1 ECONOMICS 3150N Winter 2013 Professor Lazar Office: N205J, Schulich 736-5068.

Slides:



Advertisements
Similar presentations
Ch. 8: Money and inflation Money – Definition – Types – Functions Greshams law & bimetallic standard History of banking Fractional reserve banking and.
Advertisements

10. Foreign Exchange The basics Long run / PPP Short run / Demand & Supply Gov’t intervention The basics Long run / PPP Short run / Demand & Supply Gov’t.
CHAPTER 10 EXCHANGE RATES, BUSINESS
Chapter Outline Foreign Exchange Markets and Exchange Rates
Foreign Exchange Market Exchange Rate Appreciation/Depreciation Effective Exchange Rate Trade Weighted Dollar Real Exchange Rate Interbank Market: Dealers.
Dr. Noureen Adnan Academic
Chapter 19 The Foreign Exchange Market. © 2004 Pearson Addison-Wesley. All rights reserved 19-2 Exchange Rate An exchange rate can be quoted in two ways:
Ch. 10: The Exchange Rate and the Balance of Payments.
© 2008 Pearson Education Canada13.1 Chapter 13 Hedging with Financial Derivatives.
Spot and Forward Rates, Currency Swaps, Futures and Options
Exchange Rates Theories Asset Approach. Goods flows and Capital flows When there is not much international capital flows, TB>0  Currency appreciation.
Macroeconomics (ECON 1211) Lecturer: Dr B. M. Nowbutsing Topic: Open economy macroeconomics.
Exchange Rate Determination (1) International Investment/Arbitrage J.D. Han King’s University College 13-1.
Economics 282 University of Alberta
MBMC Exchange Rates and The Open Economy. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and.
Foreign Exchange Markets and Exchange Rates. Foreign Exchange Markets A network of systems and mechanisms through which currencies are traded Market actors:
August 8, 2015Foreign Exchange Determination1 Forecasting exchange rates Foreign Exchange Determination.
Study Unit 7 Part 2 – Currency Exchange Rates & International Trade.
1 ECONOMICS 3150M Winter 2014 Professor Lazar Office: N205J, Schulich
FOREIGN EXCHANGE RISK MANAGEMENT
Copyright © 2011 Pearson Addison-Wesley. All rights reserved. Chapter 10 Exchange Rates and Exchange Rate Systems.
EXCHANGE RATES Examples. Floating, creeping, and sinking exchange rates.
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 0 Chapter 18 International Aspects of Financial Management.
The Foreign Exchange Market
Chapter 13 The Foreign Exchange Market. Copyright © 2007 Pearson Addison-Wesley. All rights reserved Topics to be Covered Foreign Exchange Market.
CHAPTER 12 INTERNATIONAL MARKETS. Copyright© 2003 John Wiley and Sons, Inc. Foreign Exchange Rates Foreign trade and funds flow must involve a conversion.
© 2008 Pearson Education Canada13.1 Chapter 13 Hedging with Financial Derivatives.
Exchange Rate Demonstration. Exchange Rate The price of one country’s currency measured in terms of another country’s currency ex. $/Pound or Pound/$
1 Welcome to EC 382: International Economics By: Dr. Jacqueline Khorassani Week Eleven.
Unit 3: Exchange Rates Foreign Exchange 3/21/2012.
Ch. 22 International Business Finance  2002, Prentice Hall, Inc.
Classical Economics & Relative Prices. Classical Economics Classical economics relies on three main assumptions: Classical economics relies on three main.
10/1/2015Multinational Corporate Finance Prof. R.A. Michelfelder 1 Outline 5: Purchasing Power Parity, Interest Rate Parity, and Exchange Rate Forecasting.
