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2Copyright K. Cuthbertson, D.Nitzsche
Investments:Spot and Derivative Markets,
K.Cuthbertson and D.Nitzsche
CHAPTER 15:CHAPTER 15:
- excluding p. 454-457, p461-477, Section 15.7 and - excluding p. 454-457, p461-477, Section 15.7 and Appendix 15.1Appendix 15.1
CHAPTER 16:CHAPTER 16:
Sections 16.1 and 16.2 and Box 16.2 and 16.3 onlySections 16.1 and 16.2 and Box 16.2 and 16.3 only
Reading
3Copyright K. Cuthbertson, D.Nitzsche
Basics: Spot, Forward and Balance of Payments
PPP -Price Competitiveness
Fixed Exchange Rate Policy
Floating Exchange Rates
Uncovered Interest Parity/ Exchange Rate Overshooting
Currency Union -EMU: Policy Issues
Topics
5Copyright K. Cuthbertson, D.Nitzsche
Spot Rates: Terminolgy and SWIFT codes
‘SWIFT’ Codes ‘TELEPHONE’
Sterling - $ GBP/USD Cable
French Franc-$ FRF/USD Paris
Deutsche Mark-$ DEM/USD Dollar-mark
Swiss Franc-$ CHF/USD Swissy
Yen-$ JPY/USD Bill and Ben
Note: e.g. Dollar - Sterling
If sterling appreciates then the USD must have depreciated
e.g. Appreciation of sterling from 2.0 $ per £ to 2.1 $ per £
6Copyright K. Cuthbertson, D.Nitzsche
Spot FX-market
Banks in London
- (“screens” \ telephone \ back office )
- Spot settled in 2 business days
300 participants (50 large banks-”own book”)
Also 10-12 FOREX brokers
Dealing spreads, commission, trading profits
International Commodities Clearing House (ICCH) - transfer of funds
7Copyright K. Cuthbertson, D.Nitzsche
Forward Market
Contract made today for delivery in the future
Forward rate is “price” agreed, today
eg. One -year Forward rate = 1.5 $ / £
Agree to purchase £100 ‘s forward
In 1-year, receive £100
and pay-out $150
8Copyright K. Cuthbertson, D.Nitzsche
Bank Calculates Outright Forward Quote
F(quote) = S [ ( 1 + rus ) / ( 1 + ruk ) ]
Covered interest parity (CIP)
Also Note:
If rus and ruk are relatively constant then
F and S will move together (positive correln)
9Copyright K. Cuthbertson, D.Nitzsche
Exchange Rate Regimes
Fixed Exchange Rates (Crawling Peg)
-in practice, these are ‘narrow bands’
Pure Float (eg. USD-Yen, USD-Euro)
- sometimes Central Bank intervention
Common Currency (EMU), Mexico-USA?
Currency Board-
- form of fixed exchange rate where domestic currency is altered one-for-one with FX-reserves - ie. net FX receipts (Hong-Kong, Latvia, Agentina)
10Copyright K. Cuthbertson, D.Nitzsche
BALANCE OF PAYMENTS
Current Account (‘Goods And Services’)
- export receipts minus import payments
Capital Account Balance
-inward investment into domestic assets (=receipts) minus outward investment (=payments)
‘investment’ can be portfolio investment (into bank account or shares) - ‘speculative’
or can be direct investment (e.g. foreigner buys the Dorchester).
Note: If the UK government could legally print USD there would be no balance of payments problem
12Copyright K. Cuthbertson, D.Nitzsche
PPP: “Law of One Price”
Let: HH= Harrod’s Hamper
SH= Sak’s Hamper
Suppose:
$P(SH) = $200 £P(HH) = £100 S = 2 $ per £
Then to a UK resident the price of SH in sterling is same as HH
UK is ‘price competitive’ and there is no incentive to switch purchases of goods between countries
This ‘special situation’ is know as purchasing power parity PPP
13Copyright K. Cuthbertson, D.Nitzsche
Purchasing Power Parity (PPP)
The Law of One Price
Note that if PPP holds at all times then:
‘Relative prices’ = $200/£100 = 2 ~ must equal the current exchange rate, S (=2$/£)
Hence algebraically PPP can be expressed
$P / £P = S ‘Relative prices’ is often referred to as ‘the PPP
exchange rate’
14Copyright K. Cuthbertson, D.Nitzsche
Actual S ($/£)= ______ and Relative Prices(Relative prices = ‘PPP-Exchange Rate’= ----- )
* Exchange Rates (Dollars per Pound)
100
150
200
250
300
Years
15Copyright K. Cuthbertson, D.Nitzsche
Figure 16.3: German Mark - Pound Sterling
(Actual and PPP Exchange Rate)
1.8
2
2.2
2.4
2.6
2.8
3
3.2
S (
DM
s p
er
Po
un
d S
terl
ing
)
actual exch. ratePPP exch. rate
16Copyright K. Cuthbertson, D.Nitzsche
Figure 16.4: French Franc - German Mark (Actual and PPP Exchange Rate)
2
2.2
2.4
2.6
2.8
3
3.2
3.4
3.6
3.8
4
S (F
RF
per
DM
)
PPP exch. rateactual exch. rate
17Copyright K. Cuthbertson, D.Nitzsche
Depreciation Of £ Improves UK Competitiveness
£P(HH) = £100 $P(SH) = $200 S = 2 $/£
STERLING DEPRECIATION TO S=1.8 $/£
Cost of HH to US resident is now $180
Cost of SH to UK resident is now £111.1
19Copyright K. Cuthbertson, D.Nitzsche
FIXED EXCHANGE RATE POLICY: UK INFLATION
HH rises in price to £P(HH) = £110 AND S=2$/£
Hence SH is cheaper for UK resident at £100 (ie, $200)
UK residents sell £ (and buy USD). Government uses FX-reserves to supply USD at 2 $/£
FX-reserves are falling - borrow from IMF?
