1. Corporate Finance MLI28C060 Lecture 2 Tuesday 13 October 2015

2. Foreign exchange I: FX markets, their structure, simple trading techniques Structure: - Types of national currency regime - Implications arising from national choice of fixed, floating or intermediate regimes - Exchange rate parity arrangements Reading: Ghosh, A. R., Gulde, A-M., Wolf, H. C., de Haan, J., & Pagano, M. (2000). Currency Boards: More than a Quick Fix? Economic Policy, 15 (31), 269-335 Bennett, A. G. G. (1993). The operation of the Estonian currency board. Staff Papers - International Monetary Fund, 40 (2), 451-470 LeClair, M. S. (2007). Currency regimes and currency crises: What about cocoa money? Journal of International Financial Markets, Institutions and Money, 17, 42–57

3. Types of national currency regime

4. What are countries doing? 1.Classification of exchange rate regimes 2.De jure vs. De facto What should countries be doing? 3.Advantages of fixed rates 4.Advantages of floating rates 5.How should the choice be made? 1.Performance by category 2.Traditional criteria for choosing: OCA framework 3.1990s criteria to suit a country for institutionally fixed rate 4.Financial development 5.External shocks: Commodity price volatility. Addenda: Attempts to classify countries’ regimes, & performance The corners hypothesis

5. 1. Classification of exchange rate regime Continuum from flexible to rigid FLEXIBLE CORNER 1) Free float2) Managed float INTERMEDIATE REGIMES 3) Target zone/band4) Basket peg 5) Crawling peg6) Adjustable peg FIXED CORNER 7) Currency board8) Dollarization 9) Monetary union

6. Bottom line on classifying exchange rate regimes It is genuinely difficult to classify most countries’ de facto regimes: intermediate regimes that change over time. Need techniques – that allow for intermediate regimes (managed floating and basket anchors) – and that allow the parameters to change over time.

7. Intermediate regimes target zone (band) Krugman-ERM type (with nominal anchor) Bergsten-Williamson type (FEER adjusted automatically) basket peg (weights can be either transparent or secret) crawling peg pre-announced (e.g., tablita) indexed (to fix real exchange rate) adjustable peg (escape clause, e.g., contingent on terms of trade or reserve loss)

8. Many countries that say they float, in fact intervene heavily in the foreign exchange market. Many countries that say they fix, in fact devalue when trouble arises. Many countries that say they target a basket of major currencies in fact fiddle with the weights. 2. De jure regime  de facto as is by now well-known

9. Implications arising from national choice of fixed, floating or intermediate regimes

10. 3. Advantages of fixed rates 1)Encourage trade <= lower exchange risk. In theory, can hedge risk. But costs of hedging: missing markets, transactions costs, and risk premia. Empirical: Exchange rate volatility ↑ => trade ↓ ? Time-series evidence showed little effect. But more in: - Cross-section evidence, especially small & less developed countries. - Borders, e.g., Canada-US: McCallum-Helliwell (1995-98 ); Engel-Rogers (1996). - Currency unions: Rose (2000).

11. Advantages of fixed rates, cont. 2) Encourage investment <= cut currency premium out of interest rates 3) Provide nominal anchor for monetary policy By anchoring inflation expectations, achieve lower inflation for same Y. But which anchor? Exchange rate target vs. Alternatives 4) Avoid competitive depreciation 5) Avoid speculative bubbles that afflict floating. (If variability were all from fundamental real exchange rate risk, and no bubbles, then fixing the nominal exchange rate would mean it would just pop up in prices instead.)

12. 4. Advantages of floating rates 1. Monetary independence 2. Automatic adjustment to trade shocks 3. Central bank retains seignorage 4. Central bank retains Lender of Last Resort capability, for rescuing banks 5. Avoiding crashes that hit pegged rates, particularly if origin of speculative attacks is multiple equilibria, not fundamentals.

13. 5. Which dominate: advantages of fixing or advantages of floating? Performance by category is inconclusive. To over-simplify 3 important studies (see Addendum I): – Ghosh, Gulde & Wolf: “hard pegs work best” – Sturzenegger & Levy-Yeyati: “floats are best” – Reinhart-Rogoff: “limited flexibility performs best” Why the different answers? – The de facto schemes do not correspond to each other. – A country’s circumstances determine the appropriate regime.

14. Which dominate: advantages of fixing or advantages of floating? Answer depends on circumstances: No one exchange rate regime is right for all countries or all times. Traditional criteria for choosing - Optimum Currency Area. Focus is on trade and stabilization of business cycle. 1990s criteria for choosing – Focus is on financial markets and stabilization of speculation.