1 ECONOMICS 3150B Fall 2015 Professor Lazar Office: N205J, Schulich
CHAPTER 12 & 13 INTERNATIONAL EXCHANGE AND CREDIT MARKETS.
McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin International Aspects of Financial Management Chapter 18.
Exchange Rates. An exchange rate is the price of one currency in terms of another. –It indicates how many units of one currency can be bought with a single.
Unit 3: Monetary Policy Foreign Exchange 11/4/2010.
MANAGING FOREIGN ECHANGE RISK. FACTORS THAT AFFECT EXCHANGE RATES Interest rate differential net of expected inflation Trading activity in other currencies.
Finance Chapter 4 The financial environment: markets, institutions, & interest rates.
© 2004 Pearson Addison-Wesley. All rights reserved 13-1 Hedging Hedge: engage in a financial transaction that reduces or eliminates risk Basic hedging.
1 ECONOMICS 3150C Fall 2010 Professor Lazar Office: N205J
1 1. The Foreign Exchange Market Some currency rates as of May 21, 2004: Per U.S. dollar: Brazil (Real) Mexico (Peso) Japan (Yen)
McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 21: Exchange Rates, International Trade, and Capital.
1 The foreign Exchange market and exchange rates Lecture 18.
1 ECONOMICS 3150B Fall 2015 Professor Lazar Office: N205J, Schulich
1 International Finance Chapter 16 Price Levels and the Exchange Rate in the Long Run.
Exchange Rates. An exchange rate is the price of one currency in terms of another. –It indicates how many units of one currency can be bought with a single.
1 ECONOMICS 3150M Winter 2014 Professor Lazar Office: N205J, Schulich
Exchange Rates and Business Cycles Building Blocks.
The International Monetary System: Order or Disorder? 19.
© 2004 by Nelson, a division of Thomson Canada Limited Chapter 18: Managing International Risk Contemporary Financial Management.
Chapter 12 The Foreign- Exchange Market. ©2013 Pearson Education, Inc. All rights reserved Topics to be Covered Spot Rates Forward Rates Arbitrage.
Chapter objectives accounting identities for the open economy
EXCHANGE RATE DETERMINATION. Demand for Foreign Exchange Refers to the amount of foreign exchange that will be bought from the market at various exchange.
© 2004 South-Western Publishing 1 Chapter 10 Foreign Exchange Futures.
18 – Monetary Policy Chapter 18. Monetary Policy Tools Policy tools – Target federal funds rate – Discount rate – Reserve requirement Effective policy.
Chapter 10 Exchange Rates, Business Cycles, and Macroeconomic Policy in the Open Economy Copyright © 2012 Pearson Education Inc.
1 ECONOMICS 3150M Winter 2014 Professor Lazar Office: N205J, Schulich
© 2004 South-Western Publishing 1 Chapter 10 Foreign Exchange Futures.
Chapter 22 International Business Finance International Business Finance  2005, Pearson Prentice Hall.
The Foreign Exchange Market
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 6 International Trade, Exchange Rates, and Macroeconomic Policy.
Foreign trade and/or investments abroad require currency conversion. Nominal exchange rate = price of one currency in terms of another currency. Direct.
CHAPTER 14 (Part 2) Money, Interest Rates, and the Exchange Rate.
Foreign Exchange Markets, ECO Money & Banking - Dr. D. Foster Purchasing Power Parity, and Real Interest Parity.
The Foreign- Exchange Market
Exchange Rates and The Open Economy
Risk Management with Financial Derivatives
Presentation transcript:

