1、Lecture 1:Balance of payment,What is a countrys balance of payment? A systematic account of all the exchanges of value between residents of that country and the rest of the world during a given time period Tow flows in any transaction: double-entry bookkeeping A credit is a flow for which the countr

2、y is paid A debit is a flow for which the country must pay,1,Six categories of flows Merchandise trade flows Service flows Income flows Unilateral transfers Private capital flows Official international reserve flows,2,Six balances Merchandise (goods) trade balance Goods and service balance (trade ba

3、lance) Goods, service, and income balance Current balance (net foreign investment) Financial account balance Overall balance (official settlement balance),3,Some examples: Exports and imports of goods Expenditures of foreign visitors Study abroad interests and dividend received International migrant

4、s remittances Lending to (borrowings from) foreigner Direct investments and international portfolio investment,4,The statistic discrepancy item Something was under-measured A net results of errors and omissions,5,The macro meaning of current account balance Financing and international financial flow

5、s: Net foreign investment (If). CA = If National saving (S) versus domestic investment (Id). S = Id + If, so that CA = S Id Domestic production (Y) versus national expenditure (E). Y = C + Id + G +(X M), E = C + Id + G, and CA = (X M) approximately, so that CA = Y E,6,The macro meaning of the overal

6、l balance The official settlement balance: B = CA + FA B + OR = 0 The international investment position A statement of the stocks of a nations international assets and foreign liabilities at a point in time Flow vs. stock (lender or borrower vs. creditor or debtor),7,Homework: Prepare Chinas BOP acc

7、ording to the format in figure 2.1 in Pugel (page 15) for 1999-2008, and analyze the trends (goods and service balances, current account balances, official settlement balances, etc.) ,8,Lecture 2: The foreign exchange market,What is foreign exchange? Dynamic concept Static concept Demand and supply

8、for foreign exchange Current account Financial account,9,Floating exchange rates Downward-sloping demand curve Equilibrium exchange rate Shift in demand and supply curves Fixed exchange rates Par value and the narrow band Supply and demand gap Government intervention,10,Foreign exchange quotation Di

9、rect quotation: the amount of DC required to purchase one unit of FC Indirect quotation: the amount of FC required to purchase one unit of DC Bid price: the exchange rate at which the dealer is willing to buy a currency Ask (offer) price: the exchange rate at which the dealer is willing to sell a cu

10、rrency,11,The dealer need to earn a profit, so she always “buy low and sell high”! Bid-ask spread: the difference between the bid price and the ask price (can be in percentage) Factors affecting the bid-ask spreads Market condition Dealer position Liquidity midpoint price: the average of the bid pri

11、ce and the ask price basic point: usually 0.0001 (0.01 for JPY) or 0.01%,Some examples: $/ = 1.6543 1.6547 (direct quote in US) /$ = 0.6043 0.6045 (indirect quote in the US) Note that the DC/FC direct bid (ask) exchange rate is the reciprocal of the indirect ask (bid) exchange rate The bid-ask sprea

12、d is 0.0004 (3bp, direct), or 0.0002 (2bp, indirect) The percentage bid-ask spread is 0.0004/1.6547=0.0242% (2.42bp, direct), or 0.0002/0.6045=0.0331% (3.31bp, indirect) The midpoint exchange rate is 1.6545 (direct), or 0.6044 (indirect),Questions: 1. Suppose you want to convert US dollar into pound

13、, and get three different quotes ($/): A: 1.6432/38 B: 1.6433/36C: 1.6434/37, from which dealer would you buy pound? 2. The interbank quotes for US dollar and pound are $/=1.6433/36. If bank A want to earn 2bp profit, what quotes should it give to its retail customers?,Cross-rate calculations with b

14、id-ask spreads Example 2.1: consider the following quotes involving the dollar, pound, and the euro. $/:0.9836/39 /: 1.5473/1.5480 Compute the effective $/ bid and ask cross-rates, as well as the /$ bid and ask cross-rates?,15,Solution 1: ($/)bid = ($/)bid*(/)bid = 0.9836*1.5473 = 1.5219 dollar per

