International Economics
Globalization is the process of integration of an economy into the world
economy. This process involves output markets, labor markets, capital
markets….
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Immigration and Economic Development
Technological Changes and Trade
Outsourcing
Foreign Investment and Currency
Currency and Trade
International Economic Shocks and
Domestic Economics Stability
International Finance
International Markets
I. ForEx Market (Currency)
II. Capital Market (Investment)
III. Market for Goods and Services
(Trade)
The planet Earth in the darkness of the night*
* Image source: NASA (http://antwrp.gsfc.nasa.gov/apod/ap001127.html)
ForEx
Average Daily Volume of Bank Foreign-Exchange Market Activity
(Source: Basel: Bank for International Settlements, September 2004)
billions of dollars
percentage share
Spot
621
35
Swaps
944
53
Forwards
208
12
Total
1773
100
Defining the Market:
Institutions facilitating the market:
Major Private Banks
Central Banks
Market Participants:
Banks, Central Banks, Corporations, Investors, even
consumers.
Brief History of the International
Monetary System
Gold Standard: 1880 - 1914
Dates of adoption of a gold standard
•1695: United Kingdom at £1 to 113 grains (7.32g) of gold.
•1818: Netherlands at 1 guilder to 0.60561g gold
•1854: Portugal at 1000 reis to 1.62585g gold
•1871: Germany at 2790 Goldmarks to 1kg gold
•1873: Latin Monetary Union (Belgium, Italy, Switzerland, France) at 31 francs to 9g gold
•1873: United States de facto at 20.67 dollars to 1troy oz
•1875: Scandinavian monetary union: (Denmark, Norway and Sweden) at 2480 kroner to 1kg gold
•1876: France internally
•1876: Spain at 31 pesetas to 9g gold
•1878: Finland at 31 marks to 9g gold
•1879: Austria 1893: Russia at 31 Roubles to 24g gold
•1897: Japan at 1 yen to 1.5g gold
Price Stability
Simplified conversion
No Future markets
1918-1939
• Great Depression and lack of international
cooperation
• 1925 -1931 UK operates on Gold
Standard
• US remains on Gold Standard till 1933
• Fixed exchange system
Post WWII era
• Bretton Woods
– IMF and the Gold Exchange Standard
• Gold Exchange Standard
–
–
–
–
–
–
Fixed system with limited (1% allowable adjustments)
Dollar is convertible into gold at 35 USD per 1 Oz
Very few monetary reforms are undertaken by member states
1950’s – 1960’s
August of 1971 USD is no longer a convertible currency
The Smithsonian Conference of December of 1971
• 38.02 USD = 1 oz
• Dollar remains inconvertible
• Increased allowable adjustment to 2.25%
• March of 1973 FLOAT begins
Spot market
•
http://www.federalreserve.gov/releases/h10/Update/default.htm
•
Ask and Bid prices and the spread
–
–
–
–
•
Ask – Bank’s asking (bank’s sales price)
Bid – Bank’s purchase price
Spread – return to the market maker, in this case the bank
Consider the following rouble quote: Ask Price: $0.0425; Bid Price: $0.0420
Alignment of exchange rates
–
Arbitrage
•
•
•
–
Simple setting (2 or more currencies):
– Consider two banks quoting the rouble:
» Bank I: $0.0425 - $0.0430.
» Bank II: $0.0435 - $0.0440
Price difference falling within the spread
Setting 2: implied exchange rate (3 or more currencies):
– Consider tw banks providing the following quotes:
» Bank I:
Between Rouble and Dollar: R1 = $0.0425
Between Rouble and Euro: R1 = EUR 0.030
Implied USD/EUR rate is: USD1 = 0.7059
» Bank II
Between Rouble and Dollar: R1 = $0.0425
Between Rouble and Euro: R1 = EUR 0.031
Implied USD/EUR rate is: USD1 = EUR0.7294
Are profits from arbitrage possible?