1 ECONOMICS 3150N Winter 2013 Professor Lazar Office: N205J, Schulich

2 Lecture 3: January 24 Ch. 15, 16

3 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 (2013?) 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=1.0051), AC will pay C$1,030M –If C$ appreciates by the time of deliveries, AC will pay less in C$ –If C$ depreciates, AC will pay more in C$

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

5 Hedging Hedging options: –Forward contract – lock in forward rate (F)  AC pays with certainty at end of year $1,125 M/F AC foregoes possibility of gaining from appreciation –One-year futures contract –One-year call option to buy US$1,035 M at a pre- specified exchange rate (e.g. E = 1.00) and pay C$1,035M if option is exercised  most costly form of hedging but allows AC to gain from appreciation of C$

6 Swaps and Comparative Advantage Two companies: –A (US multinational) can borrow medium-term (5-year bonds) at 100 basis points above US Government bonds (0.76%) and 150 basis points above Government of Canada bonds (1.44%) –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 2.94%, B issues debt in US at 2.76%

7 Swaps and Comparative Advantage Swap agreement for five years: –A issues debt in US at 1.76%, B Issues debt in Canada initially at 2.44% (identical principal amounts involved) –A and B swap interest payments –Net interest rate for A: 1.76%(US) – 1.76%(US) %(C) = 2.44% in Canadian $ –Net interest rate for B: 2.44%(C) %(US) – 2.44%(C) = 1.76% 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

8 Demand for Financial Assets Two financial assets: Government of Canada bond with one year to maturity; US Government Bond with one year to maturity C$ bonds have higher degree of risk and are more illiquid than US$ bonds   represents value of risk and illiquidity Covered interest rate parity condition must hold (with expected E – E(e) – in place of F) adjusted for greater risk and less liquidity of C$ government bonds: –R(1,C) = R(1,US) + (E*(e)-E*)/E* +  –(E*(e)-E*)/E* : expected change in value of C$ –(E*(e)-E*)/E* > 0  C$ expected to depreciate –(E*(e)-E*)/E* < 0  C$ expected to appreciate

9 Demand for Financial Assets Following graph –Horizontal axis: expected rate of return in C$ –E*(e) is assumed to be independent of E*, so the higher is E*, the smaller is the expected change in the value of the C$, and the smaller is the expected C$ return on US Government bond

10 E* R(1,C) [R(1,US) 0,  0, E*(e) 0 ] R0R0 E* 0 1

11 Impact on Exchange Rate Impact on E*: –  R(1,US) –  R(1,C) –  –  E*(e)

12 R(1,C) [R(1,US) 0,  0, E*(e) 0 ] R0R0 1 E* E* 0  R(1,US), , or E*(e) 2 E* 1 R1R1 3E* 2

13 Problems with Model Speed of adjustments – stability, herd effect Variety of assets – different terms to maturity, risks, degree of liquidity, expected returns Transactions costs; differential tax treatment Formulation of expectations –Momentum –Surprises Ignores current account transactions and direct intervention by central bank Determinants of E* -- consider case of financial assets with more than 10 years to maturity

14 Problems with Model Fundamental Problem: –When asset markets in equilibrium, flows = 0  no D/S for currencies –Flows do not = 0: asset markets not in equilibrium  uni- directional capital flows during adjustment period; speed of adjustment to restore equilibrium –To salvage model, need to consider growth in wealth and stock of assets

Flight to Safety /1009/1109/1209/1309/1409/17 A$ Real C$ Euro Rupee Peso Rouble Won Swiss franc Baht Indonesia rupiah

Flight to Safety /1209/1509/1609/1709/1809/19 A$ Real C$ Euro Rupee Peso Rouble Won Swiss franc Baht Indonesia rupiah

17 Central Banks Monetary policy conducted by central banks U.S. Federal Reserve –Most important –Created in 1913 Bank of Canada – created in 1935 Riksbank (Sweden) – 1668 Bank of England – 1694 Bank of France – 1800 Bundesbank (Germany) – re-established in 1946 European Central Bank – 1998

18 Traditional Policy Tools Open market operations –Interest rates, liquidity –Quantitative easing –Operation twist Discount rate/fed funds rate; bank rate/overnight interest rate Reserve requirements Moral suasion

19 Money, Interest Rates and Exchange Rates Demand for Money –Opportunity cost –Liquidity –Real income –M D /P = L(R, Y) Supply of Money determined by central bank M S = M D

