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FIN 6860: International Finance Management

Professor Ghassem Homaifar


Middle Tennessee State University
Summer 2017

Contents

1. Chapter 1, Global Markets: Transactions and Risks 1

2. Chapter 2, Balance of Payments Exposure Management 39

3. Chapter 3, Foreign Exchange Rate Dynamics: Managing Exposure 79

4. Chapter 4, Applications of Options in Managing Exposure 147

5. Chapter 8, Swaps 185

6. Chapter 9, Translation, Transaction, and Operating Exposure 249

7. Chapter 10, Debt, Equity, and Other Synthetic Structures 307

8. Chapter 11, Measuring, Managing, and Mitigating Credit Risk 355

9. Chapter 12, Measuring and Managing Market Risk 375

10. Chapter 16, Credit Derivatives: Pricing and Applications 415

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Global Markets for Debt, Equity, and Derivatives

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Chapter 1

Global Markets: Transactions and Risks

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

capital relief while enhancing the return on capital to financial institutions.

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

rogue trader, hid over the course of five years.

My objective is to present a coherent analysis of the financing and investment decisions of

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

in derivatives using financial engineering.

Financial risk that is induced by credit, market, and operation risk exposure of multinational

financial institutions as well as transnational corporations have a significant impact on the

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.

Increased Volatility: Opportunities and Challenges

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

giants as AIG, Lehman Brothers, and Bear Sterns.

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

are further protected by the Federal Securities Investor Protection Corporation.

An ordinary bankruptcy petitioner such as an airline or a manufacturing company, gets immediate

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

prime brokerage relationships instead of letting it to collapse.

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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

average of 10 percent by June of 1973.

EXHIBIT 1.1 Monthly Percentage Change/$ (1957-2005)

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

of pound devaluation (revaluation) over 1971-2009 periods.

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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

financial institutions particularly the savings and loans associations.

Exhibit 1.2: Monthly Percentage change in $/ Exchange Rate

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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.

Agency problems: Domestic or multinational corporations can be defined as a portfolio of various

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

various claimants based on priority of claims. Stakeholders develop a comprehensive system of

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

that drain scarce resources and destroy value.

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

manage stakeholders exposure to abuses by the management a compensation scheme is designed by

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

was sentenced to 150 years in prison, the maximum allowed.

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,

transactions and risks facing individual and corporations in a global economy.

TYPES OF MARKETS

Markets for Real Assets

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

services that the economy demands and is willing to pay for.

Markets for Financial Assets

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.

Markets for Derivatives

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:

Exhibit 1.4- U.S. Treasuries (Spot)

August 18, 2009.

U.S. Treasuries

MATURITY CURRENT PRICE/YIELD


COUPON TIME
DATE PRICE/YIELD CHANGE
3-MONTH 0.000 11/19/2009 0.18 / .18 0.004 / .004 11:00
6-MONTH 0.000 02/18/2010 0.26 / .26 0 / .000 11:14
12-MONTH 0.000 07/29/2010 0.4 / .40 -0.002 / -.002 11:04
2-YEAR 1.000 07/31/2011 99-31+ / 1.01 0-00 / .000 11:00
3-YEAR 1.750 08/15/2012 100-19 / 1.55 -0-01 / .010 11:03
5-YEAR 2.625 07/31/2014 100-29 / 2.43 -0-03 / .020 11:21
7-YEAR 3.250 07/31/2016 101-00 / 3.09 -0-01 / .005 11:21
10-YEAR 3.625 08/15/2019 101-07+ / 3.48 -0-02+ / .009 11:22
30-YEAR 4.500 08/15/2039 103-02+ / 4.32 0-04+ / -.008 11:23

Exhibit 1.5-Tuesday, August 18, 2009. 10:29:50 AM CST

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

Source: Chicago Mercantile Exchange

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

current index of 99.435.

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

the rates go up.

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

delivery in return for immediate payment.

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

the forward, futures or options markets.

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.

Forward Market Transactions

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

market price for delivery in the future.

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

as a swap is created by a portfolio of forward contracts.

Exhibit 1.6: Interactions of Various Markets

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

spot price for delivery in the future.

Clearinghouses created by member participants of organized exchanges ensures the integrity of

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

and the United Kingdom.

Exhibit 1.7: Partial Lists of Contracts Traded in Four Different Futures Exchanges

LIFFE NYMEX CME CBOT

STIR 14 Energy Related Currency Futures Long Term Bonds


Long Term Bonds Contracts & Options Municipal Bond Index
SWAPS Gold, Silver Interest Rate Futures Commodities
Equity & Index Aluminum & Options 10 years Notes
Commodity Palladium Index Futures &
Options & Futures Platinum Options
Copper Commodity Futures &
Options
Weather Futures & Options

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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,

(wealthy individuals or institutional investors).

Hedge Fund Characteristics: Four broadly defined attributes distinguish hedge funds from other

money management funds:

1. Trading strategies; short selling, derivatives, options, and other HLTS.

2. Liberal use of leverage, directly through the use of debt, or indirectly through leverage

embedded with derivatives.

3. Opacity to outsiders, absence of transparency.

4. Highly convex compensation, i.e., (2-and-20) set up, dual fee structure. Very high with good

performance, but falls very little with poor performance.