Currency Index: USD Index by the FED
Economy
Euro area
Canada
China
Japan
Mexico
United Kingdom
Korea
Taiwan
Hong Kong
Malaysia
Singapore
Brazil
Switzerland
Thailand
Australia
Sweden
India
Philippines
Israel
Indonesia
Russia
Saudi Arabia
Chile
Argentina
Colombia
Venezuela
Total
weight in percentage
1997
2003
17.49
16.92
6.58
14.27
8.5
5.73
3.68
3.77
2.65
2.25
2.87
1.82
1.43
1.59
1.31
1.22
0.88
1.18
0.84
1.25
0.78
0.8
0.53
0.61
0.49
0.58
100
18.8
16.43
11.35
10.58
10.04
5.17
3.86
2.87
2.33
2.24
2.12
1.79
1.44
1.43
1.25
1.16
1.14
1.06
1
0.95
0.74
0.61
0.49
0.44
0.41
0.3
100
change
1.31
- .49
4.77
- 3.69
1.55
- .56
0.18
- .90
- .32
- .01
- .75
- .03
0.01
- .16
- .06
- .06
0.26
- .12
0.16
- .30
- .04
- .19
- .05
- .18
- .08
- .27
0
USD weights
Source: FED
Source: FED
Recent performance of the USD
1.8
$/Euro
1.6
1.4
1.2
1
0.8
0.6
0.4
0.2
Source: FederalReserve.gov: http://www.federalreserve.gov/releases/h10/Hist/
1/3/2008
7/3/2007
1/3/2007
7/3/2006
1/3/2006
7/3/2005
1/3/2005
7/3/2004
1/3/2004
7/3/2003
1/3/2003
7/3/2002
1/3/2002
7/3/2001
1/3/2001
7/3/2000
1/3/2000
0
Role of the exchange rate in the
price of oil
USD Price of Oil
$/Euro
Euro Price of Oil
3-Mar-08
102.42
1.521
67.34
5-Mar-07
60.05
1.3094
45.86
6-Mar-06
62.46
1.2002
52.04
7-Mar-05
53.9
1.3203
40.82
8-Mar-04
36.53
1.2371
29.53
3-Mar-03
36.1
1.0835
33.32
4-Mar-02
22.55
0.8652
26.06
change in the price
79.87
% change (inflation)
354.1906874
41.27
75.7975
Source for historical oil price data – US Dept. of Energy, http://tonto.eia.doe.gov/dnav/pet/pet_pri_spt_s1_d.htm
158.36
The ForEx Market
• Supply of the USD
– Imports to the US
• Goods (trade)
• Services (tourism)
– US investment abroad
• Foreign Financial
Markets
• Direct investment
abroad
– Central Banks
– Speculation
• Demand for the USD
– US Exports
• Goods
• Services (tourism)
– Foreign Investment
into US
• US Financial markets
• Direct investment
– Central Banks
– Speculation
The Interesting 90’s
• 1991-92: Collapse of the USSR Block, beginning of the Transitional
Recession in Eastern Europe
• 1994 Mexican Currency Crisis
• 1991(2)-95 The Balkan Wars
• 1998 Recession in Japan
• 1997 (July) Beginning of the Asian Financial Crisis
• 1998 major Rouble Crisis
US ECONOMY
average % rates
19922000
20012004
Real GDP
3.7
2.5
Gross Domestic Private
Investment
8.7
1.8
Non-Residential Investment
9.1
0.2
The market for USD in the 90’s
P of USD
Influx of investment stimulated Demand
D
S
Increase in imports stimulated Supply
Demand Effect Dominated
(thus positively effecting consumers’
standard of living)
The post 90’s era
• United Europe
– 10 New Countries Entered the Union on May 1st of
2004, bringing the total number of member states to
25, with combined population of over 430 million (US
population is 293 million).
• Growth in Russia and China nearing double
digits
• Emerging Economies of Brazil and India
• Threat of Terrorism to the US
• Continuous Growth in US Trade Deficit
The market for USD in the post
90’s
era
P of USD
D
S
Supply effect appears to be dominating
The demand effect
The BIG picture
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•
•
•
Rise in Imports  Increase in Supply  Depreciation
Rise in Exports  Increase in Demand  Appreciation
Influx of Investment  Increase in Demand  Appreciation
Outflow of Investment  Increase in Supply  Depreciation
COMMODITY PRICES AND CURRENCY BEHAVIOR
• Wheat and the Australian Dollar
• Oil and the Russian Ruble
Future Markets – forward looking
instruments
• Forward Rates
• Swaps
• Futures
• Options
Forwards
• The transaction takes place at a future
time period based on the previously
specified terms (value and price)
• Forwards can be used to predict future
spot rates as they reflect expectations of
currency traders
• Forward premium versus forward discount
Implications of forecasting and the
forward transactions
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•
•
•
•
Consider that R25 = USD1 today
A 6 month forward rate is R25 = USD1
Forecast 1 predicts the future spot rate: R24 = USD1 in 6 months
Forecast 2 predicts the future spot rate: R25.20 = USD1 in 6 months
If our firm owes a payment to a Russian trading partner in 6 months
from now then these two forecasts become confusing:
– Based on Forecast 1 we should either purchase the ruble now
– Based on Forecast 2 we should wait for 6 months and purchase the
ruble then
• If after 6 months the spot rate happens to be R24.9 = $1, the First
forecaster proves to be the best in terms of policy recommendation,
even though that forecaster has a much greater error.
