 |
MAR 2020 |
0.6684 |
+0.0008 |
0.6678 |
0.6686 |
0.6678 |
1,447 |
|||
6BH0 |
MAR 2020 |
1.2930 |
+0.0001 |
1.2929 |
1.2931 |
1.2928 |
317 |
|||
6CH0 |
MAR 2020 |
0.75635 |
+0.00035 |
0.7563 |
0.75645 |
0.7562 |
363 |
|||
6SH0 |
MAR 2020 |
1.0180 |
+0.0004 |
1.0181 |
1.0182 |
1.0180 |
132 |
|||
6NH0 |
MAR 2020 |
0.6384 |
+0.0009 |
0.6385 |
0.6386 |
0.6382 |
153 |
|||
SEKH0 |
MAR 2020 |
0.10229 |
+0.00008 |
0.10229 |
0.10229 |
0.10229 |
1 |
|||
NOKH0 |
MAR 2020 |
- |
- |
- |
- |
- |
https://www.barchart.com/futures/quotes/E6*0/all-futures
1.19150s -0.00525 (-0.44%) 03/05/21 [CME]
EURO FX PRICES for Fri, Mar 5th, 2021
|
||||||||||
Contract |
Last |
Change |
Open |
High |
Low |
Previous |
Volume |
Open Int |
Time |
Links |
1.19080s |
-0.00632 |
1.19705 |
1.19770 |
1.18935 |
1.19712 |
N/A |
N/A |
03/05/21 |
||
1.19150s |
-0.00525 |
1.19750 |
1.19770 |
1.18945 |
1.19675 |
291,239 |
651,012 |
03/05/21 |
||
1.19245s |
-0.00525 |
1.19775 |
1.19850 |
1.19060 |
1.19770 |
298 |
1,422 |
03/05/21 |
||
1.19320s |
-0.00525 |
1.19730 |
1.19920 |
1.19125 |
1.19845 |
146 |
1,033 |
03/05/21 |
||
1.19395s |
-0.00520 |
1.20000 |
1.20000 |
1.19195 |
1.19915 |
15,097 |
49,876 |
03/05/21 |
||
1.19480s |
-0.00525 |
0.00000 |
1.19480 |
1.19480 |
1.20005 |
0 |
0 |
03/05/21 |
||
1.19630s |
-0.00525 |
1.20110 |
1.20160 |
1.19435 |
1.20155 |
738 |
3,462 |
03/05/21 |
||
1.19860s |
-0.00530 |
1.20300 |
1.20300 |
1.19745 |
1.20390 |
127 |
1,814 |
03/05/21 |
||
1.20140s |
-0.00520 |
1.20700 |
1.20700 |
1.20020 |
1.20660 |
6 |
149 |
03/05/21 |
||
1.20410s |
-0.00520 |
1.20440 |
1.20440 |
1.20410 |
1.20930 |
8 |
220 |
03/05/21 |
||
1.20700s |
-0.00515 |
1.21720 |
1.21720 |
1.20700 |
1.21215 |
5 |
33 |
03/05/21 |
||
1.20970s |
-0.00515 |
1.21000 |
1.21000 |
1.20970 |
1.21485 |
5 |
19 |
03/05/21 |
||
1.21225s |
-0.00525 |
0.00000 |
1.21225 |
1.21225 |
1.21750 |
0 |
0 |
03/05/21 |
||
1.21800s |
-0.00520 |
0.00000 |
1.21800 |
1.21800 |
1.22320 |
0 |
0 |
03/05/21 |
Euro
Future Contract Specifications
https://www.barchart.com/futures/quotes/E6H19
Contract
Euro FX
Contract Size
EUR 125,000
Tick Size
0.00005 points ($6.25 per contract)
Trading Hours
5:00p.m. - 4:00p.m. (Sun-Fri) (Settles 2:00p.m.) CST
Exchange
CME
Point Value
$125,000
Margin/Maintenance
$1,980/1,800
Short
and long position and payoff
For a long position, its payoff:
Value at
maturity (long position) = principal * ( spot exchange rate at
maturity –
settlement price)
Value at
maturity (short position) = -principal * ( spot exchange rate at
maturity –
settlement price)
Note: In the calculator, principal is called contract size
The currency spot
rate is the current quoted rate that a currency, in
exchange for another currency, can be bought or sold at. The two currencies
involved are called a "pair." If an investor or hedger conducts a trade
at the currency spot rate, the exchange of currencies takes place at the
point at which the trade took place or shortly after the trade. Since
currency forward
rates are based on the currency spot rate, currency
futures tend to change as the spot rates changes”.///// https://www.investopedia.com/terms/c/currencyfuture.asp
Exercise
1: Amber sells a
March futures contract and locks in the right to sell 500,000 Mexican pesos
at $0.10958/Ps (peso). If the spot exchange rate at maturity is $0.1095/Ps,
the value of Amber’s position on settlement is? (refer to ppt)
Answer: -500000*(0.1095-0.10958)
How? After entering the futures
contract, Amber is obligated to sell to
the buyer of the contract of 500,000
Mexican pesos at $0.10958/Ps. At contract maturity date, the price of Peso is
only $0.1095/Ps. So Amber could buy peso at the market price which is
$0.1095/Peso and sell at $0.10958/Ps, earning a profit of $0.00008/Ps, and a
total profit of $0.00008/Ps * 500000 Ps
Exercise
2: Amber purchases a
March futures contract and locks in the right to sell 500,000 Mexican pesos
at $0.10958/Ps (peso). If the spot exchange rate at maturity is $0.1095/Ps,
the value of Amber’s position on settlement is?
Answer: 500000*(0.1095-0.10958)
How? After entering the futures
contract, Amber is obligated to buy
from the seller of the contract of 500,000
Mexican pesos at $0.10958/Ps. At contract maturity date, the price of Peso is
only $0.1095/Ps. So Amber have to buy peso at $0.10958/Ps. Amber then could
sell Peso at the market price which is $0.1095/Peso, generating a loss of:
-$0.00008/Ps, and a total loss: -$0.00008/Ps * 500000 Ps
Exercise
3: Amber sells a March futures contract and locks in the
right to sell 500,000 Mexican pesos at $0.10958/Ps (peso). If the spot
exchange rate at maturity is $0.11/Ps, the value of Amber’s position on
settlement is? (refer to ppt)
Answer: -500000*(0.11-0.10958)
Exercise
4: Amber purchases a
March futures contract and locks in the right to sell 500,000 Mexican pesos
at $0.10958/Ps (peso). If the spot exchange rate at maturity is $0.11/Ps, the
value of Amber’s position on settlement is? (refer to ppt)
Answer: 500000*(0.11-0.10958)
Exercise
3: You expect peso to depreciate on 4/4. So you sell peso
future contract (6/17) on 4/4 with future rate of $0.09/peso. And on 6/17,
the spot rate is $0.08/peso. Calculate the value of your position on
settlement (refer to ppt)
HW of
chapter 5 part I (Due on with the
second mid-term)
1. Consider
a trader who opens a short futures position. The contract
size is Ł62,500; the maturity is six months, and the settlement price is
$1.60 = Ł1; At maturity, the price (spot rate) is $1.50 = Ł1. What is his
payoff at maturity?
(Answer: Ł6250)
2. Consider
a trader who opens a long futures position. The contract size is Ł62,500; the maturity
is six months, and the settlement price is $1.60 = Ł1; At maturity, the price
(spot rate) is $1.50 = Ł1. What is his payoff at maturity?
(Answer: -Ł6250)
3. Consider
a trader who opens a short futures position. The contract
size is Ł62,500, the maturity is six months, and the settlement price is $1.40 = Ł1;
At maturity, the price (spot rate) is $1.50 = Ł1. What is his payoff at
maturity?
(Answer: -Ł6250)
4.
Consider a
trader who opens a long futures position. The contract size is Ł62,500, the maturity
is six months, and the settlement
price is $1.40 = Ł1; At maturity, the price (spot rate) is $1.50 = Ł1. What
is his payoff at maturity?
5.
Watch this
video again and explain the following concepts.
·
What is
margin account?
·
What is mark
to market?
·
What is
initial margin?
·
What is
maintenance margin?
·
What is
margin call?
·
How is margin
call triggered?
·
What will happen
after a margin call is received?
https://www.barchart.com/futures/quotes/E6*1/profile
A
"currency" rate involves the price of the base currency (e.g., the
dollar) quoted in terms of another currency (e.g., the yen), or in terms of a
basket of currencies (e.g., the dollar index). The world's major currencies
have traded in a floating exchange rate regime ever since the Bretton-Woods international
payments system broke down in 1971 when President Nixon broke the dollar's
peg to gold. The two key factors
affecting a currency's value are central bank monetary policy and the trade
balance. An easy monetary policy
(low interest rates) is bearish for a currency because the central bank is
aggressively pumping new currency reserves into the marketplace and because
foreign investors are not attracted to the low interest rate returns available
in the country. By contrast, a tight monetary policy (high interest rates) is
bullish for a currency because of the tight supply of new currency reserves
and attractive interest rate returns for foreign investors.
The other key factor driving currency values is the nation's current account
balance. A current account surplus is bullish for a currency due to the net
inflow of the currency, while a current account deficit is bearish for a
currency due to the net outflow of the currency. Currency values are also
affected by economic growth and investment opportunities in the country. A
country with a strong economy and lucrative investment opportunities will
typically have a strong currency because global companies and investors want
to buy into that country's investment opportunities. Futures on major
currencies and on cross-currency rates are traded primarily at the CME Group.
Dollar - The dollar index (Barchart.com symbol DXY00) rallied to a 15-year
high in January 2017 on continued support from the Republican sweep of the White
House and Congress in the November 2016 election, which bolstered
expectations that a stimulus program would produce a strong economy and
higher interest rates in 2017. Indeed, the Federal Reserve at its December
2016 FOMC meeting projected three rate hikes in 2017, up from its September
estimate of two rate hikes. However, the dollar index then sold off during
most of the remainder of 2017, closing the year down -9.9%. The dollar was
undercut during 2017 as Republicans spent most of the first half of the year
trying to repeal Obamacare, leaving aside a tax cut and dropping an
infrastructure program. Congress in December 2017 finally did pass a massive
tax cut bill, which provided some underlying support for the dollar. However,
the markets were then concerned about expectations that the tax would will expand
the U.S. budget deficit in coming years, thus increasing the need for the
U.S. to import capital and leading to a larger current account deficit. The
dollar was also undercut during 2017 by political uncertainty tied to the
investigation into Russian interference in the November 2016 election. The
dollar found only modest support during 2017 from Federal Reserve policy even
though the Fed raised its federal funds rate target three times for a total rate
hike of +75 basis points to a target range of 1.25%/1.50% by the end of 2017.
Euro - EUR/USD (Barchart.com symbol
^EURUSD) slumped to a 15-year low in early January 2017 on dollar strength
and on speculation the ECB would not end its QE program anytime soon because
ECB President Draghi said there are "no convincing signs yet of an
upward trend in underlying inflation." However, EUR/USD then rallied
sharply in the second half of 2017 on (1) relief that populists failed to win
in the French national elections, (2) strength in the Eurozone economy, and
(3) growing expectations for the European Central Bank (ECB) to eventually
start to exit its extraordinarily easy monetary policy. The Eurozone economy
in 2017 showed relatively strong real GDP growth of +2.3% as the Eurozone sovereign
debt crisis finally started to fade into history. The ECB in October
announced that its quantitative easing (QE) program, which ran at 60 billion euros
per month during 2017, would be cut in half to 30 billion euros per month for
the first nine months of 2018. EUR/USD finished 2017 with a sharp +14% gain.
Yen - USD/JPY (Barchart.com symbol ^USDJPY) posted the high for 2017 in early
January on dollar strength prompted by the results of the U.S. November 2016
elections. However, USD/JPY then weakened during 2017 and closed the year
down by -3.7% at 112.69 yen. The yen during 2017 found safe-haven demand from
(1) trade tensions prompted by the Trump administration, and (2) North Korean
geopolitical risks as North Korea continued its nuclear weapons development
program and conducted ballistic missile tests, drawing a U.S. threat of
military action. USD/JPY moved higher into November after Japanese Prime
Minister Abe's ruling coalition retained its super-majority in the October
2017 general election. The strong mandate for Abenomics implied the BOJ would
continue its massive quantitative easing program. The yen also found support
during 2017 from the Bank of Japan's (BOJ) shift in September 2016 to a
yield-curve-control (YCC) policy whereby the BOJ started to target the 10-year
Japanese government bond (JGB) yield near the level of zero percent, potentially
allowing its quantitative easing program to drop in size from its target
level of 80 trillion yen per year.
(http://www.cmegroup.com/trading/fx/g10/euro-fx_contract_specifications.html)
Contract Unit |
125,000 euro |
||
Trading Hours |
Sunday - Friday 6:00 p.m. - 5:00 p.m. (5:00 p.m. - 4:00 p.m.
Chicago Time/CT) with a 60-minute break each day beginning at 5:00 p.m.
(4:00 p.m. CT) |
||
Minimum Price Fluctuation |
Outrights: .00005 USD per EUR increments ($6.25 USD). |
||
Product Code |
CME Globex: 6E |
||
Listed Contracts |
Contracts listed for the first 3 consecutive months and 20
months in the March quarterly cycle (Mar, Jun, Sep, Dec) |
||
Settlement Method |
Deliverable |
||
Termination Of Trading |
9:16 a.m. Central Time (CT) on the second business day immediately
preceding the third Wednesday of the contract month (usually Monday). |
||
Settlement Procedures |
Physical Delivery |
||
Position Limits |
|||
Exchange Rulebook |
|||
Block Minimum |
|||
Price Limit Or Circuit |
|||
Vendor Codes |
https://www.youtube.com/watch?v=unM_0Vh00K4
Foreign Exchange Market
https://www.youtube.com/watch?v=-qvrRRTBYAk
Future Trading Guide
Chapter 5 Part II
Currency Option market
NASDAQ OMX PHLX (Philadelphia Stock Exchange)
trades more than 2,600 equity options, sector index options and U.S.
dollar-settled options on major currencies. PHLX offers a combination of
cutting-edge electronic and floor-based options trading.
Nasdaq: http://www.nasdaq.com/includes/swiss-franc-specifications.stm
1. What is Call and put
option? Difference between the two?
American call option (video, khan academy)
American put option (video, khan academy)
Call payoff diagram (video, khan academy)
Put payoff diagram (video, khan academy)
For
discussion:
·
When shall you consider a call
option?
·
When shall you buy a put
option?
·
Can you draw a call payoff
diagram?
·
What about a put payoff
diagram?
Currency Option
By JAMES CHEN
Reviewed By MICHAEL J BOYLE
Updated Dec 23, 2020
https://www.investopedia.com/terms/c/currencyoption.asp
What Is a Currency Option?
A currency option (also known as a forex option)
is a contract that gives the buyer the right, but not the obligation, to buy
or sell a certain currency at a specified exchange rate on or before a
specified date.
For this right, a premium is paid to the seller.
Currency
options are one of the most common ways for corporations, individuals or
financial institutions to hedge against adverse movements in exchange rates.
KEY TAKEAWAYS
· Currency options give investors the right, but not the obligation, to buy or sell a particular currency at a pre-specific exchange rate before the option expires.
· Currency options allow traders to hedge currency risk or to speculate on currency moves.
· Currency options come in two main varieties, so-called vanilla options and over-the-counter SPOT options.
Currency Option
The Basics of
Currency Options
Investors can hedge against foreign currency risk
by
purchasing a currency put or call.
Currency options are derivatives based
on underlying currency pairs. Trading currency options involves a wide
variety of strategies available for use in forex markets. The strategy a
trader may employ depends largely on the kind of option they choose and the
broker or platform through which it is offered. The characteristics of
options in decentralized forex markets vary much more widely than options in
the more centralized exchanges of stock and futures markets.
Traders like to use currency options trading for
several reasons. They have a limit to their downside risk and may lose only
the premium they paid to buy the options, but they have unlimited upside
potential.
Some traders will use FX options
trading to hedge open positions they may hold in the forex cash market.
As opposed to a futures market, the cash market, also called the physical and
spot market, has the immediate settlement of transactions involving
commodities and securities. Traders
also like forex options trading because it gives them a chance to trade and
profit on the prediction of the market's direction based on economic,
political, or other news.
