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11/9/2001 Lecture The FOREX Market Copyright K. Cuthbertson, D. Nitzsche 1 11/9/2001 Lecture The FOREX Market Copyright K. Cuthbertson, D. Nitzsche 1

Reading Investments: Spot and Derivative Markets, K. Cuthbertson and D. Nitzsche CHAPTER 15: - Reading Investments: Spot and Derivative Markets, K. Cuthbertson and D. Nitzsche CHAPTER 15: - excluding p. 454 -457, p 461 -477, Section 15. 7 and Appendix 15. 1 CHAPTER 16: Sections 16. 1 and 16. 2 and Box 16. 2 and 16. 3 only Copyright K. Cuthbertson, D. Nitzsche 2

Topics Basics: Spot, Forward and Balance of Payments PPP -Price Competitiveness Fixed Exchange Rate Topics Basics: Spot, Forward and Balance of Payments PPP -Price Competitiveness Fixed Exchange Rate Policy Floating Exchange Rates Uncovered Interest Parity/ Exchange Rate Overshooting Currency Union -EMU: Policy Issues Copyright K. Cuthbertson, D. Nitzsche 3

Basics Copyright K. Cuthbertson, D. Nitzsche 4 Basics Copyright K. Cuthbertson, D. Nitzsche 4

Spot Rates: Terminolgy and SWIFT codes Sterling - $ French Franc-$ Deutsche Mark-$ Swiss Spot Rates: Terminolgy and SWIFT codes Sterling - $ French Franc-$ Deutsche Mark-$ Swiss Franc-$ Yen-$ ‘SWIFT’ Codes GBP/USD FRF/USD DEM/USD CHF/USD JPY/USD ‘TELEPHONE’ Cable Paris Dollar-mark Swissy Bill and Ben Note: e. g. Dollar - Sterling If sterling appreciates then the USD must have depreciated e. g. Appreciation of sterling from 2. 0 $ per £ to 2. 1 $ per £ Copyright K. Cuthbertson, D. Nitzsche 5

Spot FX-market Banks in London - (“screens”  telephone  back office ) - Spot FX-market Banks in London - (“screens” telephone back office ) - Spot settled in 2 business days 300 participants (50 large banks-”own book”) Also 10 -12 FOREX brokers Dealing spreads, commission, trading profits International Commodities Clearing House (ICCH) transfer of funds Copyright K. Cuthbertson, D. Nitzsche 6

Forward Market Contract made today for delivery in the future Forward rate is “price” Forward Market Contract made today for delivery in the future Forward rate is “price” agreed, today eg. One -year Forward rate = 1. 5 $ / £ Agree to purchase £ 100 ‘s forward In 1 -year, receive £ 100 and pay-out $150 Copyright K. Cuthbertson, D. Nitzsche 7

Bank Calculates Outright Forward Quote F(quote) = S [ ( 1 + rus ) Bank Calculates Outright Forward Quote F(quote) = S [ ( 1 + rus ) / ( 1 + ruk ) ] Covered interest parity (CIP) Also Note: If rus and ruk are relatively constant then F and S will move together (positive correln) Copyright K. Cuthbertson, D. Nitzsche 8

Exchange Rate Regimes Fixed Exchange Rates (Crawling Peg) -in practice, these are ‘narrow bands’ Exchange Rate Regimes Fixed Exchange Rates (Crawling Peg) -in practice, these are ‘narrow bands’ Pure Float (eg. USD-Yen, USD-Euro) - sometimes Central Bank intervention Common Currency (EMU), Mexico-USA? Currency Board- form of fixed exchange rate where domestic currency is altered one-for-one with FX-reserves - ie. net FX receipts (Hong-Kong, Latvia, Agentina) Copyright K. Cuthbertson, D. Nitzsche 9

BALANCE OF PAYMENTS Current Account (‘Goods And Services’) - export receipts minus import payments BALANCE OF PAYMENTS Current Account (‘Goods And Services’) - export receipts minus import payments Capital Account Balance -inward investment into domestic assets (=receipts) minus outward investment (=payments) ‘investment’ can be portfolio investment (into bank account or shares) - ‘speculative’ or can be direct investment (e. g. foreigner buys the Dorchester). Note: If the UK government could legally print USD there would be no balance of payments problem Copyright K. Cuthbertson, D. Nitzsche 10

Purchasing Power Parity PPP and Price Competitiveness Copyright K. Cuthbertson, D. Nitzsche 11 Purchasing Power Parity PPP and Price Competitiveness Copyright K. Cuthbertson, D. Nitzsche 11

