George Alogoskoufis, International Macroeconomics and Finance Chapter 2 International Financial Markets, Interest Rates and Exchange Rates This chapter examines the role and structure of international capital and financial markets, and the relationship between interest rates and exchange rates in open economies. International borrowing and lending takes place through international financial markets. Exchange rates are determined in the foreign exchange market, which is an important component of international financial markets. The major agents operating in these markets are commercial banks, non-bank financial institutions, multinational corporations, central banks and governments. International financial markets are actually a network of closely related markets in various countries, where securities denominated in various currencies and coming from different countries, such as stocks, bonds, derivatives, loans and bank deposits are created and exchanged. We can distinguish between the international bond market, the international stock market and the international money market, a significant part of which is the international foreign exchange market. Transactions in these markets take place in global financial centers linked through advanced telecommunication systems. 2.1 The Structure of International Financial Markets Because of externalities and historical circumstances, the main international financial centers are located in New York, London, Frankfurt, Hong Kong and Tokyo. The international network of financial markets engages in the exchange of securities denominated in various currencies, 24 hours a day. However, due to the development of telecommunication systems, much of the trading is done electronically now, even outside these international financial centers. The various internationally traded financial instruments are bought and sold through dealers located in major international bank and non-bank financial institutions. Dealers exchange securities, either on behalf of clients or on behalf of the financial institution they represent. Their aim is to make profits by buying cheaply and selling dearly. International financial markets are characterized by high liquidity and volatility. The volume of transactions is huge, much larger than the volume of transactions needed to finance international trade in goods and services. This is because the greatest volume of transactions is related to portfolio investment and not the financing of international trade or foreign direct investment.
Negotiators in international financial markets are usually specialized in one of the markets or submarkets, such as buying bonds, equities, currencies and derivatives. With their collective behavior, and the behavior of their clients, they influence, if not determine, international interest rates and the exchange rates of currencies. What is the exact role of the various actors involved in the international capital and financial markets? 2.1.1 Commercial Banks Commercial banks are at the center of international financial markets, and play a key role in the international payments system, engaging in a wide range of activities. A bank is a financial institution that accepts deposits from the public and creates credit. Their liabilities include deposits of different terms, as well as loans from other banks and non-bank financial institutions, via the interbank market. Their assets include loans, to households, businesses and governments, deposits with other banks and the ownership of bonds and shares. Typically, the liabilities of banks are short term, as depositors can mostly withdraw their deposits at short or zero notice. On the other hand, the bulk of the assets of banks, such as loans, bonds and shares are longer term, although banks hold short term assets as well. Most nations have institutionalized a system known as fractional reserve banking, under which banks hold liquid assets equal to only a portion of their current liabilities. In addition to other regulations intended to ensure liquidity, banks are generally subject to minimum capital requirements, based on an international set of capital standards, known as the Basel Accords. Under fractional reserve banking banks hold only a small proportion of their deposits in liquid form. This is a form of leverage, as liquid assets have lower returns and risks than assets with longer maturities, such as bank loans, bonds or shares. Because of the risks of leverage, commercial banks are regulated in most jurisdictions by government entities, and need a special bank license in order to operate in a particular jurisdiction. Capital requirements constitute a form of bank regulation, which sets a framework within which a bank or a depository institution must manage its balance sheet. The categorization of assets and capital is highly standardized so that it can be risk weighted. Thus, the main activities of commercial banks are the issuance of money in the form of bank cheques and debit cards, the netting and settlement of payments, the extension of bank loans, credit intermediation and asset-liability management. Large multinational banks undertake other activities as well, such as underwriting new stock and bond issues, mediating in mergers and acquisitions, and portfolio management for large customers. One of the main features of international banking is that banks are often able to undertake activities in international markets which they are not allowed to carry out by the regulatory authorities in their!2
