1 Key Concepts from Textbook

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1 UCLA Anderson MGMT234A: International Financial Markets (Winter 2013) Week #2 Professor Andrea Eisfeldt January 18, 2013 Handout written by Shenje Hshieh Reminder: Read chapter 4 in Bekaert and Hodrick (2012). Complete problem set 2 for your own self-study. 1 Key Concepts from Textbook 1.1 Balance of Payments (BOP): Current Account Transactions There are many ways to determine which transactions are considered credits or debits. I list several definitions (in addition to the one given by the textbook): Credits (+) 1. Transactions that conceptually increase the supply of foreign money in the forex 2. Transactions that increase domestic liabilities to foreigners (foreign claims on U.S. residents) 3. Transactions that decrease the stock of assets held by domestic residents 4. Transactions in which the ownership of something (e.g. goods, services, assets, goodwill, etc.) is transfered from the domestic country to a foreign country (an export ) Debits (-) 1. Transactions that conceptually decrease the supply of foreign money in the forex 2. Transactions that decrease domestic liabilities to foreigners 3. Transactions that increase the stock of assets held by domestic residents 4. Transactions in which the ownership of something is transferred from a foreign country to the domestic country (an import ) The first rule on both credits and debits listed above is the intuitive rule suggested by the textbook. I go over an example under the logic defined by rules 1, 3, and 4 below. Example 1 U.S. Export of Movies to Japan: Suppose we are interested in the U.S. BOP and that Japanese film importers do not have dollar-denominated bank accounts in the U.S. The export of movies is a service export. By rule 4, this should go on the credit side. However, this service can also be viewed as an asset that is created by U.S. residents, transferred to foreigners, and consumed by foreigners. Thus, by rule 3, this transaction is a decrease in assets and goes on the credit side of the BOP. We reach the same conclusion using rule 1, as there is an inflow of Yen to the forex used to exchange for U.S. dollars to pay for the services. Please me at shenje.hshieh.2015@anderson.ucla.edu if there are any errors. 1

2 The export of movies comes with an import of financial assets, namely U.S. dollars. By rule 4, this should go on the debit side. Additionally, an import of U.S. dollars increases asset holdings of U.S. residents. According to rule 3, this transaction goes on the debit side of the BOP. Note that Japan now has fewer claims on U.S. residents (decrease in U.S. liabilities to foreigners). If this can be considered as a separate transaction, by rule 1, Japanese film importers would have to convert their dollar holdings to Yen to achieve the same effect (i.e. reducing ownership of U.S. assets). This would decrease the supply of Yen in the forex. 2 Analysis of News Articles 2.1 Franc and dollar sought as havens : How well can the SNB defend the franc if demand pushes it below 1.2 CHF/EUR? To give some context to the article: because the Swiss franc has long been regarded as a safe haven asset, investors sought safety in it admist the Greek sovereign-debt crisis. As a result, the franc has appreciated massively, to the point in which the SNB saw it as a risk to exports and a threat to the economy (i.e. it may cause a recession). On September 6, 2011, the SNB set a minimum exchange rate of 1.2 CHF/EUR. This is the ceiling to which the article is referring. Lowering the ceiling would mean further depreciating the franc against the euro to the new minimum ceiling. If the SNB is to defend the ceiling, any appreciation of the franc that occurs needs to be negated by sterilization of the money supply. That is, the SNB would need to buy euros to neutralize the impact of forex demand for the franc. So, if demand pushes the CHF/EUR below 1.2, the SNB would need to buy euros for francs in order to dilute the demand for francs. A side note: as mentioned in class, taking profits is jargon for closing a position. Closing a position that bets the franc would weaken against the euro means canceling a long euro and a short franc transaction. That is, we short euro and long franc. One would close out this position if one believes such a position is no longer profitable. In the context of the article, closing out such a position is a bet that the SNB would not intervene to lower the ceiling. 2.2 Gensler calls for LIBOR replacement : How is the LIBOR fixing scandal related to our discussion of CIRP? Which direction would the alledged fixing push the spread r CIRP r quoted? The Libor fixing scandal involves banks that underreported the interest rates that they expect to be charged by other banks for a short term loan during the 2008 credit crunch. Basically, the quoted LIBOR rates were lower than those implied by CIRP. Understating LIBOR would be profitable for many of the financial institutions that were floating-rate payers in their interest-rate swap contracts. 2