PPP: “Law of One Price” Let: HH= Harrod’s Hamper SH= Sak’s Hamper Suppose: $P(SH) PPP: “Law of One Price” Let: HH= Harrod’s Hamper SH= Sak’s Hamper Suppose: $P(SH) = $200 £P(HH) = £ 100 S = 2 $ per £ Then to a UK resident the price of SH in sterling is same as HH UK is ‘price competitive’ and there is no incentive to switch purchases of goods between countries This ‘special situation’ is know as purchasing power parity PPP Copyright K. Cuthbertson, D. Nitzsche 12

Purchasing Power Parity (PPP) The Law of One Price Note that if PPP holds Purchasing Power Parity (PPP) The Law of One Price Note that if PPP holds at all times then: ‘Relative prices’ = $200/£ 100 = 2 ~ must equal the current exchange rate, S (=2$/£) Hence algebraically PPP can be expressed $P / £P = S ‘Relative prices’ is often referred to as ‘the PPP exchange rate’ Copyright K. Cuthbertson, D. Nitzsche 13

Actual S ($/£)= ______ and Relative Prices (Relative prices = ‘PPP-Exchange Rate’= ----- ) Actual S ($/£)= ______ and Relative Prices (Relative prices = ‘PPP-Exchange Rate’= ----- ) * Copyright K. Cuthbertson, D. Nitzsche 14

Figure 16. 3: German Mark - Pound Sterling (Actual and PPP Exchange Rate) Copyright Figure 16. 3: German Mark - Pound Sterling (Actual and PPP Exchange Rate) Copyright K. Cuthbertson, D. Nitzsche 15

Figure 16. 4: French Franc - German Mark (Actual and PPP Exchange Rate) Copyright Figure 16. 4: French Franc - German Mark (Actual and PPP Exchange Rate) Copyright K. Cuthbertson, D. Nitzsche 16

Depreciation Of £ Improves UK Competitiveness £P(HH) = £ 100 $P(SH) = $200 S Depreciation Of £ Improves UK Competitiveness £P(HH) = £ 100 $P(SH) = $200 S = 2 $/£ STERLING DEPRECIATION TO S=1. 8 $/£ Cost of HH to US resident is now $180 Cost of SH to UK resident is now £ 111. 1 Copyright K. Cuthbertson, D. Nitzsche 17

Fixed Exchange Rates Copyright K. Cuthbertson, D. Nitzsche 18 Fixed Exchange Rates Copyright K. Cuthbertson, D. Nitzsche 18

FIXED EXCHANGE RATE POLICY: UK INFLATION HH rises in price to £P(HH) = £ FIXED EXCHANGE RATE POLICY: UK INFLATION HH rises in price to £P(HH) = £ 110 AND S=2$/£ Hence SH is cheaper for UK resident at £ 100 (ie, $200) UK residents sell £ (and buy USD). Government uses FX-reserves to supply USD at 2 $/£ FX-reserves are falling - borrow from IMF? Will have to reduce UK inflation POLICY RESULT With fixed FX-rate your price level (inflation) is determined by the foreign price level Copyright K. Cuthbertson, D. Nitzsche 19

FIXED EXCHANGE RATE POLICY: UK INFLATION CONTROLS ON CAPITAL ACCOUNT To reduce UK inflation FIXED EXCHANGE RATE POLICY: UK INFLATION CONTROLS ON CAPITAL ACCOUNT To reduce UK inflation you can raise interest rates (tight monetary policy) ‘FREE’ CAPITAL FLOWS If you raise UK interest rates, have massive capital inflow (if fixed rate is credible policy) which will put upward pressure on sterling. Hence cannot have an independent interest rate policy reducing inflation will need fiscal policy. Copyright K. Cuthbertson, D. Nitzsche 20

FIXED EXCHANGE RATE POLICY Bretton Woods 1945 -1973 USD as “anchor currency” IMF - FIXED EXCHANGE RATE POLICY Bretton Woods 1945 -1973 USD as “anchor currency” IMF - payments imbalances/devaluations Gold at $35 per oz. (Fort Knox). USD = world’s trading currency(Seigniorage) Oil Crisis 1973 and 1979 Inflation rates differ = “strain” Copyright K. Cuthbertson, D. Nitzsche 21

FIXED EXCHANGE RATES : SUMMARY Reduces price uncertainty for exporters/importers You have to accept FIXED EXCHANGE RATES : SUMMARY Reduces price uncertainty for exporters/importers You have to accept the inflation rate of the ‘larger’ country. Cannot have an independently chosen inflation rate. If you have higher ‘core’ inflation than larger country you will have to have contractionary fiscal policy (and unemployment) With ‘free’ capital flows your interest rate must equal that of the large country May need to borrow foreign exchange - if you then devalue this is costly ! Copyright K. Cuthbertson, D. Nitzsche 22