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.

Functions of Hedge Funds

Liquidity providers;

Risk arbitrage;

Price discovery;

Efficiency of intermediation

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Hedge funds as of 2005 accounts:

o 89% of the trade in convertible debts;

o 66% of distressed debts;

o 33% of emerging markets debts;

o 20% of speculative debts;

o 58% of credit derivatives in 2006

Hedge funds survival rate 85-95 percent;

30 percent do not make it after 3-years

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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

developed counterparty credit risk management (CCRM) systems for identification,

measurement, and mitigation of various risks. The CCRM system is composed of:

Limits on the size of the exposure;

Haircut;

Setting margin; initial and variation margin;

Collateral;

Establishing risk identification, measurement, and mitigation techniques

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

haircut in finance terminology is a percentage that is an increasing function of the perceived

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

liquidation of the underlying futures by a clearinghouse.

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

would suffer is an example of systematic or market risk;

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Contagious transmission of the shock due to actual or suspected exposure to a failing bank or

banks, followed by flight to quality;

Panicky behavior of depositors or investors; or

Interruption in the payment system.

Systematic Risk

The systematic risk definition has been quite vague in the literature. Here are few definitions

suggested by economists of various persuasions:

Unfolding of a systematic crisis, where a shock affects a considerable number of major

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

stability of the real economy;

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

hedge funds and trading banks;

Optimal level of systematic risk is not zero.

Operational Risk:

The Basle Committee on Banking Supervision (BCBS) reported recently that

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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

in recent years. Exhibit 1.10 shows break down of financial risks.

A few definitions of operational risk:

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

transactions and in systems as well as technology breakdown;

3. The risk of loss from failed internal processes, people, and systems, or from external events

such as terrorism or natural disaster.

Exhibit 1.10: Break down of Financial Risks

Break down of Financial risks


Commercial Investment Treasury Retail Asset
Banking Banking Management Management Management
operational

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

transaction has the following risks.

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

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,

historically a world leader in construction of heavy equipment, found itself at a disadvantage

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

the events for a number of institutions around the world.

Exhibit 1.11: Case History of Losses


-------------------------------------------------------------------------------------------------------
Company Transaction Date Approximate Description
(Home country) inducing Loss Loss
SocGen Futures 2007 $7 billion Speculative losses
stemming from loss (France)
of internal control

Allied Irish Bank Foreign Exchange Feb 2002 $691 M Rogue trader
hides loss over
3 years

NatWest Swaption March 1997 $127 M Trader misprice


options. reputation damaged

Morgan Grenfell Stock Sep 1996 $720 M Speculative loss


as trader exceeds his limit
June 1996 2.6 Billion
Sumitomo Futures Unauthorized
(Japan) copper trader
over three years

Daiwa futures Sept 1995 $1.1 billion Unreported


loss over 11
years

Bankers Trust swaps Oct 1994 $150 M Legal risk and


reputational
damage

------------------------------------------------------------------------------------------------------------

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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

relationship context as follows:

Counterparty risk: The risk that one of the parties to the agency contract fails to perform for

whatever reasons and does not fulfill its financial obligations.7

Liquidity Risk: associated with lack of efficient secondary markets in which a long or short

position can be liquidated without substantial discount at current market price.

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

mitigate the risk of higher interest rate in the next 3-months.

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

Cooperation of West African Economies (ECOWAS)) have created an environment in which a

shock to a local economy can easily spread to other trading partners.

References:

Chance, Don. M An Introduction to Options and Futures Dryden Press 2000.

Eiteman,D, A. Stonehill and M. Moffett, Multinational Business Finance Ninth Edition,

Addison Wesley Longman 2001.

Homaifar,G, J. Zietz, O. Benkato, Determinants of Capital Structure for Multinational and

Domestic Corporations, International Economics Vol. LI. No. 2, 1998. PP. 189-210

Jensen, M. and W. Meckling,Theory of the Firm: managerial Behavior, Agency Costs,

and Ownership Structure, Journal of Financial Economics, No. 3, 1976, PP. 305-360.

Lee, K.C. and C.C.Y. Kowk,Multinational Corporations VS Domestic Corporations:

International Environmental Factors and Determinants of Capital Structure,Journal of

International Business Studies ( Summer 1988 ), 195-217.

Myers, S.C., Determinants of Corporate Borrowing, Journal of Financial Economics, 5

(November 1977), 147-175.

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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

acquired in the bankruptcy

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

access to $ in August 1997.

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

Questions and problems

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

Balance of Payments Exposure Management

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

she does not have or cannot produce as cheaply.

The theory of comparative advantage provides a reasonable explanation why countries

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

elimination of tariffs or quotas to a member country at the cost of non-member. The

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.

Comparative Advantage refers to specialization as a key for


Key Concept producing goods at a minimum average cost and trading these goods
for other products in which trading partners can produce more
efficiently.

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.

It is important to distinguish between absolute advantage and comparative advantage.

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

advantage) cannot be used as an argument in favor of protectionism; the ratio of the

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

its major trading partners during the 1999 to 2009 period.

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.

