Title: International Finance: a Foreign Exchange Regimes
1International Finance (a) Foreign Exchange
Regimes
Fall 2007
2International Finance Module
- Disclaimer
- This is just a peek into a very important area of
finance / business.
3International Finance Class
- Todays class (Available on the web so download
and use, if not done already) - Forex Regimes.
- International Parity Conditions
- Purchasing Power Parity
- Interest Rate Parity
- Forward Rates as Unbiased Predictors of Future
Spot Rates - International Investment Flows
- Managing International Risk (for Info. Brealeys
PowerPoint)
4International Finance Forex Session
- Ill focus class-time on concepts / calculations
- Information type materials available on the
site and wont devote class time to that.
5Forex Regimes - review
- Background Legal tender in one country may not
be acceptable in another, absent convertibility
and confidence in its quality/value. - Purchasing Power of currency vital. If it
decreases in the country, it will also outside. - Govt... policies may range from fixed rates to
free floating and a whole gamut of options
within these extremes. - ..(see next slide)
6Foreign Exchange Regimes
- Policies Range from
- Fixed (Managed/Dirty Float)Free Float
- Declare and defend a par value..
- Deliberate Choice
- Forex market huge, less regulated,
de-centralized - Countries have limited ability to fix rates.
Need actions taken in the real economy - trade,
capital flows etc. - Choice of Regimes and Implications
- Size, scale of economy open-ness issues
- Dependence on foreign capital flows.
- Balance of payments - issues.
- Enforcement Implications.
7Forex Regimes
- Govt... policies may range from fixed rates to
free floating (gamut of options within these
extremes.) - FIXED RATE regime Govts. declare defend a
Par value or price - intervening as needed to accomplish this.
- need reserves or access to Forex
- mechanisms to limit / manage investment trade
flows. - Monitoring mechanisms, enforcement, black markets
etc..
8Forex Regimes (contd.)
- Free Floating Regimes Markets determine rates.
What are some implications? - Prices
- Role of Govt...
- Corporations/ Individuals.
- Predictability / Forecasts.
- Economy.
9Forex - Floating Rate Regime (contd.)
- Philosophy
- Govts. can / should set rates gt Managed Floats
- Govts. cant / shouldn't set rates gt Free Floats
- If rates change due to underlying
economic/political causes, govt. may be unable to
maintain target rates without substantial costs /
dislocations - For short-term factors, govt. can/may be able to
smooth the path of rate changes.
10Forex - Managed Rate Regimes
- Rate Fixed v/s Target price based on
fundamentals - Implementation
- Peg v/s crawling peg
- Basket of Currencies - choice weight
- Index - eg. SDRs
- Effect Rate impacts economic activity, relative
competitiveness of Imports v/s Exports sectors,
and hence wealth transfers.
11Forex. Regimes - Summary
- Choice of regimes has important effects on the
country and on the expectations from the
governments. - Since Forex Markets are huge, it is nearly
impossible to maintain rates, not justified by
fundamentals (speculation role) - Intl co-ordination is important and increasing,
and major countries consult, co-operate,
co-ordinate policies. - Beyond Fixed Rates
12Beyond Fixed Rate Regimes (1 of 2)
- Minimal Govt. intervention gt Free Floating Rate
Systems - Fixed Rate systems, obligate the governments to
intervene and maintain a stated rate. - Credibility and confidence in government ability
and willingness to intervene and maintain rates
is vital. Loss of confidence in government is
expensive. - 3 variables
- Forex Rate Variability
- Open Economy (relatively free imports and
exports, and no CAPITAL FLOW CONSTRAINTS) and - Monetary Policy Independence.
