Commercial and Central Banking
I. Introduction:
Probably the most important industry to any economy is the commercial banking
industry. Commercial banks act as financial intermediaries, taking in deposits from one
group in society and making loans to another group in society. Most commercial banks
are corporations and are therefore in business to make profits. However, because banks
are so important to the economy, and because the element of public trust is so crucial to
their well being, the banking industry is usually highly regulated by the government.
Whenever the public loses confidence in the solvency of a bank, they will rush to the
bank and attempt to withdraw their deposited money. We call this a "bank run". If there
are widespread bank runs in the economy, there will be a severe recession, with many
bankruptcies and rising unemployment. This is precisely what bank regulators want to
avoid.
Like all businesses, commercial banks have both assets and liabilities. The major
liabilities of commercial banks are the various deposits which they offer to their
customers. In Taiwan, these include checking deposits, savings deposits, passbook
savings accounts, time deposits, and time saving deposits. Banks can also issue bonds
(sometimes called financial bonds) and borrow funds, both of which act as liabilities to
the banks. On the asset side of the ledger there are three principal items. These include
the reserves of the banks, the securities which they hold, and the various loans which they
make to borrowers. The difference between the assets and liabilities of a bank represents
its net worth or owners equity.
Commercial banks are important to the economy because they reduce the cost of
transactions between savers and investors, and between consumers and producers. They
also affect the amount of credit extended to borrowers. Finally, they provide a relatively
safe and convenient means for savers to hold their wealth.
II. Asset Management of Banks
In order to earn a profit, banks must carefully manage the asset side of their
balance sheet. Naturally, this involves two factors: (1) the amount of resources which the
bank has available, and (2) the attitude which the bank has towards risk and return. The
amount of resources which the bank has is determined by its capital invested, its retained
earnings, and its deposits. The bank must decide how to allocate its resources among its
reserves, securities, and loans -- that is, its assets.
A bank's reserves are defined as its vault cash plus its money deposited with the
central bank. The central bank acts as a bank for commercial banks. Just as you have a
deposit account with a commercial bank, your bank has a deposit account with the central
bank. These deposits are called reserves. A bank must keep a minimum amount of
reserves on deposit with the central bank. We call these the required reserves. Banks
usually keep their total reserves above the required reserve amount. Excess reserves are
defined as total reserves minus required reserves. Both excess and required reserves are
deposited at the central bank.
Commercial banks do not earn interest on their reserves. Therefore, they will not
want to hold a large amount of excess reserves. Required reserves are relatively easy to
determine because they are a percentage of the bank's deposits. Each type of deposit will
have a required percentage called the required reserve ratio. For example, if saving
deposits are $100 and the required reserve ratio for saving deposits is 15%, then the
required reserves on such saving deposits is $15. The required reserve ratios are
determined by the central bank.
While it is easy to determine required reserves, it is not easy to determine excess
reserves. If the outlook for the economy is good, then banks may decide to hold less
excess reserves. However, if the economy goes into recession, banks may become more
conservative and decide to hold greater excess reserves. Excess reserves can also be
affected by changes in interest rates.
Commercial banks can also use their resources to purchase securities. Usually,
these securities include government debt, but some countries such as Taiwan allow banks
to buy corporate bonds and stock. Private securities often involve greater risk, but they
also have greater returns to compensate for this higher risk. In Taiwan, banks often buy
T-Bills and CD's issued by the Central Bank of China. They also buy government bonds
issued by the Ministry of Finance, the provincial government, and the city governments.
These carry little risk of default, but there is still the problem of price risk associated with
changes in interest rates.
Commercial banks also earn interest by making loans. These include business
loans, mortgage loans, and consumer loans. Consumer loans include credit extended by
the bank for credit card purchases. Mortgages are long term loans taken out for the
purchase of a house or land. The house or land acts to collateralize the loan. Firms often
borrow funds to finance their inventories, and these inventories act to collateralize the
loan. Loans which have collateral are called secured loans. Loans which do not have
collateral are called unsecured loans. Unsecured loans will have higher interest rates
associated with them due to higher risk premiums.
III. The Role of the Central Bank
The central bank of an economy is often called the banker's bank. It accepts
deposits from commercial banks (which we call reserves), it buys securities from and
sells securities to commercial banks, and it makes loans to banks which are short of
funds. Moreover, it facilitates the transfer of funds between banks. The central bank also
oversee the operation of banks, and it often helps to stabilize the foreign exchange
markets.
