Anda di halaman 1dari 60

Factors Affecting Spot Exchange Rates

Balance of Payments

3-2

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

Balance of Payments Accounting


The

Balance of Payments is the statistical record of a countrys international transactions over a certain period of time presented in the form of double-entry bookkeeping.

3-3

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

Balance of Payments Accounts


The

balance of payments accounts are those that record all transactions between the residents of a country and residents of all foreign nations. They are composed of the following:
The Current Account The Capital Account The Official Reserves Account

3-4

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

The Current Account


Includes

3-5

all imports and exports of goods and services. Includes unilateral transfers of foreign aid. If the debits exceed the credits, then a country is running a trade deficit. If the credits exceed the debits, then a country is running a trade surplus. 2007 by The McGraw-Hill Companies, Inc. All rights res Copyright

The Capital Account


The

capital account measures the difference between U.S. sales of assets to foreigners and U.S. purchases of foreign assets. In 2004, the U.S. enjoyed a $611.2 billion capital account surplus absent of U.S. borrowing from foreigners, this finances our trade deficit. The capital account is composed of Foreign Direct Investment (FDI), portfolio investments and other
3-6

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

Statistical Discrepancy
Theres

going to be some omissions and misrecorded transactionsso we use a plug figure to get things to balance. Exhibit 3.1 shows a discrepancy of $51.9 billion in 2004.

3-7

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

The Official Reserves Account


Official

reserves assets include gold, foreign currencies, SDRs, reserve positions in the IMF.

3-8

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

The Balance of Payments Identity

BCA + BKA + BRA = 0 where BCA = balance on current account BKA = balance on capital account BRA = balance on the reserves account

3-9

Under a pure flexible exchange rate regime, Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res BCA + BKA = 0

U.S. Balance of Payments Data


Current Account 1 2 3 Exports Imports Credits $1,516.2 $16.4 $115.5 $794.4 $524.3 $611.2 51.9 $2.8 ($2,109.1) ($89.4) ($665.9) ($248.5) ($90.8) ($483.7) $2.8 Debits

UnilateralTransfers Balance on Current Account Capital Account 4 5 6 7 DirectInvestment PortfolioInvestment OtherInvestments Balance on Capital Account

StatisticalDiscrepancies Overall Balance Official Reserve Account


3-

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

U.S. Balance of Payments Data


Current Account 1 2 3 Exports Imports Credits $1,516.2 $16.4 $115.5 $794.4 $524.3 $611.2 51.9 $2.8 ($2,109.1) ($89.4) ($665.9) ($248.5) ($90.8) ($483.7) $2.8 Debits

UnilateralTransfers Balance on Current Account Capital Account 4 5 6 7 DirectInvestment PortfolioInvestment OtherInvestments Balance on Capital Account

StatisticalDiscrepancies Overall Balance Official Reserve Account


3-

In2004,the U.S.imported morethanit exported,thus runninga currentaccount deficitof $665.9billion.

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

U.S. Balance of Payments Data


Current Account 1 2 3 Exports Imports Credits $1,516.2 $16.4 $115.5 $794.4 $524.3 $611.2 51.9 $2.8 ($2,109.1) ($89.4) ($665.9) ($248.5) ($90.8) ($483.7) $2.8 Debits

UnilateralTransfers Balance on Current Account Capital Account 4 5 6 7 DirectInvestment PortfolioInvestment OtherInvestments Balance on Capital Account

StatisticalDiscrepancies Overall Balance Official Reserve Account


3-

Duringthesame year,theU.S. attractednet investmentof $611.2billion clearlytherest oftheworld foundtheU.S. tobeagood placetoinvest.

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

U.S. Balance of Payments Data


Current Account 1 2 3 Exports Imports Credits $1,516.2 $16.4 $115.5 $794.4 $524.3 $611.2 51.9 $2.8 ($2,109.1) ($89.4) ($665.9) ($248.5) ($90.8) ($483.7) $2.8 Debits

UnilateralTransfers Balance on Current Account Capital Account 4 5 6 7 DirectInvestment PortfolioInvestment OtherInvestments Balance on Capital Account

Underapure flexible exchangerate regime,these numberswould balanceeach otherout.