swaps
• A swap usually is a trade that includes a spot and a forward
transaction into one.
• Some forward-forward swaps are also being used (both transactions
are forward)
• Frequently used between banks (including Central Banks)
• Consider two banks: Citibank (US) and Lloyds (UK)
– If Citibank needs pounds, it can agree to exchange dollars for pounds
with Lloyds today and also agree to a reverse transaction at a future
date
– For example, if the spot rate is 2 USD per pound and the agreed
forward rate is 2.10 dollars per pound than this constitutes a swap
– In this case the pound is traded at a forward premium of $0.1, or 1000
basis points (a basis point is 1/100 of 1 %) in the forward market
– A percent conversion can also be made: $0.10/$2.00 = 5%, if the swap
is for 6 months, then this is equivalent to 10% rate of return for Lloyds
Futures
• Limited selection of currencies
• Specified quantities
• Traded on exchanges
options
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•
•
Call versus put
Expiration
Volatility and risk premium
Option use as a hedging tool (proper hedging)
Option use as an income source (improper use)
Option Pricing – the Black-Scholes model
– Scholes won the Nobel Prize. Was a co-founder of the LTC
venture along with another Nobel Prize winner Merton and a
number of other prominent economists (from the FED, Salomon
Brothers…). The LTC venture was one of the largest in history
financial disasters when it collapsed in 1999, losing 5 billion
dollars in about 4 months.
– Recent behavior by some hedge funds
Option
value
Risk premium = time value
Option value = time value + intrinsic value
Intrinsic value >0, otherwise no exercise
Intrinsic value
Option value
strike
Asset
price
Characteristics of hedge funds
• Unrestricted in their behavior
– May assume short positions
– Trade options/features
– May assume leverage (the Carlyle Capital
hedge fund operated at a multiple of 32
http://dealbook.blogs.nytimes.com/2008/03/14/in-carlyle-collapse-a-lesson-for-bear-stearns/
the Bear group operated with a 34 times
equity leverage)
• Note, not all hedge funds leverage themselves, after all, hedging is a
protective tool, not a speculative tool
Basic option strategies
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•
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Options can be purchased or written (sold short)
Hedging – use of options for insurance purposes
Covered call (hedging)
Covered put (hedging)
Naked call (infinite risk)
Naked put (limited risk)
Spread (risk depends on the structure)
Straddle (market movement)
Leveraging – the inappropriate
behavior
• Obtain investment
• Magnify it by using it as a collateral to
borrow money in a low interest rate
environment (say Japan)
• Magnify the funds further by issuing naked
puts (possibly calls)
• Use the funds to go into relatively safe
investment vehicles that earn income
– US Treasury bonds (short term will typically
require 5 - 10% margin requirement only)
What if markets don’t behave the
way you expected?
• If you are leveraged - CRASH
– The Carlyle group in March of 2008
• Can the markets behave in an unpredictable way?
– BSC stock moved from $159 on 4/25/07 to $2.84 3/17/08, could
that have been predicted from the past distribution of prices of
BSC?
– The LTC venture
• The Asian Crisis
• The Rouble Crisis
• Could the full extend of these crises have been predicted in
advance?
