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Contents
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Chapter 1
Introduction
Exposure has increased for the major players in the financial market as the world economy has seen
a major restructuring of financing transactions since March, 1973 (the beginning of floating rate
arrangement). The increased volatility of exchange rates and innovations in derivative products has
created opportunities and challenges for individuals, corporations, and governments. Most firms
have been able to rise to the occasion, adapted to new challenges and prospered. Some have not
fared so well and in extreme cases have like dinosaurs been unable to adapt to environmental
changes and have become extinct. Lehman Brothers and the Bear Stern, unable to manage their
exposure, are the classic examples of dinosaurs. Increased volatility of exchange rates since 1973
coupled with rising equity price risk, commodity price risk and interest rate risk; has created
challenges and opportunities for multinational corporations. As risk has increased so has the
expected reward.
Risk taking is the foundation of a capitalist economy as it is positively correlated to the reward for
entrepreneurial behavior. Global financial management in the 21st century integrates mathematical and
physical science along with behavioral finance and economics. The result is a mushrooming set of
derivative products where price is contingent on the behavior of underlying assets such as stocks, bonds,
commodities, currencies, indices and other exotic instruments. The global markets for debt, equities, and
derivatives play an ever-increasing important role in transferring risk from risk averse individuals and
institutions to those who are willing to take it for a profit. Risk taking and risk management is balanced in
the marketplace by regulatory oversight. Bank and financial services industry regulators continue to
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search for an optimum balance that protects the integrity of the banking system and provides regulatory
Recent events highlighted by the sub-prime mortgage mess in the financial markets have cast
considerable doubts on the ability of the financial markets to weather a financial storm induced by the
action of major players, i.e., banks, hedge funds, investment bankers, underwriters, rating agencies in
particular, and regulators at large. As a result systematic risk has risen to a point that threatens the well
being of the economy. Other huge losses stemming from loss of internal control are exhibited by the
actions of rogue trader Jerome Krevel of Socit Gnrale, who incurred losses in excess of $7 billion in
2008 as well as a $691 million loss on February 2002 by Allied Irish Bank which John Rusnack, also a
multinational financial and non-financial corporations facing various risks in an integrated global
market and to consider portfolio management approaches for mitigating exposures to equity price,
commodity price, foreign exchange, and interest rate changes within the context of value creation for
their stakeholders. Numerous real world examples are employed throughout the book to illustrate how
derivatives can be used to mitigate these risks. Wall Streets brightest minds continue to respond to
changes in the regulatory landscape, tax laws and business and financial risks with further innovations
Financial risk that is induced by credit, market, and operation risk exposure of multinational
profitability of these institutions. Managing and mitigating these risks are crucial in creating value
for the shareholders. Using financial derivatives such as forward, futures, options and swaps these
various risks can be mitigated. Unfortunately, there exists no coherent and concrete literature for
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students of finance or practitioners that explain the underlying principle in simple yet easily
understood concepts without alienating the intended target audience unless they hold a post graduate
degree in finance.
This chapter outlines the foundation of global markets for debt, equities and derivatives. Over the
course of the last three decades, we have witnessed major restructuring in the world economy e.g.
floating rate arrangements in 1973, increased integration of financial markets around the world,
greater cooperation of economic units, liberalization of trade policies, friendly or lax regulatory
environments, and a mushrooming innovative financial products that increased leverage and
encouraged excessive risk taking raising exposure for the major players such as banks, insurers,
investments banks, and hedge funds. Exposure, defined by Webster's dictionary as the fact of being
exposed in a helpless condition to the elements is truly revealing.1 The elements can be events
(some unforeseen) such as sub-prime mortgage mess that unraveled in 2007-08 or unique to a
particular company such as the Socit Gnrale scandal highlighted earlier. Fortunately, for
unforeseen events such as death or natural disasters, the markets have developed various types of
insurance for managing and transferring those risks to risk arbitrageurs, insurance and reinsurance
companies. What remains to be managed is the macro risk: the market risk that cannot be avoided.
Over the course of the last 10 years macro risk has continued to rise as reflected in the phenomenal
growth of highly leveraged transactions (HLTs) in derivatives with notional principal of over $600
trillion, according to the International Swaps and Derivatives Association (ISDA) survey of 2008.
The increase in market (systematic) risk to socially unacceptable level needed only a trigger event to
send shock waves around the globe. This trigger was the $1 trillion sub-prime mortgage originated in
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the real estate boom of early 2000 at teaser rate (initial low interest rate) and was stepped up in 2007.
The resulting higher mortgage payments induced mounting foreclosures, which had a snowball
effect leading to the collapse of real estate markets and markets for equities and debt.
Exposure has also increased for the major players in the market as the world economy has seen a
major restructuring of financing transactions since March, 1973 (the beginning of floating rate
arrangements). The increased volatility of exchange rates and innovations in derivative products has
created opportunities and challenges for corporations. The increased volatility of exchange rate
provided opportunities in the risk management arena as Wall Street created innovative products for
mitigating foreign exchange risk. The increased innovations in derivative products has proven to be
a two edge sword; raising efficiency of financial intermediation and increasing leverage coupled
with little regulatory oversight, which has been very costly for the major players in general and the
US and world economy in particular. For example, some of the innovations such as default insurance
(credit default swap) initially hailed as one of the most important vehicles for transferring
counterparty credit risk, is at the heart of the major collapse or near collapse for such Wall street
Washington Mutual (WAMU) filed for Chapter 11 bankruptcy protection on September 26, 2008
one day after regulators seized its assets and sold it to JPMorgan Chase in the largest bank failure in
the United States. The Office of Thrift Supervision (OTS) sold WAMUs assets to JPMorgan Chase
for $1.9bn (1bn) after $16.7bn of deposits had been withdrawn in 10 days. WAMU was hit by
mortgage defaults due to its significant exposure to sub-prime and other risky mortgages as well as
the collapse of the US housing market. The bank had approximately $307bn of assets but only about
$188bn of deposits, which meant it, had to raise funds on money markets, which had become
increasingly expensive.
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Lehman Brothers holding company filed for Chapter 11 bankruptcy protection on September
14, 2008, but none of the U.S. subsidiaries such as its brokerage-dealer subsidiaries, asset
management unit, and investment management division are supposed to continue operating as
normal. Individual investors who have accounts with Lehmans broker-dealer subsidiaries are
supposed to be protected, as their assets are not available to Lehmans creditors, and their accounts
protection from its creditors which prevents those creditors from going forward with lawsuits and
seizing the debtors assets. Runs on banks are prevented, and management gets time to organize its
affairs in a way that will, theoretically, maximize value for all creditors, and maybe even allow the
company to re-emerge in sound health. However, with a financial institution the automatic stay
offers no protection against many of its most important creditors. In a trend that began in 1978 and
was greatly expanded in 2005, most financial contracts including securities contracts, swaps,
repurchase agreements, commodities contracts, and forward trades are unaffected by automatic
stays. As Lehmans parent corporation filed for bankruptcy protection , the counterparty banks or
other institutions that entered into a securities contract with Lehman are allowed to cancel the
contract and seize whatever collateral may cover it. The counterparties are provided the opportunity
to free themselves immediately from Lehmans troubles rather than getting mired in a bankruptcy
proceeding. This is intended to reduce spillover effect of an investment bank or commercial bank
failure to the rest of the economy. In the 1990s the Federal Reserve Bank of New York decided to
place Long Term Capital Management (LTCM) with banks and other institutions with which it had
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Exhibit 1.1 shows the percentage monthly change in yen/$ exchange rates from 1957 to 2007.
Notable in the exhibit is the beginning of the floating rate arrangement of 1973 and the subsequent
significant increase in the volatility of the exchange rate particularly in the periods of 1973-74, 1979-
80 and 1995-96. The percentage changes in the yen/$ exchange rate appears to be randomly
distributed.
It is also notable to observe the absence of volatility in the foreign exchange market for yen/$ in a
pre-floating rate arrangement. This period coincided with the fixed exchange rate arrangement of
1945-1971 known as the Bretton Woods Arrangement, while allowing occasional dollar
devaluations such as in 1934 when the dollar was devalued to $35/ounce of gold from $20.67/ounce
to remedy huge deficits in the US. The dollar was devalued to $38/ounce of gold in December 17-
18, 1971, which came to be known as Smithsonian Agreement. Despite these devaluations March
1973 marks the end of fixed exchange rate arrangement when the British Pound and Swiss Franc
were allowed to float on June 1972 and January 1973, respectively. The dollar devalued by an
0.2
m o n th ly e x c h a n g e ra te /$
0.15
P e r c e n ta g e c h a n g e in
0.1
0.05
0
1957M 1
1959M 1
1961M 1
1963M 1
1965M 1
1967M 1
1969M 1
1971M 1
1973M 1
1975M 1
1977M 1
1979M 1
1981M 1
1983M 1
1985M 1
1987M 1
1989M 1
1991M 1
1993M 1
1995M 1
1997M 1
1999M 1
2001M 1
2003M 1
2005M 1
-0.05
-0.1
-0.15
Time (monthly data)
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Saving and Loans Hit by Double Whammy: Savings and Loans corporations (S&Ls) had high
duration assets on the left hand side of the balance sheet in the form of mostly fixed rate mortgages.
These were funded on the right hand side of the balance sheet with mostly low duration, short term
floating rate demand deposit and fixed rate time deposit of two to five years maturity. The mismatch
of revenue (mostly fixed rate) and cost (mostly floating rate) created exposure for S&L, as it paid for
to borrow short term and lend long term profitably when the yield curve was upward sloping.
However, the double digit inflation of the late 1970s and concurrent rise in short term interest rates
as well as recession of the early 1980s and the slow down in economic activities reduced the
incentive to borrow squeezing profit and reversing the fortunes of the S&Ls. The high interest rate of
the late1970s and early 1980s produced an inverted yield curve in1982, where the yield curve was
downward sloping (i.e., short term rate was higher than long term rate) forcing the entire industry
into bankruptcy. After the S&L debacle, the risk of rising interest rates shifted to borrowers, thereby
increasing the probability of default of the borrower. The risk of the mismatch of assets/liabilities in
the case of S&L did not disappear; banks simply transferred it to the individual borrowers.
Consider a scenario where revenue is denominated in one currency and cost is incurred in another
currency. Laker Airways was a victim of this mismatch. A weak dollar in the early1970s made
travel to United States a bargain for British travelers, raising revenue of Laker Airways and inducing
it to borrow U.S. dollar to purchase new aircrafts. Exhibit 1.2 shows the rate of monthly percentage
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Exhibit 1.3 provides some interesting statistics on the monthly change in basis points for the one-
year treasury bills since 1934. It appears that the monthly basis point change in 1-year T/bills
dramatically increased in the late 70s due to double-digit inflation raising the exposure for the
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Exhibit 1.3: First difference in 3 Months Treasury bills 1934-2009
The US dollar strengthened against the British pound by early 1980, thereby making travel to
United States very expensive and increasing the pound cost of the dollar to service the dollar
denominated debt. Laker Airways was hit by a double whammy that forced the company into
bankruptcy.
activities, where each activity is intended to produce pay-offs in sustaining and creating value for the
stakeholders. In organizing various activities firms issue claims to the assets of the corporations to
checks and balance to insure that one class of claimants such as creditors is protected against the
abuse of power of another class of claimants such as stockholders. The governing principle to settle
claims between principal and agent, stockholders and bondholders, management and the
stockholders, management and the employee and management and any other injured party is defined
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in the agency relationship. The cost associated with managing and mitigating agency related risk
could be substantial. However, without an appropriate and well-defined agency relationship that
defines the contractual obligations of various claimants the firm runs the risk of lengthy legal battles
The conflict of interest between the parties in an agency relationship gives rise to agency-related
problems and cost. In the context of two individuals in an agency relationship such as marriage,
conflict of interest lands the parties in divorce court for the resolution and division of assets
(physical and human) and liabilities. To alleviate agency related problems and the cost associated
with that, a party wishing to establish an agency relationship with another party might require a
prenuptial agreement. In this case a prenuptial agreement can be an exposure management vehicle
to avoid the cost and pain arising in the future in the event of dissolution of the agency relationship.
In the context of domestic or multinational firms, the conflict of interest between stakeholders and
management need to be managed and mitigated. Whether management acts in the best interest of
stockholders or creditors, or pursues its own self-interest by giving themselves large severance
packages or golden parachutes in the event of a corporate buyout or merger is an empirical issue. To
most firms' stakeholders to direct the management actions toward maximizing value of the firms.
Monster Mess
The Bernard Madoff scandal, where he defrauded investors over a period of 10 years in excess of
$50 billion is the classic example of operational risk and its interaction with market and credit risk
leading to severe loss of confidence in Wall Street. In this case the operational risk exacerbated the
market as well as credit risk. The credit rating plummeted for institutions weakened by this scandal,
further reducing their ability to access the credit market. Madoff was convicted of operating a Ponzi
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scheme that has been called the largest investor fraud ever committed by anyone. Federal
prosecutors estimated client losses, which included fabricated gains, of almost $65 billion, other
estimates of the fraud, excluding the fabricated gains, are $13 to $21 billion. On June 29, 2009, he
Multinational corporations are far more exposed to agency-related problems and costs due to
operational and locational diversification and various regulatory requirements than their domestic
counterparts. Executives of Japanese multinational corporations usually sit on the board of the
directors of each other and are far more effective in managing agency related cost between
management and unions than their North American counterparts. Domestic or multinational firms
should strike a balance between the costs and benefits of agency relations to a point where the
marginal cost of additional agency relationship is equal to marginal benefits realized of entering into
the additional agency relationships. The following section describes the types of the markets,
TYPES OF MARKETS
In this market individuals and corporations organize their economic activities efficiently for
producing real goods (tangible) such as food, clothing and shelter and (intangible) services such as
counseling, education and other services for allocation and distribution in meeting the demands of
the society. The producers employ factors of production labor, raw materials and capital in such a
way that pays for the cost of the factors and leave a profit for the producer. Here value is created
and opportunities expanded and the welfare of individuals in the society is increased. The governing
principle to address the three basic questions of the market economy, that is what to, how to and for
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whom to produce is the price mechanism. This mechanism ensures the production of goods and
Market for financial assets is where the capital is distributed and channeled from lenders (investors)
to ultimate users of capitals (borrowers) individuals, corporations and other entities. The
corporations issue claims to assets of their company in the form bonds and stocks for acquiring long
term capital or short term vehicles such as commercial paper or bankers acceptances known as
money market instruments for securing short term debt. The capital is expected to be channeled in
such a way that maximizes the welfare of the economic system, where the most promising projects
are funded based on the merits of the projects. Projects that produce more pay-offs than their costs
create value for the providers of capital. Examples of financial markets are stock markets, bond
markets and foreign exchange spot markets, where the underlying asset is the spot exchange rates
representing claim on the purchasing power of one currency relative to another currency.
In this market value is neither created nor destroyed, it is simply transferred from one party to
another in a given transaction. This market also is known as the sum zero game market, where the
gain of one party is exactly equal to loss of another party. Derivatives derive their value from the
underlying assets such as stocks, bonds, commodities or foreign currency spot exchange rates. The
derivative markets perform two valuable functions: transferring risk and price discovery. Without
derivative markets, the financial and real markets are not complete and may not function efficiently
in managing, mitigating and transferring risks. Some even refer to derivative markets as speculative
markets where two parties take offsetting position based on their own expectations. The profit and
loss potential is symmetrical and can be devastating to the well being of individuals or corporations.2
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The derivative markets serve to provide valuable information to participants for taking current
actions to remedy expected problems in the near future. That is this market enables individuals and
corporations and other agencies to discover today the expected market consensus of what for
example future interest rate, commodity prices, stocks or bonds prices and foreign currency
exchange rate will be. This price discovery mechanism provided by derivative markets is essential
for planning, procuring and executing production as well as managing and mitigating exposure to
various risks. Exhibit 1.4 and exhibit 1.5 highlight the price discovery mechanism of the derivatives
market and the link between markets for financial assets and derivatives:
U.S. Treasuries
Eurodollar Futures
IMM index
Sep 2009 10:29:50 AM CST
99.5525 +0.0050 99.5475 99.5450 99.5600 99.5400 76971
8/18/2009
Oct 2009 10:28:20 AM CST
99.480 a +0.005 99.475 99.485 99.485 99.485 200
8/18/2009
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Nov 2009 10:28:20 AM CST
99.435 +0.005 99.430 99.435 99.440 99.430 361
8/18/2009
Dec 2009 10:29:50 AM CST
99.385 +0.005 99.380 99.380 99.390 99.355 106229
8/18/2009
T/bills Futures
Sep 2009 101.560 7:00:00 PM CST
- - 99.560 - - - -
97.560 8/17/2009
Oct 2009 101.510 7:00:00 PM CST
- - 99.510 - - - -
97.510 8/17/2009
As shown in Exhibit 1.4 the 90-day zero-coupon T/bills interest rate is 18 basis points in U.S
Treasury markets as of August 18, 2009. The futures interest rate yield for the 90-day T/bill futures
at current price of 99.56 is 44 basis points (100- 99.56)in Exhibit 1.5 for September 18, 2009 priced
on August 18, 2009. The Eurodollar interest rate futures, the most active future for November 2009
delivery, priced on August 18, 2009 from the Chicago Mercantile Exchange is 56.5 basis points at
The T/bills futures predict that the short-term interest rate is expected to go up by 28 basis points
by September. The interest rate futures have priced as of August, 18 2009, the short term interest
rate hike by Federal Reserve board by as much as 25 basis points to take place by September 2009.
The price discovery function of derivatives is a reminder to the participants of the markets that those
who wish to borrow short term in the near future should take advantage of the lower rate right now,
or those who have a line of credit at the floating rate may consider converting to the fixed rate before
TYPES OF TRANSACTIONS
Spot Transaction
Most transactions in every economy are spot for immediate delivery of the goods or services for cash
or credit in transactions in the markets for real assets or the markets for financial assets. The spot
transaction may take place in an organized exchange such as New York Stock Exchange NYSE or
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Over the Counter (OTC) such as NASDAQ for t financial assets such as stocks, bonds and bills. The
only difference between the spot transaction in the real and financial market is that the transaction is
personal in the former and impersonal in the latter. For example the parties to a transaction
involving the purchase and sale of 100 shares of IBM stock remain anonymous to one another.
While the purchase and sale of vehicle by buyer and seller is personal where the buyer takes the
In other situations, transactions may call for delivery to take place sometime in future provided
that the terms of the contract i.e. the price, the size, the time of delivery, settlement and any other
agency related provisions are negotiated today between the two parties. In still other scenarios the
parties may arrange that no physical delivery of the goods is to take place and the parties settle their
transactions on cash basis on or before the delivery date. These types of transactions are executed in
Options Transaction
A unilateral transaction where one party has the right but not an obligation to buy (to call) or to sell
(to put) real or financial assets at a specific price (strike price) for a given future delivery period is
called an option transaction. The market for options where the call is the right to purchase or the put
is the right to sell, occurs where one party enters into unilateral transaction with no obligation to buy
or sell (from, to) another party at strike price and for a given future date. Insurance companies (e.g.,
life, property casualty and other specialized companies have underwritten put options (i.e., life
insurance, health, fire etc) in individual life, assets (i.e., property and vehicles) over centuries for
profit. For example, motor vehicle insurance that an individual buys is a put option, which gives the
right to an individual to sell the vehicle to an insurance company at strike price (the price at which
the car is insured) in the event of an accident in which the vehicle is totaled. The insurance company
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who sold the put option in this case is obligated to perform and purchase the vehicle at the strike
price even though the vehicle is nearly worthless. However, when individuals borrow against their
real assets by leveraging their portfolio to purchase financial assets such as stocks, they are
effectively buying a call option on the underlying assets and in the event stock price goes down, the
brokerage firm will liquidate the position to recover the money that was lent unless individual can
put up more money to avoid being squeezed out of the margin position.
Options on financial assets such as stocks, bonds, bills, indices, currency, commodities and
interest rate futures take place in an organized exchange where the counterparty risk is eliminated.
Examples of such markets are the Philadelphia Options Exchange and Chicago Mercantile Exchange
and other exchanges worldwide. In this market value is transferred from one party to another in a
sum zero game where the gain of one party is exactly equal but opposite of the other partys loss.