StatisticalDiscrepancies Overall Balance Official Reserve Account


3-

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

U.S. Balance of Payments Data


Current Account 1 2 3 Exports Imports Credits $1,516.2 $16.4 $115.5 $794.4 $524.3 $611.2 51.9 $2.8 ($2,109.1) ($89.4) ($665.9) ($248.5) ($90.8) ($483.7) $2.8 Debits

UnilateralTransfers Balance on Current Account Capital Account 4 5 6 7 DirectInvestment PortfolioInvestment OtherInvestments Balance on Capital Account

Inthereal world,thereis astatistical discrepancy.

StatisticalDiscrepancies Overall Balance Official Reserve Account


3-

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

U.S. Balance of Payments Data


Current Account 1 2 3 Exports Imports Credits $1,516.2 $16.4 $115.5 $794.4 $524.3 $611.2 51.9 $2.8 ($2,109.1) ($89.4) ($665.9) ($248.5) ($90.8) ($483.7) $2.8 Debits

UnilateralTransfers Balance on Current Account Capital Account 4 5 6 7 DirectInvestment PortfolioInvestment OtherInvestments Balance on Capital Account

Includingthat, thebalanceof paymentsidentity shouldhold:


BCA+BKA=BRA

StatisticalDiscrepancies Overall Balance Official Reserve Account


3-

($665.9)+$611.2+$51.9=($2.8)

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

Balance of Payments and the Exchange Rate


Current Account 1 2 3 Exports Imports Credits $1,516.2 $16.4 $115.5 $794.4 $524.3 $611.2 51.9 $2.8 ($2,109.1) ($89.4) ($665.9) ($248.5) ($90.8) ($483.7) $2.8 Debits

Exchangerate$ P S

UnilateralTransfers Balance on Current Account Capital Account 4 5 6 7 DirectInvestment PortfolioInvestment OtherInvestments Balance on Capital Account

D Q

StatisticalDiscrepancies Overall Balance Official Reserve Account


3-

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

Balance of Payments and the Exchange Rate


Current Account 1 2 3 Exports Imports Credits $1,516.2 $16.4 $115.5 $794.4 $524.3 $611.2 51.9 $2.8 ($2,109.1) ($89.4) ($665.9) ($248.5) ($90.8) ($483.7) $2.8 Debits

Exchangerate$ P S

UnilateralTransfers Balance on Current Account Capital Account 4 5 6 7 DirectInvestment PortfolioInvestment OtherInvestments Balance on Capital Account

D Q

StatisticalDiscrepancies Overall Balance Official Reserve Account


3-

AsU.S.citizensimport,theyaresupplydollarstotheFOREXmarket.

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

Balance of Payments and the Exchange Rate


Current Account 1 2 3 Exports Imports Credits $1,516.2 $16.4 $115.5 $794.4 $524.3 $611.2 51.9 $2.8 ($2,109.1) ($89.4) ($665.9) ($248.5) ($90.8) ($483.7) $2.8 Debits

Exchangerate$ P S

UnilateralTransfers Balance on Current Account Capital Account 4 5 6 7 DirectInvestment PortfolioInvestment OtherInvestments Balance on Capital Account

D Q

StatisticalDiscrepancies Overall Balance Official Reserve Account


3-

AsU.S.citizensexport,othersdemanddollarsattheFOREXmarket.

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

Balance of Payments and the Exchange Rate


Current Account 1 2 3 Exports Imports Credits $1,516.2 $16.4 $115.5 $794.4 $524.3 $611.2 51.9 $2.8 ($2,109.1) ($89.4) ($665.9) ($248.5) ($90.8) ($483.7) $2.8 Debits

Exchangerate$ P S S1

UnilateralTransfers Balance on Current Account Capital Account 4 5 6 7 DirectInvestment PortfolioInvestment OtherInvestments Balance on Capital Account

D Q

StatisticalDiscrepancies Overall Balance Official Reserve Account


3-

AstheU.S.governmentsellsdollars,thesupplyofdollarsincreases.

