Global Business Environment Capital Movements and the exchange rate Francesco Franco Nova SBE October 15, 2014 Francesco Franco Global Business Environment 1/32
The Framework What we have done so far Figure : National Financial System Francesco Franco Global Business Environment 2/32
National Accounts 101 1 GDP, GNP, NNP 2 Y=C+I+G+X-M 3 CA=X-M+iF Francesco Franco Global Business Environment 3/32
International Finance and Trade Connecting several economies through Trade and Finance: the BoP the BoP is always in in balance the current account is balanced by the reserve and financial account (capital inflow = export IOU) the fundamental significance of capital movements reflects an intertemporal trade: postpone/anticipate consumption/investment: real interest rate money veils the real aspects of capital movements Francesco Franco Global Business Environment 4/32
International Finance and Trade Connecting several economies through Trade and Finance The BoP for the Euro http://sdw.ecb.europa.eu/reports.do?node=100000210 The Current Account for the Euro The Financial account for the Euro The problem within the euro area - the World CA http://www.imf.org/external/datamapper/index.php Francesco Franco Global Business Environment 5/32
International Finance and Trade examples of credit and debit Examples: Portuguese buys a Ferrari French tourist in Portugal pays with credit card German buys Google stock Central bank accumulates Reserve Francesco Franco Global Business Environment 6/32
International Finance and Trade Accumulating debt or credit net The Net International Investment Position F t+1 = NX t +(1 + i t ) F t where NX is trade balance and i t F t is income payments (no transfers or capital acccount), or more disaggretated sÿ F j t+1 = X t M t + j sÿ (1 + it)f j t j j Francesco Franco Global Business Environment 7/32
International Finance and Trade Accumulating debt or credit gross The gross positions are also very important for liquidity di erences, capital gain, valuation e ects from prices and exchange rates... Figure : Gross International Positions Francesco Franco Global Business Environment 8/32
International Finance and Trade Shocks to gross and net: exchange rate Figure : Iceland shock Francesco Franco Global Business Environment 9/32
International Finance and Trade Shocks to gross and net: trigger ca Figure : Iceland shock Francesco Franco Global Business Environment 10/32
The Gold Standard and Fixed Exchange Regimes to maintain a Fixed Exchange rate regime you need to maintain a large enough supply of foreign currency so as to be able to make private supply and demand balance at the pegged rate could be any player in the market, but tipycally a Central Bank which accumulates foreign denominated assets and gold in her balance sheet assymetry if CB can print: can always keep her currency from appreciating but not from depreciating Francesco Franco Global Business Environment 11/32
The Gold Standard The Gold Standard was the most important method for stabilizing exchange rates. The arrangement implied that the nation Treasury would: 1 agree to buy all gold brought to it a given price (in 1948, 35 USD per ounce, 8.75 GBP per ounce) 2 o er to sell gold freely to all comers at the same price 1. and 2. imply the dollar and the pound prices of gold are prefectly fixed (mint parity). International arbitrage then imply that the dollar-pound exchange rate is 4. Francesco Franco Global Business Environment 12/32
The Gold Standard and the specie-flow-price mechanism International trade could in theory deplete one country of all the gold reserves and forces it o the gold standard (mercantilistim) Hume: automatic self-correcting mechanism based on Quantity Theory (P = 1 k M): in the surplus country the increase in gold increases the quantity of M that then increases the price level P in the deficit country the decrease in gold decreases the quantity of Money that then decreases the price level Once gold became no longer important in the money supply, Treasury would follow rules of the gold-standard game (a) increase tax collection relative to expenditure, (b) increase interest rate, (c) titghten money by increasing reserves ratio, (4) put downward pressure on wage and prices Francesco Franco Global Business Environment 13/32
The path to the Monetary Union The European States initially adhered to the par system of Bretton Woods After a first devaluation of the French Franc and a revaluation of the Deutsche Mark in 1968-1969, the Hague summit sets the goal for a MU Werner Report: final objective would be the irreversible convertibility of currencies, free movement of capital, and the permanent locking of exchange rates or possibly a single currency Collapse of Bretton Woods imply the dollar starts to float, Europe reacts with the Snake from 1972-1979: movements in a dollar band in 1979 the EMS is launched fluctuation kept between ±2.25 percent except for Italy (and then escudo, peseta and pound) ±6 percent and realignements required unanimity Francesco Franco Global Business Environment 14/32