The major goals of the central bank are to provide adequate funds to promote
stable economic growth and a stable price level. It does this by regulating the amount of
loanable reserves in the banking system. The central bank has three major tools which it
can use to accomplish its goals. First, it can change the required reserve ratios. This will
not change the overall level of reserves, but it will affect the amount of excess reserves
that can be loaned out by banks. Second, it can change the interest rate charged banks for
loans from the central bank. This interest rate is called the central bank discount rate
(sometimes called the rediscount rate). Changes in the discount rate can affect the overall
level of reserves in the banking system. Finally, it can buy or sell government securities.
When it buys bonds from the banks, this is called an open market purchase. When it sell
bonds to banks or the public, this is called an open market sale. We call this kind of
buying and selling of securities open market operations. Open market operations can
likewise change the overall level of reserves in the banking system. The central bank's
monetary policy consists of decisions on how best to use these three tools.
The central bank has a balance sheet, although it is not a corporation. The assets
of the central bank consists of foreign exchange reserves, loans to commercial banks,
gold, and government bonds. It's liabilities consist of currency, reserves, and securities
which it has issued and sold to banks. Economists are particularly concerned with
changes in currency and reserves. The sum of these two items is called the monetary base
(or high powered money). Small changes in the monetary base can lead to large changes
in the money supply, which is defined as currency plus commercial bank deposits. The
central bank can use its three tools of monetary policy to affect the level of the monetary
base, and thus change the money supply.
IV. Money Supply and Money Demand
Each person in the economy has an amount of wealth. The division of wealth
between money and non-money assets is the basic idea underlying the demand for money.
When we talk about the demand for money, we are really discussing peoples' decision to
hold a certain percentage of their wealth in the form of money.
There are many factors which can affect the demand for money, but usually we
consider only two: income and interest rates. If incomes rise, then people will want to
spend more of this income. Their demand for money will increase because they need the
additional money with which to transact. If interest rates on non-monetary assets increase,
then people will reduce their demand for money and will try to hold other assets instead.
In deciding how fast the money supply should grow, the central bank will take
into consideration how fast the demand for money is expected to increase. Suppose that
the money supply grows faster than the demand for money. Then people will find they
have too much of their wealth in the form of money. They will try to reduce their money
holdings by purchasing goods and other assets instead.
In deciding how fast the money supply should grow, the central bank will take
into consideration how fast the demand for money is expected to increase. Suppose that
the money supply grows faster than the demand for money. Then people will find that
they have too much of their wealth in the form of money. They will try to reduce their
money holdings by purchasing goods and other assets. This creates an inflation in goods
and asset prices. Conversely, if the supply of money grows slower than the demand for
money, then the prices on goods and assets will fall. There will be deflation.
Discussion Questions:
#1.
#2.
#3.
#4.
#5.
#6.
#7.
#8.
What functions do banks serve in the economy?
What is a bank run and what causes it?
What are the assets and liabilities of banks?
What are total, required, and excess reserves?
What are the three tools of monetary policy?
What are the assets and liabilities of the central bank?
What is the demand for money and why is it important to monetary policy?
What is the difference between secured and unsecured loans?
The Balance of Payments and Exchange Rates
I. Trade and Capital Flows
Each country in the world keeps an account of the transactions its citizens
have with the rest of the world. This account is called the balance of payments and its
basic function is to record the sale of goods, services, and assets between the home
country and foreign countries. The balance of payments is important because it
summarizes the condition of trade and foreign investment which the country has
experienced. Furthermore, changes in the balance of payments can affect exchange rates,
and thus employment, inflation, and economic growth. Usually, the balance of payments
is published quarterly, with an annual summary given at the end of the year. The
International Monetary Fund (IMF) provides guidelines on how the balance of payments
should be calculated, and Taiwan follows this IMF format when it publishes it data.
The balance of payments is composed of three major accounts: (1) the current
account, (2) the capital account, and (3) the official settlements (or reserve) account.
Because the balance of payments uses the method of double entry business accounting,
all three accounts must sum to zero. The current account is composed of all international
transactions in goods, services, payment of income on assets, and unilateral transfers.