20 Money, Interest Rates and Exchange Rates Assumptions –Real income constant – not impacted by changes in money supply –Price level constant –Exchange rate expectations constant –Short run Increase (decrease) in M S  decrease (increase) R  depreciation (appreciation) of exchange rate

21 Classical Monetary Theory M(t)*V(t) = P(t)*Y(t) –M: supply of money –V: income velocity of money –P: price deflator for GDP –Y: GDP –V = L(R) Real interest rates matter –%  M + %  V = %  P + %  Y

22 Classical Monetary Theory Short run: –Changes in V depend on changes in R –Price rigidity –Changes in M can affect Y and R

23 Classical Monetary Theory Long run: –Flexible prices –Assume: %  V = k; %  = n (determined by rate of growth in factors of production and multi-factor productivity growth rate) –%  P = %  M + k - n –Assume further that k = 0 and cause-effect runs from the supply of money to the rate of inflation –  inflation a monetary phenomenon –%  P = %  M - n

Canadian Experience M1+M2+Core CPI %6.6%2.1%

25 Purchasing Power Parity: Big Mac or Tall Latte Theory of Exchange Rates McDonald’s and Starbucks are global companies Law of one price – arbitrage, no transactions costs Exchange rate between two countries’ currencies = ratio of currencies’ purchasing power as measured by national price levels –Money prices of typical basket of consumption goods –E(t) = P[US,t]/P[C,t] –E  (  ): P[US]  (  ) and/or P[C]  (  ) Relative purchasing power parity: –%  E = %  P[US] - %  P[C] –Since %  E = - %  E*  %  E* = %  P[C] - %  P[US]

26 PPP and Long-Run Exchange Rate Determination Exchange rate – Relative price of US and Canadian money – determined in long run by relative supplies of those monies and elative demand for them –%  E* = %  M S [C] - %  M S [US] Relative demand depends on relative interest rates and output levels Combining interest rate parity with relative purchasing power parity: –R(C) = R(US) + (E*(e)-E*)/E* +  –%  E* = %  P[C] - %  P[US] –R(C) – R(US) = %  P[C] - %  P[US] + 

PPP Exchange Rates vs. US $ PPPActual A$ Real C$ Yuan Rupee Yen Won Peso Rouble Rand Pound

28 Limitations of PPP Trade barriers and non-tradables: –Distortions in prices of traded goods and services –Non-traded goods and services Imperfect competition: –Distortions in prices Composition of consumption baskets: –Differ between/among countries Ignore capital flows

29 Nominal and Real Interest Rates R(t) = r(t) + %  P(e,t) = r(t) + %  M(e,t) + n assume n = 0 for both C and US R(t) = r(t) + %  M(e,t) Covered interest rate parity condition: –R(C,t) = R(US,t) + [E*(e,t)-E*(t)]/E*(t) +  (t) –  R(C) = R(US) + %  M(e,C) - %  M(e,US) +  –  r(C,t) = r(US,t) +  (t) With unimpeded capital mobility, real interest rates in Canada are determined by real interest rates in US and the liquidity premium –B. of C. can only affect real interest rates in Canada if actions have some effect on liquidity premium, otherwise, monetary policy in Canada ineffective in impacting Y in short run

Real Interest Rates CanadaUSDifference Dec./ Dec./ Dec./ Dec./ Dec./ Dec./ Dec./ Dec./ Dec./ Dec./

31 Real Interest Rates Clientele effects provide scope for central banks to have some effect Clientele effects: –Preference by investors for financial instruments supplied locally –Better informed –Tax policies –Regulations – RRSPs, pension funds and foreign investments –Currency risks

32 Real Exchange Rates Real Exchange rate: Q Q = [P(US)E*]/P(C) Real depreciation (appreciation): Q  (  ) When relative PPP holds, real exchange rate cannot change in value –%  E* = %  P[C] - %  P[US] –%  Q = %  P[US] + %  E* - %  P[C] Real exchange rate can only change when relative PPP does not hold