domestic market. This asymmetry in banking regulations and supervision between countries was one of the reasons for the large increase in international banking in the last fifty years. 2.1.2 Non-Bank Financial Institutions Non-bank financial institutions such as insurance companies, pension funds, mutual funds and hedge funds, have flourished in recent years. These, have been active in international financial markets in order to diversify their portfolios. Important among them are investment banks, such as Goldman Sachs, Morgan Stanley and Lazard. Investment banks differ from commercial banks in that they specialize in underwriting securities such as shares, bonds and derivatives, in securitizing loans, stocks and bonds and marketing them to investors, trading in derivatives and organizing mergers and acquisitions. They do this for their customers, businesses and governments, but also for their own account. The rise of international investment banks took place because in 1933, the Glass-Steagal act in the USA, banned commercial banks from undertaking these activities, due to the risks involved. It is characteristic that the international financial crisis of 2007 and 2008 became worse because of the collapse of two investment banks, Bear Stearns and Lehman Brothers. The ban on commercial banks to undertaking investment banking activities in the US was effectively lifted in 1999. In any case, because the ban did not apply to the international activities of US commercial banks, large commercial banks such as Citi, and J.P. Morgan Chase display intense international investment banking activity, competing with purely investment banks. Today, the distinction between commercial and investment banks has eased, as very few pure investment banks remain. The importance for international financial markets of non-bank financial institutions is illustrated by the latest international financial crisis. Apart from the collapse of Bear Stearns and Lehman Brothers, one huge insurance company AIG (American International Group), with more than $1 trillion in assets, faced extreme difficulties, and the same happened with a number of other mutual funds and hedge funds. 2.1.3 Large Multinational Corporations Large multinational corporations are the third major player in international financial markets. Corporations such as Exxon Mobil, Apple, Coca Cola, IBM, Nike, Toyota, Nestlé, Unilever and others, borrow from a wide array of international banks, issue bonds denominated in different currencies, engage in international portfolio investment of their reserves, and are very active in mergers and acquisitions. The activity of multinational enterprises, especially trade and foreign direct investment, is also financed through international financial markets. 2.1.4 Central Banks and Governments Central banks and governments is the last major category of participants in international financial markets. Central banks systematically intervene in both domestic and international financial markets, in order to affect short-term interest rates, and invest their reserves through the foreign!3
exchange markets. On the other hand, many governments and public sector entities in different countries often borrow through international financial markets, by contracting loan agreements or issuing bonds. 2.2 The Role of International Financial Markets There are three categories of transactions in international financial markets. All three require the mediation of banks and non-bank financial institutions. The first category relates to the financing of international trade in goods and services, namely the exchange of goods and services produced in a country, for goods and services produced in another country. As known from the theory of international trade, such transactions entail benefits for all countries, as different countries can specialize in the production of goods and services at which they are relatively more effective, and to import goods and services in the production of which they are relatively less effective. Because the clearing of both exports and imports requires financial instruments and the use of foreign exchange, these transactions take place through banks, which in turn participate in international financial markets, especially in the foreign exchange market. The second category relates to financing intertemporal trade between countries, i.e reallocating the excess of savings over investment in one country to other countries. Inter-temporal trade entails additional benefits for all the countries concerned, as it allows an economy to smooth out the time paths of its consumption and investment more effectively, achieving a higher level of prosperity. When a country's income is temporarily high, the current account moves to a surplus, as national savings exceed domestic investment. On the other hand, when investment is temporary high, the current account moves into deficit, as domestic investment may exceed national savings. In intertemporal trade, the intermediation of international financial markets is