Exhibit 2.2: USA Imports from Major Trading Partners


1999-2009

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

and servives from China as import/export ratio dramatically increased to 12 by 2008.

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Exhibit 2.3: Import /Export ratio for the US Major Trading Partners
1999-2009

Absolute Advantage in wage or productivity alone is a necessary but


Key Concept not a sufficient condition for producing goods at a minimum average
cost.

The ratio of productivity over wage (comparative advantage)


dictates why a country such as U.S. with very high wages and high
Key Concept productivity in high tech trades with a country such as Mexico with
low wages (absolute advantage) and low productivity.

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 National Treasury sums up the above argument:1

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

may or may not be in the best interest of the borrowing country.

Balance of Payments as a Source and Use of Funds

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.

Key Concept The Balance of Payments summarizes revenue and expenditure on


all international transactions; involving export/import of goods,
services, and capital over a given period.

COMPONENTS OF BOP

The Current Account

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

currency to eliminate the excess supply in a floating rate environment.

Deficit in the current account is financed by issuing IOUs to foreign


Key Concept individuals or institutions as the supply of domestic currency exceeds its
demand and ultimately to the eventual devaluation of that currency.

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

current account and the net long term capital account.

Official Foreign Exchange Reserve

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

36
45
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.

Depreciation can be a double-edged sword, beneficial to exports as goods and services

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

inflation occurs in the economy.

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.

Statistical Discrepancy for Errors and Omissions

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

Current Account + Capital Account+ Official Reserve+ Statistical Discrepancy = 0

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

Federal Reserve Bank of St Louis:

United States Balance of Payments, 2008, 4th quarter in billions.

Merchandise Trade: -$178.82 +

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46
Balance on Service: +$34.326

Balance on Investment Income: $21.146 +

Balance on Net Transfer: -$31.527 +

Current Account = -$154.875

Foreign Assets in the U.S.: Net, Capital Inflow -$11.888 +


U.S. Assets Abroad, Net: Outflow $114.730
+
Statistical Discrepancy $67.236
+
Capital Account = $170.078

Current Account and Economic fundamentals

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

goods and income.

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

do not exist due to differences in individual taste across the globe.

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47
The factors inducing change in current account can be summarized as follows:
Key Concept
-Exchange Rate ratio of two prices

-Income

-Government

-Expectations Consumer Confidence

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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48
implication for managing exposure are contrary to the above analysis. This important issue is

discussed in chapter 3.

In a complete pass-through a currency appreciation/depreciation i.e.,


Key Concept say 5 percent causes export price/import price to go up/down
simultaneously by 5 percent.

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

account balance for the U.S.

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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49
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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50
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

as indicated in Exhibit 2.4.

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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51
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

nearly 20% in the U.S.

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.

However, a deficit can be harmful to the well-being of an economy. If an increase in the

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

and other long term instruments) are related to:


Interest, dividend, capital gains (losses) +/- Foreign exchange gains/losses

(1+ Return in $) = (1+Return in Pound) (1+ % change in exchange rate) 2.1

(1+ Return in $) = (1+.08) (1+.05)


= 1.1340
Return in $ = 1.1340-1
Return in $ =.1340

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 risk as measured by the variance of Equation 2.1 will be:

Volatility in $ = volatility in + volatility of percentage change in $/ exchange rate 4

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

pounds and the percentage change in exchange rates.

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.

Foreign exchange gain (loss) = (1.21 -1.10)/(1.10)


= .10
(1+ return $) = (1+.08) (1+.10)
= 1.188 -1
Return $ = .1880

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

reached nearly -.037 percent of the GDP as reflected in Exhibit 2.5.

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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%

compound rates between the 1988 to 1999 period.

Exhibit 2.6: Percentage of change in Brazilian Real 1995-


2000

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

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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

financial crisis of 1998-99:5

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

banks is put in doubt due to currency and banking crises.9


When the imbalance is financed primarily with large capital inflows and
short-term credit from large foreign banks at times of economic growth,
the return on investment is usually greater than the cost of capital.
Key Concept
However, as the boom ends and local currency devalues and as the cost
of servicing foreign currency denominated loans skyrocket,
bankruptcies mount, putting the solvency of local banks in doubt due to
currency and banking crises.

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

both currency and interest rate risk.

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

and severity of the crisis.

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.

Exhibit 2.7: CA/GDP and the Percentage Changes in Exchange Rates

CA/GDP Exchange Rate Change


Country (1996) ______ (1996-97)

Korea -4.82% -52.6%


Indonesia -3.3 -49.6
Malaysia -3.73 -35.2
Philippines -4.67 -34.4
Thailand -8.51 -44.4
China 0.52 0.0
Hong Kong -2.43 0.0
Singapore 16.23 -16.1
Taiwan 4.67 -15.9
Source: Corsetti, G, P. Pesenti, and N. Roubini. 1998. "What Caused the Asian Currency and
Financial Crisis?" Japan and the World Economy, October 1999, pp. 305-73.

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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

expectations fail to materialize.11

Causes of Financial and currency crisis in South East Asia

Many factors contributed to the collapse of currencies in the South East Asian economies in

1997. These factors were:

Rigid exchange rate mechanism;

Moral hazard associated with financial intermediaries;

Lack of transparency;

Lax regulation;

Capital account liberalization.