However, the premium charged on currency options
trading contracts can be quite high. The
premium depends on the strike price and expiration date. Also, once you buy
an option contract, they cannot be re-traded or sold. Forex options
trading is complex and has many moving parts making it difficult to determine
their value. Risk include interest
rate differentials (IRD), market volatility, the time horizon for expiration,
and the current price of the currency pair.
Vanilla Options Basics
There are two main types of options, calls and
puts.
Call options provide the holder the right (but not
the obligation) to purchase an underlying asset at a specified price (the
strike price), for a certain period of time. If the stock
fails to meet the strike price before the expiration date, the option expires
and becomes worthless. Investors buy calls when they think the share price of
the underlying security will rise or sell a call if they think it will fall. Selling an option is also referred to as
''writing'' an option.
Put options give the holder the right to sell an
underlying asset at a specified price (the strike price). The seller (or writer) of the put option
is obligated to buy the stock at the strike price. Put options can be
exercised at any time before the option expires. Investors buy puts if they
think the share price of the underlying stock will fall, or sell one if they
think it will rise. Put buyers - those who hold a "long" - put are
either speculative buyers looking for leverage or "insurance"
buyers who want to protect their long positions in a stock for the period of
time covered by the option. Put sellers hold a "short" expecting
the market to move upward (or at least stay stable) A worst-case scenario
for a put seller is a downward market turn. The maximum profit is limited to
the put premium received and is achieved when the price of the underlying is
at or above the option's strike price at expiration. The maximum loss is
unlimited for an uncovered put writer.
The trade will
still involve being long one currency and short another currency pair. In
essence, the buyer will state how much they would like to buy, the price they
want to buy at, and the date for expiration. A seller will then respond with
a quoted premium for the trade. Traditional
options may have American or European style expirations. Both the put and
call options give traders a right, but there is no obligation. If the current
exchange rate puts the options out of the money (OTM), then they will expire
worthlessly.
SPOT Options
An exotic
option used to trade currencies include single payment options trading (SPOT)
contracts. Spot options have a higher premium cost compared to traditional
options, but they are easier to set and execute. A currency trader buys a
SPOT option by inputting a desired scenario (e.g. "I think EUR/USD will
have an exchange rate above 1.5205 15 days from now") and is quoted a
premium. If the buyer purchases this option, the SPOT will automatically pay
out if the scenario occurs. Essentially, the option is automatically
converted to cash.
The SPOT is a
financial product that has a more flexible contract structure than the
traditional options. This strategy is an all-or-nothing type of trade, and
they are also known as binary or digital options. The buyer will offer a
scenario, such as EUR/USD will break 1.3000 in 12 days. They will receive
premium quotes representing a payout based on the probability of the event
taking place. If this event takes place, the buyer gets a profit. If the
situation does not occur, the buyer will lose the premium they paid. SPOT
contracts require a higher premium than traditional options contracts do.
Also, SPOT contracts may be written to pay out if they reach a specific
point, several specific points, or if it does not reach a particular point at
all. Of course, premium requirements will be higher with specialized options
structures.
Additional
types of exotic options may attach the payoff to more than the value of the
underlying instrument at maturity, including but not limited to
characteristics such as at its value on specific moments in time such as an
Asian option, a barrier option, a binary option, a digital option, or a
lookback option.
Example of a Currency Option
Let's say an
investor is bullish on the euro and believes it will increase against the
U.S. dollar. The investor purchases a currency call option on the euro with a
strike price of $115, since currency prices are quoted as 100 times the
exchange rate. When the investor purchases the contract, the spot rate of the
euro is equivalent to $110. Assume the euro's spot price at the expiration
date is $118. Consequently, the currency option is said to have expired in the
money. Therefore, the investor's profit is $300, or (100 * ($118 - $115)),
less the premium paid for the currency call option.
2. Calculate the payoff for
both call and put?
· For call: Profit = Spot rate – strike
price – premium; if option is exercised (when spot rate > strike price)
Or, Profit
= -premium, if option is not exercised (expired when spot
rate < strike
price)
In general, profit = max((spot rate – strike price -
premium), -premium ) ---------- Excel syntax
Excel payoff diagram for
call and put options (very helpful)
(Thanks to Dr. Greene http://www2.gsu.edu/~fncjtg/Fi8000/dnldpayoff.htm)
Calculator of Call and
Put Option
Example: Jim is a speculator
. He buys a British pound call option with a strike of $1.4 and a
December settlement date. Current spot price as of that date is $1.39. He
pays a premium of $0.12 per unit for the call option. Just before the
expiration date, the spot rate of the British pound is $1.41.At that time, he
exercises the call option and sells the pounds at the spot rate to a bank.
One option contract specifies 31,250 units. What is Jim’s profit or loss?
Assume Linda is the seller of the call option. What is Linda’s profit or
loss?
(refer to ppt. Answer:
Spot rate is
$1.39, Jim’s total profit: -0.12*31250
Spot rate is
$1.41, Jim’s total profit: (1.41-1.4-0.12)*31250=(-0.11)*31250
Spot rate is
$1.39, Linda’s total profit: 0.12*31250
Spot rate is
$1.41, Linda’s total profit: -((1.41-1.4-0.12)*31250)=0.11*31250
*** the loss
of taking the long position of the option is just the gain of taking the
short position. It is a zero sum game.
· For put: Profit = strike price - Spot rate –
premium, if option is exercised (when spot rate < strike price)
Example A speculator bought a put
option (Put premium on Ł = $0.04 / unit, X=$1.4, One contract specifies
Ł31,250 )
He exercise the option shortly
before expiration, when the spot rate of the pound was $1.30. What is his
profit? What is the profit of the seller? (refer to ppt) When spot
rate was $1.5, what are the profits of seller and buyer?
(refer to ppt. Answer:
Spot rate is
$1.30, option buyer’s total profit: (1.4 - 1.3 – 0.04) *31250
Spot rate is
$1.50, option buyer’s total profit: -0.04*31250
Spot rate is
$1.30, option seller’s total profit: -(1.4 - 1.3 – 0.04) *31250
Spot rate is
$1.50, option seller’s total profit: 0.04*31250
*** the loss
of taking the long position of the option is just the gain of taking the
short position. It is a zero sum game.
HW
Chapter 5 Part II (Due with the
second mid-term exam)
(Answer: 0.05; $0)
(Answer: $0.08; $0.03)
(Answer: -$0.05; 0)
4. You purchase a put option
on Swiss francs for a premium of $.05, with an exercise price of $.50. The option
will not be exercised until the expiration date, if at all. If the spot rate
on the expiration date is $.58, how
much is the payoff of this long option? And your profit? (And also, please
draw the payoff diagram to a long put option holder, optional, for extra
credits). (Answer: -$0.05; 0)
5. Set up a practice account at https://www.cmegroup.com/education/practice.html
and click on the “trading simulator” to start trading on the future market.
Choose a specific future contract, such as euro future contract expired in
March, and you can start the game. Report your account results. The following
is the summary of my account since 2/13/2019 (last year’s. This is not
required but you can give it a try)
Trade |
Symbol |
Contract |
Mo |
Strike |
C/P |
Position |
Buys |
Sells |
Average PX |
Unrealized P/L |
Realized P/L |
Flatten |
||||||||
6JJ9 |
Japanese Yen |
Short 5 |
0 |
5 |
0.0090492 |
-362.50 |
0.00 |
|||||||||||||
6EH9 |
Euro FX |
Sep |
4 |
4 |
0.00 |
6.25 |
||||||||||||||
Benefit from our award-winning
FX options platform, the market depth you need, the products you want and the
tools you require to maximize your options strategies across 24 FX options
contracts, available nearly 24 hours a day.
https://www.cmegroup.com/trading/fx/options.html
FX Options
CLEARING |
GLOBEX |
FLOOR |
CLEARPORT |
PRODUCT NAME |
PRODUCT GROUP |
SUBGROUP |
CLEARED AS |
VOLUME |
OPEN INTEREST |
EUU |
EUU |
EUU |
EUU |
FX |
Majors |
Options |
11,081 |
139,049 |
|
GBU |
GBU |
GBU |
GBU |
FX |
Majors |
Options |
3,879 |
76,359 |
|
JPU |
JPU |
JPU |
JPU |
FX |
Majors |
Options |
4,040 |
56,123 |
|
CAU |
CAU |
CAU |
CAU |
FX |
Majors |
Options |
8,199 |
45,455 |
|
ADU |
ADU |
ADU |
ADU |
FX |
Majors |
Options |
894 |
28,398 |
|
3EU |
3EU |
3EU |
3EU |
FX |
Majors |
Options |
1,526 |
5,434 |
|
WE3 |
WE3 |
WE3 |
WE3 |
FX |
Majors |
Options |
182 |
4,787 |
|
4EU |
4EU |
4EU |
4EU |
FX |
Majors |
Options |
1,717 |
1,999 |
|
3JY |
3JY |
3JY |
3JY |
FX |
Majors |
Options |
608 |
1,842 |
|
3AD |
3AD |
3AD |
3AD |
CONTRACT UNIT |
One futures contract for 125,000 Euro |
||||
MINIMUM PRICE
FLUCTUATION |
0.0001 per Euro increment = $12.50 |
||||
PRICE QUOTATION |
U.S. dollars and cents per Euro increment |
||||
TRADING HOURS |
CME Globex: |
Sunday 5:00 p.m. - Friday - 4:00 p.m. CT with a 60-minute
break each day beginning at 4:00 p.m. CT |
|||
Open Outcry: |
Monday - Friday 7:20 a.m. – 2:00 p.m. CT |
||||
CME ClearPort: |
Sunday 5:00 p.m. - Friday 5:45 p.m. CT with no reporting
Monday - Thursday from 5:45 p.m. – 6:00 p.m. CT |
||||
PRODUCT CODE |
CME Globex: 1EU,2EU,3EU,4EU,5EU |
||||
LISTED CONTRACTS |
Weekly contracts listed for 4 consecutive weeks. No weekly
contract listed the week of the quarterly or serial option expiration. |
||||
SETTLEMENT
PROCEDURES |
Option on physical delivery futures contract |
||||
TERMINATION OF
TRADING |
Trading terminates at 9:00 a.m. CT on Friday of the
contract week. that are not also terminations for quarterly and serial
options. (9:00 a.m. CT) |
||||
POSITION LIMITS |
|||||
EXCHANGE RULEBOOK |
|||||
BLOCK MINIMUM |
|||||
PRICE LIMIT OR
CIRCUIT |
|||||
VENDOR CODES |
|||||
EXERCISE STYLE |
European style. Auto-exercised against CME Group FX Fixing Price;
no contrary instructions allowed. |
||||
SETTLEMENT METHOD |
Deliverable |
||||
UNDERLYING |
Euro FX Futures |
Option Examples: Apple Options on Yahoo finance
https://finance.yahoo.com/quote/AAPL/options?date=1623974400
CallsforJune 18, 2021
Contract Name |
Last Trade Date |
Strike |
Last Price |
Bid |
Ask |
Change |
% Change |
Volume |
Open Interest |
Implied Volatility |
2021-03-01
10:34AM EDT |
104.61 |
104.50 |
105.45 |
0.00 |
- |
1 |
26 |
196.09% |
||
2021-03-04
2:17PM EDT |
100.15 |
103.40 |
104.20 |
0.00 |
- |
2 |
8 |
126.56% |
||
2021-02-04
2:50PM EDT |
114.95 |
99.70 |
100.65 |
0.00 |
- |
50 |
20 |
0.00% |
||
2021-02-04
2:50PM EDT |
113.55 |
98.80 |
99.05 |
0.00 |
- |
50 |
0 |
0.00% |
||
2021-03-03
10:41AM EDT |
99.75 |
98.35 |
99.10 |
0.00 |
- |
2 |
243 |
158.98% |
||
2021-02-22
11:59AM EDT |
99.90 |
97.00 |
97.90 |
0.00 |
- |
1 |
21 |
157.81% |
||
2021-03-09
3:25PM EDT |
93.65 |
92.75 |
93.65 |
0.00 |
- |
100 |
0 |
0.00% |
||
2021-02-26
3:01PM EDT |
94.70 |
94.60 |
95.45 |
0.00 |
- |
20 |
9 |
151.86% |
||
2021-02-23
4:00PM EDT |
95.75 |
93.40 |
94.25 |
0.00 |
- |
2 |
94 |
108.20% |
||
2021-03-17
3:54PM EDT |
93.35 |
92.15 |
92.95 |
0.00 |
- |
20 |
48 |
95.31 |
PutsforJune 18, 2021
Contract Name |
Last Trade Date |
Strike |
Last Price |
Bid |
Ask |
Change |
% Change |
Volume |
Open Interest |
Implied Volatility |
2021-03-18
9:49AM EDT |
0.01 |
0.00 |
0.01 |
0.00 |
- |
10 |
6,353 |
118.75% |
||
2021-03-10
10:30AM EDT |
0.03 |
0.00 |
0.03 |
0.00 |
- |
1 |
3,812 |
126.56% |
||
2020-12-08
12:17PM EDT |
0.03 |
0.00 |
0.03 |
0.00 |
- |
20 |
1,554 |
121.88% |
||
2021-03-02
4:14PM EDT |
0.01 |
0.00 |
0.03 |
0.00 |
- |
225 |
1,691 |
118.75% |
||
2021-03-02
2:56PM EDT |
0.01 |
0.00 |
0.03 |
0.00 |
- |
357 |
864 |
114.06% |
||
2021-03-16
3:39PM EDT |
0.01 |
0.01 |
0.03 |
0.00 |
- |
19 |
2,728 |
114.06% |
||
2021-03-12
1:18PM EDT |
0.02 |
0.01 |
0.03 |
0.00 |
- |
3 |
2,109 |
110.94% |
||
2021-03-12
4:09PM EDT |
0.02 |
0.00 |
0.03 |
0.00 |
- |
3 |
1,027 |
104.69% |
Bearish option strategies example onoptionhouse
Option Strategy graphs
Currency war explained – bear talk cartoon
https://www.youtube.com/watch?v=1jA7c1_Jtvg
Bitcoin Presentation by Rahaf Baqrish PPT
(Thanks, Rahaf)
Chapter 7 International Arbitrage And
Interest Rate Parity
Here are the countries
with the highest interest rates in the world:
Top 10 Highest Interest
Rates After Inflation by Country |
||||
Ranking |
Country |
Savings Interest Rate |
Inflation Rate |
Difference |
1 |
Kyrgyz Republic |
9.59% |
2.20% |
7.39% |
2 |
Mexico |
6.15% |
3.80% |
2.35% |
3 |
Gambia |
8.00% |
6.30% |
1.70% |
4 |
Brazil |
5.04% |
3.60% |
1.44% |
5 |
Uganda |
3.88% |
3.60% |
0.28% |
6 |
South Africa |
4.88% |
5.00% |
-0.12% |
7 |
Seychelles |
3.03% |
3.40% |
-0.37% |
8 |
Bangladesh |
3.80% |
5.40% |
-1.60% |
9 |
Kingdom of Eswatini |
3.08% |
5.60% |
-2.52% |
10 |
Zambia |
3.13% |
10.70% |
-7.57% |
Source: International
Monetary Fund |
The real interest rate is
the lending interest rate adjusted for inflation, as measured by an index
called the gross domestic product deflator. The GDP deflator measures changes
in prices. Here are the 10 countries with the highest real interest
rates, according to the latest data from the World Bank, released in
2018:
Top
10 Highest Real Interest Rates by Country |
||
Ranking |
Country |
Real
Interest Rate (2018) |
1 |
Madagascar |
44.8% |
2 |
Brazil |
35.0% |
3 |
Malawi |
21.8% |
4 |
Gambia |
21.1% |
5 |
Rwanda |
17.9% |
6 |
Kyrgyz Republic |
17.8% |
7 |
Burundi |
16.6% |
8 |
Uganda |
16.0% |
9 |
Honduras |
15.7% |
10 |
Sao Tome and Principe |
14.5% |
Source:
The World Bank |
https://www.gobankingrates.com/banking/which-country-interest-rates/
For class
discussion:
·
Why not invest in the above countries for higher interest rates?
·
For US residents, how can you make profits from currency carry
trades?
·
How can a country’s real interest rate be as high as over 40%?
Shall you consider investing in that country?