15、pound bid rate ($/)ask = ($/)ask*(/)ask = 0.9839*1.5480 = 1.5231 dollar per pound ask rate (/$)bid = (/)bid*(/$)bid = 1/(/)ask*1/($/)ask = (1/1.5480)*(1/0.9839) = 0.6566 pound per dollar bid rate (/$)ask = (/)ask*(/$)ask = 1/(/)bid*1/($/)bid = (1/1.5473)*(1/0.9836) = 0.6571 pound per dollar ask rate

16、 So, the effective $/ bid and ask cross-rates is $/=1.5219/31, and the effective /$ bid and ask cross-rates is /$=0.6566/71,Solution 2: Imaging you want to convert dollar into pound: using dollar to buy euro first (1$ =1/0.9839), and then using the euro to buy pound (1=1/1.5480). The resulting cross

17、-rate is 1$ =0.6566 , or 1= 1.5231$ If you want to convert pound into dollar: using pound to buy euro first (1 =1.5473), and then using the euro to buy dollar (1=0.9836 $). The resulting cross-rate is 1 =1.5219$, or 1$ =0.6571. So, the effective $/ bid and ask cross-rates is $/=1.5219/31, and the ef

18、fective /$ bid and ask cross-rates is /$=0.6566/71,17,Arbitrage “Pay nothing for something,” or “get something for noting” “there is not such thing as a free lunch” Any deviation from “the law of one price” will present an arbitraging opportunity! Basic strategy: “buy low, sell high”! An arbitraging

19、 strategy is risk-free. In contrast, a speculative strategy is always associated with some degree of risk,18,Bilateral arbitrage with bid-ask spreads No-arbitrage condition: (FC/DC)bid*(DC/FC)bid 1, or (FC/DC)ask*(DC/FC)ask 1, Example 2.2: DC/FC = 0.80025/0.80041, FC/DC = 1.2498/1.2503; Is there an

20、arbitrage opportunity? If so, what is the arbitraging strategy? What about DC/FC = 0.8003/0.8005, and FC/DC = 1.2484/1.2490? Note that when the rates are misquoted, the direct bid (ask) of one currency is not the reciprocal of its indirect ask (bid).,19,Triangular arbitrage with bid-ask spreads No-a

21、rbitrage condition: the implied cross-rate is consistent with the actual cross-rate Example 2.3: FC1/DC=0.9836/39; FC1/FC2=1.5373/80; DC/FC2=1.5219/31; Is there an arbitrage opportunity? If so, what is the arbitraging strategy?,20,Forward foreign exchange rate A forward forex contract is an agreemen

22、t to exchange one currency for another on a specified date in the future at a rate set now (the forward exchange rate) A spot rate is the prevailing rate in the market The forward rate is not the same as the future spot rate!,21,Trading involving forward exchange rate Open position Long position Sho

23、rt position Hedging: offsetting a long (short) position in a foreign currency, or covering the open position Speculating: deliberately establishing a net position (long or short) in a foreign currency Hedging eliminates risk exposure, whereas speculation increases risk exposure,22,Forward premium (d

24、iscount): the proportionate difference between the current forward exchange rate and current spot exchange rate f = (forward rate spot rate) / spot rate (under indirect quotation) Note: the quotation convention (direct or indirect) affects the sign of forward premium! One alternative is to convert t

25、he direct quote into indirect quote, and then calculate the premium Annualized forward premium,23,Some examples: A US exporter signs a contract with a French importer for 1 million euro of goods, to be delivered in three months. The current spot rate is /$=0.7125, and the 3-months forward rate is /$

26、=0.7225 The US exporter has an open (long) position of 1 million euro If the US exporter also signs a forward contract to sell 1 million euro in three months, she eliminates her exposure to exchange rate risk (hedging) If, instead, the US exporter expects the euro will appreciate against the dollar,

27、 she signs a forward contract to buy 1 million euro in 3 months. She increases her exposure to exchange rate risk (speculation),Lecture 3: International Parities,Some symbols Current spot rate between domestic currency and foreign currency is FC/DC = S; One-year forward exchange rate is FC/DC = F; O

28、ne-year domestic interest rate is rD; One-year foreign interest rate is rF; One-year domestic inflation rate is ID; One-year foreign inflation rate is IF; One-year forward premium is f = (FS)/S; Domestic price level PD; foreign price level PF,Interest rate parity (covered interest parity) with 1 uni