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

International Monetary System

3-

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

Evolution of the International Monetary System


Bimetallism:

Before 1875 Classical Gold Standard: 18751914 Interwar Period: 1915-1944 Bretton Woods System: 1945-1972 The Flexible Exchange Rate Regime: 1973-Present

3-

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

Bretton Woods System: 1945-1972

1-22 3-

Named for a 1944 meeting of 44 nations at Bretton Woods, New Hampshire. The purpose was to design a postwar international monetary system. The goal was exchange rate stability without the gold standard. The result was the creation of the IMF and the World Bank. Under the Bretton Woods system, the U.S. dollar was pegged to gold at $35 per ounce and other currencies were pegged to the U.S. dollar. Each country was responsible for maintaining its exchange rate within 1% of the adopted par value by buying or selling foreign reserves as necessary. Copyright system was a dollar-based gold The Bretton Woods 2007 by The McGraw-Hill Companies, Inc. All rights res

Bretton Woods System: 1945-1972


British pound
ar lue P a V

German mark
Par Value
Pa Va r lue

French franc

U.S.dollar
Peggedat$35/oz.

Gold
2-23 3-

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

The Flexible Exchange Rate Regime: 1973-Present.

Flexible exchange rates were declared acceptable to the IMF members. Central banks were allowed to intervene in the exchange rate markets to iron out unwarranted volatilities. Gold was abandoned as an international reserve asset.

3-

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

Current Exchange Rate Arrangements

Free Float

The largest number of countries, about 48, allow market forces to determine their currencys value.

Managed Float

About 25 countries combine government intervention with market forces to set exchange rates.

Pegged to another currency

Such as the U.S. dollar or euro (through franc or mark).

No national currency

1-25 3

Copyright 2007 by The McGraw-Hill Companies, Some countries do not bother printing their own Inc. All rights res currency.

European Monetary System


European

countries maintain exchange rates among their currencies within narrow bands, and jointly float against outside currencies. Objectives: To establish a zone of monetary stability in Europe. To coordinate exchange rate policies vis-vis non-European currencies. To pave the way for the European Monetary Union.
1-26 3-

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

The Long-Term Impact of the Euro


As

the euro proves successful, it will advance the political integration of Europe in a major way, eventually making a United States of Europe feasible. It is likely that the U.S. dollar will lose its place as the dominant world currency. The euro and the U.S. dollar will be the two major currencies.
1-27 3-

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

Fixed versus Flexible Exchange Rate Regimes


Argumentsinfavorofflexibleexchangerates: Easierexternaladjustments. Nationalpolicyautonomy. Argumentsagainstflexibleexchangerates: Exchange rate uncertainty may hamper internationaltrade. Nosafeguardstopreventcrises.

1-28 3-

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

Fixed versus Flexible Exchange Rate Regimes


Suppose

the exchange rate is $1.40/ today. the next slide, we see that demand for euro far exceeds supply at this exchange rate. U.S. experiences trade deficits.

In

The

2-29 3-

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

Fixed versus Flexible Exchange Rate Regimes


Dollarpriceper (exchangerate) Supply (S)

$1.4 0
Tradedeficit QS
2-30 3-

Demand (D)

QD

Qof

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

Flexible Exchange Rate Regimes


Under

a flexible exchange rate regime, the dollar will simply depreciate to $1.60/, the price at which supply equals demand and the trade deficit disappears.

2-31 3-

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

Fixed versus Flexible Exchange Rate Regimes


Dollarpriceper (exchangerate) Supply (S)

$1.6 0 $1.4 0

Dollar depreciates (flexible regime)


QD=QS

Demand (D) Demand(D*) Qof

2-32 3-

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

Fixed versus Flexible Exchange Rate Regimes


Instead,

suppose the exchange rate is fixed at $1.40/, and thus the imbalance between supply and demand cannot be eliminated by a price change. The government would have to shift the demand curve from D to D*

2-33 3-

In this example this corresponds to contractionary monetary and fiscal Copyright policies. 2007 by The McGraw-Hill Companies, Inc. All rights res

Fixed versus Flexible Exchange Rate Regimes


Dollarpriceper (exchangerate)

Contraction arypolicies (fixedregime)

Supply (S)

