1 ECONOMICS 3150B Fall 2015 Professor Lazar Office: N205J, Schulich

2 Lecture 5: September 24 Ch. 11, 12

3 Revaluations of Exchange Rates and Impacts on Relative Prices Depreciation of spot rate of C$ increases C$ price of foreign goods and services, unless foreign prices reduced –US$ price of US good/service: US$100 (PUS), with E=0.7623, C$ price of this good/service = PUS / E = C$ –Depreciation of C$: i.e. E decreases to (5% depreciation in the value of the C$ relative to the US$), C$ price of this US good/service (US$ price unchanged at US$100) at new exchange rate is C$138.08

4 Revaluations of Exchange Rates and Impacts on Relative Prices Depreciation of the spot rate for the C$ also reduces foreign currency price of Canadian goods and services, unless C$ price increased –C$ price of Canadian good/service: C$100 (PC), with E=0.7623, US$ price of this good/service = PC * E = US$76.23 –Depreciation of C$: E decreases to , US$ price of this Canadian good/service (C$ price unchanged at C$100) at new exchange rate is US$72.42 –Leakage of air travel at US border airports

5 Revaluations of Exchange Rates and Impacts on Relative Prices Ceteris paribus, competitive position of Canadian-based companies improves vis a vis foreign competitors when C$ depreciates and deteriorates when C$ appreciates as long as Canadian companies do not use many US or foreign produced/priced parts, components, services –Depreciation may lead to higher rate of inflation (prices of imported goods and services), and increase in wage demands –Foreign suppliers may improve quality, productivity to maintain competitive position –Foreign suppliers may reduce profit margins to maintain prices in C$ -- less than full pass-through, contracts priced in C$ –Canadian suppliers may become lax (X-inefficient) and less innovative

6 Demand for Financial Assets Relative expected rates of return – returns on financial assets denominated in different currencies must be compared in the same currency –Forward-looking decisions Risk – variability of expected return, default risk and expected losses in case of default, exchange rate movements –Comparison of expected return for same degree of risk –Diversification of portfolio to reduce overall risk for portfolio –Measurement of risk – credit ratings –Risk preference Liquidity: cost/speed of converting asset into cash –Precautionary motive for holding liquid assets

7 Debt Walls Unavailability of external financial capital –Hot money and changes in momentum –Do government deficits and debt influence hot money? –Herd mentality –Is there a debt wall or just unsustainably high interest rates? –Lenders of last resort – IMF, central banks

8 Derivatives Derivatives: financial instruments whose value depends upon other financial instruments or assets (commodities) –Forward contracts (provided by banks) –Futures contracts (traded on exchanges) –Options on futures – examples for interest rates, currencies, commodities –Securitized financial instruments; e.g. mortgage-backed bonds –Swaps: interest rates, currency, credit default Derivatives offer insurance against various forms of financial risks (interest rates, currencies, commodity prices, etc.) –Also enable gambling: e.g. credit default swaps

9 Links between Spot and Forward Rates Covered interest rate parity: –Invest C$1 for one year in Government of Canada bond at interest rate of R(1,C): $1 [1+R(1,C)]  C$ –Invest C$1 for one year in US Government bond at interest rate of R(1, US): $1*E[1+R(1,US)]  US$  convert into C$ at end of year at spot exchange rate at that time (speculate) or enter into forward contract at beginning of year at forward rate of F –For investor to be indifferent between two investments and not speculate: [1+R(1,C)] = E[1+R(1,US)] /F –F = E{[1+R(1,US)]/[1+R(1,C)]} – R(1,C) = {E[1+R(1,US)] – F}/F  R(1,US) + (E-F)/F  R(1,US) + (F*- E*)/E*

Links between Spot and Forward Rates 90 day premium (+) or discount (-) US$ in Canada, July

11 Financial Markets Financial intermediaries and financial intermediation –Goldman Sachs: “Doing God’s work” – insurance vs. gambling –Banks, credit unions, insurance companies, pension funds –Matching savers/lenders and investors/borrowers Disintermediation –Getting between savers and investors –Mutual funds, hedge funds, venture capital, private equity

12 Hedging Eliminate foreign exchange risks resulting from possible revaluation of exchange rate Consider case of Air Canada buying B787-8s from Boeing: 5 per year for six years starting 2014 Consider exchange rate risk in first year of deliveries – assume that all planes are delivered at end of year and fully paid for at that time; cost per plane US$207 M –AC to pay US$1,035M for first year of deliveries –Foreign exchange rate risk: How many C$ will it cost AC – Depends on value of spot rate at that time –At current spot rate (E=0.7623), AC will pay C$1,358M –If C$ appreciates by the time of deliveries, AC will pay less in C$ –If C$ depreciates, AC will pay more in C$

13 Hedging Options for Air Canada –Speculate – maximum exposure depends upon degree of appreciation –Hedge – avoid exposure

14 Hedging Hedging options: –Forward contract – lock in forward rate (F)  AC pays with certainty at end of year $1,358 M/F AC foregoes possibility of gaining from appreciation –One-year futures contract –One-year call option to buy US$1,358 M at a pre- specified exchange rate (e.g. E = 0.76) and pay C$1,358M if option is exercised  most costly form of hedging but allows AC to gain from appreciation of C$

15 Swaps and Comparative Advantage Two companies: –A (US multinational) can borrow medium-term (5-year bonds) at 100 basis points above US Government bonds (1.61%) and 150 basis points above Government of Canada bonds (0.73%) –B (Canadian multinational) can borrow medium-term at 200 basis points above US Government bonds and 100 basis points above Government of Canada bonds B has comparative advantage in Canada, A in US –A: US to Canada – 2:3; Canada to US – 3:2 –B: US to Canada – 2:1; Canada to US – 1:2 A needs to hedge against C$ revenues; B needs to hedge against US$ revenues –in absence of swap agreement, A issues debt in Canada at 2.23%, B issues debt in US at 3.61%

16 Swaps and Comparative Advantage Swap agreement for five years: –A issues debt in US at 2.61%, B Issues debt in Canada initially at 1.73% (identical principal amounts involved) –A and B swap interest payments –Net interest rate for A: 2.61%(US) – 2.61%(US) %(C) = 1.73% in Canadian $ –Net interest rate for B: 1.73%(C) %(US) – 1.73%(C) = 2.61% in US $ Counter-party risk: A or B defaults –Swap market: financial institutions operate as intermediaries between floating-rate and fixed rate payers, and between payers in different currencies