29、t of domestic currency, you can invest either in the domestic market or in the foreign market; If you invest in the domestic market, you will get (1+ rD) unit of domestic currency in one year; If you invest in the foreign market, you will get S*(1+ rF)/F unit of domestic currency in one year; No-arb

30、itrage condition implies that (1+ rD) = S*(1+ rF)/F, or F/S = (1+rF ) / (1+ rD), or (FS)/S = (rF rD) / (1+ rD) The linear approximation is: f rF rD, which states that the forward premium (in percentage) is approximately the interest rate differential,This parity relation seems to be counterintuitive

31、. After all, if interest rate increase in foreign market, capital will flow out of the domestic market, which should lead to the depreciation of domestic currency? The key to understand the interest rate parity is the expected future exchange rate. Specifically, higher foreign interest rate should i

32、ndeed lead to the outflow of domestic currency in the spot market. Consequently, on the one hand, the decreasing money supply in domestic market (due to money outflow) should lead to higher domestic interest rate, which increases the rate of return in domestic market. At the mean time, the rate of r

33、eturn in foreign market should decreases due to money inflow. On the other hand, the need for hedging should increase the demand for domestic currency in the future. Both effects lead to the expectation that domestic currency will appreciate in the future higher expected future spot rate for domesti

34、c currency. Since forward exchange rate is the unbiased predictor of future spot exchange rate, forward exchange rate should be at premium.,Uncovered interest rate parity The expected one-year spot rate is E(S1) Using the same strategy as in covered interest rate parity, except that you decide not t

35、o cover your position using forward contract In equilibrium, we have: (1+rD)=S0*(1+rF)/E(S1), or E(S1)/S0= (1+rF)/(1+rD), or approximately, E(s) rF rD, which states that the expected exchange rate appreciation should be approximately the interest rate differential.,28,Absolute purchasing power parit

36、y (PPP) With one unit of domestic currency, you can buy 1/PD unit of goods in domestic market You can also buy S/PF unit of the same goods in foreign market The law of one price implies that: PD = PF/S, or S= PF/PD,Relative PPP (Expected future PPP) By the same reasoning, at the end of the period, 1

37、/PD*1+E(ID) = E(S1)/PF*1+E(IF) PD*1+E(ID) = PF 1+E(IF)/E(S1), or E(S1)/S0 = 1+E(IF) / 1+E(ID), The linear approximation: s=E(S1)/S01E(IF)E(ID), which states that the exchange rate variation is approximately the inflation rate differential,30,Combining relative PPP, covered interest rate parity, and

38、uncovered interest rate parity, we have: E(S1)/S0=F/S=(1+rF)/(1+rD)=1+E(IF)/1+E(ID), or approximately, Expected appreciation of DC = premium on forward DC = difference between foreign and domestic interest rates = expected difference between foreign and domestic inflation rates,31,Real interest rate

39、 equilibrium From (1+rF)/(1+rD)=1+E(IF)/1+E(ID), we have: (1+rF)/(1+E(IF)=(1+rD)/1+E(ID), or approximately: rF E(IF) rD E(ID), which states that the real interest rate should be approximately equal internationally,32,International Fisher relation Domestic Fisher relation: (1+r) = (1+p)*1+E(I), or ap

40、proximately rp+E(I). Assuming that the real interest rate p is constant over time, the fluctuation in nominal interest rates are caused by revision in inflationary expectation. Applying to the international setting, and assuming that the real interest rates are equal globally, we have: (1+rF)/(1+rD)

41、=1+E(IF)/1+E(ID), or approximately: rFC rDC E(IF)E(ID), which states that the nominal interest rate differential is approximately the inflationary expectation differential,33,Foreign exchange expectation relation F = E(S1) Or, (FS0)/S0 = E(S1) S0/S0 Which states that the forward premium (discount) i

42、s equal to the expected exchange rate movement.,34,Empirical evidence on international parities Keep in mind that the various international parity relations hold under some strict assumptions, such as: Not transaction and/or transportation costs Not capital control Floating exchange regimes Not impo

43、rt tax and restriction, not export subsidies Investors are risk-natural,35,Interest rate parity holds very well both in the short run and long run, except for some developing countries with capital control and taxes Uncovered interest rate parity does not hold well in real world, particularly in the