Floating Exchange Rates Copyright K. Cuthbertson, D. Nitzsche 23 Floating Exchange Rates Copyright K. Cuthbertson, D. Nitzsche 23

FLOATING EXCHANGE RATES : UK INFLATION £P= £ 110 and S currently at $2 FLOATING EXCHANGE RATES : UK INFLATION £P= £ 110 and S currently at $2 per £ SH is cheaper than HH and demand for USD increases and USD appreciates (and sterling depreciates) Depreciation of £ implies an improvement in UK competitiveness to offset the higher £-price of HH Policy Result (ignoring capital account) High inflation countries have a depreciating exchange rate (which offsets some or all of loss of competitiveness due to high inflation)` Copyright K. Cuthbertson, D. Nitzsche 24

FLOATING EXCHANGE RATES : UK INFLATION If S falls to exactly 1. 818181 $/£ FLOATING EXCHANGE RATES : UK INFLATION If S falls to exactly 1. 818181 $/£ the SH would also cost £ 110 for a UK resident and price competitiveness is restored BUT NOTE To exactly restore price competitiveness requires the specific exchange rate of 1. 8181 and decisions by ‘rational’ FXspeculators might not result in this exact rate - see overshooting below ALSO NOTE You can raise your interest rate to try and reduce inflation. Any capital inflow will tend to raise sterling FX rate which will put downward pressure on UK inflation (as export sector becomes less competitive) Copyright K. Cuthbertson, D. Nitzsche 25

FLOATING EXCHANGE RATES : SUMMARY FX-rate is free to move (under market forces) and FLOATING EXCHANGE RATES : SUMMARY FX-rate is free to move (under market forces) and (ignoring capital flows) will tend to restore price competitiveness You can have an independent interest rate policy and hence influence your own inflation rate over the longer term (3 -5 years) and your unemployment rate over the short term (1 -3 years) Your interest rate policy has implications for the exchange rate although difficult to predict Danger is that FX-speculators will cause ‘wild’ movements in FX-rate and adversely alter price competitivenesss ‘Price uncertainty’ removed by using the forward market Copyright K. Cuthbertson, D. Nitzsche 26

. Uncovered Interest Parity and Exchange Rate Overshooting Copyright K. Cuthbertson, D. Nitzsche 27 . Uncovered Interest Parity and Exchange Rate Overshooting Copyright K. Cuthbertson, D. Nitzsche 27

Uncovered Interest Arbitrage (Parity) (UIP) (‘Smart’ , ‘rational’ Speculators) UIP is a specific (equilibrium) Uncovered Interest Arbitrage (Parity) (UIP) (‘Smart’ , ‘rational’ Speculators) UIP is a specific (equilibrium) relationship between domestic and foreign interest rates and the expected depreciation of a currency whereby speculators have no incentive to switch their funds between different countries We assume that speculators (as a whole) are only concerned about the expected return on their investments (ie. They are “risk neutral”). They know their ‘bets’ are risky but this does not influence their decision. Note: Expected (or forecast of the )spot rate in 1 years time = “ESt+1” Copyright K. Cuthbertson, D. Nitzsche 28

Uncovered Interest Arbitrage (Parity) (UIP) WHAT GIVES BEST EXPECTED PAYOUT (IN USD) FOR US Uncovered Interest Arbitrage (Parity) (UIP) WHAT GIVES BEST EXPECTED PAYOUT (IN USD) FOR US RESIDENT 1) r(UK) = r(US) = 2%, and Current St = 1 $/£ ‘Forecast, ESt+1 = 0. 5 $ per £ (ie. expected depreciation of sterling) US speculator: $100 of funds from US to UK or vice-versa? 2) r(UK) = 3%, r(US) = 2%, (ie. interest differential of 1%) Current S = 1 $/£, Forecast, ESt+1 = 0. 99029 $/£ I. e Expected depreciation of sterling of about 1% Copyright K. Cuthbertson, D. Nitzsche 29

Uncovered Interest Arbitrage (Parity) (UIP) Smart Speculators UIP =. ‘no switching of funds by Uncovered Interest Arbitrage (Parity) (UIP) Smart Speculators UIP =. ‘no switching of funds by speculators’ This will occur when: Expected (%) depreciation of sterling = Interest differential in favour of the UK= (r. UK-r. US) If r(UK) = 3% p. a. r(US) = 2%, (ie. interest differential of 1%) then ‘no switching of funds’ when speculators think that sterling will depreciate by 1% over the coming year. Copyright K. Cuthbertson, D. Nitzsche 30