These are the over the counter transactions between two or more parties where the buyer and seller
enter into an agreement for future delivery of something of value priced today. The parties are
obligated to perform on the settlement or delivery date. For centuries, forward transactions have
existed e.g. in early civilizations where crop producers entered into forward agreements, without
having a physical building, in an informal and non-standardized arrangement to buy or sell at current
Absence of organized exchange for the execution of transaction in the forward market and
absence of any formal and standardized arrangement that details and outlines the provisions of
transaction as to the size, settlement date and actual physical delivery of the goods or services raises
the agency related problems and costs associated with that in the event that one of the party to the
transaction fails to perform, which renders forward transactions risky. Although forward transaction
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these days take place between and individual or corporation and usually a major bank or financial
institution the counter-party risk still raises the exposure of the bank or the financial institution to
possible non-performance risk. To alleviate the problems associated with counterparty risk,
inconvenience of physical delivery and storage related cost an organized forward exchange was
created to address the above problems. The transactions in the organized forward market came to be
known as futures. Exhibit 1.6 demonstrates the interaction of various transactions and markets. For
example, futures and forward transactions are close cousins, one is traded in the organized exchange,
and the other one in the over the counter market. Markets for forward and swaps are closely aligned
Types of Market
Spot
futures forward
swap
Futures Transactions
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While transactions in the forward market are personal, the futures market provides impersonal
transaction between two parties in an organized, orderly and cost efficient exchange market where
parties enter into an agency contract to buy or sell claims on financial or real assets known as
derivatives. Because the exchange of value takes place in an organized physical location, the
contracts are standardized to size, settlement date and other agency-related provisions at the current
transactions and eliminates the counterparty risk by marking individual transactions to market on a
daily basis. This daily settlement requires transfer of value from one individual to another individual
in a sum zero game. As current futures price (spot) changes daily as a result of the change in the
underlying value of the assets (real or financial) due to various macro or micro factors the profit or
loss is recognized and is posted to individual account by the clearinghouse. Exhibit 1.7 provides
partial lists of contracts traded in the four different organized futures exchanges in the United States
Exhibit 1.7: Partial Lists of Contracts Traded in Four Different Futures Exchanges
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London International Financial Futures and Options Exchange LIFFE, New York Mercantile Exchange NYMEX,
Chicago Mercantile Exchange CME and Chicago Board of Trade CBOT. STIR refers to short-term interest rate contracts
traded at LIFFE.
Exhibit 1.8 shows monthly volatility of stocks, commodities, and interest rate instruments. As is
demonstrated in the graph volatility has increased in the market for stocks, and commodities due to
emergence of hedge funds and major banks proprietary trading replicating hedge funds trading.
Exhibit 1.8: Volatility of U.S. Equities, Commodities, and Interest Rate Instruments Monthly
price Volatility, 1992-2003. CBOT
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Hedge Funds: Are largely unregulated private pools of capital provided by accredited investors,
Hedge Fund Characteristics: Four broadly defined attributes distinguish hedge funds from other
2. Liberal use of leverage, directly through the use of debt, or indirectly through leverage
4. Highly convex compensation, i.e., (2-and-20) set up, dual fee structure. Very high with good
The payoff of hedge funds are structured so that, they are compensated at least say 2 percent of net
asset value, and in the event hedge fund managers performance beat the bench-mark, they are likely
to share say 20, 30 or 40 percent of the profit. For example, in a (2-and-20) set up, the manager
receives 2 percent of net asset value, and 20 percent of the profit. This highly convex pay structure
puts undue pressure on the management to take excessive risk, expecting high risk ventures to
payoff. Exhibit 1.9 highlights the amount of assets under hedge funds management.
Liquidity providers;
Risk arbitrage;
Price discovery;
Efficiency of intermediation
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Hedge funds as of 2005 accounts:
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Exhibit 1.9: Total Assets under Global Management of Hedge Funds
TYPES OF RISKS
Credit Risk
Market Risk
Operational Risk
Credit Risk: Counterparty credit risk is a high frequency and low severity risk that is mitigated
by banks through bad loan loss reserves. Credit risk originates as the counterparties are unwilling
or unable to fulfill their contractual obligations. Banks are exposed to counterparty credit risk
due to their extension of credit to hedge funds, as well as having prime brokerage relationships.
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In order to assess credit risk and limit counterparty exposure, financial institutions have
measurement, and mitigation of various risks. The CCRM system is composed of:
Haircut;
Collateral;
The limit on the size of exposure to a particular obligor or particular state or region is intended to
reduce concentration risk. For example, it would not be a prudent practice to extend credit to a
company whose failure can be devastating to the well being of a financial institution. Furthermore,
the lenders impose a significant haircut depending on the quality of the underlying collateral. A
riskiness of the underlying security that is subtracted from the par value of the assets that are being
used as collateral. For example, a bond dealer may impose a 1 percent haircut on a 5-year corporate
note, while imposing 20 percent haircut on a 5 year corporate bond posted as collateral. In the above
scenario, $1000 Treasury as collateral would be accepted for securing $990 loan, while $1000 5-year
corporate note will enable the borrower to secure $800 loan. Conventional banking imposed a 20
percent haircut on residential mortgages, as homeowners were required to post 20 percent equity for
securing a 80 percent loan form banks. LTCM was able to secure next-to-zero haircuts, as it was
considered fairly safe by its counterparties. This was likely due to the fact that no counterparty had a
total picture of the extent of its exposure to various lenders (Jorion, 1999).
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While in the over the counter market a haircut is intended to protect the lenders, in the futures
market, the exchange imposes margins for mitigating counterparty credit risk. The margin is usually
set using value at risk of the exposure at 95 percent confidence interval and assumed volatility of the
underlying exposure. The margin is marked to market on a daily basis as individual accounts long
and short simultaneously; debited and credited in a falling price scenario or credited and debited in a
rising price scenario by a Clearinghouse in a sum zero game. Once margin falls below say 75
percent, variation margin is demanded by the exchange and should be posted to the account to
prevent liquidation of the individual position. It is worth nothing that, while marking to market in
the organized exchange has eliminated counterparty credit risk, it has created another risk, namely
the liquidity risk. This risk arises when price of the futures contract moves against a party to huge
futures contracts. This creates a liquidity squeeze where a party is unable to post margin to prevent
Example: In the early 1990s, Metallgesellschaft (MG), a German Oil company, suffered a loss of
$1.33 billion in their short dated futures hedging contract, as the price of oil dropped below $20 per
barrel. MG sold oil and gas 5 to 7 years forward at 30 percent premium over the prevailing spot price
to their customers. They rolled over short dated long futures contract to hedge long term exposure to
rising price of oil. As the price of oil dropped, MG faced significant margin calls, and its banker
advised the company to abandon the hedge nearly bankrupting the Oil giant.
Market Risk
Risk of sudden shock, which could damage the financial system, in which the wider economy
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Contagious transmission of the shock due to actual or suspected exposure to a failing bank or
Systematic Risk
The systematic risk definition has been quite vague in the literature. Here are few definitions
players in the market, thereby impairing their ability to channel savings into promising
investments;
Shocks in one part of the financial system that lead to a shock elsewhere, threatening the
Major damage to the financial system and the economy as a result of collapse of real estate
and equity markets triggered by a sub-prime mortgage mess that caused substantial damage
to the US economy;
Collapse of LTCM;
Financial markets linkage to the real economy create systematic risk through players such as
Operational Risk:
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An informal survey highlights the growing significance of risks other than credit and market
risks, such as operational risk, which have been at the heart of some important banking problems
1. Any financial risk other than credit and market risk can be categorized as operational risk;
2. Risk arising from failure in operations such as back office problems, failure in processing
3. The risk of loss from failed internal processes, people, and systems, or from external events
Credit
Market
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Risk Interactions: Example: Assume that on December 31, XYZ has a spot contract to buy 10
million in exchange for delivering $16.5 million in two business days from bank 1. This simple
Market risk
Credit risk
Settlement risk
Operational risk
Market risk: Suppose after few hours exchange rate changes to $1.50/. The trader cuts the
position and enters a spot sale with Bank 2. The loss of $150,000 to be realized in two
B/days.
Credit risk: The following day, Bank 2 goes bankrupt. XYZ enters a new trade with bank 3,
and spot rate has fallen to $1.45/, the gain of $50,000 with bank 2 is now at risk.
Settlement risk: Suppose XYZ bank wires $16.5 million in the morning to bank 1, who
defaults at noon and does not deliver 10 million. This is known as Herestatt risk.
Operational risk: Suppose the XYZ bank wired the $16.5 million to a wrong bank. The back
office gets the money back after 2 days. The loss of interest on the amount due is attributed
to operational risk
Foreign exchange risk is unique to multinational corporations (MNCs) as the foreign denominated
cash inflows or outflows must at some time in the future be converted to the domestic currency of
the operating unit creating windfall gains or losses. Direct foreign investment (DFI) in the form of
making foreign acquisition of real assets (buying a plant overseas or building manufacturing
facilities) to take advantage of imperfections in off-shore markets and portfolio investment in the
form of stocks, bonds and t- bills and other short term assets entail opportunities for greater return
(exchange rate gains) and higher risk due to foreign exchange losses.
Currency exchange risk, the economic, transaction and accounting consequences of the
fluctuation of exchange rates, strongly impacts many businesses in a variety of different ways. In the
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early 1980's the tight monetary policy of Paul Volker, the chairman of the Federal Reserve resulted
in high real interest rates in the U.S. compared to other countries. This in turn resulted in a high
value of the dollar compared to other currencies, making the U.S dollar relatively very strong and in
turn U.S exports very expensive and unattractive for foreigners. Consequently Caterpillar,
compared to its main competition Komatsu, a Japanese manufacturer of hydraulic excavators. Later
in the 1980's the strong dollar eased inflationary pressure in the U.S. economy leading to lower
inflationary expectations and a decline in the long-term U.S. interest rates. The value of the dollar
also fell sharply following the September 1985 Plaza agreement in New York as the chairman of the
G-5 central banks (U.S, Japan Germany, France and U.K.) concluded a meeting in New York and
collectively decided to put downward pressure on the value of U.S dollar by selling dollars from
their inventory in order to buy other foreign currency. This led to a flight of capital from the U.S. as
foreign investors were no longer so interested in trading their currencies for dollars to invest in U.S.
financial assets.
In 1986 Caterpillar had a $100 million profit on foreign exchange due to a favorable (weak) U.S
dollar exchange rate that turned its $24 million operating loss into a $76 million profit for the year.
As a result of this experience Caterpillar established a special unit for managing currency risk
exposure.3
Other companies did not fare as well. Lufthansa, the German Airline, contracted with Boeing to
purchase 20 aircrafts for $500 million in January 1985. To manage exposure to the U.S dollar the
company purchased dollars forward in the foreign exchange market fearing revaluation of the U.S
currency, which could increase the Deutsche Mark cost of the planes. What actually happened is that
the dollar devalued against the German Mark. The forward contracts cost Lufthansa $140 to $160
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million more for the planes than if it had simply waited and purchased the dollars on the spot
market.4
To appreciate the severity of losses that firms experience due to unexpected change in spot and
forward rates, exhibit 1.11 lists case histories of various types of losses and the short description of
Allied Irish Bank Foreign Exchange Feb 2002 $691 M Rogue trader
hides loss over
3 years
------------------------------------------------------------------------------------------------------------
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Source: company reports and various newspapers
Does foreign exchange risk raise the cost of capital and lower optimum debt ratio for MNCs?5 The
authors own research provides evidence to the contrary. Due to MNCs ability to exploit
imperfections in product, factor and financial markets across international boundaries, they are able
to earn monopoly rents. This is evidenced by higher market to book value ratio for MNCs relative to
domestic corporations as documented by the author elsewhere. 6 This result does not negate the fact
that MNCs attach higher hurdle rates for analyzing cash flows of foreign projects as higher risk
adjusted required rate of return of foreign projects embody additional premium for foreign exchange
risk.
Political Risk
Political risk refers to changing political landscape and its effects on the way individuals or firms
conduct business in the world market. New political arrangements may impose various restrictions
on the flow of goods and services. The risk of takeover or expropriation of foreign owned assets or
nationalization of foreign assets as proxy for political risk has been mitigated by the disciplining
mechanism of the international capital market. The capital market has ensured and insulated capital
providers from such risk by imposing grave penalty on the perpetrators of such acts by simply
refusing capital the blood line of progress to the nations engaged in such phenomena. This risk was
significant in the past and firms mostly multinationals used to spend precious resources identifying,
quantifying and micro managing it in cases involving acquisitions, foreign direct investment and
portfolio investment.
Greater integration of the world financial markets, global securitization, liberalization of trade,
innovations of new financial products and expansion of opportunities in a global environment have
reduced and presumably eliminated the need for consideration of political risk for all practical
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purposes. The increased volatility in financial markets due to a floating exchange rate arrangement
since 1973 and greater interdependency of global economies have created new opportunities as well
as additional risks associated with innovative derivatives. These risks can be classified in an agency
Counterparty risk: The risk that one of the parties to the agency contract fails to perform for
Liquidity Risk: associated with lack of efficient secondary markets in which a long or short
Rollover Risk: the risk of being forced to close out the position without being able to
renew the contract at the market prevailing price or rate. This risk is also synonymous with the
availability of the fund. For example a financial institution may extend a 6-months fixed rate
loan to a party and be able to fund the loan for 3-months, therefore the institution is exposed with
the risk of availability (rollover) for the funding of the loan for the remainder of the next three
months for which some type of hedging in the forward or futures market is necessitated to
Risk Risk: the risk of not knowing and understanding the ramification of the type of the
agency relation one has entered and the risks entailed in such relationship. The risk of not
understanding the risk of security the (long or short) position one has taken.8
While most of these risks to a considerable degree have been eliminated in the derivative markets
in which the trade takes place in an organized exchange, the risks remain fairly substantial involving
the over the counter transactions worldwide. Furthermore, the greater interdependencies among
various economic units and the increase in the use and abuse of derivatives as well as greater
coordination of fiscal and monetary policies in the context of various treaties (i.e., European Union,
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North American free trade agreement (NAFTA), Asian free trade Agreement (AFTA) and Economic
References:
Domestic Corporations, International Economics Vol. LI. No. 2, 1998. PP. 189-210
and Ownership Structure, Journal of Financial Economics, No. 3, 1976, PP. 305-360.
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End Notes:
1
See Websters New World Dictionary of the American Language Second Edition, Simon and Schuster 1980.
2
The speculative loss in the futures market for Bank Negara the central Bank of Malaysia was in excess of $2.1 billion
in 1993. The loss for British Merchant Bank of Barings stemming from the speculative transactions by Nick Leeson the
Barings head of trading division in Singapore was in excess of $1.2 billion forcing the bank in to bankruptcy. Baring was
3
The Floating Battle Field: Corporate Strategies in the Currency War by Gregory Millman, l990.
4
Millman 1990.
5
See Eiteman, et al (2001, P-3) maintain that the foreign exchange risk raises cost of capital and lowers optimal debt
ratios for MNCs without substantiating the above hypotheses.
6
Homaifar, et al (1998) find that in contrast to conventional wisdom, MNCs employ less long term debt in their capital
structure than their domestic counterparts (DCs) which corroborate with the finding of Lee and Kowks (1988) evidence
that MNCs have lower debt ratio than domestic corporations. MNCs appear to have higher agency cost of debt than DCs.
This evidence is consistent with those of Myers (1977) and Lee and Kowk (1988). MNCs have more non-debt tax shelter
than DCs. According to Homaifar et al (1988) the significant difference in tax shelter ratio between MNCs and DCs
imply that the MNCs are better equipped to arbitrage institutional restrictions than DCs for the purpose of reducing their
tax liabilities.
7
Credit Suisse First Boston counterparty to forward ruble/$ contract fails to deliver $ when Russian government freezes
8
Orange County California state retirement plan invested in derivative interest rate futures for enhancing the yield of the
portfolio expecting interest rate to fall. This transaction was a speculative in nature and was not intended to hedge or
transfer risk. The interest rate actually did go up against the expectation of the retirement fund and the result was the loss
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of nearly $1.7 billion when interest rate futures liquidated for massive loss in December 1994. The retirement planner did
not realize a priori what risk is entailed in interest rate futures transaction.
Chapter 1
1. Identify an event that caused an increase in exposure for individuals and corporations in the
early 1970s.
2. When an institution funds its capital requirements with floating rate notes and invest its
assets in fixed rate instruments, the institution is exposed to of assets and liabilities.
3. Explain the absence of volatility in the foreign exchange market prior to 1970s.
4. When gold price rises from $20.67/oz to $35/oz, the dollar is said to devalued/revalued.
5. In the previous question the dollar devalued by how much (in percent)? -40.94%
6. In the previous question the gold revalued by how much (in percent)? +69.32%
7. When firm revenue is denominated in dollars and its debt service cost is denominated in
pounds, this firm is said to be exposed to risk.
8. Laker Airways derived revenues in pounds while borrowing in dollars exposed the company
to what type of risk?
9. Identify a transaction creating an agency relation and an agency problem.
10. The conflict of interest between two parties gives rise to what type of problem?
11. Why are multinational corporations exposed to greater amount of agency-related problems
than their domestic counterparts?
12. Markets for real assets are
13. Markets for financial assets.
14. Explain two major functions performed by derivatives.
15. The IMM index for Treasury bill futures is 97.50 for December futures at the Chicago
Mercantile Exchange CME on July 31. What forward (future) interest rate does the IMM
index imply for the above contract?
16. Suppose the spot interest rate on T-bills on July 31 is 2 percent in the previous question.
What information is the T-bill futures contract conveying to the market participants?
17. Is the futures market anticipating a rate increase/decrease by the Federal Reserve Board? And
by how much?
18. The IMM index for Eurodollar futures is 93.45 for July futures at CME on April 21. What
forward (future) interest rate does the IMM index imply for the above contract?
19. Identify the types of transactions in the market. Give an example of each transaction.
20. What distinguishes forward and futures market transactions?
21. Identify broadly the types of risks a multinational corporation faces in the market?
22. Is macro risk more relevant than micro risk for an individual with a well diversified
portfolio?
23. Give an example of foreign exchange risk for a corporation.
24. Elaborate why Caterpillars profit is highly influenced by the strength/weakness of the U.S.
dollars?
25. Caterpillar had operating losses of $24 million in 1986, while foreign exchange gains due to
a weak dollar was $100 million for that year. What was the net profit/loss for the year?
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26. Political risk arises in an international transaction with a sovereign nation. Provide an
example of this risk to a multinational corporation. How is this risk being mitigated in the 21-
century?
27. A forward transaction exposes parties to -----risk.
28. Give an example of liquidity risk.
29. Savings and Loans (S&Ls) faced ---- risk in borrowing short term and lending long term.
30. When you buy an instrument imbedded with many options that you do not understand you
are said to be exposed to-------
31. The -----risk in the organized futures markets is mitigated through a clearing corporation,
while it remains fairly significant in the ------market.
32. What is credit risk? Give an example of credit risk.
33. What is market risk? Give an example of market risk.
34. What is operational risk? Give an example of operational risk.
35. What characteristics distinguish hedge funds from tradition mutual funds?
36. NRP has invested $2.5 million in a hedge fund with a 2/20 fee structure. The value of the
portfolio has increased by 15 percent over the course of 1 year. How much profit did the
NRP realized in this investment?
37. What is the annual return net of all fees for the NRP investors?
a. 10 percent
b. 12 percent
c. 12.5 percent
d. None of the above
38. In the previous question how much money does the hedge fund make for managing the above
portfolio?
a. $100,000
b. $75000
c. $125,000
d. None of the above
HW # 1. Take any foreign currency exchange rate (monthly statistics) from www.stls.frb.org over
the last 30 years.
1. Analyze the trend in the exchange rate. Has the currency appreciated (depreciated) against
the U.S. dollar?
2. Analyze the monthly percentage change in exchange rate. Has the volatility of this currency
increased (decreased) since 1972?
HW # 2. Look at the short term interest rate (AA- commercial paper for a non-financial
corporations monthly rate at www.stls.frb.org. Look at the Eurodollar futures at the www.cme.com.
Compare the rate implied from Eurodollar futures with that of the spot AA- commercial paper rate.
What rate is the Eurodollar futures market implying, for the expected spot interest rate to prevail in
90 days using the IMM index? Is the futures market implying a rate increase or rate decrease?
