Finance 330 Exam 1 Notes
Finance 330 Exam 1 Notes 330
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Chapter 3 0 At a basic level a country s System or Regime is classi ed as a xed pegged oating exible or managed exchange rate regime o If the government doesn39t interfere in the value of its currency the currency is classi ed as oating o If the government rigidly intervenes such that its currency maintains its value relative to one or more other currencies the currency is classi ed as xed or pegged o The rate at which the currency is xed is frequently referred to as its par value A managed exchange rate regime lies somewhere in the middle 0 Devaluation of a Currency refers to a drop in foreign exchange value of a currency that is pegged to gold or another currency The opposite is Revaluation o Depreciation Weakening or Deterioration of a Currency refers to a drop in the foreign exchange value of a oating currency The opposite is Appreciation or Strengthening 0 Soft or Weak describes a currency that is expected to devalue or depreciate relative to major currencies Also refers to currencies being arti cially sustained by their governments 0 Hard or Strong describes a currency that is expected to revalue or appreciate relative to major trading currencies Sometimes describes whether the currency is convertible a hard currency Precious metals have been a medium of exchange and a store of value since 3000 BC 0 Under the gold standard 18761913 the quotrules of the gamequot were that each country set the rate at which its currency unit could be converted to a weight of gold 0 Currency exchange rates were in effect xed 0 Because of free movement of gold internationally and free convertibility between gold and currencies arbitrage kept exchange rates within a 1 band of the parity rate 0 Bene ts of the Gold Standard Highly stable exchange rates under a classical gold standard Provides an environment that is conducive to International trade International investment 0 Costs of the Gold Standard The supply of new gold is so restricted that the growth of world trade and investment can be hampered for the lack of suf cient monetary reserves As the economy grows the money supply needs to grow to enable economic transactions to take place Yet the money supply can39t grow if the supply of gold is limited 0 National monetary policies are subservient to the international monetary system 0 An expanding economy would suffer de ation Monetary policy is limited by a government39s supply of gold During the interwar years 19141944 currencies were allowed to uctuate over fairly wide ranges in terms of gold and each other Supply and demand forces determined exchange rate values The Bretton Woods Agreement 1944 established a US dollarbased international monetary system and provided for two new institutions the International Monetary Fund and the World Bank The IMF aids countries with BOP and exchange rate problems The World Bank helped fund postwar reconstruction and since then has helped support economic development Under the original provisions of the Bretton Woods Agreement all countries xed the value of their currencies in terms of gold but were not required to exchange their currencies for gold Only the dollar remained convertible into gold 35 per ounce Participating countries agreed to try to maintain the currency values within 1 of par by buying or selling foreign exchange or gold reserves Fixed Exchange Rates 19451973 Widely diverging national monetary and scal policies differential rates of in ation and various unexpected external shocks eventually resulted in the suspension of the convertibility of the dollar into gold in August 1971 The heavy overhang of dollars held by foreigners resulted in a lack of con dence in the ability of the US to meet its commitment to convert dollars into gold This forced President Nixon to suspend of cial purchases or sales of gold by the US Treasury Exchange rates of most of the leading trading countries were then allowed to oat in relation to the dollar and thus indirectly in relation to gold After a series of continuing crises in 1972 and 1973 the US dollar and the other leading currencies of the world have oated in value since that time The Floating Era and Eclectic Arrangements 19731997 Most developed countries set their longrun monetary and macroeconomic policies independently Since March 1973 exchange rates have become much more volatile and less predictable than they were during the quot xedquot periods The foreign exchange rate plays a residual role and does a great deal of adjusting to offset policy differences across countries The IMF39s 2009 de facto System attached Emerging markets often choose between two extreme exchange rate regimes either a free oating regime or an extremely xed regime such as a currency board or doarization Advantages of Fixed Regime Dollarization Monetary Union Conventional P69 0 Promotes international trade reduces price volatility for trading partners exchange rate risk 0 Promotes foreign investment increases foreign investment by reducing return volatility to foreign investors exchange rate risk O O Forces in ation and interest rates to be very closely aligned to those in the country against whose currency the exchange rate is xed Forces government to maintain scal discipline and denies governments monetary policy discretion Disadvantages of Fixed Regime O O Denies good governments control of monetary policy Instead of adjusting monetary policy money supply and interest rates in the short term to spur growth