The effects of the above factors were seen in:

Widening current account deficit;

Asset price inflation (bubble in equity and real estate prices;

Appreciation of real exchange rate;

Rising roll-over risk;

Export slow down;

50
59
Mismatch of revenue and cost (un-hedged exposure to currency risk);

Interest rate 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).

Exhibit 2.8: Short Term Foreign Liabilities/ International Reserves

Indonesia Malaysia Philippines South Korea Thailand


June 1990 2.21 .22 3.18 1.06 .59
June 1994 1.73 .25 .41 1.61 .99
June 1997 1.70 .61 .85 2.o6 1.45

Source: Bank for International Settlements, International Monetary Fund

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

has been the case for the U.S. economy so far.

Exchange Rate Arrangements, Dollarization and Pegs: Several countries particularly

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

Hungary as shown in Exhibit 2.9.

Exhibit 2.9: Currencies Pegged to U.S. dollar


-------------------------------------------------------------------------------
Country Currency Currency pegged to
Argentina Peso U.S. dollar
Hong Kong China HK$ U.S. dollar
Bahamas dollar U.S. dollar
Barbados dollar U.S. dollar
Bermuda dollar U.S. dollar
China Yaun U.S. dollar
Hungary forint Composite of European currencies
Saudi Arabia riyal U.S. dollar
Source: International Financial Statistics, International Monetary Fund, Washington DC, July
1999.

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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

financial stability and maintain purchasing power of a countrys currency.13

For example, the South Korean won was pegged to the U.S. dollar prior to its collapse in

1997, after which it was allowed to float against other currencies.

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

Argentinas monetary policy completely dependent on the U.S. monetary policy.

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

Argentinas central bank is demonstrated in Exhibit 2.10 as follows:

Exhibit 2.9: Ownership of Dollar Denominated Time Deposits by Argentineans

Year Dollar Denominated Time Deposit as a percentage of Total

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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

exactly what happened.

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.

Exhibit 2.12: Argentinas Producer and Consumer Price Changes, 1995-2002

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

Change in Consumer Price Change in Producer Price

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

56
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,

absolutely impossible to require a system with significant differences in its socioeconomic,

political and markets structure as compared to the U.S. to be dollarized overnight.

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

recovery rates ever seen by sovereign Argentina.

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The rest is history and the IMF, as a lender of last resort, required Argentina to cut spending

as a precondition to extend additional lines of credits.

Managing Balance of Payment Exposure in the Emerging Market Economies

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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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

volatile since the floating rate arrangement of 1971.

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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68
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

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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?

2. Was Chinas current account in surplus or deficit?

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.

4. Did China have a financial account surplus or deficit?

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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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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

1994 0 0 0 2000 33787 380 3923 1189 1496 32645 9100.25

1995 0 0 0 2000 35849.2 79 710.4 1081 5116.19 38673.8 17823.2

73
1996 0 0 0 2114 40180 628 2372 1126 1282 39966 15504

1997 0 21 21 2563 44237 899 7842 39608 12028 21037 22121.8

1998 0 47 47 2634 43751 3830 98 35041 8619 6275 18901.8

1999 0 26 26 1775 38753 10535 699 24394 3854 5204 17640.5

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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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

Questions and problems:

1. Balance of payments provides a summary of revenues on exports and expenditures on


imports over a given period for a country. T/F
2. Explain the theory of comparative advantage in the context of an example in which two
producers in two different nations produce a commodity for trade.
3. Distinguish between absolute and comparative advantage.

66

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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

Korean Chaebol prior to collapse of Korean Won.


12
See Radlet and Sachs (1998) and Chang and Velasco for supporting evidence.
13
According to International Financial Statistics of the International Monetary Fund more than 38 countries are in a

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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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

FOREIGN EXCHANGE MARKETS, TRANSACTIONS AND RATES

Foreign Exchange Markets

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

of purchasing power), management of exchange rate risk (transfer of foreign exchange

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

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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-

name or multi-name), accounted for more than $51 trillion by 2007.

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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

market is shown in Exhibit 3.2.

Exhibit 3.2: Currency distribution of reported foreign exchange


market turnover

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

exchange market activity.

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Foreign Exchange Transactions

A foreign exchange market is composed of spot, outright forward and swaps

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,

$382 and $1,714 billion by 2007.

Exhibit 3.3: Global Foreign Exchange Turnover

Source: Bank for International Settlements.

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

dollar terms is $30,000.

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)

market are outright forward contracts.

Example: Hedging with Forward Contract: Nissan manufacturing enters into a

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

as illustrated in Table 3.1.

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

The payoff on an un-hedged position could be higher or lower depending on the

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

receivable denominated in foreign currency as shown in Exhibit 3.4.

Exhibit 3.4: Forward Hedge and Unhedged Positions


2.95

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

unhedged forward hedge

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

receivables or payables denominated in foreign currency.

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.