Useful Links:
Chicago Mercantile Exchange provides real time prices for futures contracts at the
http://www.cme.com
Chicago Board of Trade http://www.cbot.com
http://www.bloomberg.com
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Federal Reserve Bank of St Louis http://www.stls.frb.org
Federal Reserve Bank of New York http://www.ny.frb.org
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Chapter 2
Chapter outline
Introduction
Balance of payments as a source and use of fund statement
Components of BOP:
Current Account Balance
Capital Account Balance
Official Foreign Exchange Balance
Statistical Discrepancy for Error and Omissions
Current Account and Economic Fundamentals
Capital Account, Expectation and Interest Rate
U.S. Balance of Payments: Recent Evidence and Historical perspective
Exposure Related to Capital Account
The Brazilian Experience
Currency Crisis in South East Asia and Balance of Payment Problems
Exchange Rate Arrangements, Dollarization and Peg
Argentinas Peso Doomed to Collapse
Managing Balance of Payment Exposure in Emerging Market Economies
Introduction:
The balance of payments (BOP) provide a summary of all transactions involving real
goods, services, financial assets (Portfolio investments such as stocks, bonds and bills, etc.)
and direct investments (i.e., foreign acquisitions, joint ventures and divestitures), capital
(import/export) and transfer payments in cash or in kind between any two individuals,
corporations, government entities and countries over a specific period. The goods and
services flow from one country to another to fulfill the individual desire to consume what is
not available or cannot be produced competitively in the importing local economy and desire
to expand production by the producer in the exporting country to earn a profit. The trade
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takes place when one party acquires the knowledge and technology to produce goods or
services far more efficiently than another party in order to buy goods and services that either
trade with one another. The pattern of trade between countries can provide a guiding
principle for the resurgence of trade rooted in the theory of comparative advantage. Based on
this theory it pays off to specialize in production of certain goods or services and trade these
goods and services with others where they have comparative advantage in production of
those goods and services. It should be noted that the various regional free trade agreements
(FTAs) such as the North American Free Trade Agreement (NAFTA), the Asian Free Trade
Agreement (AFTA) and others have provided a competitive advantage through reduced or
following excerpt from the Wall Street journal as of April 04, 2002 highlights the above
argument:
Unlike multilateral trade accords where all members of the World Trade Organization are
treated equally, bilateral and regional "free trade" deals create inequities by granting
preferential treatment to some countries at the expense of others. This is why economists call
FTAs by another name, preferential trade agreements. The effect of such agreements is that
production of goods shifts from countries that have a comparative advantage to countries that
are less efficient producers but have been given a competitive advantage through lowered
tariffs.
Free trade is not a sum zero game since the parties realize real gain and enhance their own
welfare by producing in the areas for which they have achieved specialization, thereby
producing at minimum average cost. For example U.S. manufacturing and technology sectors
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have acquired comparative advantage in production of goods requiring a highly skilled labor
Exhibit
force 2.1: USA
and trading these goodstofor
Export goods
Major that the
Trading trading1999-2009
Partners partners produce more efficiently.
While most of our trading partners in Latin America, South East Asia and Eastern Europe
have absolute advantage in hourly wages in manufacturing, U.S. manufacturing has absolute
advantage in productivity (output per man hour). The wage or productivity alone (absolute
productivity over wage (comparative advantage) may dictate which goods or services we buy
from our trading partners and the goods and services we sell. For example, the wage in
Mexico is much lower than that of the U.S, and so is their productivity. It then follows that
we buy goods and services from countries where the ratio of productivity over wage is
greater in that sector than the one in the U.S., and sell goods and services where our
productivity over wage is greater than our trading partners. It is no surprise that we buy steel
and auto from Japan and sell food, lumber, aircraft and semiconductors. Exhibit 2.1 and 2.2
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provides some preliminary evidence on the behavior of U.S. exports and imports to and from
It appears that the U.S. imports more goods and services from its trading partners with the
exception of France than it sells thereby running a deficit, which is financed by issuing an
IOU to its trading partners in the form of short or long-term financial assets and this creates
exposure to currency and interest rate risk. The deficit appears to be much larger with China
followed by Japan Germany, Mexico, Canada and United Kingdom (UK), while experiencing
a small surplus against France. The larger the deficit the greater the chances that interest rates
need to go up in order to entice the creditors to extend the short or long term credit.
The difference between import and export significantly widen between China and the
USA, as is shown in Exhibit 2.3. For every dollar of export USA imports over $11 of goods
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Exhibit 2.3: Import /Export ratio for the US Major Trading Partners
1999-2009
The rising cost of financing the current account deficit, particularly at the floating rate,
coupled with the availability (roll-over) risk is particularly acute for the emerging economies
and economies plagued with high inflation. Fabio de Olivera Barbosa, Brazilian Secretariat of
The turbulence involving emerging economies in general and Brazil in particular, deeply
affected countries access to international capital markets. The magnitude of change can be
seen in the widening spreads for sovereign bonds. In June 1997, the [Brazilian] Treasury
issued a global, thirty-year bond with a 395 basis point spread; two years later, a global, ten-
year bond was bearing an 850 basis point spread. The spread is over and above the equivalent
dollar denominated bond of the same maturity.
Roll over risk refers also to the availability risk as major international
Key Concept banks refuse to extend credit to a borrower at prevailing market
interest rates on a maturing debt or demand and require good
collateral and or a substantial increase in interest rate.
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When a trading partner exhausts all its options to acquire financing in the private sector,
the lender of last resort the International Monetary Fund (IMF) or the World Bank may
provide funding, however, imposing various restrictions austerity on the borrower which
BOP is a double entry of all goods, services and financial assets where each entry is a
credit and the debit over a specific period. BOP is virtually an accounting identity, where the
sources of funds are those transactions increasing the purchasing power of a nation that must
equal use of fund; those transactions reducing purchasing power of a country. Where the
export of goods, services and capital creates source of funds and the import of goods, services
and capital produces the use of funds. The export of goods, services and capital generates
demand for the currency of the exporting country and supply of foreign currency as foreign
buyers use their own currency to purchase the currency of the exporter in order to pay for the
export. Likewise, import of goods, services and capital generate supply of currency of the
importer and demand for foreign currency in order to settle transactions. Therefore, any
imbalance (surplus or deficit) in the supply of and demand for currency of the export and or
import create temporary disequilibria and exposure to currency and interest rate risks.
COMPONENTS OF BOP
The current account summarizes all transactions on the net merchandise trade balance of
goods and services, net income balance on direct investment and portfolio investment, and
net transfer payments in cash or in kind over a specific period. When a country runs a deficit
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in its current account by issuing claims to the assets acquired, it is essentially supplying more
of its currency in the market than the market demands. This phenomenon creates an excess
demand for the currency of the country where more goods and services are imported from
than exported and simultaneously increases the excess supply of currency of the country
running the deficit. The excess supply of currency as a result of trade imbalance induces a
chain reaction in the financial markets leading to the eventual devaluation of the countrys
Capital Account
The capital account summarizes transactions on the net direct foreign investment and net
portfolio investment in stocks, bonds, bills and other net short or long term financial assets of
the private sector and or government agencies over a specific period. The net current and
capital account make up the Overall Balance of a nation. However, it should be noted that,
since the floating rate arrangement of 1973 the short term capital account has become
increasingly volatile leading to the importance of the Basic Balance composed of the net
This is the central banks portfolio holding of foreign currencies, gold and other certificates
and near money such as special drawing rights (SDR), issued as a form of reserve credit to
members by the IMF whereas a member can borrow from other members up to 625% of the
members allocation. The ability of a countrys central bank to maintain its currency at a
desired exchange rate is directly related to the amount of reserves it has accumulated as a
buffer against the temporary disequilibria. Countries experiencing chronic and persistent
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deficits in their current account are forced to tap into their reserve in order to maintain their
currency value, thereby dwindling reserves and running the risk of severe depreciation.
becomes attractive to foreigners and detrimental to the economy as import prices go up (in
addition, domestic producers may see this as an opportunity to raise their product price) and
However, countries with a surplus in their current account normally build up their reserves
and enjoy the benefits of a strong currency that can be anti-inflationary as import prices fall
and local producers are forced to maintain the price of their domestic production at current
prices.
This category is created to balance source and use of fund statements due to transactions
involving barter (i.e., an exchange of service for service) and underground economic
activities (i.e. smuggling, money laundering and other illegal transactions) where no entry is
made on the port of entry as to the value of the goods over specific period of time.
Summarizing the components of BPs that produce the balance of payments equation as
follows
The following statistics (the cumulative 4-quarter balances) for the U.S. current account and
key components of the capital account as well as statistical error in 2001 are taken from the
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Balance on Service: +$34.326
The relationship between the current account and economic fundamentals is discussed
briefly in the following section. However, in the interest of clarity and providing a foundation
on which later analysis will be more meaningful, let us approach the above relationship from
a different angle. The current account summarizes all transactions originating in the asset
markets between a countrys residents and the rest of the world. Demand for particular good
in the asset market is a function of price, income and price of other goods. Where the quantity
demanded of a good is inversely related to its price and directly related to price of substitute
The same principle is applicable to the demand for imports and supply of exports
originating in the current account with few exceptions, the role of government and the action
it can take to promote or curb trade by eliminating trade barriers or by imposing tariffs and
quotas. What about exchange rates? The exchange rate is the ratio of the prices of baskets of
identical goods and services in two different currencies theoretically. In reality such baskets
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The factors inducing change in current account can be summarized as follows:
Key Concept
-Exchange Rate ratio of two prices
-Income
-Government
Other factors such as inflation and the unemployment rate affect the exchange rate and
consumer confidence respectively and shape individuals expectations about ones own state
in particular and state of the economy in general. As the state of the economy improves
(income rise), consumer confidence rises, propelling consumer propensity to consume and
spend including acquisition of more foreign goods and services imported from overseas
causing a deficit in the current account.2 Factors such as income and expectations are
interrelated.
Exchange Rate: As the dollar weakens against foreign currencies, requiring more dollars to
acquire foreign currency, the goods and services made in the U.S. becomes relatively more
attractive to foreign buyers. The exports in this scenario are expected to improve as the
domestic goods become cheaper for foreigners to acquire and imports are expected to fall as
foreign goods and services tend to be more expensive, thus creating an increase and
improvement in the current account balance. The above simplistic analysis assumes among
other things that the pass-through from the exchange rate to prices of goods and services in
the exports and imports sector of the economy is complete and simultaneous. For example,
suppose the dollar appreciates by 5% against all other currencies. If the export price goes up
by 5% and import price goes down 5% immediately following dollar appreciation, then the
pass-through is complete and simultaneous. The evidence for the U.S. economy and its
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implication for managing exposure are contrary to the above analysis. This important issue is
discussed in chapter 3.
Government: The government can and does play an important role in shaping policies
that lead to improving overall economic activities in a democracy. For years, the struggling
U.S. Steel Industry has been lobbying congress for the imposition of a tariff and/or quota on
imported cheap steel from other countries to protect domestic producers. Such actions have
common denominators: It makes imported foreign steel from countries that the Congress
imposes tariffs on more expensive at the expense of those given preferential treatment of no
or less tariffs, which invites domestic producers to raise their prices. This action, assuming it
is not reciprocated (i.e., other countries impose no tariffs on U.S. goods) by tariff-impacted
countries is expected to reduce imports and help exports thereby improving the current
Capital Account, Expectation and Interest Rate: The capital account tends to be interest
rate and yield sensitive. Expectations play a major role in making foreign direct investment
and portfolio investment by U.S. individual and institutions overseas as well as for their
foreign counterparts in U.S. markets. Investors seeking far better return overseas are usually
attracted to emerging economies with a promise of expected high yield. Particularly, the
short-term capital account is highly sensitive to interest rates and the yield in the emerging
markets stock and bonds markets. The so called hot capital in pursuit of high returns moves
swiftly from one country to another and retreats at the sign of any weakness and financial
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crises creating substantial exposure to users and providers of capital. The following example
shows the net capital in-flows (+) to U.S. in billions of $ during the year 2001:
2001.1 347.006
2001.2 226.927
2001.3 57.718
2001.4 263.806
The above example vividly reflects the impact of the September 11 attack on the World
Trade Center on the quarterly net capital in-flows to U.S. The net capital flows dramatically
fell to $57.718 billion by the end of the third quarter as foreign investors divested their
portfolio investment in the U.S. due to rising concerns of international terrorism and its
adverse impact on the performance of the overall U.S. economy. However, foreign investors
returned to the U.S. market as the pace investments in the U.S. rose over and above the pre-
September 11 to $263.806 billion by the fourth quarter of the 2001. It appears that the world
capital market has treated the September 11 as an isolated event (i.e. unsystematic risk).
Promise of higher yields attract short and long term capital as the
Key Concept capital account is interest sensitive. If the promise is unfulfilled capital
flight continues as investors liquidate their investments and run for the
exit.
U.S. Balance of Payments Recent Evidence: Exhibit 2.4 illustrates some interesting
patterns of U.S. current and capital account as a percentage of gross domestic product (GDP)
over the 1961 to 2008 period. The current account is the balance of countrys income derived
from exports and expenditure due to imports. While the current account as a percentage of
GDP is paints a widening deficit over time, the net capital account provides a picture of an
economy which has attracted long and short term net capital in the form of foreign direct
investment, portfolio investment and other short or long term capital to finance the deficit.
The excess supply of U.S. currency created as a result of deficit in current account appears
more than offset by the excess demand for the U.S dollar in capital account.
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In the 1960s the current account as a percentage of GDP was positive, ranging from .5%
in 1960 to .2% by the end of 1970, the capital account, however, was negative, ranging nearly
-.3% to -.2% during the same span. International trade, the sum of exports and imports, was
nearly 5% of GDP in the mid 1960s. In the 1970s to 1980s the pattern of U.S trade remained
fairly the same as the 1960s with a gradual increase in international trade where the current
account as percentage of GDP remaining positive in all of years except 1971, 1972, 1977-
1979 and capital account behaved the opposite of the current account during the same period
The 1980s witnessed a gradual deterioration in the current account, in particular the deficit in
the current account reached 3.24% and 3.28% of GDP by 1986 and 1987. However, the
capital account was positive reaching 2.6% and 3.4% of GDP during the same period.3 The
80s decade coincides with the defense buildup of the Reagan presidency, a rising annual
budget deficit and tripling of national debt by the end of 1989. While, nominal interest rate
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had fallen significantly by the mid 1980s due to falling inflation and inflationary
expectations, the real interest rate remained fairly attractive. This, coupled with a strong U.S
dollar and a rising equity price, helped to entice enormous foreign capital to the U.S. to
finance huge twin deficits, the deficits in current account and in the annual government
budget.
In the 90s decade, the current account continued to behave similarly to the 80s with the
exception of 1991, where the current account had a small surplus due to huge transfer receipts
from U.S. allies in the Gulf War to pay for the execution of the war. By the late 1990s and
beginning of 2000 and 2001, the deficit in current account ballooned to 3.4%, 4.4% and 4.0%
of the GDP, respectively. However, the surplus in the capital account more than offset the
deficit during the same period. By 2000, international trade as a percentage of GDP reached
The current account deficit can cut both ways. Assuming a nations productive capacity
increases as a result of importing more capital (i.e., goods, services and credit) and net capital
flows are used to build up a countrys infrastructure and foreign reserve, it follows then that
the deficit and the resulting exposure to interest rate and exchange rate changes will not
adversely affect the economy. The deficit and resulting exposure in this scenario is a value
creating phenomena, or putting it in financial terms a positive net present value. The increase
in imports over the exports is invested at the rate exceeding the cost of funding the deficit.
deficit is primarily used to finance current but not future consumption then the resulting
exposure to interest rate and foreign exchange risk can be devastating. In the scenario
discussed, the deficit is invested at a rate below the cost of capital in negative net present
value projects.
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52
Exposure Related to Cap ital Account: The exposure in the capital account is related to
foreign direct investment and portfolio investment overseas. The return of the original capital
as well as the capital gain or loss, royalties, and interest income are exposed to foreign
exchange risk as well as interest rate and market risk. This creates opportunities for a
windfall gain as a result of favorable exchange rate movements and falling interest rates or
losses stemming from unfavorable exchange rates and rising interest rates.
Example: Suppose a U.S. money manager invests in one year par bonds denominated in
British pounds promising 8 percent interest rate, assume the pound appreciates by 5% during
the year, the return to the U.S. investor as defined in equation 2.1 is: 13.40 percent.
The returns realized by the U.S. investors investing in foreign assets (i.e., stocks, bonds, bills
Ignoring the co-variation between the return in foreign currency and percentage change in
dollar value of pound, the rate of return in dollars will be simply equal to 13% the sums of
8% interest and windfall gain due to favorable exchange rate movement of 5%.
The volatility (variance) of the return realized by U.S investor is directly related to the
volatility of U.K interest rate as well as the volatility of the percentage change in the
exchange rate.
Suppose the pound devalues by 50%, due to a weakness in the U.K.s economic
fundamentals and a huge protracted deficit in its balance of payments, causing a substantial
44
53
hike in the interest rate, which results in an increase in non-performing loans due to an
inability of the borrowers to service their debt, thereby inducing a crisis in the U.K banking
sector. This in turn causes a substantial drop in the rate of return to U.S. investors as defined
by Equation 2.1 to 46%, the sums of 8% interest; 50% loss due to unfavorable foreign
exchange rate movements and 4%; due to the interaction term between the interest rate in
U.S. investors in this scenario will most likely to divest their holdings in British
denominated bonds, causing a massive flight of capital and further depreciation of the pound.
The spillover contagion effects to U.S providers of capital to British borrowers can range
from massive losses to U.S. institutions as British borrowers default and U.S. institutions
realize large losses in their portfolio investments due to rising interest rates and the falling
market value of stocks and bonds inducing a banking crisis in the U.S.
Example: Strong hedge fund invested in a one year Yankee bond promising 8 percent
interest rate with the Euro currently at $1.10/. Estimate the return realized by the U.S. based
hedge fund assuming the Euro appreciates to $1.21/ by the end of the year.
Brazilian Experience: The current account deficit in Brazil and subsequent devaluation of
its currency in January 1999 is at the center of the Brazilian currency crisis. Starting in 1994,
the current account as a percentage of GDP began to deteriorate, and by 1998 the deficit
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54
The Brazilian currency (real), which at times was relatively overvalued against the U.S.
dollar, started a significant downward spiral particularly in from 1998 to 2000 losing more
than 50% of its value since its inception in 1995. As seen in the Exhibit 2.6, the real remained
fairly stable since its inception, however it nearly depreciated by over 25% and 27%
0.3
0.2
0.1
0
-0.11994 1995 1996 1997 1998 1999 2000 2001 2002
-0.2
According to Brazils Central Bank, 59.6% of the domestic debt to finance deficit by 1999
was primarily in the form of overnight borrowing at the floating rate interest. This implies
that the significant increase in the current account deficit and subsequent speculative attack
46
55
on the Brazilian real was not a coincidence. The following excerpt from the Secretariat
Treasury of Brazil (1999) points in the right direction as to the cause of the Brazilian
The bulk of the federal budget deficit in Brazil is financed by domestic capital markets,
mostly through bonded debt. After 1994, which marked the beginning of the Real Plan and
the successful process of macroeconomic stabilization, it was clear that the federal
governments debt management strategy should be adapted to the new environment. By
That time, public debt structure was almost fully indexedmost of it to inflation indexes, the
exchange rate, or to floating, short-term, interest rates; nominal, fixed-rate instruments
represented no more than 6 percent of total outstanding debt. At that point, the basic strategy
was to modify the domestic debt structure by gradually increasing the share and average
maturity of fixed-rate instruments.
It looks like the Brazilian Central Bank was at the center of the Brazilian financial
turbulence, where short term debt financing mitigated the long-term structural deficit
problems. This action of the Central Bank amounted to implanting a ticking time bomb in the
Brazilian economy expected to go off at any time without warning. The exposure to interest
rates changes could have been mitigated by changing the composition of debt and
lengthening the duration of the bond issues, particularly reducing the size of the overnight
borrowing and restructuring the debt by reducing the Central Banks adverse selection of
accepting more poor risk associated with the short term borrowing than the long term fixed
rate borrowing. The currency crises and the risk associated with that is directly related (co-
vary) with the interest rate risk and associated banking crises that it entails.6
The run in currency and speculative attack by short sellers and arbitrageurs following the
deterioration of the countrys economic fundamentals such as prolonged deficit in the current
account, budget deficit, high inflation and high interest rate leads to currency crises.7
The Central Banks reaction to the currency crises can lead to a crisis in banking sector as
weak banks with substantial non-performing loans are forced into bankruptcy due to rising
interest rates. The Central Banks attempt to shore up the supply of its own currency on the
one hand, thereby using finite reserve to save the currency from speculative attack and its
47
56
attempt to tighten monetary aggregate by raising interest rates while, simultaneously
providing liquidity to the banking system in order to bail out the weak banks leads to the
creation of excessive money, higher inflation and interest rates that chocks up the economy.8
Currency and interest rate risks and the ensuing crises can result from the way the
imbalance in the current account is financed in economic booms. When the imbalance is
financed primarily with large capital inflows and short-term credit from large foreign banks
at times of economic growth and rising prosperity, the return on investment is usually greater
than the cost of capital. However, as the boom ends and foreign short term capital retreats as
a result of actual and expected severe currency devaluation and as the cost of servicing
foreign currency denominated loans skyrocket and bankruptcies mount, the solvency of local
Currency Crisis in South East Asia: The currencies of Thailand, Korea, Indonesia,
Malaysia and the Philippines severely depreciated during the 1997 to 1998 periods, ranging
from as high as 52.6% for the Korean won and as low as 34.4 % for the Philippines peso.