Float, example from 1919 to 1925 float between pound and dollar and again from 1973 until today Francesco Franco Global Business Environment 15/32
Float In a freely floating regime the supply and demand determine a flexible exchange rate. Now fundamental factors behind demand and supply are: 1 the preferences in terms of domestic versus foreign goods 2 the gowth rate of the economies 3 the di erences in prices and costs 4 the preferences in domestic and foreign assets (probable candidate to volatility) Francesco Franco Global Business Environment 16/32
Managed Figure : Escudo-Mark Francesco Franco Global Business Environment 17/32
Float Figure : Dollar-Euro Francesco Franco Global Business Environment 18/32
Float Figure : Yen-Dollar Francesco Franco Global Business Environment 19/32
Cross rates, no-arbitrage Figure: cross rates Figure : Cross Rates Francesco Franco Global Business Environment 20/32
Exchange Rates Trading You cannot go to a centralized location to watch exchange rates being determined: currencies are not traded on exchanges such as the New York Stock Exchange Instead, the foreign exchange market is organized as an over-the-counter market in which several hundred dealers (mostly banks) stand ready to buy and sell deposits denominated in foreign currencies Because these dealers are in constant telephone and computer contact, the market is very competitive; it functions no di erently from a centralized market http://www.ft.com/intl/topics/themes/forex_trading_probes Francesco Franco Global Business Environment 21/32
Exchange Rates Trading Figure : Forex Turnover Francesco Franco Global Business Environment 22/32
Comparing Expected Returns of eurodeposits dollar bank euro-deposits have an interest rate i $ t,k,the mautirity is k euro bank euro-deposits have an interest rate i euro t,k the currency exchange rate (the spot exchange rate) as S t the currency exchange rate one period forward rate as F t,k the rate agreed now for an exchange of currencies k periods ahead Francesco Franco Global Business Environment 23/32
Comparing Expected Returns of eurodeposits The CIP condition may be expressed (ignoring transactions costs) as 1 2 1 + i t,k $ St =(1 + it,k euro ) F t,k which can be tested running the following regression f t,k s t = + 1 i $ t,k ieuro t 2 + u t Francesco Franco Global Business Environment 24/32
Exchange Rates ComparingForeign Expected Returns ofmarket eurodeposits exchange efficiency Testing CIP Figure: CIP between euro-dollar, fs1y = ft (k) st, ii1y = it it $ euro Francesco Franco Figure : CIP between euro-dollar, International fs1y =Finance ft,1y st, ii1y = it,1y 18/51 it,1y Francesco Franco Global Business Environment 25/32
Exchange Rates Foreign exchange market efficiency Comparing Expected Returns of eurodeposits Testing CIP Table: CIP euro-dollar Variable ii1y Coefficient (Std. Err.) 0.975 (0.012) Intercept N R2 F (1,134) 0.001 (0.000) 136 0.981 6956.222 Significance levels : Francesco Franco Francesco Franco : 10% : 5% International Finance Figure : Testing CIP Global Business Environment : 1% 19/51 26/32
From forward to expected Rational expectations: E t [X t+k ]=E [X t+k I t ] Risk neutrality: do not care about the variance of returns (will give a small problem) F t,k S t+k is the profit from taking a position in the forward foreign exchange premium which implies the UIP F t = E t [S t+k ] 1 + i $ t,k =(1 + i euro t ) E t [S t+k ] S t Francesco Franco Global Business Environment 27/32
UIP in Macro Finance 1 + i $ t,k keeping everything constant =(1 + i euro t ) E t [S t+k ] S t adecreaseini $ causes the dollar to depreciate adecreaseini euro causes the dollar to appreciate a rise in the expected future exchange rate causes an appreciation of the dollar Francesco Franco Global Business Environment 28/32
Exchange Rates UIP in the data Foreign exchange market efficiency Testing UIP Figure: Ex-post UIP euro-dollar Figure : CIP between euro-dollar, International fs1y =Finance ft,1y st, ss1y = st+1y st Francesco Franco 31/51 Francesco Franco Global Business Environment 29/32
Exchange ForeignRates exchange market efficiency UIP intesting the data... UIP Table: UIP euro-dollar Variable fs1y Coefficient (Std. Err.) -1.898 (0.706) Intercept N R2 F (1,122) 0.036 (0.010) 124 0.056 7.23 Significance levels : Francesco Franco Francesco Franco : 10% : 5% Figure : International TestingFinance CIP Global Business Environment : 1% 32/51 30/32
...lead to carry trade strategy Carry trades: ex post returns Annualised average daily return, in per cent 1 AUD/JPY NZD/JPY 60 40 20 0 20 03 Q3 04 Q1 04 Q3 05 Q1 05 Q3 06 Q1 06 Q3 07 Q1 07 Q3 40 1 Calculated as the sum of interest rate differentials and the percentage change in the target currency s bilateral exchange rate against the Japanese yen. Sources: Bloomberg; BIS calculations. Graph 1 Figure : Patterns of returns suggest there is a small proba of a large loss Francesco Franco Global Business Environment 31/32
Readings The road to EMU: http://ec.europa.eu/economy_finance/euro/emu/road/index_en.htm **Krugman, Obstfeld and Melitz chapter 13 and chapter 14 Francesco Franco Global Business Environment 32/32