- Cant control all the 3 elements above. Strict
fixed rate means that underlying economy will
need to make the adjustments
13Beyond Fixed Rates ( 2 of 2)
- Govt.. can signal voluntary surrender of monetary
policy options - Currency Boards (on-going Argentina experience)
- Common Currency eg. European Currency Union
and Effects - Dollarization
- Details of these policy choices follow. Each has
its own costs benefits
14Currency Boards - (background)
- Widely introduced in British colonies (19th
century) - Hong Kong, reintroduced currency board (1983)
- In 1991 Argentina and 1992 Estonia adopted
currency board arrangements. - Urged adoption in Mexico, Russia, and Ukraine
15Currency Board (logic and operations)
- Reasons
- Disenchantment with Central Banks susceptibility
to political pressure to finance deficits - Central Banks use of discretion
- Currency Boards essentially are
- Monetary rule equating Change in Monetary Base to
the BOP Surplus or Deficit - Credible defense of Fixed Exchange rate while
giving up Monetary sovereignty
16Currency Board Advantages / Disadvantages
- Advantages
- assurance of convertibility at fixed exchange
rate, - pressure to maintain macroeconomic discipline,
- the provision of a built-in mechanism for balance
of payments adjustment, and, - so, the maintenance of confidence.
- Disadvantages include loss of ability
- to tailor monetary policy to a country's own
situation and - to use changes in the exchange rate to adjust
balance of payments. - May facilitate Capital Flight (Indonesia)
17Currency Boards - examples
18The Euro
- Economic Integration of Europe
- Since 1992, relatively free movement of goods and
people across national borders - Creation of supra-national bodies (court,
parliament, now Europe Central Bank) - Monetary Union and Single Currency
- Introduced the Euro - outside the control of
any one individual country - Implications
19International Parity Conditions
- Money Forex Markets are related, and with
appropriate transactions, one can create
synthetic contracts to give same cash flows. - Contracts with same cash flows will sell for same
price - else arbitrage possible. - Basic Relationships
- a) Fisher Effect Nominal rates in a country
real rates expected inflation.
(internationally too!) - b) P.P.P. Arbitrage in goods market creates one
price world-wide for products.
20 International PARITY Conditions
- Expectations, Hard to Measure
Actual, Can TRADE
SF
Predictive
Expected Difference in INFLATION Rates
Difference in Interest Rates
IRP
PPP
Predictive
Difference between SPOT and FORWARD rates
Expected Change in Spot Rate
21International Parity Conditions
- PPP
- absolute form law of one price
- relative form permits existing dis-equilibrium
but relates future changes in inflation to
changes in spot forex rates. - Goods Arbitrage relatively high transactions
costs, greater market segmentation possibilities,
and hence PPP may work only in the long term.
22International Parity Conditions
- IRP
- In eqbm., expected real return on capital is the
same across different countries (else, capital
flows from low to high return countries) - Covered Interest Arbitrage relatively low
transactions costs, lower market segmentation
possibilities, and hence IRP expected to work
even in short term.
23Covered Interest Arbitrage
- Borrowing in one currency, converting Spot into
another, and lending that currency is equivalent
to a forward market transaction. - Example
- a) Opportunities may be few and of short
duration. - b) Unless arbitrage is disabled, will work.
24An example
- Spot rate for Indian Re. is 48.50 / US.
- Interest rates
- India 10 per annum
- US 4 per annum
- What should the 3 month forward rate have to be?
Why? - If you are quoted 3 month rate of 48.75 Re/, can
you arbitrage? Exact Steps?
25Covered Interest Arbitrage
- All such transactions involve bridging markets.
Two money markets (Re and ) where one can
borrow or lend and two forex markets (Spot
and Forward) where one can buy or sell a
currency. - Given any 3 of the rates, the 4th is uniquely
determined. If that rate does not hold, then we
have Arbitrage possibilities. - For our purpose (understanding the logic and
developing a framework) we ignore transactions
costs, bid-ask spreads and assume same borrowing
and lending rates. the only compromise is that
in real life with these factored in, there is
more leeway for rates to vary a bit.
26Next - Foreign Investments!
- Do keep working!
- Dr. Ram
- www.usd.edu/kramakr
- 605-677-5549 (Direct - work)
- 605-677-5455 (Dept.)