The capital flows to the region in the form of foreign direct investment, portfolio investment
and bank loans that fueled the engine of the economic growth in the 1980s and much of the
1990s were reversed due to the severity of the currency devaluation and the fall out in the
equity markets as capital flight from the region led to the retrenchment of exposed capital to
According to Kowai et al (1999) the influx of global, private, short-term hot capital in
search of high yield, inflows of un-hedged capital to finance the domestic credit boom,
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57
insufficiently regulated domestic financial markets with highly leveraged corporations and
increasing political uncertainty made East Asian economies vulnerable to external shocks in
the period preceding the crisis. Implicit or explicit guarantees by the government provided the
incentive for financial institutions to borrow excessively and encouraged excessive risk
taking creating moral hazard problems for borrowers and lenders. Furthermore, the fixed
exchange rate arrangement in the pre-crisis period provided the illusion that the foreign
currency denominated loans at lower interest rate as compared to higher interest rates at home
was immune from the exchange rate and interest rate risks.10
It appears that the currency crisis in East Asia was due to the systematic failures in several
key areas and banks and finance companies supervisory institutions lacked the moral courage
and incentives to take actions that could have prevented the chaos or at least reduce the extent
Corsetti et al (1998) provide a link between the current account (CA) deficit as a percentage
of GDP and extent of the depreciation of the currencies in East Asia during 1997 as shown in
Exhibit 2.7.
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58
According to Cosetti et al (1998) countries with severe devaluations in 1996-97,
experienced high current account deficit in the 1990s financed primarily with short-term debt.
Korea and Thailand financed only 10 and 16 percent of the current account deficit with long-
term direct foreign investment. The short-term foreign liabilities to major foreign banks as a
percentage of reserves at the end of 1996 was 213% for South Korea, 181% for Indonesia,
169% for Thailand, 77% for the Philippines and 47% for Malaysia based on an estimate
provided by Corsetti et al. The current account for China, Hong Kong, Singapore and Taiwan
were near zero or positive, therefore these countries were not affected as much and as
severely as the other five countries in the region. Since short-term capital flows are highly
sensitive to expectations of higher yield, it also runs the risk of quick reversal when
Many factors contributed to the collapse of currencies in the South East Asian economies in
Lack of transparency;
Lax regulation;
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59
Mismatch of revenue and cost (un-hedged exposure to currency risk);
Most of the economies in the region experienced protracted deficit in their respective current
account as the goods and services in their export sector became fairly expensive. Current
account liberalization fueled speculative capital flowing to the region, without regard to
possible devaluation of the underlying currencies. This speculative capital was mostly
invested in equity and real estate creating asset bubble in these markets. Private banks and
finance companies borrowed dollar denominated loans in the offshore market at small
spreads over the London inter-bank offered rate (LIBOR), lending it to the local clients at a
significant margin without regard to exchange rate and interest rate risks. The Banks and
finance companies perceived that the Central Bank would maintain fixed exchange rates,
allowing them to earn excess arbitrage profit. By 1997 the party was over and rising rollover
risk forced many banks and finance companies into bankruptcy as the cost of dollar
denominated loans skyrocketed because of severe devaluation of the currencies in the South
East Asia.
Short-term foreign liabilities as a percentage of international reserves for the five Asian
economies are presented in Exhibit 2.8, taken from Chang and Velasco (1998).
Short-term foreign liabilities exceeded international reserves for Indonesia, South Korea
and Thailand, which was an indicator of international bankers refusal to roll over credit,
thereby these countries would not have had enough reserves to meet their short-term
obligations. When the value of short term international debt denominated in hard currency
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60
exceeds the liquidation value of its assets in hard currency, a countrys financial system is
internationally illiquid. That is the way in which assets are financed in the emerging
economies and the mismatch of the assets maturity and that of the foreign liabilities was at
the center of the financial panics in the South East Asian crises.12
Current account deficit can be a source of extending economic growth beyond the
countrys own means. The capital imported from overseas economies in the form of foreign
direct investment (FDI), portfolio investment and bank loans have provided the necessary
ingredients for the creation of jobs and opportunities in the U.S. economy as well as a fair
rate of return to the providers of capital. So long as, the imported capital is invested in
increasing productive capacity of a country where the cost of capital is less than return on
capital, the deficit in the current account is essentially a value producing phenomena. This
those hard hit with chronic inflations such as Brazil and Argentina have attempted to
establish a currency regime that protects the purchasing power of their currency. These
countries and their respective currencies are pegged to the U.S. dollar with the exception of
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61
There are more then eight different currency regimes in the world and countries move from
one regime to another in hopes of finding a system of exchange rates that can provide
For example, the South Korean won was pegged to the U.S. dollar prior to its collapse in
Prior to 1991, Argentina was in a managed exchange rate regime and after 1991,
established a currency board fixing the exchange rate against the U.S. dollar at a one on one
ratio requiring the central bank to maintain a 100% reserve in the form of dollars or gold for
every peso issued by the government. While the IMF and World Bank hailed this policy early
on, the 100% reserve requirement imposed unnecessary burdens to an economy with a
relatively small foreign sector. Since Argentina was required to either earn a dollar or attract
a dollar in the form of FDI or portfolio investment in order to issue pesos, it made
To add insult to injury, the central bank allowed Argentineans to hold dollar denominated
savings and checking accounts, thereby creating excessive demand for dollars. The
Argentineans, weary and distrustful of their government and its own currency continued to
accumulate U.S. dollars making maintenance of the peg at a one to one ratio impossible. The
currency board system expected to provide stability for Argentinas economy was destined to
collapse. The distribution of outstanding bank certificates of deposit held in the banking
system in U.S. dollars as a percentage of total deposit as of 1992 to 1999 reported by the
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62
1992 .61
1993 .58
1994 .61
1995 .65
1996 .72
1997 .72
1998 .70
1999 .72
The evidence from the above data indicates Argentinean preference for the U.S. dollars as
opposed to their own currency. The ownership of the dollar denominated certificate of
deposits (CD) held by individuals and institutions is nearly in the low 60s as a percentage of
the total up until 1995, and the percentage grows to the low 70s from 1996 to 1999. For
example, by December 1999 of the 47.82 billion total CDs, $34.32 billion was denominated
in U.S. dollars, only 28 percent of total certificate of deposit was in peso. The CD holders
knew more about the real value of the peso than the currency board despite the higher interest
rate differential in favor of peso, and they demonstrated this by their action of holding more
dollars than pesos. Exhibit 2.11 shows the interest rate differential between Argentinas
monthly 30 to 59 days Central Bank time deposit rate and U.S. 90-day time deposit rate from
1992 to 2002.
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63
E xibit 2.11: Interest Rate Differentials, Argentina and USA
35.00
30.00
25.00
20.00
15.00
10.00
5.00
0.00
2 3 4 5 6 7 8 9 0 1 2
9 9 9 9 9 9 9 9 0 0 0
9 9 9 9 9 9 9 9 0 0 0
1 1 1 1 1 1 1 1 2 2 2
The higher interest rate and the greater volatility in Argentinas differential reflect the higher
risk premium due to exchange rate risk and sovereign risk. Particularly notable is the rising
interest rate differential to nearly 14% by early 1995 that are attributed to the spill-over effect
from currency and banking crises in Mexico in 1994. The interest rate differential remains
under 5 percent for part of 1995 and throughout 1999 with a small spike in 1997 due to the
Asian crises and the 1998 Russian ruble devaluation. Finally the interest rates differential
approaches nearly 30%, with the collapse of the peso and rising inflation in 2001.
It appears that there was no money illusion at least for those individuals and institutions
holding CDs denominated in U.S. dollars despite relatively higher interest rate denominated
in pesos. Money illusion refers here to the inability of individuals to distinguish between
lower interest rates in hard currency (dollar) and higher interest rates in soft currency (peso).
Since the supply of dollars was limited, the demand for dollars by all individuals, cab
drivers, restaurants, property owners and service providers far exceeded the supply of dollars.
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64
The result is familiar: the peso had to devalue and the dollar had to appreciate and that is
Argentinas Peso Doomed to Collapse: Argentina, after nearly four years of recession with
an unemployment rate of 20%, ballooning foreign debt at $141 billion, decided to devalue the
peso in early December 2001 at the urging of IMF. The peso had lost more than 70 percent of
its value, falling to 3.1 pesos per U.S. dollar. According to the Wall Street Journal report
massive devaluation resulted in a default of Argentinas $141 billion loans to major foreign
banks and a banking holiday occurred on December 1 to avoid a run in the banking system.14
Devaluation re-ignited the inflation and inflationary expectations in Argentina, for years
hidden under the disguise of currency board. Exhibit 2.12 provides the percentage change in
consumer and producer price index in Argentina during the 1995 to 2002 period.
85
80
75
70
65
Percent Change in Price Index
60
55
50
45
40
35
30
25
20
15
10
5
0
-5
-10
1994 1995 1996 1997 1998 1999 2000 2001 2002
Time
While inflation appeared to be under control nearly falling to zero by 1996 and under zero
(deflation) for much of the 1999 and 2000 under the currency board, it was essentially a
bottled genie trying to get out. After the collapse of the peso the consumer (retail) inflation
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65
exceeded 24 percent. Had the peso been allowed to adjust at least periodically to macro
economic forces, the gradual transition to a system of independent float that the recent
government in Argentina is seeking would have been less painful and less costly.
This is not to say that the currency board and/or any other fixed exchange rate regime are
inherently untenable. To the contrary, fixed and managed exchange rate may provide
financial stability that policy makers in different countries seek provided that the imbalance
in the current account is used to finance projects that pays more than they cost. It is, however,
Exhibit 2.13 provides a clue as to the collapse of the peso and failure of the currency
board in maintaining and restoring stability in the formerly inflation ravaged economy of
Argentina. The current account deficit as a percentage of GDP continued to deteriorate and
reached over -5% by 1995; this was followed by the recession of 1996 to 1997 and the three
years thereafter. The overvalued peso choked the export sector by making goods produced in
Argentina extremely uncompetitive, thereby aggravating and prolonging the recession. After
Argentinas currency collapsed, devaluing by more than 70 percent, the Central Bank made
an extremely provocative decree that banks dollar denominated liabilities be converted into
new devalued Peso, while banks assets to be converted at the old exchange rate of one peso
equal to one dollar, effectively bankrupting the Argentinas banking system as liabilities far
exceeded the assets. As Argentina defaulted in one of the largest sovereign default in history
in 2001, the foreign lenders received no more than 30 cent on the dollar in one of the lowest
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66
The rest is history and the IMF, as a lender of last resort, required Argentina to cut spending
The imbalance in the current account and the way in which it is financed is at the center of
the various crises we have witnessed particularly starting with the devaluation of the Mexican
peso in 1994, the Russian currency devaluation of August 1998, Brazilian devaluation of
January 1999, South East Asian Crisis of 1996-97 and more recently Argentinas financial
and currency crisis of 2002. The external debt of the emerging and developing economies is
primarily financed either through short term or long-term jumbo loans syndicated by large
banks at a floating rate (usually LIBOR plus spread). There is almost no distinction between
short-term and long-term credit, as known in the West (short-term is usually at a floating rate,
while long-term is at a fixed rate), as related to the extension of credit to emerging market
economies.
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67
The one distinction between short and long term credit is related to the roll-over risk. This
is mitigated in the long term debt at least until its maturity, as compared to short term credit,
which at times has to be rolled over at its maturity at short term current interest rates
denominated in major foreign currency. While, individual and corporate borrowers in the
West have the option of refinancing their long-term debt when rates fall, such an option is not
usually available to the borrowers in the emerging market economies. Here is the problem.
The banks, especially in the U.S. and Europe during the aftermath of the S&L debacle,
learned a valuable lesson and started to pass the interest rate risk to the ultimate borrower.
The risk did not disappear; it indeed has increased as the exchange rate has become more
For emerging market economies external borrowing coupled with the excessive use of
leverage by corporate borrowers and associated interest rate risk and foreign exchange rate
risk has been a recipe for impending disaster, as we have seen in the 1990s. Corporate
borrowers in the emerging market economies need to restructure their balance sheet through
equity for debt swaps in order to reduce debt equity ratios. This restructuring increases equity
and reduces interest charges for servicing debt. It will be in the best long term interest of the
suppliers of foreign capital, particularly large banks to afford the same options to the users of
capital in the emerging markets similar to the own market. That is to extend long term credit
at fixed rate denominated in foreign currency to emerging market economies with the option
to refinance the loan when and if it pays off for the borrowers to do so. In this scenario the
creditors are protected from the interest and foreign exchange risk and borrowers are locked
in at the fixed foreign denominated interest rate where the cost of servicing debt is known and
the borrower can take steps to manage exposure to both types of risk.
Suggested Readings:
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Chang, Roberto, and Andrews Velasco. 1998. "Financial Fragility and the Exchange Rate
Regime." National Bureau of Economic Research Working Paper 6469, March.
Corsetti, Giancarlo, Paolo Pesenti, and Nouriel Roubini. 1998. "What Caused the Asian
Currency and Financial Crisis?" Japan and the World Economy, October 1999, pp.
305-73.
Diamond, Douglas W. and Philip H. Dybvig. 1983. "Bank Runs, Deposit Insurance, and
Liquidity." Journal of Political Economy 91: 401-19.
Furman, Jason, and Joseph E. Stiglitz. 1998. "Economic Crises: Evidence and Insights from
East Asia." Brookings Papers on Economic Activity 2:1-135.
Kaminsky, Graciela, and Carmen M. Reinhart. 1999. "The Twin Crises: The Causes of
Banking and Balance-of-Payments Problems." American Economic Review 89:473-500.
Kowai, M. et al (2001) "Crisis and Contagion in East Asia: Nine Lessons." World Bank 2001.
Washington, D.C.: World Bank.
Kawai, Masahiro. 1998a. "The East Asian Currency Crises: Causes and Lessons."
Contemporary Economic Policy 14:157-72.
Krugman, Paul. 1979. "A Model of Balance-of-Payments Crises." Journal of Money, Credit,
and Banking 11:311-25.
Krugman, Paul. 1998a. "What Happened to Asia?" Massachusetts Institute of Technology,
Cambridge, Mass. Processed.
McKinnon, Ronald I., and Huw Pill. 1996. "Credible Liberalizations and International
Capital Flows: The 'Overborrowing Syndrome.'" In Takatoshi Ito and Anne O. Krueger, eds.
Financial Deregulation and Integration in East Asia. Chicago: University of Chicago Press.
Obstfeld, Maurice. 1986. "Rational and Self-Fulfilling Balance of Payments Crises."
American Economic Review 76:72-81.
Radelet, Steven, and Jeffrey D. Sachs. 1998a. "The East Asian Financial Crisis: Diagnosis,
Remedies, Prospects." Brookings Papers on Economic Activity 1:1-90.
Radelet, Steven, and Jeffrey D. Sachs. 1998b. "The Onset of the East Asian Financial Crises."
NBER Working Paper 6680.
Summers, Lawrence H. 1999. "Roots of the Asian Crises and the Road to a Stronger Global
Financial System." Remarks made at the Institute of International Finance.
Whitt, J (Sep 1998), The U.S. Current Account Deficit: Is there trouble ahead? Economics
Update, Vol, 11, No 3, July-September 1998.
KAIROS CAPITALa
Merlina Katapodis stared through her office window, scarcely noticing the murky haze
which spread over Athens. The Aeropagus rose in the distance, but the unusually dank
60
69
morning rendered the mountain indistinct. Deep in thought, she pondered her first major
assignment with Kairos Capital, a very private investment partnership comprised of a number
of extremely wealthy and powerful shipping magnates. At the moment, she felt little of the
ambitious drive that had launched her into her present position.
Merlina had returned to her native Greece only two months before, and had been
quickly recruited by Mr. George Condoratos, Kairos Capitals primary managing partner.
Mr. Condoratos was especially impressed with the undergraduate business degree she had
earned from a major American university, and the additional graduate work she had been
exposed to at the London School of Economics. Although Merlina had not completed the
Masters degree requirements, she felt confident that her academic background in
International Economics would provide her with the appropriate analytical tools needed to
identify exceptional investment opportunities in developing countries. After only one week
on the job, her eagerness had been replaced by apprehensiveness. Her academic background,
while impressive on paper, had primarily emphasized abstract modeling and theory.
Moreover, Merlina had concentrated on the socio-economics of Latin American countries,
and while she considered herself an expert in this area, she knew little about the emerging
nations of Africa and Asia. Thus, she had been dismayed when she received Mr.
Condoratoss e-mail naming China as the focus of her initial investigation. The
memorandum was terse, offering no particular guidance, and only one restriction--that
Merlina present, on paper and orally, the results of her first-stage analysis on Thursday
afternoon of the following week. Now, two of the nine days had passed, and she had not,
except for some half-hearted exploratory forays, accomplished anything of substance. Her
attempts to elicit suggestions from the other analysts had been politely rebuffed, as all three
were currently involved in their own assignments and facing their own deadlines.
Additionally, though it was not outwardly apparent, they were loath to disclose the methods
on which their own success depended, and perhaps even jealous of Merlinas educational
background and beginning salary.
Merlina swiveled her chair from the bleak window-view back to her desk, and noticed
the framed adage, in Greek script, that had provided her with inspiration in past difficulties.
Attributed to Heraclitus, it bluntly stated, in English translation: Many fail to grasp what is
right in the palm of their hand. As she considered the years of dedicated study she had
spent, and the expertise she did possess, her doubt began to dissipate. She mused to herself,
Well, Ill start with what I can do, and learn the rest on my own as I go. She clicked the
mouse, and began.
Chinas balance of payment
The following table is the Chinas balance of payment from 1989 to 1998.
1. Did China have a merchandise (goods and services) trade surplus or deficit? What is
the trend?
3. Relate the current account as a percentage of GDP to the percentage changes in the
all-urban CPI during the same period. Is there a positive or negative relation between
the two? Use simple regression analysis for answering the above question, where
current account as a percentage of GDP is the dependent variable, and inflation
differentials between China and USA as an independent variable.
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70
5. What is the current account deficit or surplus as percentage of GDP?
6. How devaluation of Chinas currency affected the current account balance? Use
regression analysis to answer this question, where current account scaled by GDP is
used as dependent variable and Chinas currency Yaun/$ as an explanatory variable.
7. Calculate the index of real exchange rates for China (assuming base year of 1994 and
the index is set at 100).
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71
Current Account ( Units: US$ Scale: Millions)
During GOODS GOODS TRADE SERVICES: SERVICES: BALANCE INCOME: INCOME: BALANCE CURRENT CURRENT CURRENT
Period EXPORTS: IMPORTS: BALANCE CREDIT DEBIT ON CREDIT DEBIT ON TRANSFERS, TRANSFERS: ACCOUNT,
F.O.B. F.O.B GOODS GOODS, N.I.E.:CRE DEB N.I.E.
AND SERV.&
SERVICES INC.
1989 43220 48840 5620 4603 3910 4927 1894 1665 4698 477 96 4317
1990 51519 42354 9165 5855 4352 10668 3017 1962 11723 376 102 11997
1991 58919 50176 8743 6979 4121 11601 3719 2879 12441 890 59 13272
1992 69568 64385 5183 9249 9434 4998 5595 5347 5246 1206 51 6401
1993 75659 86313 10654 11193 12036 11497 4390 5674 12781 1290 118 11609
1994 102561 95271 7290 16620 16299 7611 5737 6775 6573 1269 934 6908
1995 128110 110060 18050.1 19130.3 25222.8 11957.6 5191.26 16965.1 183.75 1826.73 392.09 1618.39
72
1996 151077 131542 19535 20601 22585 17551 7318 19755 5114 2368 239 7243
1997 182670 136448 46222 24569 27967 42824 5710 16715 31819 5477 333 36963
1998 183529 136915 46614 23895 26672 43837 5584 22228 27193 4661 382 31472
1999 194716 158734 35982 26248 31589 30641 8330 22800 16171 5368 424 21115
2000 249131 214657 34473.7 30430.5 36030.6 28873.5 12549.9 27216.3 14207.1 6860.84 549.53 20518.4
2001 266075 232058 34017 33334 39267 28084 9388 28563 8909 9125 633 17401
2002 325651 281484 44166.6 39744.5 46528 37383.1 8343.96 23289.5 22437.6 13795.4 810.93 35422
2003 438270 393618 44651.6 46733.6 55306.3 36079 16094.7 23933.1 28240.6 18482.5 848.28 45874.8
2004 593393 534410 58982.3 62434.1 72132.7 49283.6 20544.1 24066.8 45761 24326.3 1428.15 68659.2
2005 762484 628295 134189 74404.1 83795.5 124798 38959.1 28324 135433 27734.9 2349.39 160818
2006 969682 751936 217746 91999.2 100833 208912 51239.8 39485.2 220667 31577.6 2378.39 249866
Source: International Financial Statistics, IMF
63
Capital Account( Units: US$ Scale: Millions)
During CAPITAL CAPITAL CAPITAL DIRECT DIR. PORTFOLIO PORTFOLIO OTHER OTHER FINANCIAL NET ERRORS
Period ACCOUNT, ACCOUNT: ACCOUNT, INVESTMENT INVEST. INVESTMENT INVESTMENT INVESTMENT INVESTMENT ACCOUNT, AND
N.I.E.: DEBIT N.I.E. ABROAD INREP. ASSETS LIAB.,N.I.E. ASSETS LIAB.,N.I.E. N.I.E. OMISSIONS
CREDIT ECON.,
N.I.E.