$1.4 0

Demand (D) Demand(D*) QD*=QS Qof

2-34 3-

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

Forecasting FX rates

3-

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

Forecasting Exchange Rates


Efficient

Markets Approach Fundamental Approach Technical Approach Performance of the Forecasters

3-

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

Efficient Markets Approach


Financial

3-

Markets are efficient if prices reflect all available and relevant information. If this is so, exchange rates will only change when new information arrives, thus: St = E[St+1] and Ft = E[St+1| It] Predicting exchange rates using the efficient markets approach is affordable2007 by The McGraw-Hill Companies, Inc. All rights res and is hard to beat. Copyright

Fundamental Approach
Involves

econometrics to develop models that use a variety of explanatory variables. This involves three steps:
step 1: Estimate the structural model. step 2: Estimate future parameter values. step 3: Use the model to develop forecasts.

The

downside is that fundamental models do not work any better than the forward rate model The McGraw-Hill Companies, Inc. All rights res or the random walk Copyright 2007 by 3-

Technical Approach
Technical

analysis looks for patterns in the past behavior of exchange rates. Clearly it is based upon the premise that history repeats itself. Thus it is at odds with the EMH

3-

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

Performance of the Forecasters


Forecasting

3-

is difficult, especially with regard to the future. As a whole, forecasters cannot do a better job of forecasting future exchange rates than the forward rate. The founder of Forbes Magazine once said: You can make more money selling financial adviceCompanies, Inc. All rights res than Copyright 2007 by The McGraw-Hill

Market Expectations
The

forward rate as a forecaster of future spot rates. and Psychological

Technical

Factors.

3-

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

Parity relationships

3-

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

Interest Rate Parity


IRP

is an arbitrage condition. If IRP did not hold, then it would be possible for an astute trader to make unlimited amounts of money exploiting the arbitrage opportunity. Since we dont typically observe persistent arbitrage conditions, we can safely assume that IRP holds.
3-

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

Interest Rate Parity


Suppose you have $100,000 to invest for one year. You can either 1. invest in the U.S. at i$. Future value = $100,000(1 + i$) or 2. trade your dollars for yen at the spot rate, invest in Japan at i and hedge your exchange rate risk by selling the future value of the Japanese investment forward. The future value = $100,000(F/S)(1 + i) Since both of these investments have the same risk, they must have the same future valueotherwise an arbitrage would exist, therefore (F/S)(1 + i) = (1 + i$)
3-

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

Interest Rate Parity

$100,000 1. Trade$100,000foratS

$100,000(1+ i$) $100,000(F/S)(1+i) 3. Oneyearlater, tradefor$atF

2. Invest100,000ati S
3-

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

Interest Rate Parity Defined


Formally, (F/S)(1 + i) = (1 + i$) or if you prefer, 1 + i$ F = 1 + i S IRPissometimesapproximatedas i$i = F S S
3-

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

IRP and Covered Interest Arbitrage


If IRP failed to hold, an arbitrage would exist. Its easiest to see this in the form of an example. Consider the following set of foreign and domestic interest rates and spot and Spotexchangerateforward exchange rates. S($/) = $1.25/
360-dayforwardrate U.S.discountrate Britishdiscountrate
3-

F360($/) = $1.20/ i$ = 7.10% i= 11.56%

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

IRP and Covered Interest Arbitrage


A trader with $1,000 to invest could invest in the U.S., in one year his investment will be worth $1,071 = $1,000 (1+ i$) = $1,000 (1.071)

3-

Alternatively, this trader could exchange $1,000 for 800 at the prevailing spot rate, (note that 800 = $1,000$1.25/) invest 800 at i = 11.56% for one year to achieve 892.48. Translate 892.48 back into dollars at 2007($/) = $1.20/, theAll rights res F360 by The McGraw-Hill Companies, Inc. Copyright

Interest Rate Parity

$1,000 1. Trade$100,000for800

$1,071 $1,071 3. Oneyearlater,trade 892.48for$atF360($/ )=$1.20/

2. Invest800at11.56%=i
3-

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

Interest Rate Parity & Exchange Rate Determination


According to IRP only one 360-day forward rate, F360($/), can exist. It must be the case that F360($/) = $1.20/ Why? If F360($/) $1.20/, an astute trader could make money with one of the following strategies:
3-