The bulk of the current account is devoted to recording exports and imports. Services are
largely payments for transportation and insurance involved in international trade. When
interest and dividends are paid to individuals internationally, these are also recorded in
the current account. By contrast, the capital account records all changes in the ownership
of assets between the home country and the rest of the world. For example, the sale of
corporate stock to foreigners represents a capital inflow, because money is flowing into
the home country, while a financial asset (i.e., the stock is flowing out). The official
settlements balance is largely composed of changes in the government's holding of
foreign assets.
If we limit our consideration to exports and imports in the current account,
we can focus on the trade balance. This is merely total exports minus total imports, and
is sometimes referred to as the merchandise balance of trade. A trade surplus means that
the value of exports during the period exceeded the value of imports during the period.
Usually a trade surplus will result in a current account surplus, since trade in goods is the
dominant part of the current account. The trade surplus is a closely watched statistic, and
can influence economic and foreign policy. Naturally, Taiwan runs trade surpluses with
some countries and trade deficits with others, but it has had an overall trade surplus every
year since 1980.
II. Determining Exchange Rates
Trade between countries means that not only goods and assets are traded, but also
different types of money must exchange as well. For example, an import from Japan may
be paid for using Japanese yen or US dollars. This implies that at some point in the
transaction, NT dollars must exchange for either Japanese yen or US dollars. Such
transactions take place on the foreign exchange market. Here the supply of and demand
for foreign money interact. The largest foreign exchange market in Taiwan, as with most
other countries, is the market for the US dollar. Those supplying US dollars are generally
firms and banks which have received US dollars in payment for an international
transaction -- for example, a Taiwan exporter. Those demanding US dollars are
individuals, firms, and banks who currently have NT dollars and wish to obtain US
money for purposes of international transactions -- for example a Taiwan importer. The
exchange rate is simply the price of the foreign money (US dollars) in terms of the
domestic currency (NT dollars).
Now suppose that Taiwan exports many goods and imports very few. The result
will be a flood of US dollars seeking to exchange for NT dollars, and such a dramatic
increase in the supply of foreign exchange will drive down the price of the US dollar.
Conversely, if Taiwanese suddenly felt a strong inclination to invest in the US and buy
American corporate stock, the demand for the US dollar would rise, and the foreign
exchange rate would increase sharply. In short, the foreign exchange rate is simply the
price of the US dollar, and is determined by the demand for and supply of the US dollar.
It is now easy to see how the balance of payments and the exchange rate are
related. Suppose that both the current account and capital account show a surplus. This
means that exports exceed imports and there is a net capital inflow. Taiwanese are
basically selling goods and assets to foreigners in excess of what they are buying from
foreigners. As a result, the surplus generates a large inflow of US dollars seeking to
exchange for NT dollars. If the government does not attempt to buy up these dollars, then
the price of the US dollar will fall and this will reduce the balance of payments surplus.
In this example, we assumed that both the current account and the capital account were in
positive surplus. Actually, all we need is for the sum of these two accounts to be in
surplus -- so one may be positive and the other negative.
Often the government can keep the exchange rate stable by entering the foreign
exchange market to buy or sell US dollars whenever there is a market disequilibrium.
This is how the government gains and loses its foreign exchange reserves. Whenever the
government buys and sells foreign exchange, the transaction will appear in the third
account mentioned above in Section I -- namely, the official settlements account. If the
government took a passive attitude towards the foreign exchange market, then the official
settlements account would be small, and the exchange rate would be determined entirely
by the balance on current and capital accounts.
III. What Determines the Balance of Payments?
Since the exchange rate is largely determined by the balance of payments, it is
natural to ask what factors affect the balance of payments. To answer this question, we
must look again at the structure of the accounts. Exports and imports dominate the
current account, and therefore anything which tends to affect trade in goods will affect the
current account. For example, if domestic prices tend to rise faster than foreign prices,
then exports will begin to fall and imports will begin to rise. Similarly, if income at home
is rising faster than abroad, then imports will tend to increase faster than exports. Both
income and prices have important effects on the balance of payments through their
influence on the current account.
The major variable which affects the capital account is the interest rate. If the
interest rate at home is significantly lower than the interest rate abroad, then people will
seek to purchase foreign assets and the capital account will be negative ( a negative
capital inflow is a positive capital outflow). On the other hand, if the domestic interest
rate rises, then foreigners will seek to buy domestic assets and there will be a surplus on
the capital account (i.e., a positive net capital outflow).