1989 0 0 0 780 3393 320 140 229 1519 3723 114.61
1990 0 0 0 830 3487 241 0 231 1070 3255 3205.17
1991 0 0 0 913 4366 330 565 156 4500 8032 6766.93
1992 0 0 0 4000 11156 450 393 3267 4082 250 8211.15
1993 0 0 0 4400 27515 597 3646 2114 576 23474 10096.4
73
1996 0 0 0 2114 40180 628 2372 1126 1282 39966 15504
2000 n.a. 35.28 35.28 916 38399.3 11307.5 7316.74 43863.5 12328.9 1957.94 11747.9
2001 n.a. 54 54 6884 44241 20654 1249 20813 3933 34832 4732.46
2002 0 49.63 49.63 2518.41 49308 12094.5 1752.02 3076.74 1029.31 32341 7503.53
2003 0 48.08 48.08 152.28 47076.7 2983.12 8443.64 17921.5 12039.8 52774 17985.4
2004 0 69.35 69.35 1805.05 54936.5 6486.44 13203.4 1979.66 35928.1 110729 26834.2
2005 4155.15 53.35 4101.79 11305.7 79126.7 26156.9 21224.1 48947.4 44921.3 58862.1 16440.6
2006 4102.48 82.36 4020.11 17829.7 78094.7 110419 42861.2 31808.7 45117.9 6016.65 13047.5
64
Source: International Financial Statistics, IMF
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65
Overall( Units: US$ Scale: Millions)
Period Overall Financing Reserve Useof National China USGDP ChinaGDP
Balance Assets Fund Currency GDP deflator% (Billions)
Credit perUS deflator change
and Dollar %
Loans change
1989 479.39 479.39 558.37 78.98 4.72 8.1 3.78 1731.13
1990 12046.8 12046.8 11555 491.8 5.22 7.64 3.82 1934.78
1991 14537.1 14537.1 14083 454.03 5.43 6.87 3.55 2257.74
1992 2060.15 2060.15 2060.15 0 5.75 6.87 2.37 2756.52
1993 1768.62 1768.62 1768.62 0 5.8 17.6 2.21 3693.81
1994 30452.8 30452.8 30452.8 0 8.45 20.22 2.11 5021.74
1995 22469 22469 22469 0 8.32 13.48 2.08 6321.69
1996 31705 31705 31705 0 8.3 6.64 1.9 7416.36
1997 35857.2 35857.2 35857.2 0 8.28 0.75 1.77 8165.85
1998 6248.15 6248.15 6248.15 0 8.28 1.73 1.13 8653.16
1999 8652.45 8652.45 8652.45 0 8.28 3.71 1.47 8967.71
2000 10693.1 10693.1 10693.1 0 8.28 2.05 2.16 9921.46
2001 47446.5 47446.5 47446.5 0 8.28 2.05 2.26 10965.5
2002 75216.9 75216.9 75216.9 0 8.28 0.59 1.62 12033.3
2003 116586 116586 116586 0 8.28 2.59 2.15 13582.3
2004 206153 206153 206153 0 8.28 6.93 2.84 15987.8
2005 207342 207342 207342 0 8.07 3.78 3.34 18321.7
2006 246855 246855 246855 0 7.81 3.6 3.26 21192.4
2007 461691 461691 0 7.3 7.41 2.86 25730.6
2008 418993 418993 0 6.83 7.25 2.14 30067
Source: International Financial Statistics, IMF
a
This case was prepared by Jonathan Adongo, Ph.D Student in Economics at Middle Tennessee
State University.
Chapter 2
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4. Productivity and wages are high in industrialized countries relative to their developing
country counterparts. Does productivity or wages alone explain why nations trade with one
another? If not, elaborate your reasoning for the resurgence of trade based on the ratio of
productivity over wages rooted in the theory of comparative advantage.
5. Define trade deficit. How trade deficit is financed between any two countries?
6. In the year 2003-2004, the United States run the highest trade deficit with (a) Japan, (b) UK,
(c) China or (d) Germany.
7. The higher the trade deficit, the greater the upward pressure on the interest rates. T/F
8. What makes up the current account? Is the U.S. current account in deficit or surplus? Check
it out using balance of payments statistics at www.stls.frb.org for the most recent quarter.
9. The merchandise trade was -$135.533 billion for the 04/01/2003
Service trade was 12.153 billion for the 04/01/2003
Investment income was 5.874 billion for the 04/01/2003
Unilateral net transfer was -$16.369 billion for the 04/01/2003
Using the above statistics estimate current account for the 04/01/2003 period.
10. Capital account is highly interest sensitive T/F
11. Elaborate on the fundamental economic factors influencing the current account.
12. Central Banks hold portfolio of foreign currency in the foreign exchange reserve account to
manage currency exposure to speculative attack. T/F
13. Statistical discrepancy for errors and omissions is the balancing account that equates source
and use of funds in the BOP equation. T/F
14. Statistical discrepancy for errors and omissions captures all forms of illegal activities in the
BOP equation. T/F
15. Other things remaining the same, appreciation of Yen makes Japanese goods less expensive
for the U.S. consumers. T/F
16. Other things remaining the same, devaluation (depreciation) of Yen makes Japanese goods
less expensive for U.S. consumers. T/F
17. Other things remaining the same, appreciation of the U.S dollar makes John Deere products
less expensive for foreigners to buy. T/F
18. Other things remaining the same, weakening of the U.S. dollars makes caterpillar products
affordable for foreigners to buy. T/F
19. Weakening of the U.S. dollar is a boon for exporters and inflationary for the economy. T/F
20. The U.S. dollar strengthens against the Euro as the Federal Reserve Board raises short term
interest rates. T/F
21. When current account as a percentage of GDP is -4 percent. This is a sure sign that U.S.
dollar will appreciate. T/F
22. When current account is - 12 billion for France, this implies an excess supply of Euro. T/F
23. In the previous question the Euro is expected to weaken against foreign currencies. T/F
24. Deficit in the current account is financed at 4.5 percent, while the amount financed is
invested at 6 percent. This deficit is a value creating phenomena. T/F
25. Deficit in current account is financed at LIBOR plus 2 %, while the amount financed is
invested at LIBOR. This deficit is value destroying phenomena. T/F
26. Strom hedge fund invested in a one year Matador bond promising 9 percent interest rate. The
Euro is currently at $1.10/, however the consensus is that by the end of the year it is
expected to appreciate to $1.21/. Estimate the return realized by the U.S. based hedge fund
assuming the consensus holds.
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27. In the previous question assume Euro devalues to $.98/ by the end of the year. What will be
the realized return to the U.S. based hedge fund?
28. A U.S. investor investing in foreign stocks, bonds, or real estates will benefit if the
underlying foreign currency devalues. T/F
29. A foreign investor investing in the U.S. stocks, bonds, or real estates will not benefit if the
underlying foreign currency revalues against the U.S. dollar. T/F
30. Consider a U.S. hedge fund investing in Japanese Nikkei index. The index was at 9874 at the
time of investment. The index goes up to 11,230 by the end of the year. The yen was at
127/$ at the beginning and at 109/$ by the end of the year. Estimate the realized yield by
the U.S. hedge fund.
31. In the previous question the foreign exchange gain (loss) was -14 percent. T/F
32. In question 30 the capital gains on the index was +14 percent. T/F
33. Volatility of return realized by a U.S. investor is related: positively to the volatility of foreign
interest rates, volatility of foreign currency, positively or negatively to the covariance of the
foreign interest rate with the percentage change in foreign currency exchange rate. T/F
34. Indonesian (Rupiah) in July 1996 was 2400 R/$ in the November, the exchange rate stood at
3600 R/$. How much had the Rupiah devalued (revalued) in percentage term?
35. A run on a currency and speculative attack by arbitrageurs following deterioration in
economic fundamentals leads to --------.
36. Deficit in current account in excess of 4 percent of GDP, contributed to severe devaluation of
currencies in the South East Asian economies during 1996-97 currency crisis. T/F
37. Define money illusion. Did Argentinean savers experience money illusion? If not, explain
why?
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End Notes:
1
The Atlanta Fed eighth annual conference on financial markets: financial crises October 1719, 1999, in Sea
Island, Georgia.
2
On the other hand when the state of the economy falters shaking consumer confidence, thereby reducing economic
activities and producing weak economic fundamentals, which could lead to investors panic and financial crises in
the extreme see Radlet and Sachs (1998a, 1998b), Furman and Stiglitz (1998).
3
See Whitt (1998), who reaches similar conclusion.
4
Here the interest rate risk in dollars and pounds is defined as the variance of the underlying interest rates, while
assuming zero co-variance between the pound interest rate and percentage change in the exchange rate.
5
Federal Reserve Bank of Atlanta conference on: Financial Crises 1999, Atlanta.
6
See Kowai et.al (2001) Development Economic research Group World Bank.
7
See for exampleKrugman, (1979) and Obstfeld (1986) who argues that currency crises can occur in a country with
sound economic fundamentals due to the self-fulfilling prophecy modeled by Diamond and Dybvig, 1983).
8
The Link between banking and currency crisis is documented in a study by Kaminsky and Reinhart (1999).
9
See for example: McKinnon and Pill (1996) and Krugman (1998a).
10
Nominal interest rate averaged 16% in Thailand during 1991-96, while U.S risk free rate was 4.5% plus spread of
2.6% for currency and macro risk factors for the loans denominated in U.S. dollar.
11
The return on invested capital according to OECD (1998) estimate was below cost of capital for two thirds of
system of exchange rate arrangement similar to the Euro zone, eight countries maintain a currency board with an
implicit legislative requirement to maintain a specific currency at fixed exchange rate provided that the monetary
policy of the country is strictly in line with the policy of the currency to which it is pegged to, 7 countries are in a
system with a pegged exchange rate allowing +/- 1 percent fluctuation around the central rate, 8 countries are in a
system of crawling pegs allowing periodic adjustment to the central rate to which it is pegged to, 25 countries
maintain a managed float and more than 48 countries have independent float.
14
Wall Street Journal January 11, 2002.
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78
Chapter 3 Foreign Exchange Rate Dynamics: Managing Exposure
Chapter outline:
Foreign Exchange Rate, Market and Transaction
Spot
Outright Forward
Forward Rate Agreement FRA an Approximation
Hedging with FRA
Syndication of Euro Credit Loans
Foreign Exchange Swaps
Forward/ Forward Swap
Foreign Exchange Market Functions
Foreign Exchange Quotations
Arbitrage in the Foreign Exchange Market
Major Players in the Foreign Exchange Market
Triangular Arbitrage
Speculative Transactions
Settlement Risk
Spot Rate and the Law of One price
The Big Mac index
Central Bank Intervention
Relative Version of Purchasing Power Parity
Exchange Rate Pass-through
Spot Exchange Rate and Nominal Interest Rate
Forward Exchange Rate and Covered Interest Parity
Forward Premium or Discount for Selected Currencies
International Parity Relationship
Macro Determinants of the Exchange Rate
Real Exchange Rate
Real Exchange Rate and East Asian Currency crisis
End Notes
The foreign exchange market is the complex network of global over the counter (OTC)
institutions and structures that facilitates: exchange of one currency for another (transfer
risk) from hedgers to risk arbitrageurs and exchange rate determination. The foreign
currency exchange market is the largest and least regulated market. Unlike the stock and
62
79
commodity markets, it operates with no supervisory or regulatory oversight. The volume
of daily transactions in the spot, outright forward and swaps markets far exceeds the
volume of the daily stocks and bonds traded in the organized exchanges worldwide. The
amount of foreign exchange contracts: outright forward, FX swaps, currency swaps and
options was in excess of $57 trillion in 2007. On the other hand interest rate contracts:
forward rate agreements (FRAs), interest rate swaps and options have notional principal
of over $388 trillion. Credit derivatives; forward and swaps, credit default swaps (single-
63
80
Exhibit 3.1: Global Positions in OTC Derivatives
The foreign exchange market is geographically dispersed around the globe extending
from Sydney, Australia to Tokyo, Singapore and other East Asian countries, Moscow,
Western Europe, New York, Chicago and San Francisco. The market is relatively thin
when trading begins in the Far East and is far more liquid when the last hours of trading
in Europe coincide with trading in the United States due to differences in the time zones.
81
The proportion of the individual currency daily turnover in the global foreign exchange
The U.S. dollar makes up 45, 44, and 43.5 percent of shares of total daily turnover of the
global foreign exchange market activity for the 2001 through 2007 periods, respectively
.1 The Euro and Japanese yen are the second and third currency as the percentage of total
in the period of 1995-98 in terms of their respective position in the global foreign
82
65
Foreign Exchange Transactions
transactions. The global, daily foreign exchange market turnover by types of transaction
as reported by the Bank for International Settlements in 1992 through 2007 is depicted in
Exhibit 3.3. Average daily turnover for spot, outright forward and swaps was $1,005,
Average daily turnover has grown by 59 percent between 2004 and 2007 for spot
transactions. For outright forward transactions over the same period the growth rate is 73
percent, while foreign exchange swap transactions have surpassed the other two
transactions with a growth rate of 79 percent as reported by the Bank for International
Settlement.
Spot Transactions: A spot transaction involves the exchange of one currency for
another. For example, the U.S. dollar with the Japanese yen at an agreed exchange rate to
be settled in cash in two business days between two counter parties. Spot transactions
83 66
accounts for nearly 31 percent of all transactions in the foreign currency exchange market
in 2007. For example Kodak needs to pay 10 million to a British supplier in a spot
transaction. The foreign exchange dealer in New York has quoted the pound as follows:
$1.5210-$1.5240
Kodak pays $15.24 million U.S. dollar in two business days to settle the spot transaction
at the ask rate of $1.5240. The foreign exchange dealers profit from the above spread in
Outright Forward: This over the counter transaction involves the exchange of one
currency, for example, the British with the euro at the forward exchange rate
determined today for the delivery to take place for cash settlement in more than two
business days. Nearly 11.25 percent of all transactions in the foreign exchange (FOREX)
forward contract with the Bank of America today to sell 350 million yen at a forward
price determined today and Nissan will deliver yen in 31 days to the Bank of America.
The Bank has the following quote for 31days yen forward:
121.32-122.40
In 31 days Nissan delivers the yen and receives $2.8595 million at the ask price of 122.40
/$. The un-hedged payoff is risky and depends on the value of the yen when it is
converted to U.S. dollars, however, the hedged pay-off at the ask price of 122.40 yen is
locked in and Nissan will receive $2.8595 million at the maturity of the forward contract
84
67
Table 3.1: Forward Hedging
yen/$ Un-hedged Forward hedge
123 2.845528 2.859477
124 2.822581 2.859477
121 2.892562 2.859477
127 2.755906 2.859477
122.4 2.859477 2.859477
130 2.692308 2.859477
122.1 2.866503 2.859477
115 3.043478 $2.86
exchange rate prevailing on the maturity of the yen receivable. It is possible for the un-
hedged position to provide more dollar receivables at the exchange rate below the
forward rate ask price of 122.40 yen/$, however, at the exchange rate above 122.40 the
hedged position with an over the counter forward contract provides more dollars for the
2.9
e
l 2.85
b
a
iv
e 2.8
c
e
R
r 2.75
a
ll
o
D 2.7
2.65
120 122 124 126 128 130 132
Yen per Dollar
85 68
The following excerpt from The Wall Street Journal provides an interesting story of the
changing corporate expectations and the strategy they follow for hedging their
Companies "are not as concerned" now that the yen will slip towards 140.00 by mid-
year and some instead expect the Japanese currency to hold in a trading range of between
120.00 and 135.00, Woolfolk added. U.S. companies that obtain a large chunk of their
revenues in foreign currency engage in hedging to protect against swings in exchange
rates that may erode their earnings, mainly by buying forward or option contracts that
insure against currency movements beyond specific levels.
The 30 days forward rate prevailing in 60 days in dollar and other currencies can be
Ninety-day fixed rate borrowing can be defined as the average of the 60-days rate and
the 30- day forward rate 60-days hence. To manufacture a forward rate, the long- term
rate has to be set equal to the geometric average of the short-term rates. For example, a
90- day rate has to be equal to the geometric average of a 60-day rate and 30-day forward
rate prevailing 30 days hence. However, simple approximation in the Equation 3.1
Where
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F- is the forward rate.
Hedging with FRA: The forward rate agreement is an over the counter instrument to
hedge the interest rate risk. The total daily transaction in the over the counter, inter-bank
market for FRA was $209 and $362 billion dollar as of 2004 and 2007, respectively, and
as a percentage of total 11 and 11.27 percent during the same time periods.
The bank selling FRA is guaranteeing the 30-day forward at 7.125 percent in the
above example. The buyer of FRA is indirectly guaranteed the rate at 7.125 percent in 60
days. However, if the actual rate exceeds the agreed rate say by 1.5 percent in 60 days the
losing party, in this case the buyer of the FRA gets compensated by the present value of
the difference in 60 days and the buyer of the FRA has to pay at the spot 1.5 percent more
87 70
to acquire the capital needed. If the rate in 60 days falls by 1.375 percent, the buyer of the
FRA in 30 days will be borrowing at spot at 1.375 percent below the agreed rate and the
present value of this amount has to be sent to the seller of the FRA in 60 days.
Example: Assuming the buyer of the FRA wished to borrow $10 million in 60 days for
only 30 days and in order to protect himself against rising interest rate buys FRA at 7.125
percent and in 60 days the 30-days rate at the spot is 9.125%. The losing party, in this
case the buyer of the FRA, will receive the present value of the difference in 60 days as
follows:
= $16,540.95
The buyer of FRA in 60-days will be borrowing $10 million at 9.125 percent for 30-days.
The interest cost will be equal to $76,041.66, however in 60 days she will receive
$16,540.95 from the seller of the FRA that can be invested at the borrowers opportunity
cost. Assuming the money received can be invested at 9.125 percent, the total out of
pocket cost of this loan will be equal to $59,375, which is exactly equal to interest cost of
the loan at 7.125 percent. The buyer of the FRA is at locked in at 7.125 percent no matter
Euro credit loans are short term or a medium term loan that is extended to multinational
dollar denominated loans that are originated in London, the base rate is LIBOR. The
88 71
borrower usually pays say 1-year LIBOR plus a spread that is dependent on credit quality
of the borrower. Since the size of the Euro credit loan is very high, lending banks form
syndication spreading risk and reward for the loan. The lending banks are also transfer
interest rate risk to the borrower by pricing the loan at floating rate of LIBOR or any
Case Study: Consider a multinational corporation who wishes to borrow a $1.25 billion
jumbo loan in the Eurodollar market at LIBOR plus 1.25 percent over a 7-year period
with an up-front fee of 1.25 percent (origination fee). The lead arranger bank Goldman
Sachs retains $100 million in its book and spreads the risk and reward proportionally
among the sub-participants as illustrated in the following Figure. The arranger bank
books $4.125 million arranger fee of the total up-front fee of $15.625 million collected
89 72
Participation Process in Syndication of Euro Credit Loan
Borrower
$1.25 billion
Questions:
1. Suppose 1-year LIBOR by the end of first year is equal to 3.75 percent. How
much interest is due to Goldman Sachs by borrower at the end of second year?
2. The $100 million loan in the Goldman Sachs book is 100 percent risk weighted,
requiring minimum 8 percent regulatory capital by the bank regulator. That means
Goldman Sachs has to put up 8 million of its own capital and borrow remaining
$92 million in the interbank market at the cost of 1-year LIBOR. What is the
return on equity for the Goldman Sachs for funding $100 million of the
syndication loan?