crucial in using the proceeds from current account surpluses in some countries, to finance the current account deficits of other countries. Thus, a country which has a deficit in the current account, because its savings are lower than investment, reduces its net assets to the rest of the world to finance its deficit. This can be done by partly increasing private and public external debt, partly by reducing its net foreign exchange reserves, and partly by selling securities and other assets owned by residents of the country. Whichever way a country chooses to finance its deficit, this will be done through transactions in international financial markets, like the exchange of bonds, shares or foreign currency, depending on the nature of the shock which causes an imbalance in the current account and the method of financing available to the country. A country which has a surplus in the current account, because its savings are greater than investment will increase its net assets towards the rest of the world. This will either lead to a reduction in private and public external debt, or an increase in foreign exchange reserves, or to a net acquisition of foreign assets by residents of the country. These transactions will also be concluded through international financial markets. Consequently, the intermediation of international financial markets is crucial for the financing of imbalances in the balance of payments of different countries. The third, and quantitatively most important, category of transactions in international capital and financial markets is international portfolio investment. When investors choose where to place their funds, an important factor is the return of their assets and a second is the risk. In general, investors!4
are characterized by risk aversion. Risk aversion means that investors will require a higher return from investments that are characterized by higher risk. It also means that they will want to diversify their portfolios in order to reduce risk, even if it means lower expected returns. The basic idea is that "you do not want to put all your eggs in one basket.. Optimal portfolio selection involves a diversified portfolio, which contains securities with different risk-return characteristics. To the extent that the securities issued in different countries entail different risks for investors, portfolio investment will be allocated among the securities of different countries and among securities denominated in different currencies, with the aim of optimizing the risk return combination. Riskier securities will have a higher return, but to the extent that risks are not highly correlated across countries, a diversified portfolio containing assets linked to different countries, will be in the interests of investors. The international diversification of assets is therefore one of the main roles of international financial markets, together with the financing of international and inter-temporal trade. Portfolio investment is perhaps the largest part of transactions in international capital and financial markets. We next turn to the international foreign exchange market, as this market plays a central role in the determination of exchange rates. 2.3 The Foreign Exchange Market The foreign exchange, or forex, market is where currencies are traded. The forex market is the largest, most liquid market in the world with an average traded value that exceeds $1.9 trillion per day and includes all of the currencies in the world. Banks have a central role in the foreign exchange market, by facilitating the exchange of bank deposits, and other short term securities, denominated in different currencies. The majority of foreign exchange transactions are spot transactions, but a relatively large part consists of swap transactions and forward transactions. In swap and forward transactions we have agreement between the parties on the future exchange of currencies at a predetermined price. Instead, spot transactions are settled immediately, immediately meaning within two working days. The spot exchange rate is determined by spot transactions, while forward exchange rates are determined through swaps and forward transactions. As the exchange rate is the relative price of deposits in two currencies, its determination takes place in the same way as the determination of the price of any other security. Equilibrium in the foreign exchange market requires equalization of returns of deposits denominated in different currencies, when returns are measured in a common currency. This is the basis of interest rate parity. 2.3.1 The Spot Exchange Rate The price of the dollar in foreign currency (i.e. 0.91 per dollar) is called the bilateral exchange rate in European terms. The reverse, a currency s value in US dollars (i.e. $1.1 per euro) is the bilateral exchange rate in American terms. An increase in the exchange rate in European terms means that the foreign currency has depreciated against the dollar, while a rise in the exchange rate in American terms means that the foreign currency has appreciated against the dollar. Generally,!5