Proceed at Your Own Risk
Before you roll the dice overseas with
dreams of double-digit interest gains, know that the international insurance
protection on your deposits is likely not as comprehensive as FDIC deposit
insurance. Although foreign central bank interest rates might be higher,
American banks protect your money either through FDIC insurance up to a
certain amount or, in the case of credit unions, National Credit Union Administration
insurance. If you make a savings deposit at an FDIC-insured bank, your
deposit is insured up to $250,000. If you bank at a credit union that is
insured by NCUA, your funds are insured up to at least $250,000.
As with all investments and bank accounts, especially in
developing countries, it’s important to weigh the amount of risk you’re
willing to take on versus the return that you can expect. Although it would be great to earn
nearly 10.00% APY on a savings account, it’s comforting to know that
money you keep in American banks is fully protected in the event that your
financial institution crumbles.
https://www.gobankingrates.com/banking/interest-rates/which-country-interest-rates/
Venezuela Interest Rate https://tradingeconomics.com/venezuela/interest-rate
Actual |
Previous |
Highest |
Lowest |
Dates |
Unit |
Frequency |
|
21.77 |
22.50 |
83.73 |
12.79 |
1998 - 2019 |
percent |
Daily |
The Central Bank of Venezuela (Banco Central de Venezuela, BCV) is not responsible for setting interest rates.
For
class discussion:
Why did interest rate drop in Venezuela in 2019? Why does interest rate rise
in 2020?
Part 1 of
chapter 7: Currency carry trade
What is a Currency Carry Trade
A currency carry
trade is a strategy in which an investor sells a certain currency with a
relatively
low interest
rate and uses the funds to purchase a different currency yielding a higher
interest rate.
A trader using
this strategy attempts to capture the difference between the rates, which can
often
be substantial,
depending on the amount of the leverage used.
Japan
Interest Rate
By Bill Camarda @ https://www.americanexpress.com/us/foreign-exchange/articles/yen-carry-trade-role-in-recession/
Abstract:
As the global financial crisis of 2007-2008 unfolded, triggering
Herculean efforts by central banks to stabilize financial markets through
aggressive monetary and fiscal stimuli, some observers pointed to the yen carry trade as a key driver of the
bubble that led up to the crisis – and a contributor
that helped deepen the crisis as the trades unwound.
A decade later, the yen carry trade appears to be undergoing a
revival, as the interest rate spreads between the U.S. and Japan are widening
again. It's worth considering
the yen carry trade's role in the Great Recession, why it happened, and any
lessons that emerge from that episode of economic history.
What is the Yen Carry Trade?
Carry trades involve borrowing in currencies with low interest rates
and investing the proceeds in currencies where interest rates are higher,
thereby earning relatively easy profits. The "Law of One Price" economic theory predicts
that the profit opportunities from price differences of this kind should
quickly disappear, as arbitrage rebalances the prices of assets across
markets. But carry trade opportunities have often lingered, offering
sustained opportunities for profit, and a growing body of academic research
now helps to explain that persistence.
For nearly two decades before the global
financial crisis, the yen-dollar carry trade was often among the most
prominent carry trades. It grew because the Bank of Japan kept interest rates
extremely low from the mid-1990s onward in an attempt to reignite Japan's
stagnant economy, while the U.S. Federal Reserve generally maintained
higher interest rates. The spread
between Japanese and U.S. interest rates encouraged many foreign exchange
traders to sell yen they had borrowed at low rates and buy dollars they could
lend at higher rates.
When the Fed started to raise interest rates
in the mid-2000s, the widening spread between U.S. and Japanese rates
triggered a sudden increase in the yen-dollar carry trade. The trade grew rapidly in the run-up to
the global financial crisis, as even individual currency traders joined hedge
funds, banks, and other financial institutions in pursuit of higher returns.
How Did the Yen Carry Trade Affect the Global Financial
Crisis?
From 2004-2007, rapid growth in yen carry
trades made far more dollars available for investment in the U.S. While some
of this money was invested in U.S. Treasury bonds, much of it found its way
into higher-yielding assets such as collateralized debt obligations (CDOs)
and U.S. subprime residential mortgage backed securities (RMBS) – assets
whose prices collapsed in 2007-8.
As the bubble burst and the Great Recession began, the Fed
dropped interest rates precipitously, eliminating the differences in rates
between Japan and the U.S.; the basis for the yen carry trade disappeared.
Yen carry trades quickly unwound, reducing dollar liquidity. Japanese
investors, and yen-leveraged American and European investors, sold RMBSes,
CDOs and other diverse assets and debt, purchasing dollars which they then
sold for yen. This contributed to the collapse of those assets' prices, which
in turn added to an extraordinary demand for dollars. The Fed responded by undertaking aggressive
quantitative easing – i.e., pouring new dollars into the economy.
The yen carry trade had worked when the yen-dollar exchange rate
was relatively stable, or when the yen declined against the dollar – as it did by roughly 20 percent from
2004-2008. But in the wake of Lehman Brothers' September 2008 collapse, the
yen rose rapidly along with USD while most other currencies fell by
comparison. Japanese investors sold risky dollar-denominated assets and
bought yen with the proceeds, pushing the yen up vs. the dollar. American
investors who had borrowed in cheaper yen to fund dollar-denominated
investments faced rising FX costs in carrying their yen loans. They rushed to
sell dollars (and other currencies) to buy yen they could use to repay their
yen loans, pushing the yen exchange rate even higher. These events
contributed significantly to the volatility then roiling currency markets.
What's Happened Since
A few years after the global financial crisis, Japan's
expansionary economic policies contributed to a re-emergence of the yen carry
trade, as the yen's value dropped by 26 percent and significant differences
between U.S. and Japanese interest rates reappeared. Yen carry trades
increased by 70 percent between 2010 and 2013. However, by early 2018, yen carry
trade strategies had racked up four straight quarters of losses. The outlook
for the yen carry trade seemed poor: the yen was rising against other
currencies, traders expected the Bank of Japan to tighten the reins on
economic growth and raise interest rates, and traders anticipated higher
volatility in connection with growing international trade frictions.
But in August 2018, the Bank of Japan
announced that it would keep interest rates extremely low for an indefinite
period. Observers noted that the Fed had already raised interest rates several
times, and was projecting five rate hikes through the end of
2019. Meanwhile, in the second quarter of 2018, Bloomberg found
borrowing yen to purchase dollar assets earned investors an exceptionally
attractive return of 4.9 percent, taking into account fluctuations in
exchange rates, levels of interest, and the funding costs.
It isn't yet clear how long the recent revival
of the yen carry trade will be sustained. Historically, the yen has often
been viewed as a safe haven currency. If increased volatility drives FX
traders to safety, the yen's value could rise, making the carry trade less
profitable.
But if the yen carry trade does keep growing,
it could again impact exchange and interest rates. When spreads between
interest rates widen, traders inevitably seek to take advantage of them. The
experience of 2007-2008 teaches that this can lead to market distortions and
even bubbles.
Homework chapter 7 (Due with the
second mid term exam)
1. What are the risks and
awards associated with currency carry trade?
2. Here are the countries
with the highest interest rates in the world:
Top
10 Highest Real Interest Rates by Country |
||
Ranking |
Country |
Real
Interest Rate (2018) |
1 |
Madagascar |
44.8% |
2 |
Brazil |
35.0% |
3 |
Malawi |
21.8% |
4 |
Gambia |
21.1% |
5 |
Rwanda |
17.9% |
6 |
Kyrgyz Republic |
17.8% |
7 |
Burundi |
16.6% |
8 |
Uganda |
16.0% |
9 |
Honduras |
15.7% |
10 |
Sao Tome and Principe |
14.5% |
https://www.gobankingrates.com/banking/which-country-interest-rates/
· Do you suggest currency carry trade with those
countries or Turkey? Why or why not?
FYI only.
Watch the following video. What is suggested by
the host? Are you interested in utilizing his strategy? Why or why not?
how to do the carry trade.
(VIDEO, BY Robert Booker)
Example: Currency carry trade
What
is a 'Currency Carry Trade'
A
currency carry trade is a strategy in which an investor sells a certain
currency with a relatively low interest rate and uses the funds to
purchase a different currency yielding a higher interest rate. A
trader using this strategy attempts to capture the difference between
the rates, which can often be substantial, depending on the amount of
leverage used.
BREAKING
DOWN 'Currency Carry Trade'
As
for the mechanics, a trader stands to make a profit of the difference in the
interest rates of the two countries as long as the exchange rate between
the currencies does not change. Many professional traders use this trade
because the gains can become very large when leverage is taken into
consideration. If the trader in our example uses a common leverage factor of
10:1, he can stand to make a profit of 10 times the interest rate difference
The
big risk in a carry trade is the uncertainty of exchange rates. Using
the example above, if the U.S. dollar were to fall in value
relative to the Japanese yen, the trader runs the risk of losing money. Also,
these transactions are generally done with a lot of leverage, so a small
movement in exchange rates can result in huge losses unless the position is
hedged appropriately.
Currency
Carry Trade Calculations Example
As
an example of a currency carry trade, assume that
a tra der notices that rates in Japan are 0.5% while in the
United States they are 4%. This means the trader expects to profit 3.5%,
which is the difference between the two rates. The first step is to borrow
yen and convert it into dollars. The second step is to invest those dollars
into a security paying the U.S. rate. Assume the current exchange rate is 115
yen per dollar and the trader borrows 50 million yen. Once converted, the amount
that he would have is:
U.S.
dollars = 50 million yen / 115 = $434,782.61
After
a year invested at the 4% U.S. rate, the trader has:
Ending
balance = $434,782.61 x (1 + 4%) = $452,173.91
Now,
the trader owes the 50 million yen principal plus 0.5% interest for a total
of:
Amount
owed = 50 million yen + (50 million yen x (1 + 0.5%)) = 50.25 million yen
If the exchange rate stays the same over the
course of the year and ends at 115, the amount owed in U.S. dollars is:
Amount owed = 50.25 million yen / 115 = $436,956.52
The trader profits on the difference between
the ending U.S. dollar balance and the amount owed which is:
Profit = $452,173.91 - $436,956.52 =
$15,217.39
Notice that this profit is exactly the
expected amount: $15,217.39 / $434,782.62 = 3.5%
If the exchange rate moves against the yen,
the trader would profit more. If the yen gets stronger, the trader will earn
less than 3.5% or may even experience a loss.
-------- from investopedia.com
******* Turkey Lira
Crisis ********
‘As bad as Brexit’:
Turkey faces currency crisis after Erdoğan sacks bank chief
Lira could plunge 15%, analysts warn, after Turkey’s president risks
destabilising fragile economy with removal of governor
The Turkish lira could fall 15% as markets react to the sacking of
the central bank chief. He had won plaudits for trying to lower inflation by
raising rates to 19%.
Martin Farrer and agencies, Sun
21 Mar 2021 01.39 EDT
The Turkish lira
could plunge up to 15% in an “ugly reaction” when financial markets reopen on
Monday, analysts have warned, after president Recep Tayyip Erdoğan
sacked the country’s central bank chief days after a sharp rise in interest
rates.
With one expert
calling the decision “as bad as Brexit”,
Erdoğan shocked global investors by removing the bank chief after only
five months and replacing him with a party loyalist.
Erdoğan has
set his face against orthodox economic policy and has repeatedly opposed
using rate hikes as a means of controlling double-digit inflation. He has now sacked three bank governors in two years.
But analysts
predicted that the lira would tumble when markets reopened as the bank’s
credibility took another hit.
The outgoing governor, Naci
Agbal, who was appointed in November, had won market praise by aggressively
raising the policy rate by a total of 875 basis points to 19%, the highest of
any big economy.
His shock removal, announced in the early hours of Saturday, came
after the bank hiked rates by a greater-than-expected 200 basis points on
Thursday in a move designed to curb
inflation, currently around 16%, and support the currency.
Erdoğan immediately appointed Sahap Kavcioglu, a former member
of parliament for his ruling AK party, and the new chief is expected to
reverse last weeks’s rate increases.
Tim Ash, senior emerging markets sovereign strategist at Bluebay
Asset Management, said: “This decision is almost as bad as Brexit in terms of
being the worst public policy decision I can remember in a country’s history.
“This announcement
demonstrates the erratic nature of policy decisions in Turkey, especially
with regard to monetary matters,” said Cristian Maggio, head of emerging
market strategy at TD Securities in London. “The Turkish lira may easily
sell-off 10-15%.... We will see this start on Monday, when Asia trading kicks
in.”
A lack of monetary independence has exacerbated Turkey’s boom-bust
economy and helped keep inflation in double digits for most of the last four years, economists say. The lira
has lost half its value since 2018.
“This implies the
government will once again try to stimulate the economy by low rate policies,” said Selva Demiralp, director of the Koc University-TUSIAD Economic
Research Forum, in Istanbul.
“Such a priority has a high
potential to backfire by causing extreme pressures on the lira and
contracting the economy even further,” she said.
Kavcioglu, the fourth central bank chief in five years, is well known
among local bankers but little known among mainstream economists and foreign
investors.
Before being elected in 2015 in Turkey’s northeast AKP stronghold, he
was deputy general manager at state lender Halkbank as part of a more than
25-year career in banking.
A trader at one local bank predicted Kavcioglu would deliver a rate
cut before the next scheduled policy meeting in April.
“There is now a very real chance that Turkey is heading for a messy balance of payments crisis,” Jason
Tuvey, analyst at Capital Economics, wrote in a note.
Since Agbal’s appointment on 7 November, the lira had rebounded more
than 15% from a record low beyond 8.50 to the dollar. He won plaudits from
foreign economists and analysts as some $20bn of foreign funds also trickled
into Turkish assets, reversing years of outflows.
But even though Erdogan appointed Agbal as part of what he called a
new market-friendly economic era, the president continued to urge lower
rates. In announcing reforms this month, he said price stability should be
“put aside”.
Turkish lira falls 15% after
bank governor sacked
Published
3/22/2021
https://www.bbc.com/news/business-56479702
Turkey's
currency tumbled as much as 15% after President Recep Tayyip Erdogan sacked
the country's central bank governor over the weekend.
Naci
Agbal had been credited as a key force in pulling the lira back from historic
lows.
Mr
Erdogan replaced him in a surprise move on Saturday, the third central bank
governor exit in under two years.
Mr
Agbal, appointed in November, had been raising interest rates to fight an
inflation rate running above 15%.
The
removal has shocked both local and foreign investors who had praised Turkey's
central bank's recent monetary policy.
The
appointment of Sahap Kavcioglu, a former banker and ruling party lawmaker,
sparked concerns of a reversal of recent rate hikes.
The fallout from the sacking
hit shares on the Istanbul stock exchange, and raised concerns about the
impact Turkey's borrowing costs.
Trading on the exchange was
suspended for a period after a sharp fall in share prices triggered automatic
circuit breakers.
After
dropping sharply, the lira then recovered some ground to stand about 8% lower
against the US dollar after Finance Minister Lutfi Elvan said Turkey would
stick to free market rules.
"The
authorities will be left with two choices, either it pledges to use interest
rates to stabilise markets, or it imposes capital controls," said Per
Hammarlund, senior strategist at SEB Research.
"Given
the increasingly authoritarian approach that President Erdogan has taken, capital controls are looking like the
most likely choice."
The
lira was at one point the best performing emerging-market currency of 2021,
having recovered almost a fifth from a low against the US dollar.
Last
week, the Turkish currency rose strongly after Mr Agbal increased interest
rates by 2 percentage points, double what economists expected.
Investors have been calling
for tighter monetary policy in Turkey to tame its high inflation rate, as
prices rise rapidly in the country.
There
are now concerns that Mr Erdogan's decision to install Mr Kavcioglu in the
role could erode the gains made during Mr Agbal's short tenure.
Mr
Kavcioglu is a little-known professor of banking and a former lawmaker from
the ruling Justice and Development party. He shares Mr Erdogan's unorthodox
view that high interest rates can fuel inflation.
Indonesian Currency Presentation by Hay Johnson PPT
(Thanks, Milton)
Chapter 7 Part II
Interest Rate Parity
In
class exercises
1. Locational arbitrage
Exercise 1: Bank1
–
bid Bank1-ask Bank2-bid
Bank2-ask
Ł in
$: $1.60 $1.61 $1.62 $1.63
How can you arbitrage?
Answer:
·
Buy
pound at bank1’s ask price and sell pound at bank2’s bid price. Profit is
$0.01/pound
·
For
instance, with $1,610, you can buy Ł at bank 1 @ $1.61/Ł and get back Ł1,000.
·
Then,
you can sell Ł at bank 2 @ $1.62/Ł and get back $1,620, and make a profit of
$10.