3. One of the sub-participating banks is a UAE bank who funded $24 million of the
above syndication loan. The regulator in the UAE requires 15 percent regulatory
capital. What is the return on equity for this bank at the end of second year
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73
provided that this bank has funding cost at the rate of LIBOR +25 bps (100 basis
4. Describe how the borrower in the above syndication loan will manage its
example, the U.S. dollar for the Singapore dollar in principal amount only, in two
business days, at the predetermined exchange rate for cash settlement at the expiration of
the contract (the short leg), and reversal of the exchange of the same two currencies at the
rate agreed by the two parties at a date in future, say three business days known as (long
leg), provided that the rate for the long leg is usually different from the rate prevailing at
the conclusion of the short leg. The above foreign exchange swap described is a spot /
forward swap. When the short leg of the swaps is more than 2 business days, then the
A FOREX swap can also be described as the portfolio of long and short positions
entered into, simultaneously, in two different dates prevailing in the future say 30 and 60
days and at the rate determined today for the respective, that is, 30 and 60 day forward
rate. In the over the counter market for forward and swaps any particular date can be
Example: An importer needs 1,000,000 in 60-days for only 30 days to pay for an
outstanding obligations entered with a British supplier. The importer can buy 30-days
FRA in 60-days as of today, can wait and borrow in 60-days by paying the prevailing
spot rate or she can enter into foreign exchange swap agreement. Suppose the importer
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sells 1,000,000 90 days forward at $1.5210/ and simultaneously buys 1,000,000
days at a fully collateralized basis at the U.S. rate of 5.36 percent per annum. This is the
implied 30-days forward repo-rate as the importer is selling pounds 90-days forward with
The actual 30-days rate in 60 days could be higher or lower than 5.36 percent.
Furthermore, the un-hedged position produces availability risk (the risk that the capital
may not be easily available) for the importer that is mitigated in the forward/future
markets. The notional principal in the above example is 1,000,000 and the ratio of the
buying rate of $1.5278/ and the selling rate of $1.5210/ after being annualized is the
predetermined rate that fixes (locks) the cost of borrowing. Foreign exchange swaps
Example: Forward/ Forward Swap. Haynes Company needs to borrow 100,000 pounds
for 30 days 60 days from today. Haynes can wait and borrow at the current market rate in
60 days, which could be higher or lower than the prevailing 30 days rate or could enter
into forward/forward swaps that can fix the cost of borrowing today. Haynes enters into a
selling 90 days pounds forward for $1.52/. Haynes pays $152,800 and receives
$152,000 and has the use of 100,000 pounds for 30 days at fully collateralized basis at the
92 75
rate of 6.32 percent annualized. Haynes is paying dollars and receiving pounds and the
swap dealer is paying pounds and receiving dollars as illustrated in the following figure.
$1.52/
Swap Dealer Haynes
$1.5280/
Foreign Exchange Market Functions: In the previous section the type of transactions in
the foreign exchange market was analyzed. Each transaction is intended to provide a
power from one party to another and vice versa. The forward transaction is intended to
transfer risk from one party to another, transferring risk is hedging that is intended to
reduce the exposure to foreign exchange risk. Finally, a swap transaction is essentially
Foreign Exchange Quotations: Foreign exchange daily quotations are reported in the
major newspapers for all major currencies worldwide. The currencies are quoted in terms
of U.S. dollar per foreign currency known as direct quote or foreign currency per U.S.
dollar equivalent known as indirect quote or European Terms. The direct quote
provides the value of the foreign currencies from the perspective of the U.S. investors in
terms of dollar per foreign currency, while indirect quote refers the foreign currency
value per U.S. dollar from the perspective of foreign investors. Exhibit 3.5 provides the
direct and indirect quotations for Japanese yen and British pound spot, 1-month through
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Exhibit 3.5: Foreign Exchange Quotations
$/Yen Yen/$
Fri Thu Fri Thu
Japan (yen) .007942 .007802 125.92 128.17
1- month forward .007954 .007814 125.72 127.97
3- month forward .007979 .007839 125.32 127.57
6- month forward .008025 .007883 124.61 126.85
Britain (pound ) 1.4582 1.4570 .6858 .6863
1- month forward 1.4556 1.4544 .6870 .6876
3-month forward 1.4501 1.4489 .6896 .6902
6-month forward 1.4421 1.4408 .6934 .6941
------------------------------------------------------------------------------------------------------------
Source: Investors Business daily, May 17, 2002.
The forward exchange rate as a measure of the market consensus of the future
exchange rate for the British pound and Japanese yen are indicating that the dollar is
expected to strengthen against the pound, while weaken against the yen in the next 1
through 6 months as of Friday May 16, 2002 based on current and expected future
information. The pound is said to be trading at discount against the U.S. dollar in the
forward market for 30 to 180 days forward as reflected in the direct quote. The dollar is
trading at a premium against the pound and at a discount against the yen that is reflected
in the indirect quote (European Term) in Exhibit 3.5. The consensus for the future
exchange (forward) rate may change as new information comes to the market and
individuals and institutions evaluate that information and push the exchange rate into the
new direction.
Cross- Exchange Rate: Based on the Exhibit 3.5 cross- currency exchange rates can be
estimated from the perspective of the Japanese investor as yen/$ and British investor as
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77
The spot exchange rate yen per pound should be 183.61; deviation provides an
opportunity for risk-less arbitrage in the currency exchange market. Likewise, the various
cross currency forward rates can be calculated as the ratio of the 1-month, 3-month or 6-
The above cross currency exchange rates are the direct quote from the Japanese
investors perspective and the indirect quote will be the ratio of one over the direct quote.
The cross currency forward rates as a forecast of the future rates hinting an appreciation
of the yen against the British pound as fewer yen are required to pay for one unit of the
British pound.
Bid and Offer Quotations in the Inter-Bank Market: In the over the counter market
for foreign exchange the quotes for the spot and forward transactions are provided by
major foreign exchange dealers in terms of the bid (buy) and offer (ask) price on the
major currencies in which the dealer is making the market. The dealer stands to buy at the
bid price and simultaneously sell at the offer price earning an arbitrage profit. The
currency may be quoted outright with a price that reflects all decimals, or it may be
Exhibit 3.6: Spot and forward Quotations for Yen and British Pound in the Inter-Bank
Market
95 78
1-month forward -20 to - 27
3-month forward -60 to - 52
6-month forward -131 to - 118
Bid Offer Bid Offer
Britain (pound ) spot 1.4582 1.4599 .6849784 .685777
1- month forward 1.4556 1.4578 .6859652 .685777
3-month forward 1.4501 1.4545 .6875215 .6896076
6-month forward 1.4421 1.4471 .6910373 .6934332
Points quotations
1-month forward -26 to - 21
3-month forward -81 to - 54
6-month forward -161 to - 128
In the inter-bank market for foreign exchange the dealer may quote outright as
$1.4582-99 per unit of British pound. In this case the dealer is indicating that he is willing
to sell pound at $1.4599 and simultaneously buy at the bid price of $1.4582, while
161 to 128. These points have a negative sign signaling deductions from the spot rate
to arrive at the respective forward rate of varying maturities. When the points quotations
are given and it is positive then the dealer is signaling that the points need to be added to
Arbitrage in the Foreign Exchange Market: Temporary deviations in the spot as well
as forward rates provide an opportunity for the major foreign exchange dealers and other
individuals and corporations to engage in arbitrage. Major banks around the world have
trading divisions with currency traders around the clock making markets in foreign
currency exchange for their clients as well as their own account. The compensations are
However, central banks foreign exchange dealers with fixed remuneration make the
market in millions of dollars in major currencies without being concerned about profit or
96 79
loss in a given daily transactions. The central bank dealers buy and sell a particular
currency in chunks of $10 to $20 million or more dollars in order to achieve certain
objectives, (i.e., stability, reduced volatility as well as pushing the currency in certain
Major Players in the Foreign Exchange Market: The market share of currency trading
This Exhibit shows that J.P. Moragan, Citigroup and Deutsche Bank nearly have 30
percent of the $1.2 trillion daily trading of the foreign exchange market transactions
involving spot, forward and swap transactions as seen in Exhibit 3.8. Currency trading by
central banks and others account for over 40 percent of the total foreign exchange
trading. The fall in the daily turnover from a high of 1.5 to 1.2 trillion reflects the
Exhibit 3.7: Foreign Exchange Market Major Players and Distribution of Their
Shares
Others
Barclays
Major FOREX Dealers
Bank of America
Morgan Stanley
State Street
U.B.S. Warburg
C.S.F.B.
Goldman Sachs
Deutsche Bank
Citigroup
J.P. Morgan
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Source: Euromoney: Bank for International Settlements
spot,forward,swaps
$1.50
$1.00
Trillions
$0.50
$0.00
Year
Triangular Arbitrage: It is possible that the foreign, spot or forward exchange rate
delivery in the inter-bank market can be out of sync temporarily and arbitrageurs try to
align the currency by buying and selling the under-valued or over-valued currency.
Suppose the bid ask price for the pound/$, yen/$ and yen/ is quoted as follows by banks
The yen appears to be non-aligned as the cross-currency implied exchange rate for the bid
and offer price for yen/ respectively has to be equal to 179.70-182.24. Using the dollar,
an arbitrageur needs to buy pounds and then use pounds to buy the cheap currency yen as
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the pound is quoted at a premium against the yen in the above cross currency inter-bank
diagram.
$1,000,000.00
$1,003,292.77
126,354,835.5 691,030
The above triangular arbitrage generates $3,292.77 profit provided that the arbitrageur
started with $1million and follows the above process illustrated in the diagram.
selling currency (long or short), expecting currency to appreciate or depreciate in the near
future. For example, a currency trader is expecting pounds to devalue in the next 60 to 90
days based on the private forecast of a weaker pound. He sells 2 million 90 days
forward at1.562/, the pound appreciates to $1.57812/ in the next three months against
the expectation of the speculator at which time the short seller buys pounds at the spot
market at $1.57812/. The loss in this speculative transaction is equal -$32,040. Had the
speculator taken the opposite position that is buying pounds 90 days forward at $1.562/
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and selling the pounds three months later at $1.5781/, the speculator would have
Profit (Loss)
Short in Long in
Foreign Exchange Loss: The speculative currency trading losses suffered by Allied
Irish Banks U.S. subsidiary in February was $750 million. An FX trader at Irelands
largest bank had taken a huge long position on the yens rise in 2001, but when the dollar
Settlement Risk
Settlement risk is one of the important issues in the FX sector of the over the counter
market, and with the global launch of the Continuous Linked Settlement (CLS) network
in July 2002, the FX payment and collection process is set to be aligned. To date, the
settlement of the FX trade in different time zones resulted in a delay between the pay and
receive legs.3 The CLS mechanism allows the two payment legs of the FX trade to be
made simultaneously. This eliminates the time lag between the two legs of the FX trade,
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Spot Rate and the Law of One price: An exchange rate is the ratio of two prices for an
identical basket of goods and services denominated in two different currencies. The
dynamics of the two baskets in reality are different as each basket has to respond to the
underlying fundamentals i.e., macro economic factors discussed in the previous chapter
as well as the factors unique to a particular economy (i.e., micro factors and the type of
According to The Law of One Price assets of the same risk class are expected to provide
the same rate of return, otherwise, arbitrageurs simultaneously buy inexpensive assets
and sell short the overvalued asset and earn risk-less profit. Assuming a basket of goods
and services is currently priced in the U.K at 100 and the same identical goods and
services in U.S. is currently priced at $150. It then follows from The Law of One Price an
implied exchange rate of $1.50 per British pound as the ratio of the two baskets of goods
The spot exchange rate implied $/ in Equation 3.2 in the above analysis is predicated
on the assumption that the price in the respective country is determined in a competitive
market and absence of any imperfections i.e., government intervention and regulatory
impediments. This is the absolute version of the Purchasing Power Parity. The
exchange rate implied in Equation 3.2 is the ratio of the two price indices. The identical
purchasing power in dollars and pounds for U.S. and U.K residents in the Equation 3.2 is
predicated on the assumption that the exchange rate, $/, is indeed the ratio of the two
price indices in dollars and pounds not distorted by market imperfections. Any deviations
101 84
The Big Mac index: The Economist has devised an index of Big Mac burgers
Corporation worldwide. The price of the burger is usually the simple average of the
prices in 120-different locations worldwide. According to The Law of One Price the price
of identical basket of goods in this case Big Mac has to be equal in dollar term
worldwide. Unlike gold, which is traded worldwide, the Big Mac is nontradeable, when
there is deviation from The Law of One Price and arbitrageurs are unable to take
advantage of price disparity in different location worldwide. For example, the ratio of the
prices in the U.S and U.K for the Big Mac is an implied parity exchange rate and as
currency is over or undervalued. Exhibit 3.10 shows the Big Mac Index for the 2009
period.
According to the Big Mac index the dollar appears to be overvalued against Argentinas
Peso by 15 percent as the price of Big Mac is equal to $3.02 and $3.57 respectively in
The dollar appears to be overvalued against most emerging market economies, while it is
undervalued against the Swiss Franc by 68%, the British pound by 3% and the Euro area
by 29 percent. The truth is that the price in the market for real assets is not usually
consumers.
102
However, supply and demand forces determine the price in the financial market for
financial assets such as stocks and bonds competitively, with central banks reacting to
economic fundamentals by changing the short-term interest rates, which inversely affect
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Exhibit 3.10: Big Mac Index 2009
104
Central Bank Intervention: The foreign exchange market is the market where the price
of a currency is determined by supply and demand forces for the independently floating
currencies and needs to be distinguished with the stock market. While, government
intervention in the stock market has been only limited to extreme cases involving events
triggering a shut down of the market, the central bank intervenes in the foreign exchange
market in order to maintain an exchange rate within a desirable range whether or not such
attempts proves to be successful or not. The U.S. Central Bank in the period 1982 to 1985
on three occasions attempted to weaken the U.S. dollar without much success by selling
dollars to buy other currencies. While, the coordinated policy can prove successful in
realigning currency value, the intervention by an individual Central Bank may prove
futile. The events of the 1990s and various crises provide evidence in support of the
above arguments that intervention by Central Banks usually distorts the currency values
for only short periods and economic fundamentals coupled with expectations ultimately
Exhibit 3.11 provides the level of the U.S. dollar index against major currencies
during 1994-2009 periods. The index of dollar continued to appreciate against most
major currencies from 1997 through 2002. From the recession of 2001 through to the
recession of 2008, the dollar index continued to gradually weaken falling below 100 of
1997, the base year. There has been some spike in the dollar value as the European
Central Bank and Central Bank of Japan undertook significant intervention to keep the
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Exhibit 3.11: Trade Weighted Index of U.S. Dollar
Although the U.S. dollar plunged in late 2003 through 2007 the rise in price of
imports was unusually slow or weak as foreign exporters tried to cut their profit margins
in order to maintain their market shares as pointed out in several studies.5 The pass-
through from the U.S. exchange rate to import price and volume was delayed for nearly
as the trade balance deteriorates following an initial devaluation of currency and later
improvement in trade balance as exports become attractive and import price rises after a
long delay accompanied by a fall in import volumes as portrayed in the Exhibit 3.12.
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89
Exhibit 3.12: J - Curve
Time
Suppose at time t0 the central bank devalues the currency, the merchandise trade
balance actually deteriorates following devaluation to lower level at time t1. However
improvement in the balance is delayed until time t2. This long delay for U.S. data takes
nearly 14 to 18 months from the initial devaluation to the improvement in the trade
Exhibit 3.13 provides the monthly percentage change in the trade- weighted index of
U.S. dollars against major trading partners from 1973 to 2002. Rising volatility, lack of
any particular patterns and randomness of the percentage change in the exchange rate is
the result of the independently floating exchange rate arrangement of the early 1970s to
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90
Exhibit 3.12 Percentage Change in the Value of Trade Weighted
Index of U.S. Dollar 1973-2002
0.05
0.04
0.03
0.02
0.01
0
-0.01
-0.02
-0.03
-0.04
-0.05
1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002
The set of all prices for all goods and services in the real and financial markets that
make up the price index are determined uniquely in each sub-segment of the market
subject to the constraint imposed by the environment in which they operate. Some prices
are very competitive in one market, while the same product produced elsewhere is not.
Some products are uniquely produced in one market and not produced at all in other
markets due to technological constraints. The exchange rate in practice is the ratio of the
Example: Assume there are only five products produced in United States and United
Kingdom. They are oil, steel, soybean, milk and chicken. Suppose U.S provides a direct
subsidy to dairy and soybean producers and indirect subsidy to steel producers in the
form of giving them protection from cheaper steel produced overseas by imposing a tariff
and quota on steel imported from other countries. However, the U.K. does not provide
any subsidy, direct or indirect, to its own producers with the exception of oil, which is
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108
indirectly subsidized. The lower price for dairy products in the U.S. is distorted and does
not take into account the true cost of production. The higher price for steel in the U.S. is
also distorted by giving local producers an opportunity to raise their price to match the
Therefore, the price index in the U.S. and U.K is distorted leading to a distorted exchange
rate between dollars and pounds. Having recognized the imperfections induced by
government actions in distorting prices, let us analyze the impact of inflation, interest
rates and other factors such as competition and institutional arrangements on the
exchange rate.
Relative Version of Purchasing Power Parity: In this context, assuming prices are
rising at a faster rate in the U.K. than the U.S. requiring 110 to acquire the same basket
of goods and services that used to cost 100 one year ago in an earlier example, while the
identical basket in the U.S requires $157.50 that used to cost $150 one year earlier. The
implied exchange rate based on the Law of One Price has to be equal to the ratio of
$157.50/110 or $1.4318/.
The loss of purchasing power in the U.K in this scenario is due to higher inflation
relative to the United States, requiring 10 percent more pounds in order to purchase the
same basket of goods. The U.S. consumers also experience a loss of purchasing power in
dollars by 5 percent, as they need $157.50 to acquire the same basket of goods and
services that only used to cost $150 domestically. However, there will be a transfer of
purchasing power from the U.K to the U.S (provided that the exchange rate adjusts to a
new equilibrium as predicated by the PPP) as British goods become relatively more
attractive as import prices fall and export prices go up (pass through is complete) due to
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92
relative loss of purchasing power by the U.K resident and relative gain of purchasing
power by the U.S. resident buying cheaper imports as illustrated in Exhibit 3.14.
$1.50/ $1.4318/
U.K
100 10% 110
Inflation
Foreign exchange markets therefore transfer purchasing power between two countries
as spot and the expected future exchange rate changes due to changing economic
fundamentals and changes in expectations. The relative PPP holds when the implied
exchange rate derived is the ratio of the prices at time 1 (future price) in the above exhibit
denominated in dollars and pounds, that is $1.4318/. Therefore it follows from Exhibit
3.13, that the expected or future exchange rate S1 is related to current spot rate S0 times
the ratio of one plus the respective inflation rates $ , f in the U.S and the U.K, that is
The approximate version of the relative PPP implies that, the percentage change in the
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Where, S1 and S0 are the direct quote spot rates at time 1 and zero and $ and f are the
inflation rates in dollars and foreign currency, respectively. The graphical representation
(S1- S0)/ S0
PPP Line
-5% ($ f)
Inflation differentials
-5%
The PPP line is the locus of all points where the percentage change in direct quote
exchange rates is identical to the inflation differential denominated in dollars and foreign
currency. Deviations from the parity line provide an opportunity to buy goods and
services from the country whose currency has not appreciated or depreciated according to
the inflation differentials and the violation of The Law of One Price. For example points
to the left of PPP line such as A where inflation differentials are positive say 3 percent
(U.S. rate is higher than foreign rate by 3 percent), while foreign currency has
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94
The above scenario makes foreign goods and services more expensive for the U.S. to
purchase and likewise U.S. goods and services becomes attractive for foreigners to
purchase until the parity is restored i.e. U.S. dollar appreciates against foreign currency
by 1 percent to maintain parity. The loss of purchasing power by U.S. residents in buying
foreign goods and services in the above scenario persuades them to withhold buying
expensive imports. The gain in purchasing power of the foreign individuals due to the
fact that their currency buys more of the U.S. dollar induces them to purchase more
goods and services imported from the U.S. The higher demand for U.S. goods and
services leads to a greater demand for dollars and its appreciation. To the left of PPP line
purchasing power transfers from the U.S. to foreign countries continues until the
To the right of the PPP line such as B, there is a transfer of purchasing power from
foreign countries to the U.S. as foreign currency fails to appreciate by the amount of the
inflation differential making foreign goods and services relatively more attractive for the
U.S. to buy. This scenario continues until parity is achieved and there is no transfer of
purchasing power from one country to the other. Most evidence tends to reject the
relative version of the PPP in the short run, while providing some support for it in the
long term.7
Exchange Rate Pass-through: The relative version of the PPP requires that the change
in price be reflected immediately in the exchange rate. The fact is that the price changes
are not reflected in exchange rate and the pass through is incomplete. The competition
and agency relationship that defines the contractual relationship between exporter and
importer and currency denomination of imports affects the degree of the pass-through.
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95
For example, Japans multinational corporations at times of rising yen value have cut
their base price in yen in order to maintain their share of market in the U.S. and Europe.