44、 short run. Possible explanations include (1) measuring error in expected future spot rate; (2) risk premium PPP performs poorly in the short run, but is supported in the long run. Possible explanations include (1) measuring error in inflation rate; (2) barriers on international trade; (3) factors o

45、ther than inflation rate may influence exchange rates,A test of international Fisher relation is actually a test of whether the real interest rates are constant internationally. The evidence is unsupported in the short run, but is supported in the long run. Possible explanations: (1) unsynchronized

46、business cycle in the short run; (2) economic integration in the long run Empirical evidence on foreign exchange expectation relation shows that, in the short run, the exchange rate is too volatile to be explained by the interest rate differential; however, over the long run, there seems to be a ris

47、k premium in the future spot exchange rate,Lecture 4What determines exchange rates?,A history of exchange rates since the start of floating exchange rate regime The long-term trends The medium-term trends The short-term variability An analytical framework Asset market approach to exchange rates in t

48、he short run (portfolio repositioning) Monetary approach to exchange rates in the long run (economic fundamental),Exchange rates in the short run The uncovered interest rate parity states that: E(s) rF rD Therefore, change in any of the other three factors should lead to change in spot exchange rate

49、 Example 1: domestic interest rate increase in favor of bond denominated in DC increasing demand for DC DC appreciate in spot market FC is expected to appreciate in the future,39,Example 2: expected future spot rate of FC appreciate in favor of bond denominated in FC increasing demand for FC DC depr

50、eciate in spot market FC is expected to appreciate in the future Self-fulfilling expectation: act on expectation Self-fulfilling expectation can have either stabilizing effect or destabilizing effect on exchange rates, depending on whether the expectation is consistent with economic fundamental,40,E

51、xchange rates in the long run PPP implies that exchange rates are closely related to the levels of prices for products in different countries, at least in the long run The price levels in different countries is affected by the money supplies in these countries Thus, in the long run, exchange rates a

52、re links to relative money supplies in different countries,41,PPP:S= PF/PD The quantity theory of money supply and demand: Thus, we have: Assuming that the Ks are constant, the equation states that DC will appreciate if (1) the growth of domestic money supply is relatively slower; (2) the growth of

53、domestic real output is relatively faster,42,Example 1: Money supplies and exchange rate cut in domestic money supply credit tightening by domestic banks decreasing domestic aggregate demand, output, job, and product prices the purchasing power of DC should rise DC appreciate Example 2; Real incomes

54、 and exchange rate real domestic income increase due to supply-side reasons more demand for money (transaction demand) if the money supply is unchanged, the purchasing power of DC should rise DC appreciate,43,Exchange rate overshooting In the short run, the actual exchange rate overshoot its long-ru

55、n value and then revert back toward it Domestic money supply unexpectedly jumps the foreign currency is expected to appreciate because product prices are sticky, domestic interest rate is driven down, leading to the appreciation of foreign currency The combination of the two effects will drive up th

56、e exchange rate of foreign currency to exceed it long-run value in the short run,44,Lecture 5Government policies toward the foreign exchange market,Why does government want to intervene the foreign exchange market? Reducing exchange rate volatility Economic reasons Political reasons Two types of gov

57、ernment intervention Policies directly applying to the exchange rate itself Exchange control,45,Floating exchange rate Clean float Managed float (or dirty float) Fixed exchange rate (pegged exchange rate) What to fix to? When to change the fixed rate? How to defend a fixed exchange rate official int

58、ervention in the foreign exchange market Exchange control Altering domestic interest rate Adjusting the countrys whole macroeconomic position surrender,46,Defending through official intervention Defending against depreciation Buying DC and selling FC Defending against appreciation Buying FC and sell

59、ing DC Temporary disequilibrium May be socially desirable Disequilibrium that is not temporary Generally unsustainable, calling for adjustment,47,Exchange control A public auction model (page 110112 in Pugel ) exchange control will certainly lead to social losses,48,International currency experience The gold standard era (18701914, fixed rates) Interwar instability The Bretton Woods era (1944-1971, adjustable pegged rates) The current system (not system),49,Lecture 6International lending and financial crisis,A model for well-behaved international len