·
Pound
is cheaper in bank 1 but more expensive in bank 2. Therefore, you can
arbitrage.
Exercise 2: Bank1
–
bid Bank1-ask Bank2-bid Bank2-ask
Ł in
$: $1.6 $1.61 $1.61 $1.62
How can you arbitrage?
Answer:
·
Buy
pound at bank1’s ask price and sell pound at bank2’s bid price. No Profit
·
For
instance, with $1,610, you can buy Ł at bank 1 @ $1.61/Ł and get back Ł1,000.
·
Then,
you can sell Ł at bank 2 @ $1.61/Ł and get back $1,610, and make a profit of
$0.
·
Pound
is cheaper in bank 1 but more expensive in bank 2. However, there is a bid
ask spread, or fees charged by dealers.
·
So
no arbitrage opportunities.
Exercise
3: If you start with $10,000
and conduct one round transaction, how many $ will you end up with ?
Answer:
10000
/ 0.64($/NZ$)) ---- the amount obtained from north bank.
Profit
= $10000 / 0.64($/NZ$)) * 0.645 ($/NZ$) =
$10078.13
2. Triangular arbitrage
Exercise
1: Ł is quoted at $1.60.
Malaysian Rinnggit (MYR) is quoted at $0.20 and the cross exchange
rate is Ł1 = MYR 8.1. How can you arbitrage?
Answer:
Either
$ č MYR č Ł č $,
or $ č Ł č MYR č $,
one way or another, you should make money. In this case, it is the latter
one. Imagine you have $1,600 č 1,000 GBP (Ł1 = MYR
8.1) č MYR8,100 č $1,620 (1MYR = 0.2$, so
8,100 *0.2= 1,620$) č profit of $20 from an
initial investment of $1,600
Exercise 2:
How can you arbitrage with the above information?
Answer:
Same as above but sell at bid and buy at ask. Only two
rounds: USDŕ GBPŕMYR,
or, USD ŕMYRŕGBP. One way make money and the other one lose
money.
We start with $1,610 č buy
GBP at ask price, so get 1,000 GBP č sell
GBP for rinngit @ 1 GBP = 8.1 MYR; so
get 8,100 MYR č sell Rinngit for $ @ bid price. 8,100 MYR
= 8,100 * 0.20 = $1,620, a profit of $10 out of $1,610 initial
investment.
The other round is: 1,610$ č 8,009.95 MYR (=1,610/0.201) č976.8GBP
(=1,610/0.201/8.2) č 1,562.9 USD
(=1,610/0.201/8.2*1.6) č a loss of 47.1 USD, so not a good deal
3. Covered Interest Arbitrage (CIA):
Exercise 1: Assume
you have $800,000 to invest. Current spot rate of pound is $1.60. 90 day
forward rate of pound is $1.60. 90 day interest rate in US is 2%. 90 day
interest rate in UK is 4%. How can you arbitrage?
Answer:
Convert at spot rate for pound and then deposit pound in
UK bank. 90 days later, convert back to $ at forward rate. Refer to the above
graph for details
Exercise 2: You have $100,000 to invest for one year. How can you
benefit from engaging in CIA?
Answer:
·
Again,
buy at ask and sell at bid. Convert at spot rate for Euro and then
deposit Euro in a European bank. One year later, convert
Euro back to $ at forward rate.
·
So,
($100,000 / 1.13)*(1+6.5%) *1.12 = $105,558.
·
However,
if keep the money in US, you can get $100,000*(1+6%) = $106,000
·
So
better to deposit in US and do not participate in CIA
·
Forward
rate is set too low.
Interest rate parity (IRP)
· The interest rate parity implies that the expected return on domestic assets = the exchanged
rate adjusted expected return on foreign currency assets.
IRP is based on that “Investors cannot earn arbitrage
profits” by
For discussion:
Assume the current spot rate of GBP is 1.5$/Ł. Interest rate in US is 5% and Interest rate
is UK is 10%. Shall you invest in US for 5% or shall you invest in UK for a
higher return?
Answer:
It should make no difference at all! Please explain.
Interest rate parity is the fundamental
equation that governs the relationship between interest rates and currency
exchange rates. The basic premise of interest rate parity is that hedged returns
from investing in different currencies should be the same, regardless of the
level of their interest rates.
There
are two versions of interest rate parity:
1. Covered interest rate parity video
Calculating
Forward Rates
Forward
exchange rates for currencies are exchange rates at a future point in
time, as opposed to spot exchange rates, which are current rates. An
understanding of forward rates is fundamental to interest rate parity,
especially as it pertains to arbitrage (the simultaneous purchase and
sale of an asset in order to profit from a difference in the price).
The
basic equation for calculating forward rates with the U.S. dollar as the base
currency is:
Forward Rate = Spot Rate X [(1 + Interest
Rate of Overseas country) / (1 + Interest Rate of Domestic country)]
Forward
rates are available from banks and currency dealers for periods ranging from
less than a week to as far out as five years and beyond. As with spot
currency quotations, forwards are
quoted with a bid-ask spread.
Consider
U.S. and Canadian rates as an illustration. Suppose that the spot rate for
the Canadian dollar is presently 1 USD = 1.0650 CAD (ignoring bid-ask spreads
for the moment). Using the above formula, the one-year forward rate is
computed as follows:
1 USD = 1.0650 X [(1 +
3.64%)/(1+3.15%)] = 1.0700 CAD
The
difference between the forward rate and spot rate is known as swap points. In
the above example, the swap points amount to 50. If
this difference (forward rate minus spot rate) is positive, it is known as a forward
premium; a negative difference
is termed a forward discount.
A currency with lower interest rates will trade
at a forward premium in relation to a currency with a higher interest rate.
In the example shown above, the U.S. dollar trades at a forward premium
against the Canadian dollar; conversely, the Canadian dollar trades at a
forward discount versus the U.S. dollar.
Can
forward rates be used to predict future spot rates or interest rates? On both
counts, the answer is no. A number of studies have confirmed that forward
rates are notoriously poor predictors of future spot rates. Given that
forward rates are merely exchange rates adjusted for interest rate
differentials, they also have little predictive power in terms of forecasting
future interest rates.
With covered interest rate parity,
forward exchange rates should incorporate the difference in interest rates
between two countries; otherwise, an arbitrage opportunity would exist.
In other words, there is no interest
rate advantage if an investor borrows in a low-interest rate currency to
invest in a currency offering a higher interest rate. Typically, the
investor would take the following steps:
The returns in this case would be the same
as those obtained from investing in interest-bearing instruments in the lower
interest rate currency. Under the covered interest rate parity condition, the
cost of hedging exchange risk negates the higher returns that would accrue
from investing in a currency that offers a higher interest rate.
Consider
the following example to illustrate covered interest rate parity. Assume that
the interest rate for borrowing funds for a one-year period in Country A is
3% per annum, and that the one-year deposit rate in Country B is 5%. Further,
assume that the currencies of the two countries are trading at par in the
spot market (i.e., Currency A = Currency B).
An
investor does the following:
The
investor can use the one-year forward rate to eliminate the exchange risk
implicit in this transaction, which arises because the investor is now
holding Currency B, but has to repay the funds borrowed in Currency A. Under
covered interest rate parity, the one-year forward rate should be
approximately equal to 1.0194 (i.e., Currency A = 1.0194 Currency B),
according to the formula discussed above.
What
if the one-year forward rate is also at parity (i.e., Currency A = Currency
B)? In this case, the investor in the above scenario could reap
risk-free profits of 2%. Here’s how it would
work. Assume the investor:
After
one year, the investor receives 105,000 of Currency B, of which 103,000 is
used to purchase Currency A under the forward contract and repay the borrowed
amount, leaving the investor to pocket the balance –
2,000 of Currency B. This transaction is known as covered interest rate
arbitrage.
Market forces ensure that forward exchange
rates are based on the interest rate differential between two currencies,
otherwise arbitrageurs would step in to take advantage of the opportunity for
arbitrage profits. In the above example, the one-year
forward rate would therefore necessarily be close to 1.0194.
Another
Example (https://finance.zacks.com/explain-concept-interest-rate-parity-3067.html)
Assume banks in
Britain offer 10 percent annual interest on British Pound deposits, while
banks in America offer 5 percent. Further assume that right now you can buy 1
Pound for $2. According to the interest rate parity theory, it should be more
expensive to buy pounds in a one-year forward contract than it is right now.
To see why, imagine what an American bank can do if it is possible to lock in
a $2 equals 1 Pound rate in a one-year forward contract. Such a bank can
accept $1 million in one-year deposits, promising to return principal plus 5
percent in a year, which makes $1.05 million. It can then buy 500,000 Pounds
right now and invest this in a British bank. At the end of the one year, it
would have 550,000 pounds and use the forward contract to convert this into
$1.1 million. After paying the depositor $1.05 million, the bank is left with
$50,000 in easy money.
Real
Life Application
As long as bank
deposits and government bonds in a country are truly risk free, the parity
theory holds perfectly in real life. In our example, the one year future rate
cannot be equal to the present rate because American banks would make
enormous risk free profits by exploiting this abnormality. The rates thus
adjust to eliminate the possibility of such easy profits. In an economy where
the banks or the government may not be able to honor payment promises due to
severe distress, there is no truly risk free rate available and the parity
theory may not hold.
Equation of IRP:
or
S$/Ą: spot rate
how many $ per Ą. Ą is the base currency and $ is quoted currency
F$/Ą: forward
rate;
So, F = S *(1+ interest
rate of quoted currency) / (1+ interest rate of base currency)
Why?
Deposit in Ą @ the Ą’s rate
and then convert back to F (forward rate)
= Convert to $ at spot rate and deposit at
$’s rate
So, (1+rateĄ)*F =
S* (1+rate$) č F
= S* (1+rate$) /((1+rateĄ)
Or,
SĄ/$: spot rate
how many Ą per $. Ą is the base $ quoted
FĄ/$: forward
rate;
So, F = S *(1+ interest
rate of quoted currency) / (1+ interest rate of base currency)
Why?
Deposit in $ @ the $’s spot rate
and then convert back to F (forward rate)
= Convert to Ą at spot rate and deposit at
Ą’s rate
So, (1+rate$)*F =
S* (1+rateĄ) č F
= S* (1+rateĄ) /((1+rate$)
Or,
The basic equation for calculating forward
rates with the U.S. dollar as the base currency is:
Forward
Rate = Spot Rate * [(1 + Interest Rate of quoted currency) / (1 +
Interest Rate of based currency)]
Spot
rate: Ą/$, or USD/YEN (Yen is quoted
and $ is based)
Or,
Forward Rate = Spot Rate * ( Interest Rate of quoted currency - Interest Rate of based currency +1 )
Exercise 1: i$ is
8%; iSF is 4%; If spot rate S
=0.68 $/SF, then how much is F90 (90 day forward rate)?
Answer:
S =0.68 $/SF č
CHF/USD = 0.68, so CHF is base currency and USD is the quoted currency.
So, F = 0.68*(1+8%/4) / (1+4%/4) = 0.6867 $/CHF (or
CHF/USD = 0.6867)
Exercise 2: i$ is
8%; iyen is 4%; If spot rate S =
0.0094 $/YEN, then how much is F180 (180 day forward rate)?
Answer:
S = 0.0094 $/YEN, so $ is the quoted currency, Yen is the
base currency.
F = S *(1+ interest rate of
quoted currency) / (1+ interest rate of base)č F=0.0094*(1+8%/2)/(1+4%/2) = 0.0096 $/YEN
Exercise 3: i$ is
4% and iŁ is 2%. S is $1.5/Ł and F is $2/Ł. Does IRP
hold? How can you arbitrage? What is the forward rate in equilibrium?
Answer:
S = $1.5/Ł, so $ is the quoted currency, Ł is the base
currency.
F = S *(1+ interest rate of
quoted currency) / (1+ interest rate of base)č F=(1.04/1.02)*1.5 = $1.529/Ł, F at $2/Ł is too high.
When
F=$2/Ł, what can US investors do to
make arbitrage profits?
For example, US investor
·
can
borrow 1,000 $, and pay back $1,040 a year later.
·
Convert to Ł now at spot rate and get $1,000/1.5$/Ł
= 666.67 Ł
·
deposit in UK @ 2%
·
so one year later, get back 666.67 Ł*(1+2%)=680Ł
·
convert to $ at F rate
·
so get back 680 Ł * 2$/Ł
= $1,360
·
So the investor can make a profit of 1,360
-1040 = $320 profit.
The forward rate is set too high. It should be set around $1.529/Ł,
so that the arbitrage opportunity will be eliminated.
Exercise 4: i$ is 2%
and iŁ is 4%. S is $1.5/Ł and F is $1.1/Ł.
Does IRP hold? How can you arbitrage? What is the forward rate in
equilibrium?
Answer:
S = $1.5/Ł, so $ is the quoted currency, Ł is the base
currency.
F = S *(1+ interest rate of
quoted currency) / (1+ interest rate of base)č F=(1.02/1.04)*1.5 = $1.471/Ł, so F at $1.1/Ł is too low.
When
F=$1.1/Ł, what can US investors do
to make arbitrage profits?
For example, US investor
·
can
borrow 1,000 $, and pay back $1,040 a year later.
·
Convert to Ł now at spot rate and get $1,000/1.5$/Ł
= 666.67 Ł
·
deposit in UK @ 4%
·
so one year later, get back 666.67 Ł*(1+4%)=693.33Ł
·
convert to $ at F rate
·
so get back 680 Ł * 1.1$/Ł
= $762.67
·
So the investor will lose money: $762.67 -1040
= -247.33, a loss.
The forward rate is set too low. It should be set around
$1.471/Ł.
SO US investors should let this CIA (covered interest rate
arbitrage) go, but UK investor could consider borrow money in UK to generate
risk free profits. So the trade by UK investors will force forward rate to
drop to its equilibrium price based on IRP.
Rule of Thumb:
· All that is required to make a covered interest arbitrage profit
is for interest rate parity not to hold.
· The key to determining whether to start CIA is to compare
the differences in interest rate to the forward premium (= F/S-1, or =forward
rate / spot rate -1).
Spot exchange rate |
S($/Ł) |
= |
$2.0000/Ł |
360-day forward rate |
F360($/Ł) |
= |
$2.0100/Ł |
U.S. discount rate |
i$ |
= |
3.00% |
British discount rate |
iŁ |
= |
2.5% |
1. With above information and $1,000 in hand, any
opportunities?
2. When F360($/Ł) = $2.50/Ł?
3. When F360($/Ł) = $1.90/Ł
Answer:
1. Either
CIA make 3% or deposit in US also 3%. F is priced correctly.
2. F is too
high for US residents and what to do? (please refer to PPT)
3.
F is too low and what to do. (please refer to PPT)
Homework chapter 7 part II (due
with the second mid term exam)
1. Suppose
that the one-year interest rate is 5.0 percent in the United States and 3.5
percent in Germany, and the one-year forward exchange rate is $1.3/€. What must
the spot exchange rate be? (Hint: the question is asking for the spot
rate, given forward rate. ~~ $1.2814/€ ~~)
2. Imagine that can
borrow either $1,000,000 or €800,000 for one year. The one-year interest rate
in the U.S. is i$ = 2% and in the euro zone the
one-year interest rate is i€ = 6%. The one-year
forward exchange rate is $1.20 = €1.00; what must the spot rate be to
eliminate arbitrage opportunities? (1.2471$/€. It does not matter
whether you borrow $ or euro)
3. Image that the future
contracts with a value of €10,000 are available. The
information of one year interest rates, spot rate and forward rate available
are as follows.
Question: profits that you
can make with one contract at maturity?
Exchange
rate Interest
rate APR
So($/€) $1.45=€1.00 Interest
rate of $ 4%
F360($/€) $1.48=€1.00 Interest
rate of € 3%
Hint: The future contract is available, so you
can get 10,000 euro in the future. So at
present, you can
borrow €9,708.3 (=10,000 euro /
1.03) euro and purchase the future contract of €10,000, since € interest rate
is 3%. Let’s see you can make money or not .
Convert €9,708.3 to $ at spot rateč get back €9,708.3
*1.45 $/€= $14,077.67 č deposit at US @4% interest rate, and get back
$14,077.67 *(1+3%) = $14,640.78 č convert at F rate, and get back $14,640.78 / 1.48 $/€ =9,892.417 euro
, less than 10,000 euro č But if you deposit the
borrowed euro in Europe, it will be 10,000 euro and you can pay back the loan
with the 10,000 euro future contract value č so this round of trading is not a good idea.
