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

2. 2 Lecture 3: January 24 Ch. 15, 16

3. 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. 4 Hedging Options for Air Canada –Speculate – maximum exposure depends upon degree of appreciation –Hedge – avoid exposure

5. 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. 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. 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) + 2.44%(C) = 2.44% in Canadian $ –Net interest rate for B: 2.44%(C) + 1.76%(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. 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. 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. 10 E* R(1,C) [R(1,US) 0,  0, E*(e) 0 ] R0R0 E* 0 1

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

12. 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. 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. 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

15. Flight to Safety 200109/1009/1109/1209/1309/1409/17 A$1.9481.9181.9391.9401.9431.995 Real2.5972.6662.6542.7232.7022.667 C$1.5651.5661.5591.5691.5641.569 Euro1.1121.0961.1031.0991.086 Rupee47.3447.4147.4447.5347.7947.85 Peso9.379.509.439.479.499.43 Rouble29.4629.47 29.4829.46 Won128512911284129012971299 Swiss franc1.6871.6421.6611.6521.6231.614 Baht44.64 44.4144.2044.1043.96 Indonesia rupiah 910191059065912090959339 15

16. Flight to Safety 200809/1209/1509/1609/1709/1809/19 A$1.2241.2371.2601.2771.2521.207 Real1.7821.8071.8291.8821.9141.825 C$1.0611.0681.0731.0781.0701.047 Euro0.7060.7050.7070.7080.695 Rupee45.6345.9446.8346.1846.3645.72 Peso10.5810.7110.7410.8910.8510.61 Rouble25.57 25.5925.6225.3825.36 Won1106 1159111611541140 Swiss franc1.1341.1191.1201.1211.0991.111 Baht34.6734.5834.2534.3334.12 Indonesia rupiah 938894499416937693879348 16

17. 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. 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. 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. 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. 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. 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. 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

24. Canadian Experience M1+M2+Core CPI 200110.3%6.6%2.1% 200210.97.22.4 20035.04.82.2 20048.94.91.5 20056.94.71.6 20068.26.31.9 20078.98.12.1 20088.910.21.7 200913.411.61.8 20109.14.71.5 20119.36.01.9 24

25. 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. 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] + 

27. PPP Exchange Rates vs. US $ PPPActual 2001200820012008 A$1.331.481.931.19 Real1.021.462.351.83 C$1.221.231.551.07 Yuan3.293.798.286.95 Rupee13.815.947.243.5 Yen149116122103 Won75776212911102 Peso6.317.829.3411.13 Rouble8.3218.4229.1724.85 Rand3.324.638.618.26 Pound0.630.660.690.54 27

28. 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. 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

30. Real Interest Rates CanadaUSDifference Dec./032.792.310.48 Dec./042.112.000.11 Dec./051.442.09-0.65 Dec./061.732.23-0.50 Dec./071.992.06-0.07 Dec./082.102.43-0.33 Dec./091.521.97-0.45 Dec./101.121.67-0.55 Dec./110.470.51-0.04 Dec./120.38-0.060.44 30

31. 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. 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