reduce unemployment and promote exports The government must change money supply in response to changes in the foreign exchange market Greatly limits the central bank acting as the lender of last resort in dollarized monetary union and currency board regimes Governments often restrict international tradeinvestment in order to maintain the xed exchange rate This is a selfdefeating measure What39s good about the xed exchange rate if international trade need to be restricted Takes away the power of seignorage the ability to pro t from printing money Requires central banks in a conventional pegged regime to maintain large quantities of reserve currencies and gold to defend the xed rate 0 If the ideal currency existed in today39s world it would possess three attributes 0 Exchange rate stability the value of the currency would be xed in relationship to other major currencies so traders and investors could be relatively certain of the foreign exchange value of each currency in the present and into near future Full nancial integration complete freedom of monetary ows would be allowed so traders and investors could willingly and easily move funds from one country and currency to another in response to perceived economic opportunities or risks Monetary independence domestic monetary and interest rate policies would be set by each individual country to pursue desired national economic policies especially as they might relate to limiting in ation combatting recessions and fostering prosperity and full employment These qualities are termed the impossible trinity because a country must give up one of the three goals described The forces of economics do not allow the simultaneous achievement of all three Full Capital Controls Monetary Independence and Exchange Rate Stability Pure Float Monetary Independence and Full Financial Integration Monetary Union Full Financial Integration and Exchange Rate Stability The members of the European Union are also members of the European Monetary System EMS This group has tried to form an island of xed exchange rates among themselves in a sea of major oating currencies Members of the EMS rely heavily on trade with each other so the daytoday bene ts of xed exchange rates between them are perceived to be great The Maastricht Treaty speci ed a timetable and a plan to replace all individual EMS member currencies with a single currency the euro According to the EU the EMU is a single currency area within the EU single market now known informally as the Eurozone in which people goods services and capital are supposed to move without restrictions The EMU would be implemented by a process called convergence 0 Nominal in ation rates should be no more than 15 above the average for the three members of the EU with lowest in ation rates during previous year 0 Longterm interest rates should be no more than 2 above the average for the three members of the EU with lowest interest rates 0 Fiscal de cits should be no more than 3 of GDP 0 Government debt should be no more than 60 of GDP 0 ERM target zone should be maintained for two years The single most important mandate of the European Central Bank was its charge to promote price stability within the European Union On January 4 1999 the Euro was of cially launched the 11 countries were Austria Belgium Finland France Germany Ireland Italy Luxembourg the Netherlands Portugal and Spain Greece was added two years later The UK Sweden and Denmark chose to maintain their individual currencies The euro affects markets in three ways 0 Countries with in the euro zone enjoy cheaper transaction costs 0 Currency risks and costs related to exchange rate uncertainty are reduced 0 All consumers and businesses both inside and outside the euro zone enjoy price transparency and increase pricebased competition Chapter 4 o The Balance of Payments is the summary statement of all international transactions between one country and all other countries for some period of time typically a year 0 BOP data is important for government policymakers as it is a gauge of a nation s competitiveness or health domestic andor foreign o The BOP is an important indicator of pressure on a country s foreign exchange rate future government policy initiatives and the attractiveness of a country for exportation or investment 0 Generic BOP 0 Current Account produced assets Goods Services Primary Income 0 Compensation to employees 0 Investment income Secondary Income 0 Personal transfers personal quotgiftsquot 0 Other current transfers government quotgiftsquot 0 Capital Account AcquisitionDisbosal of nonproduced or non nancial assets 0 Natural resources contracts leases and licenses marketing assets franchises trademarks brand names logos Capital transfers debt forgiveness investment grants 0 Financial Account Shows the acquisition and disposal of nancial assets and liabilities Direct Investment Portfolio Investment Financial Derivatives Other investment currency and deposits loans trade credits 0 Net Errors and Omissions A double entry system is used for recording the BOP Although in theory the BOP must always balance in practice there are substantial imbalances as a result of statistical errors and misreporting of the current account and nancialcapital account ows these imbalances are displayed in Net Errors and Omissions 0 Reserves and Related Items tracks central bank transactions Chances in official monetary reserves held within a country Monetary gold Special Drawing Rights SDRs Reserve position in the IMF Other reserve assets currency and deposits