4. Image that you find that
interest rate per year is 3% in Italy. You also realize that the spot rate is
$1.2/€ and forward rate (one year maturity) is $1.18/€.
Question: Use IRP to
calculate the interest rate per year in US. (1.28%)
The followings are useful websites
Exchange
rate forecast
http://exchangerateforecast.com/
Daily
FX News(has news, technical analysis and live rates):http://www.dailyfx.com/
Technical
analysis _ chart example book
http://www.forex-charts-book.com/
Forex Trend
lines
http://www.forextrendline.com/
Historical
currency rate
http://www.xe.com/currencytables/
Historical
currency chart
http://www.xe.com/currencycharts/
Forex trading
demo
http://www.fxcm.com/forex-trading-demo/
Purchasing
power parity (cartoon)
https://www.youtube.com/watch?v=i0icL5zlQww
https://www.investopedia.com/terms/u/uncoveredinterestrateparity.asp
Uncovered interest rate parity (UIP) states that
the difference in interest rates between two countries equals the expected
change in exchange rates between those two countries. Theoretically, if the interest rate
differential between two countries is 3%, then the currency of the nation
with the higher interest rate would be expected to depreciate 3% against the
other currency.
In reality, however, it is a different story.
Since the introduction of floating exchange rates in the early 1970s,
currencies of countries with high interest rates have tended to appreciate,
rather than depreciate, as the UIP equation states. This well-known
conundrum, also termed the “forward premium puzzle,” has been the subject of several academic research papers.
The anomaly may be partly explained by the “carry trade,” whereby speculators
borrow in low-interest currencies such as the Japanese yen, sell the borrowed
amount and invest the proceeds in higher-yielding currencies and instruments.
The Japanese yen was a favorite target for this activity until mid-2007, with
an estimated $1 trillion tied up in the yen carry trade by that year.
Relentless selling of the borrowed currency has
the effect of weakening it in the foreign exchange markets. From the
beginning of 2005 to mid-2007, the Japanese yen depreciated almost 21%
against the U.S. dollar. The Bank of Japan’s target
rate over that period ranged from 0 to 0.50%; if the UIP theory had held, the
yen should have appreciated against the U.S. dollar on the basis of Japan’s lower interest rates alone.
Covered interest parity (CIP) involves using
forward or futures contracts to cover exchange rates, which can thus be
hedged in the market. Meanwhile, uncovered interest rate parity involves
forecasting rates and not covering exposure to foreign exchange risk – that is, there are no forward rate contracts, and it
uses only the expected spot rate.
There is no theoretical difference between covered and
uncovered interest rate parity when the forward and expected spot rates are
the same.
Updated
Feb 26, 2021
What Are Negative
Interest Rates? (FYI)
Negative
interest rates occur when borrowers are credited interest rather than paying
interest to lenders. While this is a very unusual scenario, it is most likely
to occur during a deep economic recession when monetary efforts and market
forces have already pushed interest rates to their nominal zero bound.
Typically,
a central bank will charge commercial banks on their reserves as a form of
non-traditional expansionary monetary policy, rather than crediting them
interest. This extraordinary monetary policy tool is used to strongly
encourage lending, spending, and investment rather than hoarding cash, which
will lose value to negative deposit rates. Note that individual depositors
will not be charged negative interest rates on their bank accounts.
KEY
TAKEAWAYS
• Negative interest rates occur when
borrowers are credited interest rather than paying interest to lenders.
• With negative interest rates, central
banks charge commercial banks on reserves in an effort to incentivize them to
spend rather than hoard cash positions.
• With negative interest rates,
commercial banks are charged interest to keep cash with a nation's central
bank, rather than receiving interest. Theoretically, this dynamic should
trickle down to consumers and businesses, but commercial banks have been
reluctant to pass negative rates onto their customers.
Understanding
a Negative Interest Rate
While
real interest rates can be effectively negative if inflation exceeds the nominal
interest rate, the nominal interest rate is, theoretically, bounded by zero.
Negative interest rates are often the result of a desperate and critical
effort to boost economic growth through financial means.
The
zero-bound refers to the lowest level that interest rates can fall to; some
forms of logic would dictate that zero would be that lowest level. However,
there are instances where negative rates have been implemented during normal
times. Switzerland is one such example; as of mid-2020, its target interest
rate was -0.75%.1 Japan adopted a similar policy, with a mid-2020 target rate
of -0.1%.2
Negative
interest rates may occur during deflationary periods. During these times,
people and businesses hold too much money—instead of
spending money—with the expectation that a dollar
will be worth more tomorrow than today (i.e., the opposite of inflation).
This can result in a sharp decline in demand, and send prices even lower.
Often,
a loose monetary policy is used to deal with this type of situation. However,
when there are strong signs of deflation factoring into the equation, simply
cutting the central bank's interest rate to zero may not be sufficient enough
to stimulate growth in both credit and lending.
In
a negative interest rate environment, an entire economic zone can be impacted
because the nominal interest rate dips below zero. Banks and financial firms
have to pay to store their funds at the central bank, rather than earn
interest income.
Consequences
of Negative Rates
A
negative interest rate environment occurs when the nominal interest rate
drops below zero percent for a specific economic zone. This effectively means
that banks and other financial firms have to pay to keep their excess
reserves stored at the central bank, rather than receiving positive interest
income.
A
negative interest rate policy (NIRP) is an unusual monetary policy tool.
Nominal target interest rates are set with a negative value, which is below
the theoretical lower bound of zero percent.
During
deflationary periods, people and businesses tend to hoard money, instead of
spending money and investing. The result is a collapse in aggregate demand,
which leads to prices falling even further, a slowdown or halt in real
production and output, and an increase in unemployment.
A
loose or expansionary monetary policy is usually employed to deal with such
economic stagnation. However, if deflationary forces are strong enough,
simply cutting the central bank's interest rate to zero may not be sufficient
to stimulate borrowing and lending.
Example
of a Negative Interest Rate
In
recent years, central banks in Europe, Scandinavia, and Japan have
implemented a negative interest rate policy (NIRP) on excess bank reserves in
the financial system. This unorthodox monetary policy tool is designed to
spur economic growth through spending and investment; depositors would be
incentivized to spend cash rather than store it at the bank and incur a
guaranteed loss.
It's
still not clear if this policy has been effective in achieving this goal in
those countries, and in the way it was intended. It's also unclear whether or
not negative rates have successfully spread beyond excess cash reserves in
the banking system to other parts of the economy.
Frequently
Asked Questions
How
can interest rates turn negative?
Interest
rates tell you how valuable money is today compared to the same amount of
money in the future. Positive interest rates imply that there is a time value
of money, where money today is worth more than money tomorrow. Forces like inflation,
economic growth, and investment spending all contribute to this outlook. A
negative interest rate, by contrast, implies that your money will be worth
more in the future, not less.
What do negative interest
rates mean for people?
Most instances of negative
interest rates only apply to bank reserves held by central banks; however, we
can ponder the consequences of more widespread negative rates. First, savers
would have to pay interest instead of receiving it. By the same token,
borrowers would be paid to do so instead of paying their lender. Therefore,
it would incentivize many to borrow more and larger sums of money and to
forgo saving in favor of consumption or investment. If they did save, they
would save their cash in a safe or under the mattress, rather than pay
interest to a bank for depositing it. Note that interest rates in the real
world are set by the supply and demand for loans (despite central banks
setting a target). As a result, the demand for money in-use would grow and
quickly restore a positive interest rate.
Where
do negative interest rates exist?
Some
central banks have set a negative interest rate policy (NIRP) in order to
stimulate economic growth in the financial sector, or else to protect the
value of a local currency against exchange-rate increases due to large
inflows of foreign investment. Countries including Japan, Switzerland,
Sweden, and even the ECB (eurozone) have adopted NIRPs at various points over
the past two decades.
Why
would a central bank adopt a NIRP to stimulate the economy?
Monetary
policymakers are often afraid of falling into a deflationary spiral. In harsh
economic times, such as deep economic recessions or depressions, people and
businesses tend to hold on to their cash while they wait for the economy to
improve. This behavior, however, can weaken the economy further as a lack of
spending causes further job losses, lowers profits, and prices to drop—all of which reinforces people’s
fears, giving them even more incentive to hoard. As spending slows even more,
prices drop again, creating another incentive for people to wait as prices
fall further. And so on. When central banks have already lowered interest
rates to zero, the NIRP is a way to incentivize corporate borrowing and
investment and discourage hoarding of cash.
https://www.investopedia.com/terms/n/negative-interest-rate.asp
Second Mid-Term Exam spring 2021 Study Guide – 36
multiple choice questions
1)
What is forward contract? What is futures
contract? The differences between the two??
2)
What is call option? What is put option? What is
spot rate? What is strike rate?
For example, if you believe that euro will
devalue, how can you make profits as a speculator?
For example, if you believe that euro
will appreciate, how can you make profits as a speculator?
3)
What shall you sell (short) a futures contract?
What shall you long (buy) a futures contract?
4)
Calculate the gain and losses from the futures
market?
Hint: use the https://www.jufinance.com/futures/
5) Calculate the gain and losses from the call and put options – both payoff and profits. The payoff graph is not required.
Hint: use the https://www.jufinance.com/option1/
6) What is IRP? What is CIA?
7) Use IRP to calculate the forward rate.
Hint: use https://www.jufinance.com/irp/
8) CIA: Similar to the in class exercise question:
i$ is 4% and iŁ is 2%. S is
$1.5/Ł and F is $2/Ł. Does IRP hold? How can you arbitrage? What is the
forward rate in equilibrium?
9) Forward premium and forward discount: concepts, not calculation
10) Triangular arbitrage:
Similar to the in class exercise question: Ł is quoted at $1.60.
Malaysian Rinnggit (MYR) is quoted at $0.20 and the cross exchange
rate is Ł1 = MYR 8.1. How can you arbitrage?
Second Mid Term Exam on Thursday (4/8/2021) starting at 1:00 pm on
blackboard collaborate under “Second Mid Term Exam” Folder in the left column
Chapter 8 Purchasing Power Parity,
International Fisher Effect
Part I: PPP
1) Purchasing power parity (PPP)
Purchasing power parity (cartoon) https://www.youtube.com/watch?v=i0icL5zlQww
|
· A theory which states that exchange rates between
currencies are in equilibrium when their purchasing power is the same in
each of the two countries. · This means that the exchange rate between two countries
should equal the ratio of the two countries' price level of a fixed basket
of goods and services. · When a country's domestic price level is increasing
(i.e., a country experiences inflation), that country's exchange rate must
depreciated in order to return to PPP. |
· The basis for PPP is the "law of one
price": In the
absence of transportation and other transaction costs, competitive markets
will equalize the price of an identical good in two countries when the
prices are expressed in the same currency. · There are some caveats with this law of one price (for
class discussion) · (1) transportation costs, barriers to trade,
and other transaction costs, can be significant. · (2) there must be competitive markets for the
goods and services in both countries. · (3) tradable goods; immobile goods such as
houses, and many services that are local, are of course not traded between
countries. What else? Your opinion? |
|
2) The Law of one price THEORY:
All else
being equal (no transaction costs), a product’s price should be the same in
all markets
So price in $
sold in US = price in $ sold in Japan after conversion to $ from Ą
P$ = P Ą * Spot Rate $/Ą
Where the price of the product in US dollars (P$),
multiplied by the spot exchange rate (S, dollar per yen), equals
the price of the product in Japanese yen (PĄ)
Or, S = P$/ P Ą
---- from investopedia.com
|
·
No. ·
Exchange rate movements in the short
term are news-driven. ·
Announcements
about interest rate changes, changes in perception of the growth path of
economies and the like are all factors that drive exchange rates in the
short run. ·
PPP, by comparison, describes the long
run behaviour of exchange rates. ·
The
economic forces behind PPP will eventually equalize the purchasing power of
currencies. This can take many years, however. A time horizon of 4-10 years
would be typical. What else? Your opinion? |
4) How to
calculate exchange rate based on PPP? ---- Example of the big mac index
·
PPP states that the spot exchange rate is determined by the
relative prices of similar basket of goods.
·
The simplest way to calculate purchasing power parity between
two countries is to compare the price
of a "standard" good that is in fact identical across countries.
·
Every year The Economist magazine publishes a
light-hearted version of PPP: its "Hamburger Index" that
compares the price of a McDonald's hamburger around the world. More
sophisticated versions of PPP look at a large number of goods and services.
·
One of the key problems is that people in different countries
consumer very different sets of goods and services, making it difficult to
compare the purchasing power between countries.
For class discussion: Can bitcoin be used be an
item to calculate the exchange rates based on PPP?
Using Hamburgers to Compare Wealth
- Big mac index explained video
The Economist’s Big Mac index is based on the theory of purchasing-power
parity, which holds that exchange rates should adjust until the price of
an identical basket of goods costs the same everywhere. Our basket has just
one item, a Big Mac. The double-decker
sandwich is uniquely suited for such an analysis thanks to its consistency
(it is nearly identical everywhere) and ubiquity (it is sold in more than 100
countries). Consider the Chinese yuan. A Big Mac costs 21.50 yuan, or
$3.12, in China, compared with $5.67 in America. Burgernomics would suggest,
therefore, that the yuan is 45% undervalued against the dollar; adjusted for
GDP per person, it is roughly 8% below fair value.
|
The currencies listed
below are compared to the US Dollar. A
green bar indicated that the local currency is overvalued by the percentage
figure shown on the axis; the currency is thus expected to depreciate
against the US Dollar in the long run. A
red bar indicates undervaluation of the local currency; the currency is
thus expected to appreciate against the US Dollar in the long run. |
The currencies listed below are compared to the Euro.
6) Where can I get more information?
|
|
||||||||||||
• OECD National Accounts: The OECD
publishes PPPs for all OECD countries. You can
retrieve a table with the OECD's 1950-2015 PPP rates. This is a
comma-seprated file that can be easily imported into a spreadsheet
program. |
|
||||||||||||
Data table for: Purchasing power parities (PPP),
Total, National currency units/US dollar, 2005– 2016 |
|||||||||||||
▾ 2008 |
▾ 2009 |
▾ 2010 |
▾ 2011 |
▾ 2012 |
▾ 2013 |
▾ 2014 |
▾ 2015 |
||||||
Argentina |
1.077 |
1.188 |
1.331 |
1.607 |
1.841 |
2.199 |
2.665 |
3.201 |
3.904 |
5.38 |
6.63 |
9.217 |
|
Brazil |
1.06 |
1.098 |
1.139 |
1.215 |
1.294 |
1.386 |
1.471 |
1.559 |
1.65 |
1.748 |
1.866 |
1.995 |
|
China (People's Republic
of) |
2.821 |
2.845 |
2.987 |
3.159 |
3.131 |
3.308 |
3.506 |
3.524 |
3.546 |
3.512 |
3.478 |
3.474 |
|
France |
0.916 |
0.896 |
0.89 |
0.882 |
0.863 |
0.854 |
0.841 |
0.844 |
0.812 |
0.808 |
0.814 |
0.806 |
|
Germany |
0.873 |
0.848 |
0.838 |
0.82 |
0.811 |
0.804 |
0.789 |
0.787 |
0.775 |
0.769 |
0.779 |
0.78 |
|
Greece |
0.709 |
0.693 |
0.719 |
0.708 |
0.704 |
0.721 |
0.713 |
0.685 |
0.631 |
0.611 |
0.61 |
0.604 |
|
Italy |
0.855 |
0.824 |
0.81 |
0.784 |
0.771 |
0.772 |
0.759 |
0.748 |
0.737 |
0.74 |
0.743 |
0.722 |
|
Japan |
129.552 |
124.504 |
120.392 |
116.846 |
115.171 |
111.624 |
107.454 |
104.274 |
101.303 |
103.052 |
102.763 |
100.279 |
|
Mexico |
7.127 |
7.186 |
7.348 |
7.47 |
7.43 |
7.668 |
7.673 |
7.859 |
7.884 |
8.045 |
8.541 |
8.869 |
|
https://data.oecd.org/conversion/purchasing-power-parities-ppp.htm#indicator-chart Data
table for: Actual Exchange Rate,
National currency units/US dollar, 2005– 2016 |
|||||||||||||
▾ 2008 |
▾ 2009 |
▾ 2010 |
▾ 2011 |
▾ 2012 |
▾ 2013 |
▾ 2014 |
▾ 2015 |
||||||
Argentina |
2.904 |
3.054 |
3.096 |
3.144 |
3.71 |
3.896 |
4.11 |
4.537 |
5.459 |
8.075 |
9.233 |
14.758 |
|
Brazil |
2.434 |
2.175 |
1.947 |
1.834 |
1.999 |
1.759 |
1.673 |
1.953 |
2.156 |
2.353 |
3.327 |
3.491 |
|
China
(People's Republic of) |
8.194 |
7.973 |
7.608 |
6.949 |
6.831 |
6.77 |
6.461 |
6.312 |
6.196 |
6.143 |
6.227 |
6.644 |
|
France |
0.804 |
0.797 |
0.731 |
0.683 |
0.72 |
0.755 |
0.719 |
0.778 |
0.753 |
0.754 |
0.902 |
0.904 |
|
Germany |
0.804 |
0.797 |
0.731 |
0.683 |
0.72 |
0.755 |
0.719 |
0.778 |
0.753 |
0.754 |
0.902 |
0.904 |
|
Greece |
0.804 |
0.797 |
0.731 |
0.683 |
0.72 |
0.755 |
0.719 |
0.778 |
0.753 |
0.754 |
0.902 |
0.904 |
|
Italy |
0.804 |
0.797 |
0.731 |
0.683 |
0.72 |
0.755 |
0.719 |
0.778 |
0.753 |
0.754 |
0.902 |
0.904 |
|
Mexico |
10.898 |
10.899 |
10.928 |
11.13 |
13.513 |
12.636 |
12.423 |
13.169 |
12.772 |
13.292 |
15.848 |
18.664 |
◦ the relative change in prices between countries over a period of
time determines the change in exchange rates
◦ if the spot rate between 2
countries starts in equilibrium, any change in the differential rate of
inflation between them tends to be offset over the long run by an equal but
opposite change in the spot rate
Relative Purchasing Power
Parity (RPPP)
By
JAMES CHEN Reviewed by MICHAEL J
BOYLE Updated Dec 1, 2020
https://www.investopedia.com/terms/r/relativeppp.asp
Relative
Purchasing Power Parity (RPPP) is an
expansion of the traditional purchasing power parity (PPP) theory to include
changes in inflation over time. Purchasing power is the power of money
expressed by the number of goods or services that one unit can buy, and which
can be reduced by inflation. RPPP
suggests that countries with higher rates of inflation will have a devalued
currency.