Will have to reduce UK inflation
POLICY RESULTWith fixed FX-rate your price level (inflation) is determined by the
foreign price level
20Copyright K. Cuthbertson, D.Nitzsche
FIXED EXCHANGE RATE POLICY: UK INFLATION
CONTROLS ON CAPITAL ACCOUNT
To reduce UK inflation you can raise interest rates (tight monetary policy)
‘FREE’ CAPITAL FLOWS
If you raise UK interest rates, have massive capital inflow (if fixed rate is credible policy) which will put upward pressure on sterling.
Hence cannot have an independent interest rate policy - reducing inflation will need fiscal policy.
21Copyright K. Cuthbertson, D.Nitzsche
FIXED EXCHANGE RATE POLICY
Bretton Woods 1945-1973
USD as “anchor currency”
IMF - payments imbalances/devaluations
Gold at $35 per oz. (Fort Knox).
USD = world’s trading currency(Seigniorage)
Oil Crisis 1973 and 1979Inflation rates differ = “strain”
22Copyright K. Cuthbertson, D.Nitzsche
FIXED EXCHANGE RATES : SUMMARY
Reduces price uncertainty for exporters/importers
You have to accept the inflation rate of the ‘larger’ country. Cannot have an independently chosen inflation rate.
If you have higher ‘core’ inflation than larger country you will have to have contractionary fiscal policy (and unemployment)
With ‘free’ capital flows your interest rate must equal that of the large country
May need to borrow foreign exchange - if you then devalue this is costly !
24Copyright K. Cuthbertson, D.Nitzsche
FLOATING EXCHANGE RATES : UK INFLATION
£P= £110 and S currently at $2 per £
SH is cheaper than HH and demand for USD increases and USD appreciates (and sterling depreciates)
Depreciation of £ implies an improvement in UK competitiveness to offset the higher £-price of HH
Policy Result (ignoring capital account)High inflation countries have a depreciating exchange
rate (which offsets some or all of loss of competitiveness due to high inflation)`
25Copyright K. Cuthbertson, D.Nitzsche
FLOATING EXCHANGE RATES : UK INFLATION
If S falls to exactly 1.818181 $/£ the SH would also cost £110 for a UK resident and price competitiveness is restored
BUT NOTETo exactly restore price competitiveness requires the specific
exchange rate of 1.8181 and decisions by ‘rational’ FX-speculators might not result in this exact rate - see overshooting below
ALSO NOTE
You can raise your interest rate to try and reduce inflation. Any capital inflow will tend to raise sterling FX rate which will put downward pressure on UK inflation (as export sector becomes less competitive)
26Copyright K. Cuthbertson, D.Nitzsche
FLOATING EXCHANGE RATES :SUMMARY
FX-rate is free to move (under market forces) and (ignoring capital flows) will tend to restore price competitiveness
You can have an independent interest rate policy and hence influence your own inflation rate over the longer term (3-5 years) and your unemployment rate over the short term (1-3 years)
Your interest rate policy has implications for the exchange rate - although difficult to predict
Danger is that FX-speculators will cause ‘wild’ movements in FX-rate and adversely alter price competitivenesss
‘Price uncertainty’ removed by using the forward market
28Copyright K. Cuthbertson, D.Nitzsche
Uncovered Interest Arbitrage (Parity) (UIP)(‘Smart’ , ‘rational’ Speculators)
UIP is a specific (equilibrium) relationship between domestic and foreign interest rates and the expected depreciation of a currency whereby speculators have no incentive to switch their funds between different countries
We assume that speculators (as a whole) are only concerned about the expected return on their investments (ie. They are “risk neutral”). They know their ‘bets’ are risky but this does not influence their decision.