Forward Rate Agreement (FRA) - an Approximation: Consider the quotes in the


inter-bank Euro-currency interest rates for dollar, pound, Swiss Franc and Euro as
follows:

US dollar UK sterling Swiss franc Euro

30-days 5 3/4 5 7/8 5 5/8 5 6/8 4 7/8 5 5.50 5 5/8


60-days 6 6 1/8 6 1/8 6 1/4 5 1/8 5.25 5 7/8 6
90-days 6 1/4 6 3/8 6 6 5/8 5 4/8 5 5/8 6 1/4 6 3/8

The 30 days forward rate prevailing in 60 days in dollar and other currencies can be

estimated using an approximation as follows:

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

provides a useful framework for estimating forward rates as follows:

Rl = (Sm* Rs + Fm*F)/(Sm + Fm) 3.1

Where

Rl - is the long term rate,

Rs - is the short term rate,

86
69
F- is the forward rate.

Fm is the forward rate maturity

Sm is the short term rate maturity

90-day rate = (60 * 60-day rate + 30 * 30-day forward rate) /90

6 3/8 = (60* 6 + 30* 30-day forward) /90

30-days forward rate = 7.125%

The forward rate is produced schematically as follows:

Borrow at ask rate of 6 3/8 for 90 days

Or Luck at FRA Rate for 30 days

Invest for 60 days at Bid Invest at an unknown rate for 30-days?

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:

Cash received by the losing party = 10M (0.02 ) (30/360)] / (1+09125x30/360)

= $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

which way interest rates move.

Syndication of Euro credit Loan

Euro credit loans are short term or a medium term loan that is extended to multinational

corporations, sovereign governments, and international organizations. For example, the

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

other variable rate index.

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

from the borrower as shown in Table 3.

Table 3: Participation and Sub-Participation


Banks fee Amount of Fee income
capital funded
12 sub- .01 $600 million $6,000,000
participants

10 sub- .01 $310 million $3,100,000


participants

12 sub- .01 $240 million $2,400,000


participants

Arranger .04125 $100 million $4,125,000


total 1.25 % $1.25 billion $15,625,000

89 72
Participation Process in Syndication of Euro Credit Loan

Borrower
$1.25 billion

Arranger fee Arranger Bank


Servicer fee Arranges $1.25 billion Loan
Retains $100 million

12 Sub-participants 10 Sub-participants 12 Sub-participants


$50 million each $31 million each $20 million each

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

90
73
provided that this bank has funding cost at the rate of LIBOR +25 bps (100 basis

points is equal to 1 percent)?

4. Describe how the borrower in the above syndication loan will manage its

exposure to interest rate risk.

Foreign Exchange Swaps: A contract involving two counterparties to exchange, for

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

swap is the forward/forward swap.

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

arranged with the swap dealer that is usually a major bank.

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

91 74
sells 1,000,000 90 days forward at $1.5210/ and simultaneously buys 1,000,000

60 days forward at $1.5278/. This swap transaction is borrowing in disguise for 30

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 agreement to buy it back in 60-days as follows:

(1+ repo-rate)= $1.5278//$1.5210/

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

interest rate denominated in dollars. By selling forward one essentially is borrowing

(financing) and by buying forward one is equivalently lending (investing) at a

predetermined rate that fixes (locks) the cost of borrowing. Foreign exchange swaps

make up over 50 percent of all the transactions in the FOREX market.

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

swap agreement by buying 60 days pounds forward at $1.5280/ and simultaneously

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

particular function. For example, a spot transaction is intended to transfer purchasing

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

financing at a fully collateralized basis.

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

3-months forward rates as of May 17, 2002.

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76
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

pound/$ as the yen/pound as follows:

125.92/. 6858= 183.61yen/pound

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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-

month forward yen/$ and 1-month, 3, or 6-month forward pound/$ as follows:

125.72/. 6870=182.99 yen/pound, 181.72 yen/pound and 179.70 yen/pound

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

quoted as points quotations as shown in Exhibit 3.6.

Exhibit 3.6: Spot and forward Quotations for Yen and British Pound in the Inter-Bank
Market

Offer $/ Bid Bid /$ Offer

Japan (yen) spot .007942 .0078666 125.92 127.12


1- month forward .007954 .0078833 125.72 126.85
3- month forward .007979 .0078989 125.32 126.60
6- month forward .008025 .0079403 124.61 125.94
Points quotations

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

quoting the 1, 3, and 6-month forward in point quotations as 26 to 21, - 81 to 54 and

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

the spot rate to arrive at a particular forward rate.

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

tied to the performance of individuals in generating arbitrage profit in private banks.

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

direction against speculative attacks on dollars, pounds or yen).

Major Players in the Foreign Exchange Market: The market share of currency trading

and distribution of the major financial institutions is shown in Exhibit 3.7.

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

growing use of electronic trading in the inter-bank market.

Exhibit 3.7: Foreign Exchange Market Major Players and Distribution of Their
Shares

Foreign Exchange Market 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

0.00 10.00 20.00 30.00 40.00 50.00


Percent

97 80
Source: Euromoney: Bank for International Settlements

Exhibit 3.8: Daily Turnovers

spot,forward,swaps

$1.50

$1.00
Trillions

$0.50

$0.00

1989 1992 1995 1998 2001

Year

Source: Euromoney: Bank for International Settlements

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

in United Kingdom, United States and Japan.

