UNDERSTANDING

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Lecture 5

• UNDERSTANDING
• EXCHANGE RATES (2)

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A typical trading desk for spot forex
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Volatility USD/EUR, tick chart
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Exchange rates in the short run

• The theory of the long-run behavior of exchange
  rates cannot explain the large changes of current
  (spot) exchange rates.
• In order to understand the short-run behavior, we
  have to recognize that the exchange rate reflects
  the price of domestic bank deposits (in )
  denominated in terms of foreign bank deposits (in
  ).

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Comparing expected returns across nations

• We consider Euroland the home country, and the
  domestic currency .
• The USA are the foreign country with the
  foreign currency .

Euro deposits bearan interest rate i.
Dollar deposits bearan interest rate i.
How does Hans, the European, compare the return
on dollar deposits abroadwith the return on
domesticinvestments in ?
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Comparing expected returns across nations

• If Hans invests in the USA, he must realize that
  his return in terms of is not i. He must
  adjust the return for any expected
  appreciation/depreciation of the against the .
• If -deposits bring an interest rate of i 5
  p.a., and the dollar is expected to depreciate
  by 10 p.a. (w / ?), the expected return in
   is 5 - 10 -5.

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Comparing expected returns across nations

• More formally

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Comparing expected returns across nations

• If Bill invests in Euroland, he must realize
  that his return in terms of is not i. He
  must adjust the return for any expected
  appreciation/depreciation of the against the
  .
• If -deposits bring an interest rate of i 3
  p.a., and the euro is expected to appreciate by
  10 p.a. (w / ? ), then the expected return
  is 3 10 13.

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Comparing expected returns across nations

• More formally

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The key point

• RET and RET are symmetrical (with opposite
  sign)

As the relative expected return on -deposits
increases, both domestic and foreign
residentsrespond in the same way they want to
holdmore -deposits and fewer deposits in .
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Interest parity condition

• At present, international capital markets are
  relatively open. There are few impediments to the
  flow of capital, and and have similar
  liquidity and risk.
• When capital is mobile and bank deposits are
  perfect substitutes, the expected return must
  become identical

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Why? Arbitrage and liquidity trading

• Whenever there emerge small differences between
  interest rates and/or changes of expectations on
  the exchange rate, there will be arbitrage in
  international money markets that evens out the
  differential between domestic and foreign returns
  denominated in one currency gt Interest parity
  condition

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Market adjustment Examples

• We assume i 10, and wet1 1 /.
• When wt 1.0 /, the expected appreciation/
  depreciation of the   0 and the expected
  return in is then equal to i 10 (Point B).
• When wt 0.95 /, ?wet 0.052 5.2, and the
  expected return in 4.8 (Point A).
• When wt 1.05 /, ?wet -0.048 -4.8, and the
  expected return in 14.8 (Point C).

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Equilibrium in forex markets
wt (/)
RET
RET
1.05
C
1.00
B
0.95
A
10
5.2
14.8
Expected return ()
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What happens in disequilibrium

• When w ? 1.0, there is a market reaction
• w gt 1 People will try to sell and buy .gt
  Selling and buying
• But no one holding will sell at that price,
  there is excess supply of eurosi.e. the
  price of -deposits relative to -deposits must
  fall.
• The amount of dollars per euro falls, the euro
  depreciates.

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What happens in disequilibrium

• When
• w lt 1 People will try to sell and buy .gt
  Selling and buying
• But no one holding will sell at that price,
  there is excess supply of dollarsi.e. the
  price of -deposits relative to -deposits must
  fall.
• The amount of dollars per euro increases, the
  euro appreciates.

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Change in the foreign interest rate

• If the foreign interest rate increases, the
  expected return RET also increases.
• This leads to a depreciation of the euro.
• The same is true if the expected return on dollar
  deposits increases (at the original equilibrium
  exchange rate).

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Equilibrium in forex markets
wt (/)
RET
RET
RET
wB
B
C
wC
iD
Expected return ()
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Change in the domestic interest rate

• An increase in the domestic interest rate raises
  the expected return on euro deposits, shifts the
  RET schedule to the right, and leads to a rise
  in the exchange rate.
• It creates an excess demand for -deposits at
  the original exchange rate, and this leads to an
  appreciation of the .

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Equilibrium in forex markets
wt (/)
RET
RET
RET
wC
C
wB
B
iC
iB
Expected return ()
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What about inflation ?

• If we assume that rational investors ask for a
  compensation for the erosion of a nominal value
  due to inflation, i.e. the Fisher equation
  holds, we have to be more specific
• Expected inflation-rate differentials are
  embedded in nominal interest rates, and hence in
  the nominal exchange rate.
• On top of the inflation-rate differential, the
  exchange rate reacts to differentials in the
  real interest rate.