Note: Expected (or forecast of the )spot rate in 1 years time = “ESt+1”
29Copyright K. Cuthbertson, D.Nitzsche
Uncovered Interest Arbitrage (Parity) (UIP)
WHAT GIVES BEST EXPECTED PAYOUT (IN USD) FOR US RESIDENT
1) r(UK) = r(US) = 2%, and Current St = 1 $/£
‘Forecast, ESt+1 = 0.5 $ per £ (ie. expected depreciation of sterling)
US speculator: $100 of funds from US to UK or vice-versa?
2) r(UK) = 3%, r(US) = 2%, (ie. interest differential of 1%)
Current S = 1 $/£, Forecast, ESt+1 = 0.99029 $/£
I.e Expected depreciation of sterling of about 1%
30Copyright K. Cuthbertson, D.Nitzsche
Uncovered Interest Arbitrage (Parity) (UIP)Smart Speculators
UIP =. ‘no switching of funds by speculators’
This will occur when:
Expected (%) depreciation of sterling
= Interest differential in favour of the UK= (rUK-rUS)
If r(UK) = 3% p.a. r(US) = 2%, (ie. interest differential of 1%) then ‘no switching of funds’ when speculators think that sterling will depreciate by 1% over the coming year.
31Copyright K. Cuthbertson, D.Nitzsche
Uncovered Interest Arbitrage (Parity) (UIP)Smart Speculators
Assume UIP is correct then
If the UK already has ‘high’ interest rates this implies that speculators expect sterling to depreciate over the coming year
Note that the above says nothing about the current level of the exchange rate St. The current level of the exchange rate may (or may not) be ‘high’ , but all CIP implies is that whatever the value of St is now, speculators believe it will fall in the future.
32Copyright K. Cuthbertson, D.Nitzsche
POLICY IMPLICATIONS OF UIP:EXCHANGE RATE OVERSHOOTING
Start: UIP holds:
rUK = rUS = 10% Expected depn £ = 0% (ie you expect spot rate to remain constant over coming year)
What are the implications for the current spot rate of an unexpected rise in UK interest rates by 2% by the MPC?
If speculators initially believe that sterling will remain constant then US investors will want to buy UK bonds and hence they buy spot £ , pushing up the sterling Ex-Rate today.
33Copyright K. Cuthbertson, D.Nitzsche
POLICY IMPLICATIONS OF UIPEXCHANGE RATE OVERSHOOTING
How high will todays spot rate rise ?
Sterling will appreciate today until it gets so high that US investors think it will fall by 2% over the coming year.
Now UIP is restored and capital inflows into the UK will cease.
34Copyright K. Cuthbertson, D.Nitzsche
Using UIP: Exchange rate Overshooting Increase in UK interest rates = ‘Tight’ Monetary Policy
1.03
1.00
B
A
Expected depreciation of 2%
today Time
1.01C
Exchange Rate
Appreciation
of Sterling, $ per £
C = Final ‘long run’ level for Exchange Rate
+1 year
35Copyright K. Cuthbertson, D.Nitzsche
Overshooting: UIP+’STICKY’ PRICES
The appreciation of sterling and overshooting of the exchange rate leads to an immediate loss of UK competitiveness. Exports fall (and imports increase), which further exacerbates the recession initially caused by the rise in interest rates.
The recession may last for 2-5 years -severe problem.
It can also be exacerbated if “the herd” (e.g. chartists) follow the “rational speculators” and buy spot sterling when it begins to rise, thus pushing sterling up even further.
In the longer term the economy may return to its ‘normal’ growth path and interest rates in the two countries may be again be equalised (this is a “big”, involved and complex story)
37Copyright K. Cuthbertson, D.Nitzsche
CURRENCY UNION:“Single currency”:EMU
Like an irrevocable fixed exchange rate regime
No independent interest rate policy (ECB, Frankfurt)
Must accept the inflation rate of other member states (OR UNEMPLOYMENT IF HIGH INFLATION)
Prices are ‘transparent’ and ‘uncertainty’ removed - within Euroland only
Unelected MPC in Threadneedle St or in Frankfurt ?
38Copyright K. Cuthbertson, D.Nitzsche
“Single currency”:EMU
One (‘size’) interest rate fits all ? (In EMU)
Symmetric country ‘shocks’Unemployment increases (equally) in all states. ECB
lowers interest rates - ‘no problem’.Asymmetric “shocks” Unemployment in Scotland, a boom in Germany. ECB
keeps interest rates high.Solutions?Fall in (real) wages in Scotland and work comes to the
workers orScots migrate to GermanyWelfare expenditure in UK increases.
39Copyright K. Cuthbertson, D.Nitzsche
“Single currency”:EMU
FISCAL ISSUES
Large budget deficits?
- welfare payments
- pension commitments of the State
Must be financed by issuing say Italian government bonds, denominated in Euros.
Default and bail-out ?
Budget deficit limited to 3% (on average) of GDP - otherwise fines