Finally, we have seen that the government can also influence the balance of
payments by buying and selling foreign exchange whenever there is disequilibrium in the
foreign exchange market. Some economists have argued that this is another form of
protectionism. If a government wanted to promote its exports and retard the growth of
imports, it could simply buy foreign exchange and support the price of the foreign money.
At other times we hear of the US government and the Bank of Japan working together to
prop up the value of the US dollar. The idea is the same as we have discussed before.
Essentially, the governments of both countries are working together to buy dollars with
Japanese yen in order to keep the US dollar at a reasonable level. The monetary
authorities are always concerned that a free market in the dollar may result in a disastrous
"free fall" in the value of the dollar, as one can see from the experiences of the late1980's.
Discussion Questions:
#1.
#2.
#3.
#4.
#5.
What is the function of the balance of payments?
What are the three accounts included in the balance of payments?
What items are included in the current account?
What items are included in the capital account?
Give some examples of current account transactions and give some examples of
capital account transactions.
#6. What is a foreign exchange rate?
#7. How is the exchange rate related to the balance of payments?
#8. What factors influence the current account and what factors influence the capital
account?
Taiwan's Foreign Exchange Reserves
I. How are Foreign Exchange Reserves Accumulated?
The last reading introduced some of the basic elements of the balance of payments
and determination of foreign exchange rates. In that reading, we found that the
government often enters the foreign exchange market and buys or sells foreign money
(usually US dollars) to stabilize the foreign exchange rate. If there is an excess demand
for foreign money, then the central bank can sell foreign exchange, thus eliminating the
pressure for the exchange rate to rise. Similarly, if there is an excess supply of foreign
exchange on the market, possibly caused by a large capital inflow, the central bank can
purchase the foreign money and relieve pressure on the exchange rate to fall. The key
here is to remember that the foreign exchange rate is the price of foreign money, and that
the government often influences this price by buying and selling foreign money.
In deciding how it will act, the central bank must consider a number of different
factors. First, if there are no capital controls in place, and foreign exchange can be
bought and sold freely on the open market, then small changes in domestic interest rates
relative to foreign interest rates can alter the supply and demand for foreign exchange.
Central bankers are therefore constantly looking at the movement of relative interest rate
differentials. Since changes in expected inflation can alter the level of interest rates, this
variable must also be properly gauged. Relative growth rates of real income between
countries are also important in determining medium to long run levels of the exchange
rate. A faster growing country will tend to import more than a slower growing country,
and this will put pressure on the faster growing country's foreign exchange rate to rise.
One major factor which must be considered by the central bank is the so-called
flow of "hot money". Short term movements in exchange rates often give rise to
expectations of future movements in exchange rates. If the domestic currency is expected
to depreciate significantly, then speculators will attempt to exchange domestic money for
foreign money. This increases short term capital outflow, and produces pressure on the
exchange rate to rise. If the local currency is expected to appreciate, then this will induce
short term capital inflows and the exchange rate will fall. The central bank must stand
ready to step in, on one side of the market or the other, to balance the change in supply or
demand for foreign exchange. When it does this, it either accumulates or diminishes the
government's foreign exchange reserves. Thus, such reserves act as a buffer against
sudden and undesirable changes in the exchange rate.
II. Foreign Exchange Reserves and the Money Supply
One of the problems with accumulating foreign exchange reserves, as Taiwan has
done, is that it can lead to excessive growth in the money supply, and therefore can fuel
inflationary pressure. To see this clearly, we should consider a simple example.
Suppose that an Taiwan exporter receives payment in US dollars for his shipment
of goods (which would also be registered as a capital outflow in Taiwan's balance of
payments). This means that the exporter owns US dollars contained in a bank account in
the US. The exporter may sell these dollars to his bank in Taiwan, in which case the
dollars are transferred to an account in the US owned by the Taiwan bank. If the Taiwan
bank does not want to hold these dollars, then it may be able to sell them to the Central
Bank of China (CBC). The US dollars are then transferred to an account owned by the
CBC, and Taiwan's balance of payments will show an increase in the capital account
balance, and a decrease in the official settlements balance. The US dollars never leave
America, but merely change ownership in Taiwan.
In our example, the exporter sold his US dollars for NT dollars. The Taiwan bank
used its NT dollar reserves to accomplish this. When the bank sold the US dollars to the
CBC, the central bank provided new NT dollar reserves to the banking system. These
new reserves are the foundation on which the money supply begins to grow. Additional
loaning of the reserves by the banking system will cause the money supply to grow
several times more than the initial increase in reserves. The simple act of the CBC
buying US dollars has led to a multiple increase in the money supply.