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Factors that affect the exchange rate
Change invariable
Exchange rate change
Domestic interest rate
Foreign interest rate
Price expectations (D/F)
Expected import demand
Expected export demand
Expected productivity (D/F)
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The analysis of forex markets
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Volume of forex transactions, in bill.
Daily, month of April
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Forex turnover by currency pairs (in per cent)
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Forex transactions by market place (April 2001)
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Actors in forex markets
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The forex market is highly concentrated
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And will be concentrated even more

• Since September 2002 the forex market has
  changed The CLS Bank started operating. It
  highly concentrates forex dealings due to a new
  technology.
• On October 29th, the CLS Bank settled 15,200
  transactions, totaling 395 billion, which
  required only 17 billion of payments between
  member banks, a 95 reduction.

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Short and long run the /DEM-market
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Short and long run the /-market
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Pound sterling during the 1992 crisis

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• Zweite Ebene
• Dritte Ebene
• Vierte Ebene
• Fünfte Ebene

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The Asian crisis 1997-98
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The crisis of the Argentinian peso
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Systemic stability of the financial sector
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Factors driving the financial sector

• The financial system is in a continuing flux
  driven by transactions costs motives.
• The developments of forex markets demonstrate the
  importance of cost reduction.
• The strategies are
• Bundling of funds (economies of scale)
• Risk reduction through diversification
• Explicit Hedging
• Expertise (legal, technological)

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Information inefficiencies

• Market participants can have insufficient
  information about their counterparts (asymmetric
  information). It leads to
• Adverse selection. This is an information problem
  occurring before the transactionPotential bad
  credit risks are those who seek loans most
  actively.
• Moral hazard. This occurs after the trans-action
  Borrowers may take on big risks.

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Adverse selection The lemons problem

• A lemon is a bad car purchased second hand.
• Akerlof studied the used-car market and found an
  asymmetric information problem
• Potential buyers cant tell a lemon from a good
  car.
• They offer an average price,between the value of
  a lemon and a good car.

George Akerlof 1940, Nobel Prize 2001
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The lemons problem

• The owner of a used car knows whether the car is
  good or bad.
• If the car is a lemon, he is of course happy to
  sell at the average price.
• If the car is good, the owner has little
  incentive to sell at average prices.
• Transaction volumes are low and the market may
  even break down.

• Similar problems arise in the securities markets
  (bonds, and stocks).
• An investor will only pay a price that reflects
  the average quality of firms.
• Bad firms are happy to take loans from investors.
• Good firms are not willing to borrow on this
  market.

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Moral hazard in equity contract (1)

• Equity contracts (shares) are subject to a
  particular principal-agent problem.
• Stockholders (principals) are not the same as
  managers (agents). This separation involves moral
  hazard because managers may act in their own
  interest.
• Example Steve has an ice-cream shop, and you
  become his silent partner. The capital is shared
  at 1090. Profits are also shared in these
  proportions.

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Moral hazard in equity contract (2)

• Option 1 Steve works hard and provides good
  service, but earns only 10 or the profit.
• Option 2 Steve does not provide good service,
  and uses the capital to buy artwork for his
  office, a luxury car for business he thus
  acquires fringe benefits at your expense.
• Option 3 Steve is not only a poor manager, but
  also dishonest. In this case the moral hazard
  problem may become extreme.

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Elimination of asymmetric information (1)

• A first solution to the problem is the private
  production and sale of information.
• There are professional rating agencies (Standard
  and Poors, Moodys, Value Line), and you can set
  up costly monitoring and auditing (state
  verification) of the firm.
• But there is s free-rider problem to this. If
  you buy a security, people my simply copy your
  behavior without paying for the information.
• This erodes potential extra profits, and you may
  not have bought the information in the first
  place.

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Elimination of asymmetric information (2)

• A second possibility could be to involve the
  government in regulating the market.
• The objective is to make firms reveal honest
  information by adhering to standard accounting
  practices and to disclose pertinent information.
• Government can also impose stiff criminal
  penalties to contain fraud.
• Government regulation may ease the asymmetric
  information problems, but it is difficult to
  eliminate them totally.

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Elimination of asymmetric information (3)

• A third solution is to involve financial
  intermediaries as experts in the production of
  information.
• A private loan is not traded, so others cannot
  watch and imitate (no free rider).
• This explains why indirect finance is more
  important than direct finance.
• Larger firms (because they are better known)
  obtain easier access to capital markets than
  smaller firms.