15. Optimum Currency Area Theory (OCA) Broad definition: An optimum currency area is a region that should have its own currency and own monetary policy. This definition can be given more content: An OCA can be defined as: a region that is neither so small and open that it would be better off pegging its currency to a neighbor, nor so large that it would be better off splitting into sub-regions with different currencies

16. Optimum Currency Area criteria for fixing exchange rate: Small size and openness – because then advantages of fixing are large. Symmetry of shocks – because then giving up monetary independence is a small loss. Labor mobility – because then it is possible to adjust to shocks even without ability to expand money, cut interest rates or devalue. Fiscal transfers in a federal system – because then consumption is cushioned in a downturn.

17. New popularity in 1990s of institutionally-fixed corner currency boards (e.g., Hong Kong, 1983- ; Lithuania, 1994- ; Argentina, 1991-2001; Bulgaria, 1997- ; Estonia 1992- ; Bosnia, 1998- ; …) dollarization ( e.g, Panama, El Salvador, Ecuador; or euro-ization: Montenegro ) monetary union ( e.g., EMU, 1999)

18. Definition: A currency board is a monetary institution that only issues currency that is fully backed by foreign assets. Its principal attributes include the following: An exchange rate that is fixed not just by policy, but by law. A reserve requirement stipulating that each dollar’s work of domestic currency is backed by a dollar’s worth of foreign reserves. A self-correcting balance of payments mechanism, in which a payments deficit automatically contracts the money supply, resulting in a contraction of spending. Currency boards

19. 1990’s criteria for the firm-fix corner suiting candidates for currency boards or union (e.g., Calvo) Regarding credibility: a desperate need to import monetary stability, due to: history of hyperinflation, absence of credible public institutions, location in a dangerous neighborhood, or large exposure to nervous international investors a desire for close integration with a particular neighbor or trading partner. Regarding other “initial conditions”: an already-high level of private dollarization high pass-through to import prices access to an adequate level of reserves the rule of law.

20. Two additional considerations, particularly relevant to developing countries (i) Level of financial development (ii) Supply shocks, especially: – External terms of trade shocks and the proposal for Product Price Targeting PPT

21. (i) Level of financial development Aghion, Bacchetta, Ranciere & Rogoff (2005) – Fixed rates are better for countries at low levels of financial development: because markets are thin. – When financial markets develop, exchange flexibility becomes more attractive.

22. (ii) External Shocks An old wisdom regarding the source of shocks: – Fixed rates work best if shocks are mostly internal demand shocks (especially monetary); – floating rates work best if shocks tend to be real shocks (especially external terms of trade). One case of supply shocks: natural disasters – R.Ramcharan (2007) finds support. Most common case of real shocks: trade

23. Terms-of-trade variability returns Prices of crude oil and other agricultural & mineral commodities hit record highs in 2008, and again in 2011. => Favorable terms of trade shocks for some (oil producers, Africa, Chile, etc.); => Unfavorable terms of trade shock for others (oil importers like Japan, Korea). Textbook theory says a country where trade shocks dominate should accommodate by floating.

24. IMF classification Of 185 Fund members, Have given up own currencies: – Euro-zone: – CFA Franc Zone: – E.Caribbean CA – “dollarized” Currency boards: Intermediate regimes: – pegs to a single currency – pegs to a composite – crawling pegs – horizontal bands – crawling bands – managed floats “independent floaters”: (end-2004 “de facto”) 41 12 14 6 9 7 104 33 8 6 5 1 51 35

25. Exchange rate parity arrangements

26. International Parity Conditions The economic theories which link exchange rates, price levels, and interest rates together are called international parity conditions These theories may not always work out to be “true” when compared to what students and practitioners observe in the real world, but they are central to any understanding of how multinational business is conducted

27. P $  S = P ¥ Where the price of the product in US dollars (P $ ), multiplied by the spot exchange rate (S, yen per dollar), equals the price of the product in Japanese yen (P ¥ ) Prices and Exchange Rates The Law of one price states that all else being equal (no transaction costs) a product’s price should be the same in all markets Even if prices for a particular product are in different currencies, the law of one price states that

28. ¥ $ Prices and Exchange Rates Conversely, if the prices were stated in local currencies, and markets were efficient, the exchange rate could be deduced from the relative local product prices

29. Purchasing Power Parity & The Law of One Price If the Law of One Price were true for all goods, the purchasing power parity (PPP) exchange rate could be found from any set of prices Through price comparison, prices of individual products can be determined through the PPP exchange rate This is the absolute theory of purchasing power parity Absolute PPP states that the spot exchange rate is determined by the relative prices of similar basket of goods

30. Relative Purchasing Power Parity If the assumptions of absolute PPP theory are relaxed, we observe relative purchasing power parity – This idea is that PPP is not particularly helpful in determining what the spot rate is today, but that the relative change in prices between countries over a period of time determines the change in exchange rates – Moreover, if the spot rate rate between 2 countries starts in equilibrium, any change in the differential rate of inflation between them tends to be offset over the long run by an equal but opposite change in the spot rate