The CBC can slow the increase in the money supply now by issuing bonds (or
time deposits) and selling them to the banking system. This process is called
"sterilization". By sterilizing the increase in reserves, the CBC can avoid a free fall in the
exchange rate and also control money growth and inflationary pressure. However, the
CBC must now pay interest on the bonds and time deposits which it has issued. Where
will the CBC get the funds to pay this interest? The answer is that the foreign exchange
reserves also have interest income (in US dollars) and after this income is exchanged for
NT dollars, it can be used to pay the interest owed on the debt issued by the CBC.
Therefore, anything which reduces the interest income earned on the foreign exchange
reserves creates financial problems for the central bank. Taiwan has experienced an
explosive growth in its foreign exchange reserves. From 1980 to 1990, Taiwan's foreign
exchange reserves grew an average of 34% per year. It now comprises roughly 80% of the
total assets of Taiwan's central bank and is roughly equal to 90 billion US dollars, ranking
Taiwan at the very top in the world in size of foreign reserves. Beginning in 1984 and
continuing until the late 1980's, the CBC engaged in a massive sterilization effort.
Despite this, the money supply grew extremely fast, especially during 1986-1988, when
the average rate of growth of the money supply (M1B) was 40%. The CBC used three
major tools to sterilize the growth in bank reserves, including the issuance of (1) Treasury
Bills - B, (2) certificates of deposits, and (3) redeposit of postal savings. Currently, about
60% of the foreign exchange reserves are held in US dollar denominated assets, with the
rest being held in yen, deutschmark, and other foreign currency denominated assets.
III. How Can the Foreign Exchange Reserves be Used?
One of the most difficult questions which we can ask concerns the appropriate use
of foreign exchange reserves. These reserves are an asset of the government, and they
yield considerable income. Theoretically, the foreign exchange reserves should act as a
cushion to help stabilize the exchange rate, but Taiwan has much more reserves than are
needed to do this. A rule of thumb often used by central bankers is to keep reserves close
to about three months of the value of imports. In Taiwan, this would be about 25 billion
US dollars. However, if there were a sudden increase in capital outflow, the demand for
the US dollar would rise and the foreign exchange rate would experience pressure to rise.
The CBC would then have to sell US dollars to accommodate the increase in demand.
Thus, the CBC must also consider the highly erratic movements in capital flows in
determining its foreign exchange reserves policy. Nevertheless, Taiwan appears to have
too much foreign exchange reserves, even after considering these factors.
There are two basic uses which the foreign reserves can serve -- one is economic
and the other is political. The reserves can be used as a pool of funds from which foreign
currency loans can be made. For example, if EVA Air or China Airlines needed US
dollar loans to purchase new aircraft, they could apply for loans from the CBC directly.
Such large loans are especially useful since they avoid upsetting the domestic foreign
exchange market. Similarly, any government organization which needed foreign currency
loans to purchase goods or services from abroad could use the foreign exchange reserves.
In each case, the loan would have to produce interest income, since the CBC receives
most of its revenue from the foreign exchange reserves, and any reduction in these
reserves reduces its operating income. The foreign reserves can also be used for political
purposes. In this case Taiwan uses its foreign exchange reserves to buy US government
securities. This gives the ROC government a great deal of leverage with the US Treasury,
and consequently with the US government as a whole. Finally, the foreign exchange
reserves can be used to fund foreign aid programs and to help other countries which are
having balance of payments problems. This can help to foster Taiwan's international
relations.
Sometimes misconceptions arise about the nature and use of foreign exchange
reserves. For example, many people believe that the high level of foreign exchange
reserves indicate that Taiwan is very wealthy. It is true that the reserves are an asset of
the government, but this wealth is located overseas. They are not the same as a school,
highway, or bridge which the Taiwan government builds and which is directly productive
to the national economy. Remember that many countries in the world have higher per
capita incomes and wealth than Taiwan, but have less foreign exchange reserves than
Taiwan. Second, if the reserves are not adequately sterilized, the result is often inflation.
Taiwan suffered very high inflation in its real estate market for just this reason. Third,
some people feel that the reserves can be used to buy advanced military equipment. This
is possible, but not likely because buying such weapons does not produce interest income.