depreciation of a currency occurs when we need more units of the currency for the purchase of a dollar and appreciation when we need fewer units. Figure 2.1 depicts the daily evolution of the spot exchange rate of the euro vis-a-vis the US dollar, in American terms, i.e dollars per euro. This means that an increase in the exchange rate implies an appreciation of the euro and a depreciation of the dollar, since more dollars are required per euro. Figure 2.1 reveals the high daily volatility of the exchange rate and the appreciation and depreciation cycles of the euro. When the euro was created in early 1999, the exchange rate to the dollar was $1.179 per euro. For the first two years, the euro depreciated against the dollar, with the bottom on October 26, 2000, when it reached $0.825 per euro. Since early 2002, the euro started to appreciate against the dollar, although the appreciation has not been smooth. The first cycle of the appreciation of the euro was completed in late 2004, when the euro reached $1.363 per euro. A second three-year euro appreciation cycle began in early 2006. On September 15, 2008, the day of the collapse of Lehman Brothers, and a key date for the international monetary crisis of 2008, the euro was at historically highest point, $1.599 per euro. Within a month the euro exchange rate had collapsed to $1.246 (October 27, 2008). Between the end of 2008 and the spring of 2014, the euro exchange rate has been fluctuating in a range between $1.5 and $1.2. The latest depreciation cycle of the euro started in April 11, 2014 and lasted for almost a year. The euro exchange rate collapsed from $ 1.3872 per euro on that date, to $ 1.0570 on April 10, 2015. A depreciation of almost 24%. In the last year or so, the euro exchange rate has been hovering around $1.1. In Figure 2.2 the same exchange rate is depicted in European terms, i.e. euros per dollar. Of course, one is a mirror image of the other. When the euro appreciates, its exchange rate goes up in American terms and it goes down in European terms, and vice versa. 2.3.2 Triangular Trades and Arbitrage in the Foreign Exchange Market For most of the postwar period, trading for most internationally traded currencies has been taking place through the US dollar. The US dollar is considered a vehicle currency for transactions in the foreign exchange market. For example, to convert sterling for yen usually takes two transactions. One to convert sterling to dollars, and one to convert dollars to yen. Because of the high trading volume (depth) in the dollar market for any currency, the cost of this triangular transaction is usually less than the cost of one direct transaction of sterling for yen. With the introduction of the euro, there is now a second vehicle currency in the global economy, but the dollar remains the dominant international vehicle currency. In the spot markets for foreign exchange, there cannot be non-exploited potential profits from triangular transactions in different currencies. For example, if S1 is the dollar sterling parity, S2 is the dollar euro parity and S3 is the euro sterling parity, and there are no transactions costs, in equilibrium, it can only be the case that, S1 = S3 x S2 (2.1) If (2.1) holds, there is no possibility to profit from triangular trades. If it is violated, traders would rush to make profits from triangular transactions. This behavior, a form of arbitrage, will ensure!6
that all profit opportunities will be exploited instantly, and that (2.1) will generally hold. Continuous trading in the foreign exchange market eliminates any profit opportunities from triangular transactions between currencies. 2.3.3 Categories of Transactions in the Foreign Exchange Market Transactions in the foreign exchange market are divided into three main categories. The first category is spot transactions (spot), where the transaction closes immediately, In fact it is settled within two days. These transactions determine spot exchange rates. The second category is swap transactions, in which a currency is sold (or bought) today, and repurchased (or resold) at a future date. Both the current and future exchange rates are determined today. The swap rate is the difference between the repurchase rate and the spot exchange rate. The spot exchange rate and the swap rate determine the forward exchange rate for the future date. The third category is pure forward transactions. These are current agreements for future purchase or sale of a currency. The price, quantity and the date of the transaction are determined currently. Such transactions are carried out for 1 to 2 weeks, and 1, 3, 6 and 12 months. We say that a currency trades at a premium when the forward rate is higher than the spot rate (on the American definition). Otherwise it trades at a discount. The vast majority of transactions in the foreign exchange market are spot transactions between dealers. Swap transactions are about 1/3 of the total volume. Forward trading is a very small percentage of the total volume. Eurocurrencies play an important role in the foreign exchange market. A eurocurrency is a generic term for a foreign currency denominated deposit outside the country where that currency is legal tender. Although called Eurocurrencies for historical reasons, these deposits are not necessarily in Europe. A deposit in US dollars in a London bank is a Eurodollar deposit, while a deposit in yen at a bank in New York is a Euroyen deposit. Most eurocurrency deposits