– The Carlyle Group
• The US housing market (see the next slide)
The Housing Market
Median Home Price
2005
2006
2007 2007: QIV
US
219,000
221,900
217,800
206,200
Atlanta, GA
167,200
171,800
172,000
164,300
Sacramento, CA
375,900
374,500
342,700
297,600
99,000
97,900
104,000
105,400
256,100
254,800
269,700
278,800
Buffalo, NY
Atlantic City, NJ
Home Sales in the US decreased from 6,380,000 in 2006 to 4,890,000 in 2007,
suggesting that the quantity decreased along with the price – characteristics of a
demand pull back (http://www.realtor.org/Research.nsf/files/MSAPRICESF.xls/$FILE/MSAPRICESF.xls )
Revisiting the ForEx Market
• Nominal exchange rates versus Real exchange rate
– Real Exchange rate
• Er = En * (Pd)/(Pf)
• Law of one price
– Undervalued versus overvalued exchange
» Real exchange rate must be equal to one
– Economic agents respond to real changes
• Redistribution of wealth within the country
– Appreciating dollar in the 1990’s and the impact on the “rust belt” of the
US
– Appreciating Canadian Dollar and the redistribution of wealth across
the Canadian provinces
• Prices act as signals of information
– Frequent changes may produce incorrect signals
Purchasing Price Parity
•
Absolute
– Internationally traded goods
– Limited trade restrictions (natural and artificial)
– The law of one price: Pd = E * Pf
• The Big Mac index
• Commodity prices
• Cross-border trade with Canada
– International trade as the corrective mechanism
– Implications:
• Nominal exchange rates change to offset changes in the price levels, but the real
exchange rate remains constant
•
Relative
– Role of inflation
– International trade as the corrective mechanism
– Nominal exchange rate movement as the differential in the inflation rates
•
Deviations from PPP
– Non-tradable goods
– Heterogeneity of goods and consumer demand
– Trade restrictions
• Current export restrictions on grain (Kazakhstan)
• Russian Export tariffs
• Import tariffs
Relative prices and the exchange
rate
• Rise in the price of a heavily consumed
product can lead to currency appreciation
• Rise in the price of a product that is being
exported (and the foreign demand is
inelastic), can lead to currency
appreciation
Fixed Exchange Rate
• Overvalued
–
–
–
–
Current account deficit
Possibility of currency attack
Loss of reserves
Russia, 1998
• Undervalued
– Current account surplus
– Accumulation of reserves
– Effectively, monetary expansion is caused at the forex
window of the CB
Capital Movements and the ForEx
market
• Interest Rate Parity
– Money follows the highest risk adjusted rate of return,
thus a rise in the interest rate will cause an influx of
foreign investment, all else held constant
• Recent depreciation of the USD
• Canadian Central Bank behavior in light of US rate
reductions
• Uncovered interest rate parity
– No forward market cover transaction
– Ex: 2006-2007 US hedge funds’ borrowing in Japan
• Covered interest rate parity
– Covered with a forward transaction to exit the
currency
Uncovered interest rate parity
US
Japan
interest rate
i$
iY
starting balance
A
A*Ex
Ex = Yen per USD
balance after investing
A*(1+i$)
A*Ex*(1+iY)
in equilibrium, the returns should be the same
A*(1+i$) = A*Ex(1+iY)
(1+i$)/(1+iY) = Ex
taking natural log and differentiating gives us the relationship between the
exchange rate and the interest rate
Covered interest rate parity
US
Japan
interest rate
i$
iY
starting balance
A
A*Ex
Ex = Yen per USD
balance after investing
A*(1+i$)
A*Ex*(1+iY)
Balance after covered exit
A*(1+i$)
A*Ex*(1+iY)*(1/Fx)
Fx = forward rate, Yen per USD
in equilibrium, the returns should be the same
A*(1+i$) = A*Ex(1+iY)(1/Fx)
(1+i$)/(1+iY) = Ex/Fx
to simplify the equation, subtract 1 from each side
(i$-iY)/(1+iY) = (Ex - Fx)/Fx
Interest Rate Parity
• Movements of the government bond rates
• Actions of the Central Banks
• Expected future return and the real
interest rate (investment into Russia today,
due to commodity pricing)
Balance Of Payments
• Summary of all international transactions
• Current Account
– US trade deficit and the outflow of foreign exchange
(dollar is the international reserves currency)
• Financial Account
– US borrowing from overseas and the inflow of foreing
exchange
– Paying for trade deficit, the US style
• Reserves Account
– Choice of exchange rate regime
Balance of Payments and the
Choice of the Exchange Rate
Regime
• Float – USA (trade deficit)
• Fixed – Russia, 1998 (Currency Crisis)
Economic Stabilization Policies and
the choice of the exchange rate
regime
• Monetary Policy
• Fiscal Policy
Monetary Side of Economy
Money
• Properties of Money
– Store of Value
– Unit of Account
– Medium of Exchange
• Fiat money versus Commodity Based
money
– Gold Standard
Supply of Money
•
•
•
How to measure money?