3 2.2.1 A Brief Introduction to Interest-Rate Swaps In an interest-rate swap contract, two parties exchange periodic interest payments based on an agreed-on principal, which is called the notional amount. Each party would pay to the other party on an set of agreed-on periodic interest rates multiplied by the notional amount. In the most common type of swap, one party agrees to pay the other party a fixed interest payment at designated dates for the life of the contract. This party is the fixed-rate payer. The other party, called the floating-rate payer, makes an interest-rate payment that float with some reference rate. I illustrate an interest-rate swap with the following example below. Example 2 Fixed rate for LIBOR: Suppose for the next five years party X agrees to pay party Y 10% per year, while party Y agrees to pay party X six-month LIBOR. Assume that the notional amount is 50 million and payments are exchanged every six months for the next five years. This means that every six months, party X will pay party Y 10% 50 million = 2.5 million. The amount party Y will pay party X will be LIBOR 6-month 50 million Relationship to CIRP Note from the example above that X, the fixed-rate payer, essentially has a long position on sixmonth LIBOR. Y, the floating-rate payer, can be seen as having a short position on six-month LIBOR. Thus, understating LIBOR would reduce the payments for Y. If r CIRP r quoted > 0, 1 + r quoted < 1 + r CIRP = F S (1 + r ) (1) where S is the spot exchange rate of U.S. dollars per pound (any foreign currency would work as well) and F is the forward exchange rate. As indicated in the week 1 handout, this is an arbitrage opportunity: 1. Borrow 1 in U.S. for one period. At the end of the period, pay back (1 + r quoted ). 2. Enter forward contract: agree to pay 1 (1 + rquoted F ) and have your contract partner pay (1 + r quoted ) at the end of the period (no future exchange risk). 3. Exchange the borrowed 1 for 1 S on the spot market (no spot risk). 4. Lend out 1 S on the U.K. market for 1 S (1 + r ) at the end of the period (no investment). 5. Receive 1 (1 + r S ), pay 1 (1 + rquoted F ), and keep the difference (a profit). For further reading, I recommend The Handbook of Fixed Income Securities by Frank Fabozzi and Steven Mann. 3

4 3 Problem Set 2 Solutions (TA version) 3.1 Let S T be the spot exchange rate of euros per pounds (e/ ) before any currency manipulation by the European Central Bank (ECB) or the Bank of England (BOE). Suppose the ECB and the BOE had agreed to fix their currencies at S P, such that S P > S T. In order to achieve this fixed rate, all else equal, one of the following must occur: (a) the supply of euros need to increase to dilute the demand for euros, (b) the supply of pounds need to decrease to strengthen demand for pounds, or (c) both (a) and (b). (c) can be achieved when both central banks directly exchange pounds for euros (i.e. buy pounds for euros). Technically, it is sufficient for just one of them to conduct such transactions. The ECB can sell euros for pounds and therefore accumulate foreign reserves. The BOE can buy pounds for euros and lose foreign reserves. (a) can be achieved if the ECB increase their domestic money supply by purchasing assets. (b) can be achieved if the BOE decrease their domestic money supply by selling assets. Looking ahead: What are the monetary policy implications of fixing exchange rates? We can gain further insight with the Uncovered Interest Rate Parity (UIRP), which Prof. Eisfeldt will lecture next week. Under certain assumptions (namely symmetric information and risk neutral investors), the following parity is hypothesized to hold: 1 + r e = E[S ] S (1 + r ) (2) where S and S are quoted as euro per pound (e/ ) and S is the future spot exchange rate one period later. The E indicates the expected value or average. In other words, S is known, but S is unknown and could take on a range of values. Under this model, if investors believe that the ECB will maintain a fixed exchange rate permanently, then E[S ] = S, which implies r e = r! Therefore, to maintain a fixed currency rate, the ECB must conduct monetary policy in a way to match their domestic interest rate to foreign interest rates. This is usually done by manipulating their money supply. 3.2 We are told that both central banks of Peru and Rwanda have implemented a fixed exchange-rate system. Peru has a black market in which goods and services are quoted in U.S. dollars instead of the Peruvian nuevo soles. Since the nuevo sole is actually weaker against the dollar than suggested by the fixed exchange rate set by the Peruvian central bank, it is reasonable to conclude that the black market exchange rate for dollars is probably closer to reality. In other words, the Peruvian central bank did not reduce their domestic money supply enough (e.g. by selling assets) to appreciate their currency to the declared fixed rate. It is possible that Peru decided to maintain the fixed exchange rate by fiat (i.e. by imposing legal sanctions against those who trade at an exchange rate other than the rate fixed by law) as opposed to market intervention. Nonetheless, the existence of a black 4

5 market exchange rate clearly suggests that the Peruvian central bank does not have a monopoly over the exchange rate. The Rwandan central bank, on the other hand, is probably sterilizing the money supply properly to maintain their fixed exchange rate with the dollar. 3.3 From lecture, we learned that the BOP of credits and debits must sum to zero. A current account deficit implies a net surplus of the capital and official reserves account. A positive net holding of foreign assets implies that Bermuda has a capital account deficit. Bermuda must have financed these deficits by selling foreign currency reserves. That is, a total of 500 million million = 800 million must have been exchanged by the Bermuda central bank. Therefore, Bermuda does not really have a fully floating exchange rate since their central bank intervenes in the currency markets. 3.4 Read examples 4.2, 4.3, and 4.4 in the textbook. 5