KEY
TAKEAWAYS
·
Relative purchasing power parity (RPPP) is
an economic theory that states that exchange rates and inflation rates (price
levels) in two countries should equal out over time.
·
Relative PPP is an extension of absolute
PPP in that it is a dynamic (as opposed to static) version of PPP.
·
While PPP is useful in understanding
macroeconomics in theory, in practice
RPPP does not seem to hold true over short time horizons.
Understanding Relative
Purchasing Power Parity (RPPP)
According
to relative purchasing power parity (RPPP), the difference between the two
countries’ rates of inflation and the cost of commodities will drive changes
in the exchange rate between the two countries. RPPP expands on the idea of
purchasing power parity and complements the theory of absolute purchasing
power parity (APPP). The APPP concept declares that the exchange rate between
the two nations will be equal to the ratio of the price levels for those two
countries.
The
relative version of PPP is calculated with the following formula:
Purchasing Power Parity in
Theory
Purchasing
power parity (PPP) is the idea that goods in one country will cost the same
in another country, once their exchange rate is applied. According to this
theory, two currencies are at par when a market basket of goods is valued the
same in both countries. The comparison of prices of identical items in
different countries will determine the PPP rate. However, an exact comparison
is difficult due to differences in product quality, consumer attitudes, and
economic conditions in each nation. Also, purchasing power parity is a theoretical concept which may not be
true in the real world, especially in the short run.
Empirical
evidence has shown that for many goods and baskets of goods, PPP is not
observed in the short term, and there is uncertainty over whether it applies
in the long term.
Dynamics of Relative PPP
RPPP
is essentially a dynamic form of PPP, as it relates the change in two
countries’ inflation rates to the change in their exchange rate. The theory holds
that inflation will reduce the real purchasing power of a nation's currency.
Thus if a country has an annual inflation rate of 10%, that country's
currency will be able to purchase 10% less real goods at the end of one year.
RPPP
also complements the theory of absolute purchasing power parity (APPP), which
maintains that the exchange rate between two countries will be identical to
the ratio of the price levels for those two countries. This concept comes
from a basic idea known as the law of one price. This theory states that the
real cost of a good must be the same across all countries after the
consideration of the exchange rate.
Example of Relative
Purchasing Power Parity
Suppose
that over the next year, inflation causes average prices for goods in the
U.S. to increase by 3%. In the same period, prices for products in Mexico
increased by 6%. We can say that Mexico has had higher inflation than the
U.S. since prices there have risen faster by three points.
According
to the concept of relative purchase power parity, that three-point difference
will drive a three-point change in the exchange rate between the U.S. and
Mexico. So we can expect the Mexican peso to depreciate at the rate of 3% per
year, or that the U.S. dollar should appreciate at the rate of 3% per year.
Math equation: ef= Ih- If or ((1+ Ih)/(1+If) -1= ef; ef: change in exchange rate
RPPP Calculator at https://www.jufinance.com/rppp/
Answer:
(1+ 9%) /(1+5%)
-1 = ef = 4%
, and 1Ł=1.6$, so the new rate of Ł =1.6*(1+4%) = 1.66 $/Ł
Or, think about a Big Mac is selling at 1Ł
in UK and 1.6$ in US. Price goes up by 9% in US and 4% in UK.
So
new price in US = 1.6$*(1+9%)
New
price in UK = 1Ł *(1+4%)
Based on PPP, price should be equal after the
adjustment of exchange rate.
1.6$*(1+9%)
= 1Ł *(1+4%) * new exchange rate č new exchange rate = 1.6$*(1+9%) / (1Ł
*(1+4%)) = 1.6*1.09/1.04 = 1.66$/Ł
Example
2: 1Ł=1.6$. US inflation rate is 5%. UK
inflation is 9%. What will happen? Calculate the new exchange rate using the
RPPP equation.
Answer:
ef = Ih – If, Ih= 5%, If =9%,
so ef = 5%-9% = -4%, so the old rate is that 1Ł=1.6$.
The new rate should be 4% lower. So new rate is that 1Ł=1.6*(1-4%)
= 1.536$
Or, think about a Big Mac is selling at 1Ł
in UK and 1.6$ in US. Price goes up by 5% in US and 9% in UK.
So
new price in US = 1.6$*(1+5%)
New
price in UK = 1Ł *(1+9%)
Based on PPP, price should be equal after the
adjustment of exchange rate.
1.6$*(1+5%) = 1Ł *(1+9%) * new exchange rate č new exchange rate = 1.6$*(1+5%) / (1Ł
*(1+9%)) = 1.6*1.05/1.09 = 1.536$/Ł
Example 3:
1Ł=1.2€. Inflation rate in Germany is 4%. UK
inflation is 9%. What will happen? Calculate the new exchange rate using the
PPP equation.
Answer:
Home currency is euro and foreign currency is
pound. ef = Ih – If, Ih=
4%, If =9%, so ef = 4%-9% = -5%, so the
old rate is that 1Ł=1.2€. The new rate should be 5%
lower. So new rate is that 1Ł=1.2*(1-5%) = 1.14€
Or, think about a Big Mac is selling at 1Ł
in UK and 1.2€ in Germany. Price goes up
by 4% in Germany and 9% in UK.
So
new price in Germany = 1.2€ *
(1+4%)
New
price in UK = 1Ł *(1+9%)
Based on PPP, price should be equal after the
adjustment of exchange rate.
1.2€ *
(1+4%) = 1Ł *(1+9%) * new exchange rate č new exchange rate = 1.2€ *
(1+4%)/ (1Ł *(1+9%)) = 1.2*1.04/1.09 = 1.14€
Or
use RPPP calculator at https://www.jufinance.com/rppp/
What Is Purchasing Power Parity (PPP)?
· BY MARY HALL
Updated
Feb 24, 2019
Macroeconomic
analysis relies on several different metrics to compare economic productivity
and standards of living between countries and across time. One popular metric
is purchasing power parity (PPP).
Purchasing power parity (PPP) is an
economic theory that compares different countries' currencies through a
"basket of goods" approach.
According to this concept, two currencies are in equilibrium or at par when
a basket of goods (taking into account the exchange rate) is priced the
same in both countries. Closely related to PPP is the law of one price (LOOP), which is an
economic theory that predicts that after accounting for differences in
interest rates and exchange rates, the cost of something in country X should
be the same as that in country Y in real terms.
How to Calculate
Purchasing Power Parity
The
relative version of PPP is calculated with the following formula:
Where:
S represents
the exchange rate of currency 1 to currency 2
P1 represents
the cost of good X in currency 1
P2 represents
the cost of good X in currency 2
How PPP Is Used
To
make a comparison of prices across countries that holds any type of meaning,
a wide range of goods and services must be considered. The amount of data
that must be collected and the complexity of drawing comparisons makes this
process difficult. To facilitate this,
the International Comparison Program (ICP) was established in 1968 by the
University of Pennsylvania and the United Nations. Purchasing power parities
generated by the ICP are based on a worldwide price survey comparing the
prices of hundreds of various goods. This data, in turn, helps international
macroeconomists come up with estimates of global productivity and
growth.
Every three years, the World Bank constructs
and releases a report comparing various countries in terms of PPP and
U.S. dollars. Both the International Monetary Fund (IMF) and the
Organization for Economic Cooperation and Development (OECD) use weights
based on PPP metrics to make predictions and recommend economic policy. These actions often impact financial markets in
the short run.
Some forex traders also
use PPP to find potentially overvalued or undervalued currencies. Investors
who hold stock or bonds of foreign companies may survey PPP figures to
predict the impact of exchange-rate fluctuations on a country's economy.
PPP: The Alternative to Market Exchange Rates
Using
PPPs is the alternative to using market exchange rates. The actual purchasing
power of any currency is the quantity of that currency needed to buy a
specified unit of a good or a basket of common goods and services. Purchasing
power is determined in each country based on its relative cost of living
and inflation rates. Purchasing power plus parity equalizes the
purchasing power of two differing currencies by accounting for differences in
inflation rates and cost of living.
The Big Mac Index: An Example of PPP
As a light-hearted annual test of PPP,
The Economist has tracked the price of McDonald's Corp.’s (MCD) Big Mac
burger in many countries since 1986. The
highly publicized Big Mac index measures the purchasing power parity
(PPP) between nations using the price of a Big Mac as the benchmark. The
Big Mac index suggests, in theory, changes in exchange rates between
currencies should affect the price consumers pay for a Big Mac in a
particular nation, replacing the "basket" with the famous
hamburger. This is a prime example of how the "law" of one price
fails in practice.
For example, if the price of a Big Mac is
$4.00 in the U.S. and 2.5 pounds sterling in Britain, we would expect the
exchange rate to be 1.60 (4/2.5 = 1.60). If the exchange rate of
dollars to pounds is any greater, the Big Mac index would state the
pound was overvalued, any lower and it would be undervalued.
That
said, the index has its flaws. First, the Big Mac's price is decided by
McDonald's Corp., which can significantly affect the Big Mac index.
Also, the Big Mac differs across the world in size, ingredients and
availability. That being said, the index is meant to be light-hearted and is
a great example used by many schools and universities to teach students
about PPP.
GDP and PPP
In
contemporary macroeconomics, gross
domestic product (GDP) refers to
the total monetary value of the goods and services produced within one
country. Nominal GDP calculates the monetary value in current, absolute
terms. Real GDP takes the nominal GDP and adjusts it for
inflation. Further, some accounts of GDP are adjusted for PPP. This
adjustment attempts to convert nominal GDP into a number more easily
comparable between countries with different currencies.
One
way to think of what GDP with PPP represents is to imagine the total
collective purchasing power of Japan if it were used to make the same
purchases in U.S. markets. This only works after all yen are exchanged for
dollars. Otherwise, the comparison does not make sense.
The
following example illustrates this point. Suppose it costs $10
to buy a shirt in the U.S., and it costs €8.00 to buy the same shirt in
Germany. To make an apples-to-apples comparison, the €8.00 in Germany needs
to be converted into U.S. dollars. If the exchange rate was such that the
shirt in Germany costs $15.00, the PPP would be 15/10, or 1.5. For every
$1.00 spent on the shirt in the U.S., it takes $1.50 to obtain the same shirt
in Germany.
Which
Nations Have the Highest Purchasing Power?
The
five nations with the highest GDP in market exchange terms are the U.S.,
China, India, Japan and Germany. This comparison changes when PPP is
used. According to 2017 data from the International Monetary Fund (IMF),
China has overtaken the U.S. as the world's largest economy based on
purchasing power with 23,122 billion current international dollars. The U.S.
comes in second with 19,362 billion. India, Japan and Germany follow
with 9,447 billion, 5,405 billion, and 4,150 billion, respectively.
The Downfalls of PPP: Short-Term vs. Long-Term Parity
Empirical
evidence has shown that for many goods and baskets of goods, PPP is not
observed in the short-term, and there is uncertainty over whether it applies
in the long-term. In “Burgernomics,” (2003) a prominent paper that explores
the Big Mac Index and PPP, authors Michael R. Pakko and Patricia S. Pollard
cite several factors as to why PPP theory does not line up with reality:
While
not perfect, purchase power parity does allow one to compare pricing
between countries with differing currencies. Just don't try to buy a
hamburger in Luxembourg if you plan on exchanging for Russian rubles!
(https://www.investopedia.com/updates/purchasing-power-parity-ppp/)
Determine which two
currencies you would like to compare for purchasing power parity. The formula
for purchasing power parity requires two prices in different currencies to
calculate the price ratio:
S (purchase power parity
ratio) = Price 1/Price 2
In
this case, P1 refers to one price in a specific currency, and P2 refers to
another price in a different currency.
For
instance, suppose you want to calculate the purchasing price parity between
the United States and Mexico. Your comparison prices will be in U.S. dollars
and Mexican pesos.
Determine which product is commonly available in both the
United States and Mexico. For simplicity, we'll compare the price of Coca
Cola in both countries.
Although comparing one common product is one strategy, economic analysts may
also select a group of common products to calculate a more broad measure of
purchasing power parity. This group of products is commonly called a basket
of goods and may include food staples such as bread, milk and other related
items. Although the basket approach may be broader, the single item method
helps illustrate the calculation in simpler terms.
Research the prices of Coca
Cola in Mexico and the United States. The purchasing power parity formula
requires you to know the price of the item you are comparing. Assume for this
example that a 12-ounce can of Coca Cola costs $1.50 in U.S. dollars and $9
Mexican pesos. Divide the $9 pesos by $1.50. The result is the price ratio
for purchasing power parity. To illustrate the calculation refer to the
following:
S = P1/P2
S = 9/1.50
S = 6
Compare the result of the
purchasing power parity to the currency exchange rate between the United
States and Mexico. Assume that the exchange rate between the Mexican peso and
U.S. dollar is 5.7 pesos for every dollar. Recall that for purchasing power
parity to exist, the exchange rate and the purchasing power parity ratio must
be equal. The purchasing power parity ratio of 6 and a $5.7 peso per dollar
exchange rate between the currencies in Mexico and the United States
indicates that the purchasing power of the peso and the dollar are similar
but not exact. This means that Mexican and U.S. consumers have similar
purchasing power with their respective currencies.
However, if the exchange
rate between the dollar and the peso suddenly changed to $17 pesos per dollar
and the purchasing power parity ratio remained at 6, the purchasing power
parity calculation shows a loss of purchasing power for Mexican consumers
relative to the U.S. consumers.
----- FROM WWW.SAMPLING.COM
Part II:
International Fisher Effect (IFE)
Fisher Effect: Nominal
interest rate (R) = real interest rate (r) + inflation (I)
By assuming real interest rates in two countries are the same,
we conclude that inflation moves along with the nominal interest rate which
is observable and reported.
The international
Fisher effect (sometimes
referred to as Fisher's open hypothesis) is a hypothesis in international finance that suggests differences in nominal interest rates reflect expected changes in the
spot exchange
rate between countries. The
hypothesis specifically states that a
spot exchange rate is expected to change equally in the opposite direction of
the interest rate differential; thus, the currency of the country with the higher nominal interest rate is
expected to depreciate against the currency of the country with the lower
nominal interest rate, as higher nominal interest rates reflect an
expectation of inflation.