Defining supply of money based on liquidity
M1 – most liquid assets (in Dec of 2007 - 1364.2 billion $)
– Cash
– Demand deposits (all forms of checking accounts)
– Traveler’s checks
•
M2 – less liquid than M1 (in Dec of 2007 - 7447.0 billion $)
–
–
–
–
–
•
M1
Retail money market mutual fund balances
Savings accounts
Money market accounts
Small time deposits (CDs)
M3
–
–
–
–
–
M2
Large time deposits (CDs in excess of 100K)
Repurchase agreements
Eurodollars
Institution-only money market mutual fund balances
Statistical Source: http://www.federalreserve.gov/releases/h6/Current/
Demand for Money
• Transaction demand
– Function of income
• Opportunity cost of holding money
– Function of the interest rate
Quantity theory of Money
the long-run role of money
• Money x Velocity = Prices x Transactions
• Noting that transactions are based on the level of real
GDP, we can rewrite the above:
• M x V = P x Real GDP
• Assuming constant velocity of money:
• Inflation = money supply growth – real output growth
• The above provides us with the fundamental look at
inflation
• Examples:
– Russia in 1990’s
– Germany in the post WWI era
Other Causes of Inflation
• Resource supply shock
– USA and the oil price today
– Reduced supply of cheap foreign labor and
the US inflation today
• Demand driven overheating
– Operating at unemployment rates below the
natural unemployment rate
– USA in 2000
• Expectations of future price increases
Impact of inflation
unexpected versus fully anticipated inflation
COSTS
•
•
•
•
Menu cost
Uncertainty
Ability of inflation to reduce forward looking financial arraignments
Redistribution of wealth
• Impact of inflation on banks:
– Banks are short-term borrowers, long-term lenders.
• Rise in inflation increases borrowing costs (recall the Fisher
equation)
BENEFITS
• Reduced real wages (effectively enables fixed [sticky]
wages to become flexible, the long-run adjustment)
Hyperinflation
• Really high
– Russia 1990-1995
• Sources
– Typically: Monetary Expansion
• Effects
– May lead to dollarization
Modern Banking System and
Money Creation
• Fractional Reserve System
– Required Reserves
– Excess Reserves
• Money Creation Process
– Multiplication
– Potential money multiplier
– Actual money multiplier
• Reserve Requirements as a monetary
policy instrument
Monetary Policy Today
US example
• Central Bank – FEDERAL RESERVE
• FOMC – Policy Making Body
– Meets typically 8 times a year
• Policy Objectives
– Economic stability and growth
• Real GDP, Employment, Inflation
• Policy Mechanism
– Interest Rate
• Real GDP is a function of the Interest rate
– Investment is a function of the Interest Rate
– Consumption is a function of the Interest Rate
– Interest Rate is a function of the Supply of Money
• Market for Loanable Funds
• Interest Rate as the price of Money
Monetary Policy In Action
• Reserve Requirements Ratio
– Current structure based on size of liabilities
http://www.federalreserve.gov/monetarypolicy/reservereq.htm
• Discount Rate
• Open Market Operations
– Federal Funds Rate
• Term Auction Facility (introduced in 2007)
Policy Impact
• Domestic response in the GDP
– Consumption Spending
– Investment Spending (2001-2003 and the housing
market)
• International response
– Currency depreciation in the case of expansionary
monetary policy (USA today)
– Response of exports/imports to currency depreciation
 impact on the GDP
• Impact on Prices
Monetary Policy
• Floating exchange rate regime:
– Monetary expansion leads to currency
depreciation
• Fixed exchange rate regime:
– Monetary policy is ineffective (EU12)
Fiscal Policy
• Floating exchange rate regime
– Currency appreciation makes fiscal expansion
ineffective
• Fixed exchange rate regime
– Fiscal expansion leads to monetary
expansion