Uncovered Interest Arbitrage (Parity) (UIP) Smart Speculators Assume UIP is correct then If the Uncovered Interest Arbitrage (Parity) (UIP) Smart Speculators Assume UIP is correct then If the UK already has ‘high’ interest rates this implies that speculators expect sterling to depreciate over the coming year Note that the above says nothing about the current level of the exchange rate St. The current level of the exchange rate may (or may not) be ‘high’ , but all CIP implies is that whatever the value of St is now, speculators believe it will fall in the future. Copyright K. Cuthbertson, D. Nitzsche 31

POLICY IMPLICATIONS OF UIP: EXCHANGE RATE OVERSHOOTING Start: UIP holds: r. UK = r. POLICY IMPLICATIONS OF UIP: EXCHANGE RATE OVERSHOOTING Start: UIP holds: r. UK = r. US = 10% Expected depn £ = 0% (ie you expect spot rate to remain constant over coming year) What are the implications for the current spot rate of an unexpected rise in UK interest rates by 2% by the MPC? If speculators initially believe that sterling will remain constant then US investors will want to buy UK bonds and hence they buy spot £ , pushing up the sterling Ex. Rate today. Copyright K. Cuthbertson, D. Nitzsche 32

POLICY IMPLICATIONS OF UIP EXCHANGE RATE OVERSHOOTING How high will todays spot rate rise POLICY IMPLICATIONS OF UIP EXCHANGE RATE OVERSHOOTING How high will todays spot rate rise ? Sterling will appreciate today until it gets so high that US investors think it will fall by 2% over the coming year. Now UIP is restored and capital inflows into the UK will cease. Copyright K. Cuthbertson, D. Nitzsche 33

Using UIP: Exchange rate Overshooting Increase in UK interest rates = ‘Tight’ Monetary Policy Using UIP: Exchange rate Overshooting Increase in UK interest rates = ‘Tight’ Monetary Policy Appreciation of Sterling, $ per £ 1. 03 Expected depreciation of 2% B Exchange Rate C 1. 01 1. 00 C = Final ‘long run’ level for Exchange Rate A today Copyright K. Cuthbertson, D. Nitzsche +1 year Time 34

Overshooting: UIP+’STICKY’ PRICES The appreciation of sterling and overshooting of the exchange rate leads Overshooting: UIP+’STICKY’ PRICES The appreciation of sterling and overshooting of the exchange rate leads to an immediate loss of UK competitiveness. Exports fall (and imports increase), which further exacerbates the recession initially caused by the rise in interest rates. The recession may last for 2 -5 years -severe problem. It can also be exacerbated if “the herd” (e. g. chartists) follow the “rational speculators” and buy spot sterling when it begins to rise, thus pushing sterling up even further. In the longer term the economy may return to its ‘normal’ growth path and interest rates in the two countries may be again be equalised (this is a “big”, involved and complex story) Copyright K. Cuthbertson, D. Nitzsche 35

. Currency Unions - EMU Policy Issues Copyright K. Cuthbertson, D. Nitzsche 36 . Currency Unions - EMU Policy Issues Copyright K. Cuthbertson, D. Nitzsche 36

CURRENCY UNION: “Single currency”: EMU Like an irrevocable fixed exchange rate regime No independent CURRENCY UNION: “Single currency”: EMU Like an irrevocable fixed exchange rate regime No independent interest rate policy (ECB, Frankfurt) Must accept the inflation rate of other member states (OR UNEMPLOYMENT IF HIGH INFLATION) Prices are ‘transparent’ and ‘uncertainty’ removed within Euroland only Unelected MPC in Threadneedle St or in Frankfurt ? Copyright K. Cuthbertson, D. Nitzsche 37

“Single currency”: EMU One (‘size’) interest rate fits all ? (In EMU) Symmetric country “Single currency”: EMU One (‘size’) interest rate fits all ? (In EMU) Symmetric country ‘shocks’ Unemployment increases (equally) in all states. ECB lowers interest rates - ‘no problem’. Asymmetric “shocks” Unemployment in Scotland, a boom in Germany. ECB keeps interest rates high. Solutions? Fall in (real) wages in Scotland work comes to the workers or Scots migrate to Germany Welfare expenditure in UK increases. Copyright K. Cuthbertson, D. Nitzsche 38

“Single currency”: EMU FISCAL ISSUES Large budget deficits? - welfare payments - pension commitments “Single currency”: EMU FISCAL ISSUES Large budget deficits? - welfare payments - pension commitments of the State Must be financed by issuing say Italian government bonds, denominated in Euros. Default and bail-out ? Budget deficit limited to 3% (on average) of GDP otherwise fines Copyright K. Cuthbertson, D. Nitzsche 39

. END OF LECTURE / SLIDES Copyright K. Cuthbertson, D. Nitzsche 40 . END OF LECTURE / SLIDES Copyright K. Cuthbertson, D. Nitzsche 40