The CBC needs interest income from the foreign exchange reserves to operate without
subsidies. Tanks and planes may provide greater safety in Taiwan, but they do not
produce interest income like the foreign exchange reserves. Finally, the reserves cannot
be withdrawn. The foreign exchange reserves, like foreign land, are held outside of
Taiwan. They cannot be "brought back" to Taiwan. They can only be sold to other
people wanting foreign exchange. Attempting to sell large amounts of foreign exchange
would only bid down the value of the assets which the Taiwan government is holding.
The real issue is how best to manage the foreign exchange reserves, and not whether
Taiwan should get rid of them.
Discussion Questions:
#1. What are foreign exchange reserves?
#2. How do governments accumulate foreign exchange reserves?
#3. How can a trade surplus lead to greater foreign exchange reserves?
#4. What is the relation of the foreign exchange reserves to the money supply?
#5. What is meant by the term "sterilization"?
#6. What has been the history of Taiwan's foreign exchange reserves?
#7. How can Taiwan use its foreign exchange reserves?
#8. What are some popular misconceptions about the reserves?
#9. How could Taiwan's foreign exchange reserves be reduced?
#10. What is a reasonable level for the foreign exchange reserves?
The Forward Market and Hedging
I. Introduction
Usually, when we discuss the forward market, we are talking about foreign
currencies, although there are many other types of forward markets. For example, when
one buys Japanese yen forward, one is fixing the exchange rate at which one will buy yen
in the future, say in three months time. This rate is often called the 90 day forward rate
on yen. If one wanted to buy yen today, then one would buy at the spot yen rate.
It may seem that the forward market is very much the same as the futures market.
But, there are still some important differences. First, there are no standardized contracts
in the forward market, which means that the amount transacted can be anything. Second,
there is no organized exchange as there is in the futures market. Instead, transactions are
handled over the counter between contracting parties. Third, unlike the futures market,
the forward market does not have daily settlement. Profit or loss is determined at the
expiration of the forward contract. Finally, the futures market has a clearinghouse, which
accepts the risk of non-payment by participants. The forward market does not have such
a clearinghouse, and each party must accept the risk of non-payment by the other
contracting party. Beyond this, there are differences in commissions and margins which
must be paid.
To understand the forward market better, it might be useful to consider an
example. An important concept which we must remember at all times is that a forward
contract cannot be liquidated before it expires. One must wait until expiration of the
forward contract in order to collect one's profits or pay one's losses. Thus, one must be
always considering the present value of these profits or losses before expiration of the
agreement.
Suppose that you buy a forward contract today at $100. The agreement will
expire in 90 days and the risk free interest rate is 10%. After 20 days, suppose that the
same type of forward contract is selling for $104 with 70 days left before expiration. You
could now sell the underlying product forward 70 days, and this would guarantee that you
have $4 profit 70 days later. What is the present value of your certain $4 profit to be
received 70 days later. To find this one would simply discount this amount at the risk
free rate of interest of 10% over the remaining 70 days -- which gives $3.93 of present
value profit. In our example, we bought forward at $100 and sold forward at $104, but
we never said what the product was that we were transacting forward. This is not really
necessary, since the principle is the same whether we are transacting forward in
currencies or commodities, or anything else. The key here is to understand that one's
profit (or loss) is not realized until expiration, although the profit (or loss) can be
determined before expiration.
If the forward (or futures) price is less than the current spot rate, then a state of
backwardation is said to exist. Conversely, if the forward price is above the current spot
price, then a contango is said to exist. The forward rate (price) is sometimes thought to
be a good measure of the expected spot rate (price), but this is not necessarily true. The
forward rate may be biased upward or downward from the investor's expected spot rate.
If the forward rate is not biased, we say that it is unbiased. This means that on average
the forward rate correctly predicts the future spot rate.
II. Hedging Currency Risks
The forward market can be used to hedge currency exchange risks. For example,
suppose that EVA, an international airline in Taiwan, decides to purchase three 747-40
jets from Boeing. The total cost will be $180 million USD, and payment will be made in
270 days. EVA is worried that the NT$ may depreciate during this time. The current
spot rate is $27.5 NT/1US$, and at this rate, the cost would be $4.95 billion NT. If the
NT$ depreciates 1.82%, the cost to EVA would rise to $5.04 billion NT, for an exchange
loss of about $90 million NT. EVA could hedge this risk by purchasing $180 million
USD 270 days forward. Suppose that the forward rate is $27.8 NT/1US$, which means
that the cost of the jets to EVA would be roughly $5 billion NT. By doing this EVA
eliminates the risk that the NT$ will greatly depreciate. This hedging policy merely fixes
the rate which EVA must use, 270 days later, to convert its NT$ to US$. There is no
guarantee that this forward rate will be the same as the spot rate 270 days later. The
actual spot rate may be either higher or lower.