Exchange Rate Bid Offer


Pound/$ .69103 .69343
$ /yen 124.61 125.94
Yen/ 182.85 183.92

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

98 81
the pound is quoted at a premium against the yen in the above cross currency inter-bank

market as compared to implied cross exchange rates as illustrated in the following

diagram.

Start with $1 million

$1,000,000.00

$1,003,292.77

126,354,835.5 691,030

Sell for $ at bid Buy with at bid Buy with $ at bid


Direct term European term European term

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.

Speculative Transactions: Currency market speculative transactions involve buying or

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/

99
82
and selling the pounds three months later at $1.5781/, the speculator would have

realized a profit of $32,040, before transaction cost as demonstrated in Exhibit 3.9.

Exhibit 3.9: Profit (Loss) in Speculative Long and Short Position

Profit (Loss)

Short in Long in

-$32,040 $1.562/ $1.57812/ $/

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

continued to climb against the yen, the losses piled up.2

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,

which lies at the center of FX settlement risk.4

100
83
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

exchange rate arrangements in place in the respective economy).

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

and services denominated in dollar and pound.

Price in $= Price in .$/ 3.2

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

from parity will lead to risk-less arbitrage in a frictionless market.

101 84
The Big Mac index: The Economist has devised an index of Big Mac burgers

denominated in currencies in which there is Burger King Franchise owned by McDonalds

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

compared to actual exchange rate can provide a rough approximation as to whether a

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

Argentina and the United States, ($3.02/$3.57)-1= -.15

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

determined at least for classes of goods in a competitive environment. The government

intervenes in the process of price determination or institutes regulatory requirements that

impose additional cost on the producer, which ultimately has to be passed on to

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

the value of financial assets.

103
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

determines currency values.

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

dollar from falling below 90 yen.

105
88
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

14 to 18 months following dollar devaluation.6 This phenomenon is known as a J-Curve

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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Exhibit 3.12: J - Curve

Merchandise Trade Balance

Time

Time t 0 Time t1 Time t2

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

balance as documented by Rosensweig and Koch (1988).

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

which U.S. currency belongs.

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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

prices of unidentical products produced in two different countries.

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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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

higher price of steel produced elsewhere, which is induced by imposition of a tariff.

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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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.

Exhibit 3.14 Relative Version of PPP

Time 0 U.S Time 1


$150 5% Inflation $157.50

$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 expected exchange rate S1 is as defined in Equation 3.3 as follows:

S1 = S0 (1+$) / (1+ f) 3.3

S1= $1.50/. (1+. 05)/(1+. 10) = $1.4318/

The approximate version of the relative PPP implies that, the percentage change in the

exchange rate is equal to inflation differentials as shown in the Equation 3.4.

(S1- S0)/ S0 = ($ f) 3.4

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93
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

of the above approximation in Equation 3.4 is provided in Exhibit 3.15.

Exhibit 3.15 Parity Relationship

(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

appreciated by 4 percent against dollar that is ((S1- S0)/ S0 = 4%).

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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

exchange rate parity is restored.

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

own currency appreciation it is willing to absorb.

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

exporter, 100% pass-through.

3. Absorb some of the increase and pass the remaining to the importer, partial pass-

through, under 100%.

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

358 /$ in 1971 to 80 /$ by the mid 90s, nearly 77 percent appreciation.

Exhibit 3.16: Yen/$ over time

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

rates to import prices.8

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

to unity and zero for no pass-through. The Pass-through coefficient is as high as 88

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

cost or profit margins.

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98
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

99

116
be identical in future i.e. there should be parity in dollar and euro returns. Let us start

with $100 equal to 100 Euro in Exhibit 3.18.

Exhibit 3.18: International Fisher Parity

Time 0 U.S Time 1


$100 4% Interest $104
rate

S0 = $1/euro S1= $.9905/euro


U.K
100 5% Interest 105 Euro
Euro rate

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

nominal interest rate in foreign currency.

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

foreign currency) as expressed in the Equation 3.5.

S1= S0 (1+R$) / (1+Rf) 3.5

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

dollars and foreign currency in Equation 3.6.

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101
Exhibit 3.19 Forward Interest Rate Parity

$145.82 U.S.A $152.38


4.5% $152.38

S0 =$1.4582/ F=$1.4376/

106
100 6% 106

U.K

F= S0 (1+R$) / (1+Rf) 3.6

Where the parameters are as defined previously.

The forward premium or discount (F S0)/ S0 in direct quote and in equilibrium has to be

equal approximately to interest rates differential in Equation 3.7 as follows:

(F S0)/ S0 (R$ Rf) 3.7

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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102
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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103
dollars and foreign currency and it pays to borrow foreign currency and invest in U.S.

dollars and sell dollars forward for a risk-less arbitrage profit.

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

arbitrageur borrowed SF1, 000,000.00 at 3 percent.

Interest rate parity as an equilibrium relationship between forward premium or discount

and interest rate differentials requires two crucial assumptions as follows:

Rational Expectations

Absence of Risk Premium

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

competitive capital market has to be equal to zero.

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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

environment, the actions of currency speculators can be expected to lead to deviation

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

impossible for the small investors to benefit from such events.