securities and nancial derviatives The BOP as a Cash Flow Statement 0 Exchange of real assets the exchange of G amp S for other G amp S barter or for money 0 Exchange of nancial assets the exchange of nancial claims for other nancial claims or for money 0 The term credit is used to denote a reduction in assets or an increase in liabilities o The term debit is used to denote an increase in assets or a reduction in liabilities The BOP interaction with key macroeconomic variables 0 GDP 0 Exchange rate 0 Interest rate 0 In ation rate GDPCIGXM o C consumption spending l capital investment spending G Government spending X M Exports minus imports the balance on the current account when including current income and transfers Domestic Spending DS C I G GDP DS X M Fixed Exchange Rate Countries the government bears the responsibility to ensure that the BOP is near zero If not the government is expected to intervene in the FX market by either buying or selling of cial FX reserves Floating Exchange Rate Countries the government of a country has no responsibility to peg its foreign exchange rate The fact that the current and capital account balances do not sum to zero will automatically in theory alter the exchange rate in the direction necessary to obtain a BOP near zero Managed Floats Countries operating with managed oats often nd it necessary to take action to maintain their desired exchange rate valued When are Current Account De cits Bene cial 0 To promote economic development 0 To smooth consumption 0 The US nances this de cit by issuing nancial claims such things as stocks bonds and bank loans to the rest of the world Net International Investment Position the equivalent of a balance sheet for a country It is the stock of external assets minus the stock of external liabilities or the Foreign assets owned by residents less domestic assets owned by foreigners 0 Net Creditor NH gt 0 0 Net Debtor Nll lt 0 o The calculation of the NH cumulates currentaccount de cits and adjusts for changes in the market valuation of previous claims US claims on foreigners have a higher average return than foreign claims on the US OOO Sovereign Wealth Funds SWFs are government investment funds funded by a foreign currency but managed separately from official currency reserves Basically they are pools of money governments invest for higher pro t Often this money is used to invest in foreign companies 0 The current account and nancialcapital account are typically inverse on balance one in surplus and the other in de cit in oating exchange rate countries Chapter 7 One set of economic theories that link exchange rates prices in ation and interest rates together is called the international parity conditions If one identical product or service can be sold in two different markets and no restrictions or costs exist on the sale or transportation of the product between markets the product s price should be the same in both markets This is called the Law of One Price 0 A primary principle of competitive markets is that prices will equalize across markets if frictions or costs of moving the products or services between markets do not exist If the Law of One Price is imposed on an identical basket of consumer goods in two countries we have a condition known as Purchasing Power Parity By comparing the prices of identical baskets of products denominated in different currencies we may estimate the exchange rate that should exist with ef cient markets This is the Absolute Purchasing Power Parity APPP exchange rate Alternatively a price level or cost ofliving in each country may be calculated by weight averaging all consumer goodsservices De ne internal purchasing power as the number of consumption bundles purchasable with one unit of domestic US currency De ne external purchasing power as the number of foreign consumption bundles purchasable with one unit of domestic currency To calculate this value in Japan for a US dollar Absolute purchasing power parity is then de ned as the assertion that exchange rates adjust such that internal and external purchasing power are equal Purchasing power describes the rate at Which currency can be converted into real goods and services Purchasing power parity is the equivalence in purchasing power of a currency at home and in a foreign country after conversion Overvalued Currencies have greater external purchasing power than internal purchasing power Undervalued currencies have greater internal purchasing power than external The Big Mac Index is prepared the same way in all countries and the price re ects the same weightsproportions on components But there is the inability to quotarbitragequot price differences because a Big Mac is perishablenontradable APPP holds up well over the very long run but poorly for shorter time pe ods The real exchange rate describes deviations from APPP APPP works better during periods of high in ation the adjustment of prices is more frequent quotsticlq pricesquot become more costly relative to quotmenu costsquot Why might APPP not hold 0 Inability to arbitrageexploit pricing differences high transaction costs nontradable goods and services o Tariffs and Quotas 0 Different tastes for goods and consume different consumption bundles 0 Different levels of price elasticity and market power The degree to which the prices of imported goods change as a result of exchange rate changes is termed passthrough o APPP implies that 100 of exchange rate changes are passed through by equivalent changes in prices to trading partners Also called the terms