EVA could hedge the same transaction using a variety of other means (if they are
available), such as currency futures, currency options, or even through a money market
hedge.
For a money market hedge, EVA would borrow $4.774 billion NT for 270 days
and immediately sell these NT dollars on the spot market to get $173.62 million USD.
Suppose the riskless US interest rate in 5%. Then EVA would invest the $173.62
million USD in US money market instruments for 270 days. At the end of this time, it
would have $180 million USD which it would use to pay Boeing for the jets. Note that
EVA eliminated its exchange risks since the $180 million USD is guaranteed (riskless).
Furthermore, when EVA pays off its NT$ loan, it does not need to worry about
exchanging NT$ for US$ -- that is, the NT$ loan carries no exchange risk. If the interest
rate on the 270 day NT$ loan is 8%, then EVA pays $5.054 billion for the Boeing jets. It
would appear that the forward market is a cheaper way to hedge the risks, given these
interest rates.
III. Interest Rate Parity and Covered Interest Arbitrage
An important concept showing the relation between interest rate, the spot
exchange rate, and the forward exchange rate is that of interest rate parity. The word
parity refers to a balance which should exist between these variables. Interest parity is a
type of equilibrium condition. If parity doesn't hold, then it should be possible for an
investor to profit from the imbalance. The imbalance can be arbitraged away by
investors. This type of arbitrage is often called covered interest arbitrage. Therefore, to
really understand covered interest arbitrage, one must clearly understand interest rate
parity.
Suppose that you have $100 USD and you have a choice of investing this money
in the US or in Taiwan. In equilibrium, it should not matter whether you invest in
Taiwan or in the US. The rate of return on your investment should be the same, as long
as everyone can freely invest where they want and the tax treatment on such investment is
the same in Taiwan and the US. Now suppose that RT is the risk free return in Taiwan,
RUS is the risk free return in the US, e is the spot rate on the US dollar ( NT$/US$), and f
is the forward rate on the US dollar (NT$/US$). Interest rate parity refers to a balance
between these variables. We can write this parity condition as (1 + RUS) = (1+RT)e/f.
Now suppose that (1+RUS) is greater than (1+RT)e/f. Interest parity does not hold,
so it must be possible to make a profit. How can this be done?
If you were a Taiwanese investor, then you would borrow NT$ at interest rate RT
and sell these NT$ for US$ on the spot market at rate e. The US dollars you receive
would today be invested in the US at interest rate RUS. You would also sell US dollars
forward today for NT$ at forward rate f. At the end of your investment period, you would
be able to pay back your NT$ loan with interest and still make a profit.
Note that borrowing NT dollars puts pressure on RT to rise, and selling NT$ for
US$ on the spot market causes e to rise. Finally, selling the US$ forward will cause f to
fall and investing these US dollars in the US will cause RUS to fall. Therefore, there is
string pressure to bring all the variables back into balance. This transaction is an example
of covered interest arbitrage.
Interest rate parity shows clearly how that changes in short term interest rates can
affect exchange rates. If RUS rises sharply, then there will be pressure on both e and RT to
rise, and f to fall. We have seen before that short term interest rates are important to the
economy because they can influence the exchange rate. We now see that international
interest rate differentials can affect both the spot and the forward exchange rates. It is
because of this that investors must carefully watch changes in monetary policies of
different countries, especially the US. Changes in monetary policy can affect short term
interest rates and thus the spot and forward exchange rates.
Discussion Questions:
#1. What is a forward contract to sell German deutschmarks?
#2. Why do we consider the present value of profits and losses in the forward
market?
#3. Suppose that today you buy yen 90 days forward at 97. After 30 days you
find that you can sell yen 60 days forward at 100. If the riskless yield to
maturity is 6%, then what is the present value of your profit.
#4. When is there backwardation in the forward market?
#5. Explain the basic idea of a money market hedge.
#6. How is the forward market used to hedge exchange risks?
#7. What is interest rate parity?
#8. What is covered interest arbitrage?