122
Exhibit 3.21: Forward Premium (discount) and Interest Rates Differential

Yen Pound S/peseta


1-Month Forward 5.4 (5.7) -1.9 (-1.9) 1.2 (1.2)
3- Month Forward 4.8 (5.3) -1.9 (-1.8) 1.2 (1.2)
1- year Forward 4.5 (5) -1.8 (-1.6) 1.6 (1.5)

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.

International Parity Relationship: Assuming the following parameters, the

international parity relationships can be illustrated in Exhibit 3.22 as follows:

S0 = $1/euro
S1= $0.9903/euro
F= $0.9903/euro
R$ = 4%
Rf = 5%
$ = 2.5%
f = 3.5%

Exhibit 3.22: International Parity Relationship

-1

Percentage change
exchange rate

Interest rate Forward premium


-1 differential or discount -1 -1

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

forward premium or discount is identical, therefore international parity ex-ante is in line

with its theoretical counterpart.

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

determination as shown in the Equation 3.8.

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

for the U.S. and the U.K are provided as follows

Growth rate of money supply $ = 6 %

Growth rate of money supply = 8.5 %

Growth rate of GDP $= 2.75 %

Growth rate of GDP = 3.25 %

Change in velocity $ = 1%

Change in velocity = 1/2 %

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

pound assuming PPP holds.

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

differentials in two economies as illustrated in the Equation 3.11.

Er = En (Pf / P$) 3.11

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

unity as shown in 3.12.

Er = (P$ /Pf ) (Pf / P$) = 1 3.12

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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

currencies in the sample periods.

Exhibit 3.23: Real Exchange Rates for Major Currencies

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

years following 1995 making exports extremely uncompetitive as reflected in widening

the current account deficits. Japanese exports before and after the base period 1995

appear to be extremely uncompetitive as the real exchange rate appreciated by 33.8

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 expensive for the trading partners.

Canada appears to have gained relative competitiveness as is evidenced by the

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

uncompetitive particularly that of Germanys. Exhibit 3.24 provides a graphical

representation of the real exchange rate for the selected countries.

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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.

Exhibit 3.25: Real Exchange Rate for selected Emerging Economies

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

the financial and the banking sector.

Exhibit 3.26: Real Exchange Rate Indices for East Asian Economies 1991to 2009

129
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

China relative to Korea, Indonesia and Thailand enjoyed a comparative advantage in

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.

113

130
Real-Wood Furniture, Inc.
by
Lee Sarver

Well, there goes my weekend, Mary S. Lytle-Lamm thought glumly, as she


started back toward her office. With a mint-shiny MBA from Pacific Northwest
University, she had joined Real-Wood Furniture, Inc. only three weeks earlier and had
hoped to feel her way gradually into the job of financial analyst. (After all, doing finance
in class and doing it with real moneyother peoples, at thatare two very different
things!) Evidently, it was not to be. Still awed by the prospect of doing it for real, she
had been trying to determine the most efficient and business-like arrangement for the
objects on her desk, when her new boss, the director of Accounting and Finance stuck his
head through her door at about 10:30. Whatever youre doing can wait. Grab a notepad
and come along. With that, he headed down the hall. Mary reached the conference room
only a few steps behind him and stopped dead. More new faces, she thought, A lot of
them. Whats going on? Waved to a seat without introduction, she soon realized that
whatever it was, it seemed urgent.
Real-Wood Furniture began as a hobby. Its foundera civil engineer with the
U.S. Bureau of Reclamationhad built furniture and cabinets in his suburban Spokane
garage beginning in the 1970s. Appreciative friends and family persuaded him to go into
business during the 1980s, and by 1996 the firmwhich sold to decorators and
independent shops as far away as northern Californiahad grown to 120 employees.
Because the firms founders and senior managers still did not think of themselves as
business professionals, they had recently begun hiring people with formal training like
Mary and her boss.
For years, Real-Wood had bought most of its raw materialswood solids
locally, with more attention to convenience and quality than to cost. (The founder and
chairman still never missed an opportunity to sneer about sawdust-and-glue boards with
a photo of wood stuck on. He scorned even hardwood-solids-and-veneers construction. )
However, as the firms market grew, competition sharpened and cost-control became an
issue. Accordingly, while maintaining relationships with long-time suppliers, Real-Wood
had relied increasingly on newer, more capital-intensive, lower-cost Canadian mills to
meet its needs. Because imported wood had until recently constituted only a small part of
the firms costsskilled labor was by far the largestand because it negotiated long-
term contracts, the management of Real-Wood had not felt much concern about foreign
exchange risk. The firms managers were not nave; they simply had other priorities. As it
turned out, that had just changed.
The new U.S administration had just announced a 27 percent tariff on imported
Canadian lumber, ostensibly to protect domestic mills from unfair competition. At the
same timepresumably to head off protests from both Canadians and their erstwhile
customersthe U.S. Trade Representative gave assurances that exceptions could be
made in cases of hardship. How they could be obtained and how they would work was
not yet clear, although the local congressman had already blandly assured his constituents
that business could proceed as usual. These were the events that had precipitated todays
unplanned meeting of the management of Real-Wood with the firms bankers and other
outside advisors.