31. Figure 1: Relative Purchasing Power Parity (PPP)

32. Relative Purchasing Power Parity Empirical tests of both relative and absolute purchasing power parity show that for the most part, PPP tends to not be accurate in predicting future exchange rates Two general conclusions can be drawn from the tests: – PPP holds up well over the very long term but is poor for short term estimates – The theory holds better for countries with relatively high rates of inflation and underdeveloped capital markets

33. i = r +  + r  Where i is the nominal rate, r is the real rate of interest, and  is the expected rate of inflation over the period of time The cross-product term, r , is usually dropped due to its relatively minor value Interest Rates and Exchange Rates Prices between countries are related by exchange rates and now we discuss how exchange rates are linked to interest rates The Fisher Effect states that nominal interest rates in each country are equal to the required real rate of return plus compensation for expected inflation. As a formula, The Fisher Effect is

34. i = r +  ; i = r +  $$$¥¥¥ It should be noted that this requires a forecast of the future rate of inflation, not what inflation has been, and predicting the future can be difficult! Interest Rates and Exchange Rates Applied to two different countries, like the US and Japan, the Fisher Effect would be stated as

35. ¥ Interest Rates and Exchange Rates The international Fisher effect, or Fisher-open, states that the spot exchange rate should change in an amount equal to but in the opposite direction of the difference in interest rates between countries – if we were to use the US dollar and the Japanese yen, the expected change in the spot exchange rate between the dollar and yen should be (in approximate form)

36. Interest Rates and Exchange Rates Justification for the international Fisher effect is that investors must be rewarded or penalized to offset the expected change in exchange rates The international Fisher effect predicts that with unrestricted capital flows, an investor should be indifferent between investing in dollar or yen bonds, since investors worldwide would see the same opportunity and compete it away

37. Interest Rates and Exchange Rates The Forward Rate – A forward rate is an exchange rate quoted today for settlement at some future date – The forward exchange agreement between currencies states the rate of exchange at which a foreign currency will be bought or sold forward at a specific date in the future (typically 30, 60, 90, 180, 270 or 360 days) – The forward rate is calculated by adjusting the current spot rate by the ratio of euro currency interest rates of the same maturity for the two subject currencies

38. Interest Rates and Exchange Rates The Forward Rate

39. Interest Rates and Exchange Rates The Forward Rate example with spot rate of Sfr1.4800/$, a 90-day euro Swiss franc deposit rate of 4.00% p.a. and a 90-day euro-dollar deposit rate of 8.00% p.a.

40. Interest Rate Parity (IRP) Interest rate parity theory provides the linkage between foreign exchange markets and international money markets The theory states that the difference in the national interest rates for securities of similar risk and maturity should be equal to, but opposite sign to, the forward rate discount or premium for the foreign currency, except for transaction costs

41. Interest Rate Parity (IRP) – In the diagram in the following slide, a US dollar- based investor with $1 million to invest, is shown indifferent between dollar-denominated securities for 90 days earning 8.00% per annum, or Swiss franc-denominated securities of similar risk and maturity earning 4.00% per annum, when “cover” against currency risk is obtained with a forward contract

42. Figure 2: Interest Rate Parity (IRP)

43. Covered Interest Arbitrage (CIA) Because the spot and forward markets are not always in a state of equilibrium as described by IRP, the opportunity for arbitrage exists The arbitrageur who recognizes this imbalance can invest in the currency that offers the higher return on a covered basis This is known as covered interest arbitrage (CIA) The following slide describes a CIA transaction in much the same way as IRP was transacted

44. Figure 3: Covered Interest Arbitrage (CIA)

45. Covered Interest Arbitrage (CIA) A deviation from CIA is uncovered interest arbitrage, UIA, wherein investors borrow in currencies exhibiting relatively low interest rates and convert the proceeds into currencies which offer higher interest rates The transaction is “uncovered” because the investor does not sell the currency forward, thus remaining uncovered to any risk of the currency deviating

46. Covered Interest Arbitrage (CIA) Rule of Thumb: – If the difference in interest rates is greater than the forward premium (or expected change in the spot rate), invest in the higher yielding currency. – If the difference in interest rates is less than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.

47. Figure 4: Uncovered Interest Arbitrage (UIA): The Yen Carry Trade

48. Figure 5: Interest Rate Parity (IRP) and Equilibrium

49. Forward Rates as an Unbiased Predictor If the foreign exchange markets are thought to be “efficient” then the forward rate should be an unbiased predictor of the future spot rate This is roughly equivalent to saying that the forward rate can act as a prediction of the future spot exchange rate, and it will often “miss” the actual future spot rate, but it will miss with equal probabilities (directions) and magnitudes (distances)

50. Figure 6: Forward Rate as an Unbiased Predictor for Future Spot Rate