Note:
·
The IFE theory suggests that if a firm
periodically capitalized on the higher interest rates in foreign countries,
it will achieve a yield that is above or below the domestic rate.
·
On average, the yield on investment in
foreign countries with higher interest
rate should be similar to the investment with the domestic interest rate.
·
Since IFE is based on PPP, if PPP does not
hold, then IFE will not hold.
https://www.swlearning.com/finance/madura/ifm7e/powerpoint/expanded08/sld001.htm
Suppose the current spot exchange
rate between the United States and the United Kingdom is 1.4339 GBP/USD.
Also suppose the current interest rates are 5 percent in the U.S. and 7
percent in the U.K. What is the expected spot exchange rate 12 months from now
according to the international Fisher effect?
Solution:
The
effect estimates future exchange rates based on the relationship between
nominal interest rates. Multiplying the current spot exchange rate by the nominal
annual U.S. interest rate and dividing by the nominal annual U.K. interest
rate yields the estimate of the spot exchange rate 12 months from now.
$1.4339*(1+5%)/(1+7%)
= $1.4071
The expected percentage change in the exchange rate is a
depreciation of 1.87% on the GBP (it now only costs $1.4071 to purchase 1 GBP
rather than $1.4339), which is consistent with the expectation that the value
of the currency in the country with a higher interest rate will depreciate.
https://en.wikipedia.org/wiki/International_Fisher_effect
ef:
changes in exchange rate
Calculator for
IFE
Example 4: If the interest rate of US is 10% and that of UK is 5%, which country’s currency will appreciate,
by how much? Imagine 1Ł=1.6$.
Answer:
Home currency is $ and foreign currency is Ł. ef = Rh – Rf, Rh= 10%, Rf =5%,
so ef = 10%-5% = 5%, so the old rate is that 1Ł=1.6$.
The new rate should be 5% higher. So new rate is
that 1Ł=1.6*(1+5%) = 1.68$
Example
5: If the interest rate of US is 5% and
that of UK is 10%, which country’s currency will appreciate,
by how much? Imagine 1Ł=1.6$.
Answer:
Home currency is $ and foreign currency is Ł. ef = Rh – Rf, Rh= 5%, Rf =10%,
so ef = 5%-10% = -5%, so the old rate is that 1Ł=1.6$.
The new rate should be 5% lower. So new rate is that 1Ł=1.6*(1-5%)
Differences between
IRP, PPP, and IFE
https://www.swlearning.com/finance/madura/ifm7e/powerpoint/expanded08/sld001.htm
For class discussion:
·
Why currency carry trade could
work, if higher interest rate just means higher inflation and reduced
currency value?
An example of
investing in higher interest rate in foreign countries (FYI)
·
The Asian Financial Crisis is
a crisis caused by the collapse of the currency exchange rate and hot money
bubble. The financial crisis started in Thailand in July 1997 after the Thai
baht plunged in value. It then swept over East and Southeast Asia.
The causes of the Asian
Financial Crisis are complicated and disputable. A major cause is considered to be the collapse of the hot money
bubble. During the late 1980s and early 1990s, many Southeast Asian
countries, including Thailand, Singapore, Malaysia, Indonesia, and South
Korea, achieved massive economic growth of an 8% to 12% increase in their
gross domestic product (GDP). The achievement was known as the “Asian
economic miracle.” However, a significant risk was embedded in the
achievement.
The economic developments in the countries mentioned above were
mainly boosted by export growth and foreign investment. Therefore, high
interest rates and fixed currency exchange rates (pegged to the U.S. dollar)
were implemented to attract hot money. Also, the exchange rate was pegged at a
rate favorable to exporters. However, both the capital market and corporates
were left exposed to foreign exchange risk due to the fixed currency exchange
rate policy.
In the mid-1990s, following
the recovery of the U.S. from a recession, the Federal Reserve raised the interest rate against inflation. The
higher interest rate attracted hot money to flow into the U.S. market,
leading to an appreciation of the U.S. dollar.
The currencies pegged to the U.S. dollar also appreciated, and
thus hurt export growth. With a shock in both export and foreign investment,
asset prices, which were leveraged by large amounts of credits, began to
collapse. The panicked foreign investors began to withdraw.
The massive capital outflow caused a depreciation pressure on
the currencies of the Asian countries. The Thai government first ran out of
foreign currency to support its exchange rate, forcing it to float the baht.
The value of the baht thus collapsed immediately afterward. The same also happened to the rest of the Asian countries soon
after.
IMF’s Role in the Asian Financial Crisis
The International Monetary
Fund (IMF) is an international organization that promotes global monetary
cooperation and international trades, reduces poverty, and supports financial
stability. The IMF generated several bailout packages for the most affected
countries during the financial crisis. It provided packages of around $20
billion to Thailand, $40 billion to Indonesia, and $59 billion to South Korea
to support them, so they did not default.
The bailout packages are structural-adjustment packages. The
countries that received the packages were asked to reduce their government
spending, allow insolvent financial institutions to fail, and raise interest
rates aggressively. The purpose of the adjustments was to support the
currency values and confidence over the countries’ solvency.
Lessons Learned from the Asian Financial Crisis
One lesson that many countries
learned from the financial crisis was to build
up their foreign exchange reserves to hedge against external shocks. Many
Asian countries weakened their currencies and adjusted economic structures to
create a current account surplus. The surplus can boost their foreign
exchange reserves.
The Asian Financial Crisis also raised concerns about the role
that a government should play in the market. Supporters of neoliberalism
promote free-market capitalism. They considered the crisis as a result of
government intervention and crony capitalism.
The conditions that IMF set within their structural-adjustment
packages also aimed to weaken the relationship between the government and
capital market in the affected countries, and thus to promote the neoliberal
model.
Homework chapter 8 (due with Final)
1. If
a Big Mac costs $2 in the United States and 300 yen in Japan, what is the
estimated exchange rate of yen/ $ as hypothesized by the Big Mac index? (Answer:
150 yen /$)
2. Interest
rates are currently 2% in the US and 3% in Germany. The current
spot rate between the € and $ is $1.5/€. What is the expected spot rate in one
year if the international Fisher effect holds? (Answer:1.4854$/€)
3. You
find that inflation in Japan just reduced to 1.3%, while in US, the inflation
rate just increased to 3%. You also observed that the spot rate for yen was
$0.0075 before the adjustment by economists. With new inflation released, the
demand and supply for currencies will drive the exchange rate to a new
equilibrium price.
Question: Use
RPPP to estimate the new exchange rate for yen. (Answer:0.0076$/yen)
4. You
observed the nominal interest rate (annual) just increased to 6% in China,
while the nominal annual interest rate is 3% in US. The spot rate for Chinese
Yuan is $6.8 before the adjustment.
Question: Use
IFE to estimate the new spot rate for Chinese Yuan after the interest rate
changes. (Answer:6.6075$/RMB. Note: Dollar is more valuable. In this example, RMB becomes
the more valuable currency. Sorry for the mistake)
International Fisher Effect (IFE)
By
INVESTOPEDIA STAFF Reviewed by CHARLES
POTTERS Updated Mar 30, 2021
What Is the International Fisher Effect?
The International Fisher Effect (IFE) is an
economic theory stating that the expected disparity between the exchange rate
of two currencies is approximately equal to the difference between their
countries' nominal interest rates.
KEY TAKEAWAYS
· The International Fisher Effect (IFE) states that differences in nominal interest rates between countries can be used to predict changes in exchange rates.
· According to the IFE, countries with higher nominal interest rates experience higher rates of inflation, which will result in currency depreciation against other currencies.
· In practice, evidence for the IFE is mixed and in recent years direct estimation of currency exchange movements from expected inflation is more common.
Understanding the International Fisher Effect
(IFE)
The IFE is
based on the analysis of interest rates associated with present and future
risk-free investments, such as Treasuries, and is used to help predict
currency movements. This is in
contrast to other methods that solely use inflation rates in the prediction
of exchange rate shifts, instead functioning as a combined view relating
inflation and interest rates to a currency's appreciation or depreciation.
The theory stems
from the concept that real interest rates are independent of other monetary
variables, such as changes in a nation's monetary policy, and provide a
better indication of the health of a particular currency within a global
market. The IFE provides for the
assumption that countries with lower interest rates will likely also
experience lower levels of inflation, which can result in increases in the
real value of the associated currency when compared to other nations. By
contrast, nations with higher interest rates will experience depreciation in
the value of their currency.
This theory
was named after U.S. economist Irving Fisher.
Calculating the International Fisher Effect
IFE is
calculated as:
For example,
if country A's interest rate is 10% and country B's interest rate is 5%,
country B's currency should appreciate roughly 5% compared to country A's
currency. The rationale for the IFE is that a country with a higher interest
rate will also tend to have a higher inflation rate. This increased amount of
inflation should cause the currency in the country with a higher interest
rate to depreciate against a country with lower interest rates.
The Fisher Effect and the International Fisher
Effect
The Fisher
Effect and the IFE are related models but are not interchangeable. The Fisher
Effect claims that the combination of the anticipated rate of inflation and
the real rate of return are represented in the nominal interest rates. The
IFE expands on the Fisher Effect, suggesting that because nominal interest
rates reflect anticipated inflation rates and currency exchange rate changes
are driven by inflation rates, then currency changes are proportionate to the
difference between the two nations' nominal interest rates.
Application of the International Fisher Effect
Empirical research testing the IFE has shown mixed
results, and it is likely that other factors also influence movements in
currency exchange rates. Historically, in times when interest rates were
adjusted by more significant magnitudes, the IFE held more validity. However,
in recent years inflation expectations and nominal interest rates around the
world are generally low, and the size of interest rate changes is
correspondingly relatively small. Direct indications of inflation rates, such
as consumer price indexes (CPI), are more often used to estimate expected
changes in currency exchange rates.
Chapter 11: Managing
Transaction Exposure
Transaction
exposure is the level of uncertainty businesses involved in international
trade face.
Specifically, it is the risk that currency exchange rates will
fluctuate after a firm has already undertaken a financial obligation. A high
level of vulnerability to shifting exchange rates can lead to major capital
losses for these international businesses. One way that firms can limit their exposure to changes in the
exchange rate is to implement a hedging strategy. Through
hedging using forward rates, they may lock in a favorable rate of
currency exchange and avoid exposure to risk.
The danger of
transaction exposure is typically one-sided. Only the business that completes
a transaction in a foreign currency may feel the vulnerability. The entity
that is receiving or paying a bill using its home currency is not subjected
to the same risk. Usually, the buyer
agrees to buy the product using foreign money. If this is the case, the
hazard comes it that foreign currency should appreciate, costing the buyer to
spend more than they had budgeted for the goods.
Suppose that a
United States-based company is looking to purchase a product from a company
in Germany. The American company agrees to negotiate the deal and pay for the
goods using the German company's currency, the euro. Assume that when
the U.S. firm begins the process of negotiation, the value of the euro/dollar
exchange is a 1-to-1.5 ratio. This rate of exchange equates to one euro being
equivalent to 1.50 U.S. dollars (USD).
Once the
agreement is complete, the sale might not take place immediately. Meanwhile,
the exchange rate may change before the sale is final. This risk of change is
transaction exposure. While it is possible that the values of the dollar and
the euro may not change, it is also possible that the rates could become more
or less favorable for the U.S. company, depending on factors affecting the
currency marketplace. More or less favorable rates could result in changes to
the exchange rate ratio, such as a more favorable 1-to-1.25 rate or
a less favorable 1-to-2 rate.
Regardless of
the change in the value of the dollar relative to the euro, the Belgian
company experiences no transaction exposure because the deal took
place in its local currency. The Belgian company is not affected if it
costs the U.S. company more dollars to complete the transaction
because the price was set as an amount in euros as dictated by the
sales agreement.
(https://www.investopedia.com/terms/t/transactionexposure.asp)
Types of foreign exchange exposure
Transaction Exposure – measures changes in the
value of outstanding financial
obligations incurred prior to a change in exchange rates but not to be
settled until after the exchange rate changes
Operating (Economic) Exposure – also called economic exposure,
measures the change in the present
value of the firm resulting from any change in expected future operating
cash flows caused by an unexpected change in exchange rates
Translation Exposure – also called accounting
exposure, is the potential for accounting derived changes in owner’s
equity to occur because of the need to “translate”
financial statements of foreign subsidiaries into a single reporting currency
for consolidated financial statements
Tax Exposure – the tax consequence of foreign exchange exposure varies by country,
however as a general rule only realized foreign losses are deductible
for purposes of calculating income taxes
\
What is transaction exposure
Example of transaction exposure
— Purchasing or selling
on credit goods or services when prices are stated in foreign currencies
— Borrowing or
lending funds when repayment is to be made in a foreign currency
— Being a party to
an unperformed forward contract and
— Otherwise
acquiring assets or incurring liabilities denominated in foreign currencies
How to reduce the transaction exposure risk?
· To
hedge a foreign currency payable
buy calls on the currency.
· To
hedge a foreign currency receivable
buy puts on the currency.
Exercise 1: Hedging
currency payable (refer to the PPT of chapter 11 for answers)
A U.S.–based importer of Italian
bicycles
· In
one year owes €100,000 to an Italian supplier.
· The
spot exchange rate is $1.18 = €1.00
· The
one year forward rate is $1.20 = €1.00
· The
one-year interest rate in Italy is i€ =
5%
· The
one-year interest rate in US is i$ = 8%
— Call option
exercise price is $1.2/ € with premium of $0.03.
How to hedge the currency payable risk
a. With
forward contract?
b. With
money market?
c. With
call option? Can we use put option?
Answer: Need €100,000
one year from now to pay the payable and plan to hedge the risk of overpaying
for the payable one year from now.
1) With
forward contract:
Buy the
one year forward contract @$1.20 = €1.00. So need
100,000€*1.2$/€ = $120,000
one year from now. So the company needs to come up with $120k for this
payable obligation.
2) With
money market:
Need €100,000 one year from now, and the rate is 5% in Italy, so
can deposit €100,000/(1+5%) = €95238.10
now.
For
this purpose, need to convert from € to
$: €95238.10*$1.18 /€=$112380.98.
Imagine
the company does not have that much of cash and it borrows @8%. So one year
from now, the total $ required to pay back to the banks is: $112380.98
*(1+8%) = $121371.43. So the company needs to come up
with $121371.43for this payable obligation.
Summary: Borrow
$112380.98 @8% and convert to €95238.10 at present;
One year later, the company can get the €100,000 and
needs to pay back to the bank a total of $121371.43.
3) With
call option:
Imagine
the rate one year later is $1.25/€. So should
exercise the call option and the cost one year later should be
€100,000
*(1.2+0.03) $/€ = $123000, lower than the actual cost
without the call option. So $123k is the most that the company needs to
prepare for this payable obligation. USING CALL OPTION, THE ACTAUL PAYMENT
COULD BE A LOT LESS, DEPENDING ON THE ACTAUL EXCHANGE RATE ONE YEAT LATER.
Exercise
2: Hedging currency receivable
(refer to the PPT of chapter 11 for answers)
· A
U.S.–based exporter of US bicycles to Swiss
distributors
· In
6 months receive SF200,000 from an Swiss distributor
· The
spot exchange rate is $0.71 = SF1.00
· The
6 month forward rate is $0.71 = SF1.00
· The
one-year interest rate in Swiss is iSF = 5%
· The
one-year interest rate in US is i$ = 8%
· Put
option exercise price is $0.72/ SF with premium of $0.02.
How to
hedge the currency payable risk
a. With
forward contract?
b. With
money market?
c. With
call option? Can we use put option?
Answer: Will
receive SF200000 six month from now as receivable and plan to
hedge the risk of losing value in the receivable six month from now.
1) With
forward contract:
Sell
the one year forward contract @$0.71 = €1.00. So get
200,000SF * 0.71$/SF = $142,000 six month from now. So the company could
receive $142k with forward contract.
2) With
money market:
Get SF200000
six month from now, and the rate is 5% in Swiss (or 2.5% for six months), so
can borrow SF 200,000/(1+2.5%) = SF195121.95 now.
And can
convert @ spot rate to SF195121.95 * 0.71$/SF = $138536.59. This is
the money you have now.
So six
month from now, the total you have in the bank is: $138536.59*(1+4%) =
$144078.05. And you can use the SF200000 receivable to pay back the
loan. So the company could receive $144078.05 with money
market.