are fixed interest time-deposits, with terms reflecting those available for forward foreign exchange transactions. The LIBOR (London Interbank Offer Rate) is the rate at which banks are willing to lend dollars or sterling to the most reliable banks and corporations participating in the London interbank market. Loans to less reliable banks and corporations have a higher rate than LIBOR (premium). Correspondingly, the EURIBOR (Euro Interbank Offer Rate) is the rate at which banks in the euro area are prepared to lend euros to the most reliable banks and corporations participating in the Euro interbank market of the Euro (Frankfurt, Paris, Milan and elsewhere). Loans to less reliable banks and corporations have a higher interest rate than the EURIBOR (premium). The evolution of EURIBOR since 1998 for one week, three months, and twelve months loans is shown in Figure 2.3. 2.4 Covered Interest Parity Spot exchange rates, forward exchange rates and eurocurrency interest rates are linked through the so called covered interest parity condition, which is another arbitrage condition.!7
If i is the interest rate of a eurodollar deposit for one period t, i* the interest rate for a euro deposit, S the spot exchange rate (euros per dollar) and F the forward exchange rate for one period, the yields of the two deposits must be equal when expressed in a common currency. This is the nature of covered interest parity. Suppose an investor who has one million dollars to deposit. If she deposits them in a dollar denominated deposit, at the end of the period she will receive 1+i million dollars. If she converts them into euros at the spot exchange rate S, deposits the proceeds in a euro deposit, and sells the euros forward for dollars at the forward rate F, at the end of the period she will receive (1+i*)S/F million dollars. If the two returns differ, all investors will try to buy the currency that offers the higher return, causing its spot exchange rate to appreciate relative to its forward rate, until the two returns are equalized. Thus, arbitrage will ensure that the two returns cannot be different. This means that in equilibrium, 1+ i t = (1+ i t * ) S t F t (2.2) Thus, the return of a dollar deposit and the return of a euro deposit in dollars cannot differ because of arbitrage. If (2.2) is violated, as in the case of triangular transactions, there are profit opportunities through arbitrage, which will be almost immediately exploited, ensuring that (2.2) is satisfied. Thus, in the absence of frictions in the foreign exchange market, (2.2) is expected to hold continuously. (2.2) is often expressed in terms of its logarithmic approximation, i t! i t * + s t f t (2.3) where f=ln(f), s=ln(s). 2.5 Uncovered Interest Parity The profit from a forward transaction in the foreign exchange market is equal to the difference between the forward exchange rate and the spot exchange rate at the end of the forward contract. It thus follows that at the time of the agreement of the forward contract, under the assumption of risk neutrality, the forward rate must be equal to the expected future spot rate. Thus, it must follow that, e F t = S t+1 (2.4) where e denotes the expectation of St+1 at time t. (2.4) implies that, in the absence of frictions and under risk neutrality, traders must be indifferent between buying a currency spot and selling it forward, or buying a currency spot, holding it, and selling it spot in a period. Thus, arbitrage would again ensure that (2.4) holds. Substituting (2.4) in (2.2), we get the so called uncovered interest parity condition.!8
1+ i t = (1+ i * t ) S t e S t+1 (2.5) This condition is often expressed in terms of its logarithmic approximation, i t! i * e t + s t s t+1 (2.6) (2.5) and (2.6) imply that the rate of return of a deposit in dollars must be equal to the expected rate of return of a deposit in euros, when the dollars are converted into euros at the spot exchange rate, and converted back to dollars at the end of the term of the deposit. Alternatively, it says that the rate of return of a deposit in dollars should be equal to the expected dollar rate of return of a deposit in euros. In short, the expected rates of return cannot differ when expressed in a common currency. For this to happen, the interest rate differential must reflect the expected change in the exchange rate between the two currencies. If i>i*, then the dollar is expected to depreciate against the euro. If i<i* then the dollar is expected to appreciate against the euro. If the i=i*, then the exchange rate is expected to remain constant. If (2.5) (or (2.6)) is violated, then there is the possibility of making expected profits, through the strategy to borrowing in one currency and making uncovered loans in another. These expected gains will generate trades in the spot market that will lead to the satisfaction of (2.5) and (2.6) through arbitrage. 