Example: Suppose Lexus is priced at 3.5 million yen, the current spot is 100/$.
Assuming yen appreciates to 90/$, the dollar price of the Lexus will rise from $35,000
to $38,889 in a complete pass-through. However, at this price Lexus might lose business
to competing cars and therefore, the price in the U.S. may go up to $37,100. The price in
the U.S. is only increased by 6 percent while the yen appreciated by 11.11 percent. The
pass-through is incomplete and the degree of pass through as the ratio of the change in
U.S. price and the change in the exchange rate or .06/. 1111, is 54 percent.
An exporter has three options as far as how much of the increase in import price due to its
1. Absorb all of the increase in import price by cutting its profit margin and or cost,
zero pass-through.
2. Absorb none of the increase in import price and passes all of the increase to
3. Absorb some of the increase and pass the remaining to the importer, partial pass-
Exhibit 3.16 provides the yen per dollar index over the 1970 to 2009 period as
reported by Federal Reserve Bank of Saint Louis. The yen continued to revalue against
the U.S. dollar until mid 1995 reaching nearly 80 yen per dollar. The pass-through from
the exchange rate to import price has been partial as major Japanese multinational
companies such as Sony, Mitsubishi, Komatsu, Toyota and others have absorbed some of
the increase in import price since, in a complete pass through the price of Japanese import
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96
price would have been extremely uncompetitive. The yen revalued in nominal terms from
The invoicing practice also helps to explain the partial pass-through. The International
Monetary Fund reports that nearly 70 percent of U.S. imports is denominated in dollars.
For example, 48 percent of Japanese exports were not denominated in yen in 1986
according to IMF (1987). Furthermore, U.S. imports are acquired in contracts that fix
prices in dollar terms for extended periods that delay the pass-through from exchange
Yang (1997) has provided new evidence in favor of the partial exchange rate pass-
through in the U.S. manufacturing industries during the sample period 1980-91 as shown
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97
in Exhibit 3.17. The coefficients for the complete pass-through are expected to be equal
percent for Stone, Glass, and Concrete products and as low as 8 percent for lumber and
wood products. The average coefficients for all industries is equal to 42 percent, implying
that for every one percent change in the U.S dollar 0.042 percent of the change is passed
to the importer and the manufacturer absorbs 0.058 percent of the change in the price.
The industries with products that are highly capital intensive (specialized products) are
able to pass through the greater proportion of the change in price due to change in
exchange rate to the importer, while industries in which there is stiff competition from
other producers overseas find it difficult to pass-through the change in exchange rate to
the price they charge the importer. For example, U.S. apparel faces tough competition
from their southern neighbors as the small coefficient of pass-through of 10.68 percent
reveals. It looks like U.S. apparels absorb nearly 89.32 of the increase in price by cutting
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Exhibit 3.17: Pass-through coefficient for selected industries
Industry Code (SIC) Industry Pass-Through
Coefficient
20 Food and kindred products 0.2485
22 Textile mill products 0.3124
23 Apparels 0.1068
24 Lumber and wood products 0.0812
25 Furniture and fixtures 0.3576
28 Chemicals and allied products 0.5312
30 Rubber and plastic products 0.5318
31 Leather products 0.3144
32 Stone, glass, concrete products 0.8843
33 Primary metal industries 0.2123
34 Fabricated metal products 0.3138
35 Machinery, except electrical 0.7559
36 Electrical and electronic machinery 0.3914
37 Transportation equipment 0.3583
38 Measurement instruments 0.7256
39 Miscellaneous manufacturing 0.2765
Average 0.4205
Spot Exchange Rate and Nominal Interest Rate: The capital account, which is the
financing vehicle for the current account, is interest sensitive. Capital moves from one
location to another not only at the expectation of the higher yield but also promise of the
higher returns. Assuming a frictionless, competitive, capital market the real return on the
capital after adjusting for the change in exchange rate and inflation has to be the same
across the globe. However, the evidence is to the contrary and real rate differentials are
significant and the market is far from the textbook definition of perfectly competitive.9
Example: Assume nominal interest rates in the U.S. and Euro zone are expected to be 4
and 5 percent respectively next year and current spot rate is $1/ euro. Invoking The Law
of One Price requires that the terminal (future) value of the investment in dollar and euro
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116
be identical in future i.e. there should be parity in dollar and euro returns. Let us start
The exchange rate S1 is the ratio of the future value of two investments denominated in
dollars and Euros at the respective expected interest rate of 4 and 5 percent at time 1. The
International Fisher Parity (IFP) is maintained provided that the expected future
exchange rate is equal to the ratio of the two investments as illustrated in Exhibit 3.18. In
the above scenario regardless of the currency of chosen the return realized in dollars and
Euros will be the same at 4 percent for a U.S. investor trying to take advantage of higher
In the above example if a U.S. investor converts $100 to 100 euro at the current spot
rate and invests the euro at 5 percent, the proceeds of 105 Euros will convert to U.S.
dollars at $.9905/euro at the expected future exchange and will be equal to $104, which is
identical to the investment at home at the home rate of 4 percent. It then follows that the
expected spot rate in the future S1 is the ratio of two present values (the current spot rate
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100
of S0 times the ratio of the one plus nominal interest rate denominated in dollars and
Where, R$ and Rf are the interest rates in dollars and foreign currency.
The crucial assumption in the maintenance of the IFP is predicated on the equality of the
real interest rates worldwide as well as nominal interest rates to be an unbiased predictor
of future inflation.10 The real rate of interest is related to productivity of labor and capital
and there are vast sectoral differences in a given economys labor productivity as well as
differences worldwide.
Forward Exchange Rate and Covered Interest Parity: There is a great deal of
empirical evidence in support of or against the efficiency of the foreign exchange for
forward rates. The parity exists when the forward rate is the rational expectation of all
individuals and embodies no risk premium over time. Suppose the expected interest rate
in dollars and pounds will be 4.5 and 6 percent respectively in one period in future. The
current spot rate is $1.4582/ which is the ratio of two identical baskets of goods and
services denominated in dollars and foreign currency and priced today (ratio of two
present values). Invoking rational expectations and zero risk premiums, the forward rate
has to be equal to the ratio of two future values denominated in dollars and pounds. In
this example assuming we invest 100 and its dollar equivalent $145.82 in the respective
currency as shown in Exhibit 3.19. The forward interest rate parity (IRP) relationship as
illustrated in Exhibit 3.19 is defined as the ratio of two future values denominated in
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Exhibit 3.19 Forward Interest Rate Parity
S0 =$1.4582/ F=$1.4376/
106
100 6% 106
U.K
The forward premium or discount (F S0)/ S0 in direct quote and in equilibrium has to be
The forward premium or discount (S0 F)/ F is in the European term and may need to be
annualized.
The forward pound in the above exhibit is at a discount of approximately 1.5 percent
since, fewer dollars are required to buy the pound and the interest rates differential is also
1.5 percent as illustrated in the Interest rate parity IRP relationship below in Exhibit
3.20.
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Exhibit 3.20: IRP Relationship
(F S0)/ S0
IRP Line
X
Y
-1.5%
( R$ Rf)
-1.5 %
The IRP line is the locus of all points that are in equilibrium where the forward
premium or discount has to be equal to the interest rate differential and any temporary
deviations results in a risk-less arbitrage. For example, any point to the left of the IRP
line such as X indicates that the forward premium or discount in foreign currency exceeds
the interest rate differential in dollars and foreign currency and investors realize risk-less
arbitrage profit by borrowing dollars and investing in foreign currency and selling foreign
currency forward. In Exhibit 3.19 suppose the actual quoted forward exchange rate is
equal to $1.50/. The forward pound is at a premium. Other things remaining the same
(interest rates differential of 1.5 percent and borrowing $145.82 to buy 100) there will
be $6.62 risk-less arbitrage profit for following the strategy just described.
However, the points to the right of IRP line such as Y refer to a situation where the
forward premium or discount in foreign currency is below the interest rate differential in
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dollars and foreign currency and it pays to borrow foreign currency and invest in U.S.
Example: Suppose the interest differential in dollars and Swiss francs is 4 percent per
annum (U.S. and Swiss interest rates are 7 and 3 percent respectively) and SF is at a 1.4
percent premium against the dollar, with spot rate at $0.633/SF and one year forward in
SF is $0.6419/SF. There is deviation from parity and following the strategy just described
above will result in a risk-less arbitrage profit of SF25,164.35 provided that the
Rational Expectations
Rational expectations: This assumption requires that investors in the U.S. would not
be fooled by higher nominal interest rates in the U.K as they see the higher rate that is
contaminated with higher inflation and covered interest parity (CIP) arbitrage will be a
zero net present value investment for them. As seen in the above exhibit assuming U.S
investors convert dollars for pounds at the spot rate and invest the proceeds in pound
denominated bonds at 6 percent interest and sell pounds one year forward today in order
to hedge against foreign exchange rate risk at the forward rate of $1.4376/, realizing
exactly $152.38 that is identical to the future value of the investment had the investors
invested in the bond denominated in U.S. dollars. The risk-less arbitrage profit in a
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104
Absence of Risk Premium: This assumption requires that the forward rate does not
embody a risk premium constant or time varying, that the forward rate does not deviate
from the ratio of the two futures value as is seen in the above exhibit. Uncertainty about
the future course of the exchange rate can account for observed deviations from the
covered interest parity hypothesis. It is likely that the uncertainty will be largest when
exchange rates change dramatically compared to their recent historical trend. In such an
from the CIP simply because speculators are still in the process of adapting to the change.
Not only will they have temporary problems forecasting the exchange rate without
systematic error, but they are also likely to demand risk premia because of it.11
Forward Premium or Discount for Selected Currencies: Exhibit 3.21 provides the
observed behavior of forward premium or discount and interest rate differentials between
the U.S. dollar and yen, pound and Spanish Peseta as of September 10, 1998.
The Japanese yen appears to be over-valued against the U.S. dollar as the three forward
rates are at a premium exceeding the interest rate differential. All three observations for
yen are to the left of the IRP line and as demonstrated earlier it pays off to borrow dollars
and buy yen while, investing in yen at the Japanese yen rate and selling yen forward for
risk-less arbitrage profit. Since deviations from parity are relatively small, the large
institutional investors will be able to take advantage of small deviations to make arbitrage
profit, where as the larger bid and ask spread in the inter-bank market makes it almost
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Exhibit 3.21: Forward Premium (discount) and Interest Rates Differential
Source: The figures are interest rate differential and forward premium (discount) in the
parentheses versus US dollar September 10 1998, The Financial Times.
The forward market for foreign exchange for 1-month peseta and pound and three-
month Spanish pesetas appears to be in line with the interest parity relationship.
S0 = $1/euro
S1= $0.9903/euro
F= $0.9903/euro
R$ = 4%
Rf = 5%
$ = 2.5%
f = 3.5%
-1
Percentage change
exchange rate
Nominal Inflation
differential
-1
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106
The euro is at a 1 percent discount against the dollar due to 1 percent higher nominal
interest rate that is reflected in the inflation differential of 1 percent. The real interest rate
is 1.5 percent in both dollars and Euros and percentage changes in exchange rate and
Macro Determinants of the Exchange Rate: Using the framework from the quantity
theory of money, the real sector of the U.S. economy where production takes place is
related to the financial sector where production is financed. The PPP can be used to link
the real sector to the financial sector into the monetary approach to exchange rate
P. Q = M . V 3.8
Where the left hand side defines the total nominal output as the product of price index
P and output Q in an economy, and the right hand side is the amount of money M
supplied to the economy and the velocity turnover of money V. The percentage change in
price index of P is the rate of the inflation in the economy and is determined in Equation
3.9.
$ = m q + v 3.9
Where $ is the rate of inflation in $, m, q and v are respectively the growth rate of
monetary aggregates, growth rate of the GDP and percentage change in velocity. The
inflation differentials as defined in the equation 3.10 between any two countries will be
equal to:
$ f = ( m mf ) ( q qf) + ( v vf ) 3.10
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107
Example: Suppose the growth rate of money supply, GDP and changes in the velocity
Change in velocity $ = 1%
Using the above information the inflation differentials between the U.S. and the U.K
will be equal to 1/2 percent and the dollar expected to revalue by percent against the
Real Exchange Rate: The nominal exchange rate adjusted for the respective inflation
rates in two different economies provides a measure of the economys real cost of
producing goods for consumption and goods for export over the given period. The real
exchange rate Er is defined as the nominal exchange rate En adjusted for the inflation
Where Pf and P$ are the price index in foreign currency and dollars respectively. Since
nominal exchange rate is the ratio of the price index denominated in dollars and foreign
currency, P$ /Pf, it then follows that the real exchange rate has to be constant and equal to
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Real exchange rates can be viewed as a measure of an economys true competitiveness
as compared to other economies. At times when the U.S. real exchange rate appreciates
against all other currencies, the cost of producing exports rises, which makes U.S. exports
uncompetitive in the world market. Exhibit 3.23 provides preliminary evidence of the
behavior of the real exchange rate for the several major currencies over the period 1989
to 1998 with 1995 as the base year with real exchange rate at 1 or 100 percent. Real
exchange rate is by no means constant and deviates from unity substantially for all of the
COUNTRY
NAME Canada France Germany Japan Singapore U.K U.S
1989 86.0 129.5 134.1 150.3 140.7 94.2 109.3
1990 85.9 111.4 116.3 157.4 129.9 85.6 104.7
1991 82.8 114.1 119.0 144.6 122.8 89.1 103.5
1992 89.6 106.7 107.0 136.4 115.7 89.9 101.2
1993 95.2 114.4 113.7 120.2 114.8 107.8 104.7
1994 102.4 112.3 113.1 110.7 107.2 103.3 103.4
1995 100.0 100.0 100.0 100.0 100.0 100.0 100.0
1996 100.6 103.5 106.5 118.9 100.8 102.1 104.3
1997 101.4 118.4 121.5 129.4 104.6 96.1 112.0
1998 108.6 119.3 123.8 140.4 119.8 93.5 120.0
1999 109.3 124.2 121.6 99.0 119.3
2000 109.4 119.2 123.5 105.2 125.2
2001 113.5 133.8 128.3 110.6 134.5
Source: Authors own estimates, real exchange rate index set at 100 for 1995.
The U.S dollar and British Pound appear to have appreciated in real terms by 34.5 and
10.6 percent respectively between 1995 the base year through the 2001 period. U.S.
exports were relatively more competitive prior to the base year of 1995 as compared to
the current account deficits. Japanese exports before and after the base period 1995
126109
percent relative to the base year in 2001. Japanese real exchange rate in the year 1989
appears to have appreciated by 50 percent as compared to the base year making exports
very uncompetitive as reflected in the decade of recession in Japan and falling equity
prices. The widening trade deficit in the U.S. in the 1990s and 2000 to 2001 (see Exhibit
2.3) may be attributed to the appreciation of the real exchange rate making U.S. goods
relatively smaller increase in its real exchange rate 13.5 percent as opposed to 34 percent
compared to its main trading partner the United States. France and Germanys exports
appear to be relatively more competitive than that of the U.S. as their respective real
exchange rate appreciated by nearly 19 and 23 percent between 1995 and 1998,
respectively. The real exchange rate remains over 100 for all the years proceeding the
base year of 1995 for both countries implying that their exports remained relatively
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110
E x h i b i t 3 . 2 4 : R e a l E x c h a n g e R a t e s o f I n d u s tr i a l C o u n t ri e s 1 9 8 9 -2 0 0 1
18 0 .0
16 0 .0
14 0 .0
e
t
a
R 12 0 .0
e
g
n
a 10 0 .0
h
c
x
E
l 8 0 .0
a
e
R
6 0 .0
4 0 .0
2 0 .0
0 .0
1 98 9 19 90 1 99 1 19 92 1 9 93 1 99 4 19 95 1 99 6 19 9 7 1 9 98 1 99 9 20 00
T i m e (Y e a r )
The real effective exchange rate for a sample of emerging economies is presented in
Exhibit 3.25. Malaysias ringget after suffering devaluation in excess of 35 percent in the
1997 Asian crises appears to have appreciated by 54 percent in real terms relative the
base year through 2001. Venezuelas real exchange rate has appreciated by nearly 274
percent relative to the base year through 2001, thereby making exports prohibitively
uncompetitive.
COUNTRY
NAME Bolivia Chile China Malaysia Venezuela
1989 51.0 60.3 40.0 110.5 11.1
1990 59.4 64.3 58.5 110.9 19.9
1991 64.0 75.3 64.1 109.9 25.0
1992 74.7 81.6 63.9 100.3 30.3
1993 84.4 93.0 62.0 102.2 38.3
1994 91.6 97.5 85.3 103.7 53.6
1995 100.0 100.0 100.0 100.0 100.0
1996 96.7 99.6 94.6 100.3 121.5
1997 106.9 101.9 98.8 112.0 188.5
1998 108.3 112.1 101.6 151.3 231.6
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111
1999 121.1 126.8 102.8 151.2 283.3
2000 127.2 134.4 102.2 154.8 342.1
2001 139.4 158.9 101.6 154.1 373.9
Source: Authors own estimates.
Chile and Bolivia have had their real exchange rate appreciate by 39.4 and 58.9 percent
respectively over the 1989 to 2001 periods. China, equipped with relatively cheap labor
and an extremely inexpensive currency exchange rate, has enjoyed growth in exports and
as the success story of 90s is on the verge of becoming an economic super power in the
21 century.
Real Exchange Rate and East Asian Currency crisis: Corsetti et al (1999) have
provided the estimate of the real exchange rate relative to the U.S. dollar for South East
Asian economies with 1990 as the base year and real rates for all countries set at 100. My
own estimates of the real exchange rates for 8 South East Asian economies is presented
in Exhibit 3.26 with the Taiwan excluded as the IFS database does not provide any data
for this economy. With the exception of Hong Kong and Singapore all other countries
experienced significant appreciation in their real exchange rates. For example Korea,
Indonesia, Malaysia, Philippines and Thailands real exchange rate appreciated by 131.8,
134.5, 43.6, 37.9 and 81 percent respectively between 1990 and 1997 (see Exhibit 3.26).
These countries saw an erosion of their competitiveness in exports and bore the brunt of
the crises in the currency market with the collapse of their currency and ensuing fallout in
Exhibit 3.26: Real Exchange Rate Indices for East Asian Economies 1991to 2009
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112
South
China,PR China
Country Thailand Malaysia Singapore Indonesia Philippines (mainland) Korea Hong Kong Taiwan Japan
1990 100 100 100 100 100 100 100 100 100 100
1991 98.36 101.61 96.09 100.86 99.63 112.67 98.73 93.20 100.32 93.94
1992 96.86 92.55 91.29 100.53 87.74 114.43 102.01 87.47 92.83 89.48
1993 96.24 92.97 91.16 97.04 89.74 111.62 103.06 82.96 97.37 79.88
1994 93.27 93.77 85.75 94.99 82.83 143.20 99.60 78.93 96.23 74.78
1995 89.89 88.95 80.41 92.86 76.75 116.66 94.08 74.48 95.57 70.88
1996 88.87 88.87 81.21 92.20 73.84 107.34 96.24 72.09 98.93 84.24
1997 106.18 99.02 85.80 109.83 80.06 103.83 111.36 69.78 105.17 94.23
1998 132.14 133.31 98.48 249.42 103.02 104.78 155.15 68.93 122.34 102.86
1999 122.98 128.36 101.88 161.78 94.31 108.51 133.41 73.46 120.23 91.69
2000 132.83 130.69 105.68 172.93 105.59 112.73 128.31 79.24 118.77 90.34
2001 148.85 132.52 111.83 194.70 118.13 115.36 144.80 82.90 132.15 105.59
2002 145.30 132.24 113.96 160.36 117.80 117.52 138.67 86.85 137.36 111.66
2003 140.94 133.91 112.89 139.40 123.02 120.16 130.46 94.81 140.38 105.92
2004 136.56 135.43 110.58 135.48 122.91 119.95 124.30 100.51 135.60 101.45
2005 135.05 135.52 112.10 137.92 115.09 119.25 111.86 103.02 134.04 107.23
2006 125.49 130.79 109.36 118.63 104.13 118.12 105.28 103.78 138.92 116.43
2007 113.78 123.54 104.56 114.48 93.72 112.71 102.79 105.09 147.66 121.18
2008 108.42 115.33 90.56 139.71 93.17 93.65 123.68 93.68 132.20 100.30
2009 108.80 115.43 89.90 144.58 94.75 91.80 127.49 91.88 131.02 97.73
Source: Authors own estimates using annual real exchange rates from the Economic
Research Service, United States Department of Agriculture, with a base year of 1990 i.e.