Summary: Borrow SF195121.95
@5% at present; six month later, the company can get
the SF200,000 receivable and payback the loan. Meanwhile, convert
the borrowed SF to $ and deposit in US banks @ 8%.
3) With
put option: With SF200000 received six month later, need
to converting it back to $. So can buy put option which allows to sell SF for
$ at the exercise price $0.72/ SF.
Imagine
the rate one year later is $0.66/ SF. So should exercise the put option
and the total amount of $ six month later should be SF
200,000 *(0.72-0.02) $/ SF = $140000. So $140k is the LEAST that
the company CAN OBTAIN. USING PUT OPTION, THE ACTAUL INCOME COULD
BE A LOT MORE, DEPENDING ON THE ACTAUL EXCHANGE RATE ONE YEAT LATER.
Homework of
Chapter 11 (due with final)
1. Suppose that your company
will be billed Ł10 million payable in one year. The money market
interest rates and foreign exchange rates are given as follows. How to hedge
the risk for parable using forward contract. How to hedge the risk using
money market? How to hedge risk using call option?
Call option exercise price The U.S. one-year interest
rate: |
$1.46/ €
with premium of $0.03 6.10% per annum |
The U.K. one-year interest rate: |
9.00% per annum |
The spot exchange rate: |
$1.50/Ł |
The one-year forward exchange rate |
$1.46/Ł |
(Answer: With forward
contract: $14.6 million; Money market: $14.6million; Call option:
$14.9million)
2. Suppose that your
company will be billed Ł10 million receivable in one year. The
money market interest rates and foreign exchange rates are given as follows.
How to hedge the risk for parable using forward contract. How to hedge the
risk using money market? How to hedge risk using put option?
put option exercise price The U.S. one-year interest rate: |
$1.46/ €
with premium of $0.03 6.10% per annum |
The U.K. one-year interest rate: |
9.00% per annum |
The spot exchange rate: |
$1.50/Ł |
The one-year forward exchange rate |
$1.46/Ł |
(Answer: With forward contract: $14.6 million;
Money market: $14.6million; Put option: $14.3million)
Chapter 18 Interest rate swap
Requirement: Concepts only. Calculation not required
Intro:
• All firms—domestic or multinational, small
or large, leveraged, or unleveraged—are sensitive to interest rate
movements in one way or another.
• The single largest interest rate risk of the nonfinancial firm
(our focus in this discussion) is debt service
– The multicurrency dimension
of interest rate risk for the MNE is a complicating concern.
• The second most prevalent
source of interest rate risk for the MNE lies in its portfolio holdings of interest-sensitive securities
Example: Consider a firm
facing three debt strategies
– Strategy #1: Borrow $1
million for 3 years at a fixed rate
– Strategy #2: Borrow $1
million for 3 years at a floating rate, LIBOR + 2% to be reset annually
(LIBOR: London Interbank Offered Rate,)
– Strategy #3: Borrow $1
million for 1 year at a fixed rate, then renew the credit annually
– Although the lowest cost of
funds is always a major criterion, it is not the only one
• Strategy #1 assures itself
of funding at a known rate for the three years
– Sacrifices the ability to enjoy a fall in future interest rates for the security of a fixed
rate of interest should future interest rates rise
• Strategy #2 offers what #1
didn’t, flexibility (and, therefore, repricing risk)
– It too assures funding for
the three years but offers repricing risk when LIBOR changes
– Eliminates credit risk as
its spread remains fixed
• Strategy #3 offers more
flexibility but more risk;
– In the second year the firm
faces repricing and credit
risk, thus the funds are not guaranteed for the three years and neither
is the price
– Also, firm is borrowing on
the “short-end” of the yield curve which is typically upward sloping—hence,
the firm likely borrows at a lower rate than in Strategy #1
Volatility, however, is far greater on the short-end
than on the long-end of the yield curve.
From investopedia.com
What is
interest rate swap?
Swaps are
contractual agreements to exchange or swap a series of cash
flows
– Whereas a forward rate
agreement or currency forward leads to the exchange of cash flows on just one
future date, swaps lead to cash flow
exchanges on several future dates
– Most commonly, interest rate swaps are associated with a debt service,
such as the floating-rate loan described earlier
– An agreement between two parties to exchange fixed-rate for
floating-rate financial obligations is often termed a plain vanilla swap
– This type of swap forms
the largest single financial derivative market in the world.
Why
Interest-rate Swaps Exist
• If company A (B)
wants a floating- (fixed-) rate loan, why doesn’t it just do it from the
start? An explanation commonly put forward is comparative
advantage!
• Example: Suppose that two
companies, A and B, both wish to borrow $10MM for 5 years and have been
offered the following rates:
Fixed Floating
Company
A 10% 6 month LIBOR+0.3%
Company B 11.2% 6 month LIBOR+1.0%
– The difference between the
two fixed rates (1.2%) is greater than the difference between the two
floating rates (0.7%)
• Company B has a comparative advantage in floating-rate markets
• Company A has a comparative advantage in fixed-rate markets
• In fact, the combined
savings for both firms is 1.2% - 0.70% = 0.50%
Plain vanilla swap: An agreement between two
parties to exchange fixed-rate for floating-rate financial obligations
What Is a Plain Vanilla
Swap?
https://www.investopedia.com/terms/p/plain-vanilla-swap.asp
A plain vanilla swap is one
of the simplest financial instruments contracted in the over-the-counter
market between two private parties, both of
which are usually firms or financial institutions. There are several types of
plain vanilla swaps, including an
interest rate swap, commodity swap, and a foreign currency swap. The term plain vanilla swap is most
commonly used to describe an interest rate swap in which a floating interest
rate is exchanged for a fixed rate or vice versa.
KEY
TAKEAWAYS
·
A plain vanilla swap is the simplest type
of swap in the market, often used to hedge floating interest rate exposure.
·
There are various types of plain vanilla
swaps, including interest rate, commodity, and currency swaps.
·
Generally, both legs of the swap are denominated in the same currency, and
interest payments are netted.
Understanding a Plain Vanilla
Swap
A
plain vanilla interest rate swap is often done to hedge a floating rate
exposure, although it can also be done to take advantage of a declining rate
environment by moving from a fixed to a floating rate. Both legs of the swap
are denominated in the same currency, and interest payments are netted. The
notional principal does not change during the life of the swap, and there are
no embedded options.
Types of Plain Vanilla Swaps
The
most common plain vanilla swap is a floating rate interest rate swap. Now,
the most common floating rate index is the London Interbank Offered Rate
(LIBOR), which is set daily by the International Commodities Exchange (ICE).
LIBOR is posted for five currencies—the U.S. dollar,
euro, Swiss franc, Japanese yen, and British pound. Maturities range from
overnight to 12 months. The rate is set based on a survey of between 11 and
18 major banks.
The
Intercontinental Exchange, the authority responsible for LIBOR, will stop
publishing one-week and two-month USD LIBOR after Dec. 31, 2021. All other
LIBOR will be discontinued after June 30, 2023.1
The
most common floating rate reset period is every three months, with
semi-annual payments. The day count convention on the floating leg is
generally actual/360 for the U.S. dollar and the euro, or actual/365 for the
British pound, Japanese yen, and Swiss franc. The interest on the floating
rate leg is accrued and compounded for six months, while the fixed-rate
payment is calculated on a simple 30/360 or 30/365 basis, depending on the
currency. The interest due on the floating rate leg is compared with that due
on the fixed-rate leg, and only the net difference is paid.
Example of a Plain Vanilla
Swap
In
a plain vanilla interest rate swap, Company A and Company B choose a maturity,
principal amount, currency, fixed interest rate, floating interest rate
index, and rate reset and payment dates. On the specified payment dates for
the life of the swap, Company A pays Company B an amount of interest
calculated by applying the fixed rate to the principal amount, and Company B
pays Company A the amount derived from applying the floating interest rate to
the principal amount. Only the netted difference between the interest
payments changes hands.
No
Homework for this chapter
How Goldman Sachs Profited
From the Greek Debt Crisis (FYI)
The investment bank made millions by helping to hide the true
extent of the debt, and in the process almost doubled it.
By Robert B. Reich JULY 16, 2015
https://www.thenation.com/article/archive/goldmans-greek-gambit/
The Greek debt crisis offers another illustration of Wall
Street’s powers of persuasion and predation, although the Street is missing
from most accounts.
The crisis was exacerbated years ago by a deal with Goldman
Sachs, engineered by Goldman’s current CEO, Lloyd Blankfein. Blankfein and
his Goldman team helped Greece hide
the true extent of its debt, and in the process almost doubled it. And
just as with the American subprime crisis, and the current plight of many
American cities, Wall Street’s predatory lending played
an important although little-recognized role.
In 2001, Greece was looking for ways to disguise its mounting
financial troubles. The Maastricht Treaty required all eurozone member states
to show improvement in their public finances, but Greece was heading in the
wrong direction. Then Goldman Sachs
came to the rescue, arranging a secret loan of 2.8 billion euros for Greece,
disguised as an off-the-books “cross-currency swap”-- a complicated
transaction in which Greece’s foreign-currency debt was converted into a
domestic-currency obligation using a fictitious market exchange rate.
As a result, about 2 percent
of Greece’s debt magically disappeared from its national accounts.
Christoforos Sardelis, then head of Greece’s Public Debt Management Agency,
later described the deal to Bloomberg Business as “a very sexy story between
two sinners.” For its services, Goldman received a whopping 600 million euros
($793 million), according to Spyros Papanicolaou, who took over from Sardelis
in 2005. That came to about 12 percent of Goldman’s revenue from its giant
trading and principal-investments unit in 2001—which posted record sales that year. The unit was run by
Blankfein.
Then the deal turned sour. After the 9/11 attacks, bond yields
plunged, resulting in a big loss for
Greece because of the formula Goldman had used to compute the country’s debt
repayments under the swap. By 2005, Greece owed almost double what it had
put into the deal, pushing its off-the-books debt from 2.8 billion euros to
5.1 billion. In 2005, the deal was restructured and that 5.1 billion euros in
debt locked in. Perhaps not incidentally, Mario Draghi, now head of the
European Central Bank and a major player in the current Greek drama, was then
managing director of Goldman’s international division.
Greece wasn’t the only sinner. Until 2008, European Union
accounting rules allowed member nations to manage their debt with so-called
off-market rates in swaps, pushed by Goldman and other Wall Street banks. In the late 1990s, JPMorgan enabled Italy
to hide its debt by swapping currency at a favorable exchange rate, thereby
committing Italy to future payments that didn’t appear on its national
accounts as future liabilities.
But Greece was in the worst shape, and Goldman was the biggest
enabler. Undoubtedly, Greece suffers from years of corruption and tax
avoidance by its wealthy. But Goldman wasn’t an innocent bystander: It padded
its profits by leveraging Greece to the hilt—along with much of the rest of the global economy. Other Wall
Street banks did the same. When the bubble burst, all that leveraging pulled
the world economy to its knees.
Even with the global economy reeling from Wall Street’s
excesses, Goldman offered Greece another gimmick. In early November 2009,
three months before the country’s debt crisis became global news, a Goldman
team proposed a financial instrument that would push the debt from Greece’s
healthcare system far into the future. This time, though, Greece didn’t bite.
As we know, Wall Street got bailed out by American taxpayers.
And in subsequent years, the banks became profitable again and repaid their
bailout loans. Bank shares have gone through the roof. Goldman’s were trading
at $53 a share in November 2008; they’re now worth over $200. Executives at
Goldman and other Wall Street banks have enjoyed huge pay packages and
promotions. Blankfein, now Goldman’s CEO, raked in $24 million last year
alone.
Meanwhile, the people of Greece struggle to buy medicine and
food.
There are analogies here in America, beginning with the
predatory loans made by Goldman, other big banks, and the financial companies
they were allied with in the years leading up to the bust. Today, even as the
bankers vacation in the Hamptons, millions of Americans continue to struggle
with the aftershock of the financial crisis in terms of lost jobs, savings,
and homes.
Meanwhile, cities and states across America have been forced
to cut essential services because they’re trapped in similar deals sold to
them by Wall Street banks. Many of these deals have involved swaps analogous
to the ones Goldman sold the Greek government. And much like the assurances
it made to the Greek government, Goldman
and other banks assured the municipalities that the swaps would let them
borrow more cheaply than if they relied on traditional fixed-rate bonds—while downplaying the risks they faced.
Then, as interest rates plunged and the swaps turned out to cost far more,
Goldman and the other banks refused to let the municipalities refinance
without paying hefty fees to terminate the deals.
Three years ago, the Detroit Water Department had to pay
Goldman and other banks penalties totaling $547 million to terminate costly
interest-rate swaps. Forty percent of Detroit’s water bills still go to
paying off the penalty. Residents of Detroit whose water has been shut off
because they can’t pay have no idea that Goldman and other big banks are
responsible. Likewise, the Chicago
school system—whose
budget is already cut to the bone—must
pay over $200 million in termination penalties on a Wall Street deal that had
Chicago schools paying $36 million a year in interest-rate swaps.
A deal involving
interest-rate swaps that Goldman struck with Oakland, California, more than a
decade ago has ended up costing the city about $4 million a year, but Goldman has refused to allow Oakland
out of the contract unless it ponies up a $16 million termination fee—prompting the city council to pass a
resolution to boycott Goldman. When confronted at a shareholder meeting about
it, Blankfein explained that it was against shareholder interests to tear up
a valid contract.
Goldman Sachs and the other giant Wall Street banks are
masterful at selling complex deals by exaggerating their benefits and
minimizing their costs and risks. That’s how they earn giant fees. When a
client gets into trouble—whether that client is an
American homeowner, a US city, or Greece—Goldman ducks and hides behind legal formalities and
shareholder interests.
Borrowers that get into trouble are rarely blameless, of
course: They spent too much, and were gullible or stupid enough to buy
Goldman’s pitches. Greece brought on its own problems, as did many American
homeowners and municipalities.
But in all of these cases, Goldman knew very well what it was
doing. It knew more about the real risks and costs of the deals it proposed
than those who accepted them. “It is an issue of morality,” said the
shareholder at the Goldman meeting where Oakland came up. Exactly.
Final
Exam (chapters 8, 11, 18), May 4th, start at 12 pm
Study
Guide
Final Exam Study Guide
Total
about 30 questions including T/F and multiple choice questions
Chapter 8:
True/False
1. IFE: the relationship between inflation and currency value
2. IFE: the relationship between nominal interest rate and currency value
3. What is bid mac index? What do we learn from big mac index?
Multiple
Choices
4. Use big mac index to calculate the exchange rate of foreign currency per dollar (two questions (could use PPP calculator)).
5. Determine the foreign currency per dollar is over-priced or under-valued based on big mac index (could use PPP calculator).
6. Use PPP to calculate the exchange rate of foreign currency per dollar (two questions).
7. Use RPPP (given inflations in the two countries) to calculate the new exchange rate of foreign currency per dollar (RPPP calculator is available)
8. When $ strengthens, exporter / importer, which party will benefit from it?
9. IFE: Determine new exchange rate based on IFE given interest rates in both countries (two questions, IFE calculator available).
10. IFE: Determine interest rate, given new exchange rates based on IFE (use IFE equation, or calculator).
Chapter
11:
Multiple
Choices
1. How to hedge transactions involving foreign currencies using forward contract?
2. Hedge international transaction receivable using forward contract: As the seller of a forward contract, the gains or losses? (refer to the in class exercise on receivables on class website – chapter 11)
3. Hedge international transaction receivable using put option: the gains or losses? (refer to the in class exercise on receivables on class website – chapter 11)
4. Hedge international transaction payable using money market: the gains or losses? (refer to the in class exercise on payable on class website – chapter 11)
5. Hedge international transaction payable using call options: the gains or losses? (refer to the in class exercise on payable on class website – chapter 11)
6. Hedge international transaction payable using forward contract: the gains or losses? (refer to the in class exercise on payable on class website – chapter 11)
7. Hedge international transaction receivable using money market: the gains or losses? (refer to the in class exercise on receivables on class website – chapter 11)
8. Hedge international transaction receivable using call options: the gains or losses? (refer to the in class exercise on receivables on class website – chapter 11)
9. Hedge international transaction receivable using forward contract: the gains or losses? (refer to the in class exercise on receivables on class website – chapter 11)
10.
To hedge payable, use call or put?
11.
To hedge receivable, use call or put?
Chapter 18:
True/False
1.
What is interest rate swap?
2.
What is plain vanilla swap?
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