2.6 Uncovered Interest Parity and Exchange Rate Determination The condition of uncovered interest parity is widely used in international macroeconomics and finance, as an approximation to the equilibrium conditions in international foreign exchange markets. As such, it serves as the basis of all theories of exchange rate determination. Of course, it must be understood that uncovered interest parity will hold in a strict sense only under risk neutrality and in the absence of frictions such as transaction costs and capital controls. From the uncovered interest parity condition (2.5), one can see that the spot exchange rate is determined by, e 1+ i! S t = S t t+1 (2.7) * 1+ i t Thus, the current spot exchange rate depends on the expected future spot exchange rate and the current interest rate differential between the two currencies. An increase in the dollar interest rate i causes an appreciation of the dollar and a depreciation of the euro (increase in S), while an increase in the euro interest rate i* causes an appreciation of the euro and a depreciation of the dollar (fall in S). We can use a diagrammatic analysis to determine how the current exchange rate depends on its three determinants, the domestic interest rate i, the foreign interest rate i*, and the expected future exchange rate S e.!9
Uncovered interest parity implies a positive relation between the exchange rate and the domestic nominal interest rate. A rise in the domestic interest rate causes the exchange rate to appreciate, i.e S to rise in order for uncovered parity to be satisfied. The equilibrium relation between the exchange rate and the domestic interest rate is depicted in Figure 2.4, as the UIP curve. If domestic interest rates rise from i0 to i1 then the exchange rate appreciates from S0 to S1. If domestic interest rates fall from i0 to i2 then the exchange rate depreciates from S0 to S2. An increase in foreign interest rates shifts the UIP curve downwards, reducing its slope too, and causing the exchange rate to depreciate for any given domestic interest rate (Figure 2.5). A reduction in foreign interest rates has the opposite effect, causing the domestic exchange rate to appreciate for any given domestic interest rate. On the other hand, an expected future depreciation of the exchange rate causes the current exchange rate to depreciate immediately, shifting the UIP curve downwards in a parallel fashion (Figure 2.6). A expected future appreciation of the exchange rate has the opposite effect, causing the current exchange rate to appreciate. Uncovered interest parity, which is nothing other than an equilibrium condition in foreign exchange markets, thus suggests that any theory of exchange rate determination must rely on a model of the determination of interest rates and interest rate differentials between currencies, and it must also rely on a hypothesis about the formation of expectations. 2.7 Conclusions Exchange rates are determined in international markets for foreign exchange. The main participants in such markets are banks, non-bank financial institutions, multinational corporations, governments and central banks. Banks have a key role by facilitating the exchange of bank deposits in different currencies, which constitute the bulk of transactions in the foreign exchange market. The international foreign exchange market is essentially a unified world market that operates almost 24 hours per day. The majority of foreign exchange transactions are spot transactions, but about one third constitute transactions in foreign exchange swaps, and a small proportion are pure forward transactions. Swap and forward contracts are current agreements between the parties on the future exchange currencies at a predetermined price, for terms from one week to twelve months. Instead, spot transactions are settled immediately. As the exchange rate is the relative value of financial instruments denominated in different currencies, its determination is related to the determination of the prices of financial instruments. In the absence of frictions in financial markets, equilibrium in the foreign exchange market requires the equalization of the returns of deposits denominated in different currencies, when returns are measured in a common currency. This is the basis of interest rate parity conditions, such as covered and uncovered interest parity. For given interest rates on deposits denominated in various currencies, and for given expectations for the future development of the spot exchange rate, uncovered interest parity determines the current exchange rate. For example, ceteris paribus, an increase in dollar interest rates causes the!10
dollar appreciation. A rise in euro interest rates causes a euro appreciation. Finally, an expected future appreciation (depreciation) of a currency, leads directly to a current appreciation (depreciation) of that currency. In order to delve deeper at the determinants of exchange rates, one has to consider the determinants of interest rates and interest rate differentials between currencies. To do that, we must look at how interest rates are determined in national money and financial markets.!11
Figure 2.1 The Dollar Euro Exchange Rate ($ per ) Source: European Central Bank!12
Figure 2.2 The Euro Dollar Exchange Rate ( per $) Source: European Central Bank!13
Figure 2.3 EURIBOR 1998-2015 Source: European Money Market Institute. Red (12 month), Blue (3 month), Green (1 week).!14
Figure 2.4 Exchange Rate Determination by Uncovered Interest Parity!15
Figure 2.5 The Effects of a Rise in Foreign Interest Rates on the Exchange Rate!16
Figure 2.6 The Effects of an Expected Future Appreciation on the Current Exchange Rate!17