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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

Money Market Rates


3-month rate, Canada 2.83% p.a.
3-month rate, United States 1.70% p.a.

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?

4. What is the dealer profit in the previous question?


5. Forward transactions are approximately 10 percent of all foreign exchange
transactions. T/F
6. Vanitys treasurer has to buy 125 million pounds to pay for the imports. The pound
is quoted at:

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

180-day 1.7178 1.8017


forward
1-year forward 1.7198 1.8066

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:

American term European term


Bid Offer Bid Offer
British pounds 1.5678 1.5683 .6376 .6378
Japanese Yen .0093 .0095 105.26 107.52

a) What is the yen/pound implied cross exchange bid/offer rate?


b) Suppose a dealer is offering yen/pound at 162/, how much is the arbitrage profit?
c) Which currency is over (undervalued)?

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

18. A revaluation is an attempt by a country to depreciate its currency relative to its


trading partners. 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

22. An individual or institution in the foreign exchange market is a demander of one


currency while, at the same time, a supplier of another currency. 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

25. The collection of accounts receivable denominated at a weakening currency should be


accelerated. T F

26. U.S. bonds sold in Japan are known as Yankee bonds. 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

33. Purchasing power parity holds if:


A. the law of one price is not violated
B. goods in question are traded internationally

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139
C. prices adjust in the long run for differences in quality
D. all of the above hold

34. Based on purchasing power parity:


A. the percentage change in exchange rate is equal to the ratio of relative price
changes of two countries
B. the percentage change in discount rate is equal to the rate of change in inflation
C. the percentage change in exchange risk is equal to the rate of change in inflation
D. the percentage change in real interest rate is equal to rate of change in exchange
risk

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

42. If accounts receivable is dominated by a strengthening currency it pays off:


A. to stretch collection of receivables
B. to expedite collection of receivables
C. to forego collection of receivables
D. all of the above

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

Bilson, J. "The Choice of an Invoice Currency in International

Transactions." In Economic Interdependence and Flexible Exchange

Rates, edited by J. Bhandari and B. Putnam, 384-401. Massachusetts

Institute of Technology Press, 1983.

Cassel Gustav "Abnormal Deviators in International Exchange

Economic Journal December 1918, pp. 413-415.

Cumby, R and M. Obstfield "A Note on Exchange Rate Expectations and Nominal

Interest differentials, a test of Fisher-hypothesis,. "Journal of Finance, June 1981,

pp.697-703.

125
142
Frankel, J. "In search of The Exchange Risk Premium a Six Currency

Test Assuming mean-variance optimization." Journal of

International Money and Finance, December 1982, pp. 255-274.

Gaillot, H. "Purchasing Power Parity as an Explanation of Long-term

changes in Exchange Rates," Journal of Money, Credit and Banking.

August 1971, pp. 348-357.

Homaifar Ghassem and Joachim Zietz Official Intervention in the Foreign Exchange

Market and the Random Walk Behavior of Exchange rates. Economia

Internationale, Vol. 48, No. 3 (August 1995): 359-373.

Lothiar, J and M. Taylor "Real Exchange Rule Behavior: the recent float

from the perceptive of the past two centuries." Journal of Political

Economy, June 1996.

Krugman, Paul. "Pricing to Market When the Exchange Rate Changes."

National Bureau of Economic Research Working Paper no. 1926

(May 1986).

Mann, Catherine. "Prices, Profit Margins and Exchange Rates." Federal

Reserves Bulletin 72 (June 1986): 336-379.

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.

Mishkin, F. "Are real interest Rates equal across countries." An International

Investigation of Parity Conditions." Journal of Finance 1984, pp.1345-57.

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143
Rosensweig, J and P. Koch. The U.S. Dollar and the delayed J-curve,

Economic Review Federal Reserve Bank of Atlanta. July/August

1988. Pp 2-16.

Zietz Joachim and Ghassem. Homaifar Exchange rate Uncertainty and the Efficiency of

the forward Market for Foreign Exchange: A Reply. Weltwirtschaftliches

Archive, Vol. 131. No. 4 (1995): 789-791.

Zietz Joachim and Ghassem. Homaifar Exchange Rate Uncertainty and the Efficiency of

the Forward Market for Foreign Exchange. Weltwirtsschaftliches archive,

Vol. 130, No. 3 (1994): 461-475.

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144
End Notes:

1
Central Bank Survey of Foreign Exchange and Derivatives Activity 1998, Bank for International

Settlements, Basle May 1999.


2
Euromoney, March 2002.
3
With the launch of new CLS network, members can settle trades and net positions in each 24-hour period
through its payment-versus-payment process in the books of a central entity, CLS Bank International.
Notes Daniel Koh, head of trading at Standard Chartered Singapore, one of the member banks.
4
Euromoney, March 2002.
5
See for example Mann (1986), Krugman and Baldwin (1987); and Rosensweig and Koch (1988)

Economic Review July /August 1988, p 2-15


6
The evidence of delayed reaction of the change in exchange rate and the import price and volume is

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

predictor of future inflation.


11
See Zietz and Homaifar (1994, 1995) who find evidence particularly for the German Mark and Swiss

Franc in the time period from 1976-84 that their respective forward rates were close to the theoretical

values.

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