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Systemic instability and financial crises

• Financial crises are characterized by abrupt
  declines in asset prices and by insolvencies of
  financial and non-financial firms.
• Such crises are reoccurring in many countries.
  They are caused by a sharp increase in adverse
  selection and moral hazard problems.
• Four categories of factors trigger crises
• Increases in interest rates
• Increases in uncertainty
• Asset market effects on balance sheets and
• (Multiple) bank failures.

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Asset market effects on balance sheets

• Balance sheets have important repercussions on
  the financial system
• A deterioration (fall in stock or housing prices)
  of the balance sheet reduces the net worth of a
  firm.
• Lenders are less willing to lend because of
  reduced collateral.
• This induces moral hazard because borrowers take
  higher risks.
• The increase in moral hazard makes lending less
  attractive this reduces economic activity.

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Typical financial crises
Increase inuncertainty
Stock marketdecline
Increase ininterest rates
Deterioration of a banks balance sheet
Adverse selection andmoral hazard problems worsen
Economic activity declines
Bank panic
Adverse selection andmoral hazard problems worsen
Economic activity declines
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The stock market and speculative frenzies

• Stock markets have indeed often created havoc to
  the economy and to peoples life
• Early example the tulip bubble in the
  Netherlands (approximately 1620 to 1637)

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The tulip boom

• The boom involved rare tulips
• Bulb prices rose steadily throughout the 1630s,
  as ever more speculators wedged into the market.
• In 1633, a farmhouse in Hoorn changed hands for
  three bulbs
• In 1637 the bubble stretched . and burst !!

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Precedents of the crisis

• The basis of the bubble was an economic boom
  caused by shocking new technologies (Amsterdam
  merchants were at the center of the new and
  lucrative East Indies trade)
• But enabling the bubble was leveraged through
  credit, future contracts, and an innovative
  climate of Dutch finance (that coined new
  instruments such as options)
• Did the burst of the bubble drag down the Dutch
  economy?

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Financial crisisThe US stock market 1871-1914

• Financial crises have been frequent and
  persistent throughout economic history

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What causes stock market volatility?

• Financial crises exhibit a similar pattern
• Promising novel technologies or markets
• A psychologically boosted investment frenzy
• Financial leverage and concentration of
  resources into an emerging segment of the
  economy
• Over-expansion of a sector and its bust
• Contagion of the overall economy

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Examples

• This pattern was typical for
• The railway frenzy of the mid-19th century
• The initiation of electrical appliances at the
  turn of the last century
• But the best analyzed event in economic history
  is the one following the expansion of the
  roaring 1920s ..

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How do financial bubbles affect activity?

• The NY stock market crashed on Friday, October
  1929, initiating a persistent and long downturn
  of the economy

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Development of Stock Market Index
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Repercussions on the real economy
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Impact on peoples lives

• Top CEOs had a especially hard time !

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What dragged the economy down?

• The impact was then
• Increase of personal savings (and hence a
  reduction of consumer spending) due to a
  perceived reduction of personal wealth
• Change in consumer behavior due to higher
  unemployment
• Credit implosion with an induced reduction of
  demand, notably fixed investment
• Reduction of housing investment due to prior
  over-investment

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The Great Depression Further problems

• And
• A general loss in consumers and investors
  confidence
• Change in spending behavior due to insolvencies
  and bankruptcies
• Disintermediation due to a lack of liquidity
• Negative impact on public investment due to a
  fall in tax revenue
• Policy failures, e.g. strategic trade policies
  (Smoot-Hawley Act)

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The Great Depression US imports
November
Monthly data. Imports from 75 Countries (in bill.
Gold )
January
February
December
March
November
April
October
May
September
June
August
July
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The Great Depression Monetary policy

• Policy failure of central banking
• Reduction in the supply of money
• High real interest rates
• Failure of financial institutions

Anna Schwartz
Milton Friedman
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What have we learned since?

• Social protection, especially of the old and the
  unemployed
• Consolidation of financial sector to avoid credit
  implosion, insolvency and break-downs
• Fiscal and monetary management
• International institutions to provide
  international means of payment (IMF) and to
  protect free trade (WTO)
• International cooperation and integration
• And in particular ..

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Our leaders are much brighter !!
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• Today we are technically more advanced and
  smarter than our grandparents!

However animal spirits are persistent and
remain
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Irrational exuberance A bubble that will burst!
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and it did!
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The central bank and systemic stability

• The health of the economy and the effectiveness
  of monetary policy depend on a sound financial
  system. Through supervising and regulating
  financial institutions, the ECB is better able to
  make policy decisions.
• But should it intervene?
• Rescue failing banks?