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

Arbitrage Strategy I
If F360($/) > $1.20/ i. Borrow $1,000 at t = 0 at i$ = 7.1%. ii. Exchange $1,000 for 800 at the prevailing spot rate, (note that 800 = $1,000$1.25/) invest 800 at 11.56% (i) for one year to achieve 892.48

iii. Translate 892.48 back into dollars, if F360($/) > $1.20/ The892.48 will Inc. All rights res , McGraw-Hill Companies, be Copyright 2007 by 3-

Arbitrage Strategy II
If F360($/) < $1.20/ i. Borrow 800 at t = 0 at i= 11.56% . ii. Exchange 800 for $1,000 at the prevailing spot rate, invest $1,000 at 7.1% for one year to achieve $1,071.

iii. Translate $1,071 back into pounds, if F360($/) < $1.20/ , $1,071 will be more than enough to repay your obligationCopyright 2007 by The McGraw-Hill Companies, Inc. All rights res of 892.48. 3-

IRP and Hedging Currency Risk


You are a U.S. importer of British woolens and have just ordered next years inventory. Payment of 100M is due in one year.
Spotexchangerate U.S.discountrate Britishdiscountrate S($/) = $1.25/ i$ = 7.10% i= 11.56% 360-dayforwardrate F360($/) = $1.20/

IRPimpliesthattherearetwowaysthatyoufixthecashoutflowtoa certainU.S.dollaramount: a) Putyourselfinapositionthatdelivers100Minoneyearalong forwardcontractonthepound.Youwillpay(100M)(1.2/)= $120M b) Formaforwardmarkethedgeasshownbelow.


3-

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

IRP and a Forward Market Hedge


Toformaforwardmarkethedge: Borrow$112.05millionintheU.S.(inoneyearyou willowe$120million). Translate$112.05millionintopoundsatthespotrate S($/)=$1.25/toreceive89.64million. Invest89.64millionintheUKati=11.56%for oneyear. Inoneyearyourinvestmentwillhavegrownto100 millionexactlyenoughtopayyoursupplier.
3-

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

Forward Market Hedge


Wheredothenumberscomefrom?Weoweoursupplier100 millioninoneyearsoweknowthatweneedtohavean investmentwithafuturevalueof100million.Sincei= 11.56%weneedtoinvest89.64millionatthestartofthe year. 100 89.64= 1.1156 Howmanydollarswillittaketoacquire89.64millionatthe startoftheyearifS($/)=$1.25/?

$1.00 $112.05 = 89.64 1.25


3-

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

Purchasing Power Parity and Exchange Rate Determination


The

exchange rate between two currencies should equal the ratio of the countries price levels: P$

S($/)=

Forexample,ifanounceofgoldcosts$300in

theU.S.and150intheU.K.,thenthepriceofone poundintermsofdollarsshouldbe: P$ $300 S($/)= = =$2/ P 150


3-

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

Purchasing Power Parity and Exchange Rate Determination


Relative

PPP states that the rate of change in the exchange rate is equal to the differences in the rates of inflation: ($) $ e= (1+)

IfU.S.inflationis5%andU.K.inflationis8%,the poundshoulddepreciateby2.78%oraround3%.
3-

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

PPP Deviations and the Real Exchange Rate


The real exchange rate q= (1+e)(1+) is (1+$) IfPPPholds, (1 + e)= thenq=1. (1+) Ifq<1competitivenessofdomesticcountry improveswithcurrencydepreciations. Ifq>1competitivenessofdomesticcountry deteriorateswithcurrencydepreciations.
3-

(1+$)

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

Fisher Effect
The

Fisher effect implies that the expected inflation rate is approximated as the difference between the nominal and real interest rates in each country, i.e. i = +(1+ )E[ ] +E[ ]
$ $ $ $ $ $

E[$]=
3-

(i$$) (1+$)

i$$

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights res

International Fisher Effect


If the International Fisher Effect holds, (i$i) E(e)= (1+i) andifIRPalsoholds FS S = (i$i) (1+i) E(e)= FS

thenforwardparityholds.
3-

S Copyright 2007 by The McGraw-Hill Companies, Inc.

All rights res