of trade the real exchange rate removes currency from the calculation and expresses the rate of exchange in real goods alone 0 The real exchange rate is de ned in terms of the nominal exchange rate the and price levels in the respective countries 0 When a foreign currency is overvalued dollar is undervalued relative to APPP the real exchange rate gt 1 0 When a foreign currency is undervalued dollar is overvalued relative to APPP the real exchange rate lt 1 When APPP holds a rm might make its investment and exporting decisions Without great concern for exchange rate uctuations However APPP like all the international parity conditions becomes important to decision makers When it does NOT hold The Balance of Trade depends on the real exchange rate All else equal managers would prefer to make foreign direct investments in subsidiaries in countries whose currency is undervalued they would want the real exchange rate lt 1 The expected strengthening of a currency increases inbound FDI D you want to go from undervalued to overvalued from lower production costs to higher pro ts Note that these real exchange rates R are glculated from a nominal rate in foreian currencv per 5 termsand indicate foreian items per one US item Relative Purchasing Power Parity RPPP relates the spot exchange rate at some future point in time to the current exchange rate using price changes in ation rates in the corresponding countries RPPP can hold even if APPP does not Changes in the real exchange rate imply deviations from RPPP 1 The absolute theory of PPP applies the Law of One Price crosscountry to baskets of goods and states that the spot rate is determined by the relative prices of the baskets in two countries 2 The relative theory of PPP states that the appreciation of one currency relative to another should be proportional to the difference between the countries39 in ation rates 3 The real exchange rate takes into account the nominal exchange rate and the relative price levels in two countries expresses the exchange rate in terms of real goods and provides implications for international trade and direct investment The Fisher Effect 1 i 1 reall 11 0 i nominal interest rate o r real interest rate 0 n in ation rate The International Fisher Effect or Uncovered Interest Rate Parity UIRP estimates the spot exchange rate at some future point in time using the current exchange rate and the interest rates in the corresponding countries Uncovered Interest Rate ParityThe International Fisher Effect IFE states that the expected appreciation of one currency relative to another should be proportional to the difference between the countries39 interest rates quotFisheropen is an implication UIRP and states that the spot exchange rate should appreciate in proportion to the difference in interest rates between two countries The International Fisher Effect links 0 The current spot rate 0 The expected future spot rate and o The nominal interest rates in each country The end result is Uncovered Interest Rate ParityInternational Fisher Effect It relates the current spot rate to the expected future spot rate A forward rate is an exchange rated quoted for settlement at some future date A forward exchange agreement between currencies states 0 The rate of exchange at which a foreign currency will be bought forward or sold forward 0 The amount of currency to be bought or sold 0 The speci c transaction date in the future Covered Interest Rate Parity CIRP states that the forward premium of one currency relative to another should be proportional to the difference between the countries39 interest rates CIRP links 0 the current spot rate 0 the forward rate and o the interest rates in each country CIRP differs from UIRP in that the covered parity condition is a relation among knowcertain rates 0 The forward rate replaces the expected future spot rate and therefore obviates any exchange rate uncertainty 0 Unlike RPPP and the UIRP CIRP holds even if we relax many of the formal assumptions that underlie these relations The forward premium for some number of days fdays is the percentage difference between the spot and forward exchange rate usually stated in annual percentage terms The unbiasedness hypothesis implies that the forward premium equals the expected appreciation of a currency Arbitrage of a violation of CIRP is known as Covered Interest Arbitrage CIA This is when the forward and spot market rates are not in equilibrium according Covered Interest Rate Parity an opportunity for riskfree arbitrage exists The arbitrageur will exploit the relative imbalance by 0 investing in the relatively high interest rate currency and borrowing in the relatively low interest rate currency 0 Selling in the relatively overvalued currency market spot vs forward and buying in the relatively undervalued currency market A twist on covered interest arbitrage is Uncovered Interest Arbitrage UIA This is when investors believe expected future spot rates and current spot rates are not in equilibrium according to Uncovered Interest Rate ParityInternational Fisher Effect an opportunity for risky arbitrage exists In practice investors are often betting that the future spot rate will not be much different from the current spot rate despite an interest rate differential This is called a currency carry trade for example the yen carry trade In this case investors borrow in currencies exhibiting relatively low interest rates and convert the proceed into currencies that offer higher interest rates
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