1990=100
this period over its trading partners in the region in the form of cheap labor and relatively
inexpensive currency, thereby capturing export markets lost by others in the erosion of
their competitiveness particularly the steel market at the expense of Korea and the
apparel market to the detriment of Indonesia and Malaysia. Singapore and Hong Kong
were not as hard hit as the other countries in the 1997 Crisis, which may be due to surplus
in their current account and the build up of their foreign reserve as compared to other
countries in the region that had significant deficits and dwindling foreign exchange
reserves.
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130
Real-Wood Furniture, Inc.
by
Lee Sarver
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114
However important, everyone realized it had become time for the firm to analyze
its international position from a strategic perspective, that was, in fact, merely the
background to this meeting. In the foreground was a particular deal. Several of the
Canadian mills supplying Real-Wood had joined together to offer the firm delivery of a
large shipment of assorted hardwoods before the effective date of the tariff. Essentially,
they offered to consolidate several orderssome not due for almost a yearfor delivery
in 90 days at most, with payment of 2.5 million Canadian dollars (CD) due then. Such a
large delivery would help the firm to postpone facing the costs of the tariff, perhaps even
until an exception was obtained or policy changed again.
However, there was no way the proposed shipment could be worked in to the
production schedule anytime soon; if the wood could not be sold or bartered to other
firms, it would have to be stored. Even the latter course was feasible, since Real-Wood
had just finished a new curing facility. (Insurance for this surge in inventory would be
covered for a year under the blanket policy the firm purchased when construction began.)
Marys boss confirmed that Real-Woods cash balance could be stretched to cover the
approximately 1.41.6 million US dollars (USD) necessary. At this point, the firms lead
banker, Morgan J. Pierpont, who was present at the meeting, announced that the lenders
he represented were more than willing to provide the financing. Eventually, the deal was
approved and the real issue became exactly how the firm should structure the transaction.
Several alternatives were discussed.
The simplest thing for us to do is nothing, said the production manager. I
mean, lets take delivery of the wood, buy the Canadian dollars when we need them, and
get on with building furniture. After all, how much can happen in the space of 90 days?
The purchasing manager jumped in, Maybe we can negotiate a price in US
dollars! When Marys boss observed that the Canadians would surely raise their asking
price, if they had to bear the exchange riskassuming that they would even discuss it
he countered, But they approached us! After all, they have the most to lose from the
tariff. Besides, if theyve made a number of similar proposals to other customers, they
might generate enough volume to get a good rate.
Well, maybe we can, at that. Thats your department; you know those people,
answered Marys boss but it still seems like a long shot. Good luck. But what I do know
we can do todayand for exactly how muchis hedge. In response to several pairs of
raised eyebrows: For example, we can buy Canadian dollars forward. Morgan can get us
a quote or we can shop around. Pierpont smiled without humor. Or we can buy
Canadian dollar futures. Heck, we can even borrow Canadian dollars and park them in a
CD for 90 days. Right, Morgan? Pierpont nodded. And Mary can figure out the best
course. He looked in her direction and everyone elses glance followed his. All eyes
were on her. Right, Mary?
*****
Marys self-confidence returned during lunch, since she had spent the time
thumbing through her old class notes (now yogurt-stained). When she returned to her
office, she found a single hand-written sheet on her desk (See Exhibit 1), with some
numbers and the notation, Sorry to put you on the spot. I got these from Morgan. Work
out our alternatives. Lets take care of this before quitting time today. Mary opened a
new spreadsheet and grinned. Maybe I will have a weekend, after all.
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115
Exhibit 1
Foreign Exchange Rates
Canadian dollar, spot 1.5728
Canadian dollar, 3-month forward 1.5783
Canadian dollar, 4-month futures 1.5828
Questions
1. a. What, in general, is exchange risk?
b. What risk does Real-Wood face specifically?
2. a. What is political risk?
b. Is political risk confined exclusively to international transactions?
c. Do only less-sophisticated governments of the Third World pose political
risk?
3. a. Distinguish hedging and speculation.
b. In what sense does failure to hedge constitute speculation?
c. Could Real-Wood profit by not hedging?
4. How does hedging resemble diversification? How does it differ?
5. a. Are the exchange rates in Exhibit 1, direct or indirect quotations?
b. Calculate the corresponding direct/indirect quotations.
6. a. What is Purchasing Power Parity?
b. If a Big Mac costs $1.99 (on average) in the United States, what should it
cost (on average) in Canada?
7. a. Distinguish spot and forward rates.
b. What is meant by a forward premium or discount?
c. What does the forward rate imply about the expected future spot rate?
8. a. What is the relationship between inflation and interest rates in one
country?
b. What is the relationship between inflation and interest rates between two
countries?
9. a. What is Covered Interest Rate Parity (CIRP)?
b. According to the Exhibit 1, does CIRP hold between Canada and the
United States?
c. If CIRP does not hold, where can you earn the best return?
10. Evaluate Real-Woods alternatives.
Chapter 3
Questions & Problems:
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116
1. The foreign exchange market is the largest and least regulated market in the world.
T/F
2. Three types of transactions takes place in the foreign exchange markets. Discuss
each transaction using an example.
3. Your firm is trying to buy 200 million yen in the market. The spot price quoted per
dollar is as follows:
Bid Offer
122.34 123.79
How much in dollars does the firm pay to buy the required yen?
Bid Offer
$1.7843/ $1.7892/
How much in dollars does the treasurer pay to fulfill its obligations?
7. A forward contract is for delivery of the underlying commodity in more than two
business days in future at a price determined today. T/F
8. A swap transaction is a portfolio of two offsetting forward transactions at prices
determined today. T/F
9. A foreign exchange swap is a financing means at a fully collateralized basis. T/F
10. A foreign exchange swap is borrowing and lending simultaneously at the known
forward exchange rates. T/F
11. Nissan manufacturing plans to buy 1.5 million pounds 180 days forward on July 6,
2005 at an exchange rate quoted below:
Bid offer
Spot rate 1.7120 1.7184
30-day forward 1.7134 1.7192
90-day forward 1.7156 1.8001
a) How much in dollars does Nissan pay in 180 days to secure 1.5 million pounds?
b) If the exchange rate in 180 days is $1.83/, how much in foreign exchange gains
will Nissan experience?
c) If the exchange rate in 180 days is $1.63/, how much in foreign exchange losses
will Nissan experience?
12. In the previous question suppose Nissan plans to sell 1.5 million pounds at the
exchange rate quoted above.
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117
a) How much in dollars does Nissan receive in 180 days for selling 1.5 million
pounds 90-day forward?
b) If the exchange rate in 180 days is $1.83/, how much in foreign exchange gains
(losses) will Nissan experience?
c) If the exchange rate in 180 days is $1.63/, how much in foreign exchange gains
(losses) will Nissan experience?
13. A forward rate agreement (FRA) is an OTC contract of varying maturities used to
hedge interest rate risk. T/F
14. Agilan treasurer plans to borrow $20 million for three months, 6 months from
today. A 6X9 FRA is offered by a financial institution at 4 percent. In 6 months 3-
month interest rate is 5.25 percent. What rates does Agilan treasurer pay and receive in
6 months?
14. A Foreign exchange swap is a portfolio of a long and a short position entered into
simultaneously by two counterparties at predetermined rates and dates in the future. T/F
15. A Nashville importer of fine silks from the UK needs 1.5 million in 90 days for
only 60 days, enters into a swap agreement to sell 1.5 million 90-day forward at an
exchange rate of $1.6015/ and simultaneously buy 1.5 million 150-day forward at the
current prevailing150-day forward exchange rate of $1.6098/. What is the implied 60-
day forward repo rate?
16. In the previous question the forward/forward swap locks the importers financing
of 1.5 million at an annualized rate of 3.1 percent for a 60-day loan. T/F
17. The foreign exchange market performs all of the following functions except:
a) Transfer risk
b) Transfer purchasing power
c) Financing at a fully collateralized basis
d) None of the above
18. Given the following quotes estimate cross exchange rate between yen/pound.
125 /$
$1.65/
19. In the previous question if yen/pound is 200/, is there an arbitrage profit if you
had $1 million to start? Verify that arbitrage profit is $31,250.
20. In question 18, if the quoted cross exchange rate is 210.50/, will there be an
arbitrage profit if you had $1 million to start?
21. In the interbank market for foreign exchange a dealer has quoted outright yen/$ as,
118.06-97. What is the bid/ask price?
22. A dealer in New York has the following quotes:
Bid offer
Spot $1.5712/ $1.5756/
Point quotations
1-month forward 14-30
3-month forward 43-68
6-month forward 77-99
a) What is the bid/offer rate for the 1, 3, and 6-month forward?
b) If you wish to sell 2.5 million 3 months forward, how much in dollars would you
receive?
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118
c) If you wish to buy 2.5 million 6 months forward, how much in dollars would you
pay?
23. Given the following quotations, identify an arbitrage opportunity assuming you
have $3 million to start:
24. A trader in Hong Kong buys 8 contracts on 3-month pound futures at $1.6732.
Each contract is for delivery of 62,500 units of pounds. The pound devalues to
$1.6325 by the expiration of the futures contract. How much profit or loss does the
trader experience?
25. In the previous question suppose the trader shorts 8 contracts. Other things
remaining the same. How much profit or loss does the trader experience?
26. Gold price is $408/oz in New York and 235/oz in London. What is the implied
exchange rate assuming law of one price holds?
27. In the previous question if the actual exchange rate is $1.78/, what would you do
to profit if you had $3.56 million or its pound equivalent? How much in profits
would you realize in the above scenario?
28. A Big Mac in the U.S. is $2.60. The price of a Big Mac in local currency in
Germany is 2.4, and the actual dollar/ exchange rate is $1.23/. Which currency
is overvalued (undervalued), and by how much?
29. In the previous question Euro is overvalued by 13.5 percent against dollars. T/F
30. In question 28 the implied exchange rate from the law of one price is equal
to..
31. A Big Mac in the U.S. is $2.90 in 2004. The price of a Big Mac in local currency in
Russia is 14.5 rubles. The actual dollar/rubles exchange rate is $.10/R. Which
currency is overvalued (undervalued), and by how much?
32. Assuming the merchandise trade balance deteriorates following devaluation, this
phenomenon produces a J-curve as imports remain inelastic for some time. T/F
33. Suppose BMW Z7 is priced at 60,000. The Euro appreciates from $1.20 to $1.28.
What will be the dollar price of the BMW in a complete pass-through? In the event
the dollar price of the BMW is equal to $62,500 following Euros appreciation to
$1.28, what is the degree of pass-through?
34. Pass-through coefficient is expected to be equal to zero in a complete pass-through.
T/F
35. The pass-through coefficient of 0.72 for instrumentation means what?
36. A real exchange rate is equal to the nominal exchange rate adjusted for the inflation
differential between two countries. T/F
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119
37. The Canadian dollar nominal exchange rate is C$1.24/$. Assuming U.S. and
Canadas inflation rates are 2.5 and 4 percent respectively, estimate the real
exchange rate.
38. The real exchange rate is viewed as a measure of an economys true
competitiveness as compared to other economies. T/F
True-False Questions
1. Currency Exchange risk refers to fluctuations of the exchange rate of one currency
with that
of its trading partners. T F
2. The exchange rate is a relative price, the price of a unit of foreign currency in terms of
European economic currency. T F
3. In the quotation, 3 DM are equal to $1, the unit of account is the Deutsch Mark and
currency being priced is the dollar. T F
4. Cross-currency is the product of two indirect quotes, given that neither currency is the
dollar. T F
5. If lira per dollar is equal to 1300.75 and dollars per rupee is equal to $ .777/ rupee,
then lira/ per rupee will be 1010.68. T F
6. If the British pound falls from $1.56/ pound to $1.45/ pound; the U.S. dollar is said to
have depreciated. T F
7. If the Deutsch Mark (DM) rises from $.35/ DM to $.50/ DM; one could say that the
U.S. dollar has depreciated and DM appreciated. T F
8. If the price of a Cadillac rises from $22,000 to $25,000, one could say that the U.S.
dollar has depreciated and Cadillac appreciated. T F
9. The world price of the dollar is determined by the U.S. Central Banks trading
partners worldwide. T F
10. If world demand for the dollar exceeds the world supply of dollars, the dollar will
depreciate in value. T F
11. An increase in real interest rate in Japan Ceteris Paribus leads to depreciation of
Japans trading partners currency. T F
12. Increase in aggregate income in Japan relative to its trading partners causes
depreciation of the Japanese yen. T F
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120
13. Increasing inflation in Japan relative to its trading partners causes appreciation of the
Japanese yen. T F
14. Based on purchasing power parity (PPP), the change in exchange rate between two
currencies is related to the change in price inflation of the home country relative to its
trading partners. T F
15. As deflation makes domestic goods less expensive, there will be less incentive to
substitute the more expensive foreign goods for domestic ones. T F
16. The U.S. was the first country to adhere to the gold standard. T F
17. Under the gold standard, the exchange rate was pegged between countries. T F
19. In the Bretton Woods agreement (1944-1971), the U.S. was not obligated to convert
various currencies into gold upon demand except the U.S. dollar, which was
convertible to gold at the price of $35/ per ounce of gold. T F
20. Under the current floating rate system, the exchange rate is determined by market
supply and demand forces. However, from time to time, the Central Bank intervenes
in the market to support or devalue its own home currency relative to other
currencies. T F
21. An increase in the U.S. deficit will continue to put downward pressure on the value of
the U.S. dollar. T F
23. If the spot rate is greater than the forward rate, the currency is said to be trading at a
premium. However, the rate is expected to fall (depreciate) in the future. T F
24. The British pounds current, 30-day, 60-day, and 90-day forward are equal to .50, .55,
.57, and .58 per U.S. dollar respectively. The forward rate is indicating appreciation
of the U.S. dollar relative to the pound. T F
138
Multiple Choice Questions
27. What distinguishes international financial management from that of domestic
finance?
A. currency exchange
B. tax consideration
C. capital market
D. all of the above
28. The Canadian dollar is equal to $0.75 U.S. dollar. What is the indirect quote for
Canadian dollar per U.S. dollar?
A. 1.25/ $ U.S.
B. 1.333/ $ U.S.
C. 1.75/ $ U.S
D. none of the above
29. Assume Italian lira per U.S. dollar is equal to 1,400 and U.S. dollar per Swiss franc is
$.68/ Fr. What is the cross rate between Italian lira and Swiss franc?
A. 952 lira/Swiss franc
B. 800 lira/Swiss franc
C. 1,200 lira/Swiss franc
D. 650 lira/Swiss franc
30. Assume 1.5 DM per U.S. dollar. A Mercedes 300 costs 30,000 Deutsch Marks.
What is the equivalent in U.S. dollars?
A. $19,300.00
B. $19,736.84
C. $25,172.50
D. none of the above
31. In previous problem, suppose DM per U.S. dollar becomes 1.75. What is the
equivalent in U.S. dollars for the car?
A. $16,250.00
B. $16,180.00
C. $17,142.85
D. $16,178.63
32. In problem 31, depreciation of Deutsch Mark (1.50 to 1.75 DM) gives a car importer
from West Germany an instant saving of:
A. $2,493.00
B. $2,593.99
C. $2,600.00
D. none of the above
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139
C. prices adjust in the long run for differences in quality
D. all of the above hold
35. Deutsch Mark per dollar rises from 1.50 to 1.65. Assuming zero inflation in the U.S.,
what rate of inflation does PPP imply for West Germany?
A. 5 percent
B. 8 percent
C. 10 percent
D. none of the above
36. In the previous problem, assume the expected inflation one year from now in U.S.
and West Germany of .05 and .08, respectively. What is the one year forward rate
assuming current spot rate of 1.50 DM/ $ if PPP is to hold?
A. 1.5428 DM/ $U.S.
B. 1.48 DM/ $U.S.
C. 1.47 DM/$U.S.
D. none of the above
37. The spot Canadian dollar per U.S. dollar is equal to 1.25/ $U.S. If inflation is
expected to be 5% in Canada and 10% for U.S. next year, what exchange rate does
this imply if the PPP is to hold?
A. 1.25 Canadian/ U.S.$
B. 1.193 Canadian $ per U.S. dollar
C. 1.20 Canadian $ per U.S. $
D. none of the above
38. In the previous question, what happens to exchange rate if inflation is expected to be
5% or 10%, respectively in U.S. and Canada?
A. 1.27 Canadian $ per U.S. $
B. 1.28 Canadian $ per U.S. $
C. 1.309 Canadian dollar per U.S. $
D. none of the above
39. All of the following factors can lead to appreciation of home currency except:
A. a decrease in inflation
B. an increase in real interest
C. a decrease in real interest
D. a decrease in aggregate income
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140
40. If spot rate for Deutsch Mark (DM) is less than the forward rate, the currency is said:
A. to be selling at discount
B. to be selling at premium
C. the market expects the value of DM to rise
D. both A and C
41. If the spot rate for the Japanese yen is greater than the forward rate, this implies:
A. Japanese yen is selling at premium
B. Japanese yen is expected to appreciate in value
C. Japanese yen is expected to depreciate in value
D. A and C are true
43. The spot, 30-day, 60-day, and 90-day forward for the Swiss franc, respectively, are
$.60, $.63, $.65, and $.70. This implies:
A. Swiss franc is depreciating relative to U.S. dollar
B. Swiss franc is appreciating relative to U.S. dollar
C. U.S. dollar is depreciating relative to Swiss franc
D. B or C
Problems
44. Compute the equivalent indirect quotes from the following direct quotes:
A. $.5/ DM B. $.155/ French franc C. $1.50/ pound
45. What is the cross rate between DM and French franc, DM/ pound, and French franc/
pound in the previous problem?
46. What happens if the cross rate between DM and French franc is equal to 3FF/ per
DM?
47. A German importer buys 200,000 cases of wine at 50 French francs. How much
should the importer pay in terms of local currency in problem__?
48. A French car dealer buys 2 Rolls Royce at 100,000 British pounds per car. How
many French francs should be supplied in the Currency Exchange Market in order to
buy 200,000 pounds in problem__?
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141
49. The current exchange rate between the Deutsch Mark and U.S. dollar is 3.5 DM/ $. If
inflation of 3 and 10 percent is expected to prevail in West Germany and U.S., what
will be the exchange rate if the purchasing power parity is maintained?
50. In July 1985, one DM was selling for 2.5 French francs. One year later, 3.2 French
francs were equal to one DM. If we assume zero inflation in West Germany, what
rate of inflation does PPP imply France?
51. On June 20, the U.S. / Japan exchange rate was 200 yen/ per $. On July 20, the
exchange rate was 206 yen/ per $. What is the annual exchange rate profit (loss) by
investors holding Japanese yen?
52. In the previous problem assume on July 20 the exchange rate was 192 yen/ per U.S.
$. What annual exchange rate profit (loss) will the holder of Japanese yen make?
53. A California wine producer will buy 10,000 cases of wine at a price of 200 French
francs, payable in French francs in 60 days. The French spot and 60-day forward rate
is 7 and 6.9 French francs per U.S. dollar. What transaction should the U.S. wine
producer undertake to hedge his position?
References
Cumby, R and M. Obstfield "A Note on Exchange Rate Expectations and Nominal
pp.697-703.
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142
Frankel, J. "In search of The Exchange Risk Premium a Six Currency
Homaifar Ghassem and Joachim Zietz Official Intervention in the Foreign Exchange
Lothiar, J and M. Taylor "Real Exchange Rule Behavior: the recent float
(May 1986).
Marston, Richard C. "Tests of Three Parity Conditions: Distinguishing Risk Premia and
Systematic Forecast Errors, "Journal of International Money and Finance, 1997, pp.
1345-1357.
126
143
Rosensweig, J and P. Koch. The U.S. Dollar and the delayed J-curve,
1988. Pp 2-16.
Zietz Joachim and Ghassem. Homaifar Exchange rate Uncertainty and the Efficiency of
Zietz Joachim and Ghassem. Homaifar Exchange Rate Uncertainty and the Efficiency of
127
144
End Notes:
1
Central Bank Survey of Foreign Exchange and Derivatives Activity 1998, Bank for International
documented in a study by Rosensweig and Koch (1988) Economic Review July /August 1988, p 2-15
7
See for example the classic study by Gailliot (1971) and Lothian and Taylor (1996)
8
See Bilson (1983).
9
See Cumby and Obstfeld (1981), Frankel (1982) Mishkin (1984) Cumby (1988) and Marston (1997) for a
classic study of real interest rate differentials and deviation on uncovered interest parity.
10
Schwebach and Zorn (1997) provide a simple algorithm challenging the Fisher nominal interest rate as
sums of the real rate and inflation premium (constant). Assuming uncertain inflation the authors provide an
alternative algorithm consistent with observed behavior and why nominal interest rate is not an unbiased
Franc in the time period from 1976-84 that their respective forward rates were close to the theoretical
values.
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