International Economics Immigration and Economic Development Technological Changes and Trade...
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International Economics • Immigration and Economic Development • Technological Changes and Trade • Outsourcing • Foreign Investment and Currency • Currency and Trade • International Economic Shocks and Domestic Economics Stability lization is the process of integration of an economy into the my. This process involves output markets, labor markets, capi ts….
International Economics Immigration and Economic Development Technological Changes and Trade Outsourcing Foreign Investment and Currency Currency and Trade
International Economics Immigration and Economic Development
Technological Changes and Trade Outsourcing Foreign Investment and
Currency Currency and Trade International Economic Shocks and
Domestic Economics Stability Globalization is the process of
integration of an economy into the world economy. This process
involves output markets, labor markets, capital markets.
Slide 2
International Finance International Markets I.ForEx Market
(Currency) II.Capital Market (Investment) III.Market for Goods and
Services (Trade)
Slide 3
The planet Earth in the darkness of the night * * Image source:
NASA (http://antwrp.gsfc.nasa.gov/apod/ap001127.html)
Slide 4
ForEx Average Daily Volume of Bank Foreign-Exchange Market
Activity (Source: Basel: Bank for International Settlements,
September 2004) billions of dollarspercentage share Spot62135
Swaps94453 Forwards20812 Total1773100 Defining the Market:
Institutions facilitating the market: Major Private Banks Central
Banks Market Participants: Banks, Central Banks, Corporations,
Investors, even consumers.
Slide 5
Slide 6
Brief History of the International Monetary System
Slide 7
Gold Standard: 1880 - 1914 Dates of adoption of a gold standard
1695: United Kingdom at 1 to 113 grains (7.32g) of gold. 1818:
Netherlands at 1 guilder to 0.60561g gold 1854: Portugal at 1000
reis to 1.62585g gold 1871: Germany at 2790 Goldmarks to 1kg gold
1873: Latin Monetary Union (Belgium, Italy, Switzerland, France) at
31 francs to 9g gold 1873: United States de facto at 20.67 dollars
to 1troy oz 1875: Scandinavian monetary union: (Denmark, Norway and
Sweden) at 2480 kroner to 1kg gold 1876: France internally 1876:
Spain at 31 pesetas to 9g gold 1878: Finland at 31 marks to 9g gold
1879: Austria 1893: Russia at 31 Roubles to 24g gold 1897: Japan at
1 yen to 1.5g gold Price Stability Simplified conversion No Future
markets
Slide 8
1918-1939 Great Depression and lack of international
cooperation 1925 -1931 UK operates on Gold Standard US remains on
Gold Standard till 1933 Fixed exchange system
Slide 9
Post WWII era Bretton Woods IMF and the Gold Exchange Standard
Gold Exchange Standard Fixed system with limited (1% allowable
adjustments) Dollar is convertible into gold at 35 USD per 1 Oz
Very few monetary reforms are undertaken by member states 1950s
1960s August of 1971 USD is no longer a convertible currency The
Smithsonian Conference of December of 1971 38.02 USD = 1 oz Dollar
remains inconvertible Increased allowable adjustment to 2.25% March
of 1973 FLOAT begins
Slide 10
Spot market
http://www.federalreserve.gov/releases/h10/Update/default.htm Ask
and Bid prices and the spread Ask Banks asking (banks sales price)
Bid Banks purchase price Spread return to the market maker, in this
case the bank Consider the following rouble quote: Ask Price:
$0.0425; Bid Price: $0.0420 Alignment of exchange rates Arbitrage
Simple setting (2 or more currencies): Consider two banks quoting
the rouble: Bank I: $0.0425 - $0.0430. Bank II: $0.0435 - $0.0440
Price difference falling within the spread Setting 2: implied
exchange rate (3 or more currencies): Consider tw banks providing
the following quotes: Bank I: Between Rouble and Dollar: R1 =
$0.0425 Between Rouble and Euro: R1 = EUR 0.030 Implied USD/EUR
rate is: USD1 = 0.7059 Bank II Between Rouble and Dollar: R1 =
$0.0425 Between Rouble and Euro: R1 = EUR 0.031 Implied USD/EUR
rate is: USD1 = EUR0.7294 Are profits from arbitrage possible?
Slide 11
Currency Index: USD Index by the FED
Slide 12
USD weights Source: FED
Slide 13
Slide 14
Recent performance of the USD $/Euro Source:
FederalReserve.gov:
http://www.federalreserve.gov/releases/h10/Hist/
Slide 15
Role of the exchange rate in the price of oil USD Price of
Oil$/EuroEuro Price of Oil 3-Mar-08 102.42 1.52167.34 5-Mar-07
60.05 1.309445.86 6-Mar-06 62.46 1.200252.04 7-Mar-05 53.9
1.320340.82 8-Mar-04 36.53 1.237129.53 3-Mar-03 36.1 1.083533.32
4-Mar-02 22.55 0.865226.06 change in the price79.8741.27 % change
(inflation)354.190687475.7975158.36 Source for historical oil price
data US Dept. of Energy,
http://tonto.eia.doe.gov/dnav/pet/pet_pri_spt_s1_d.htmhttp://tonto.eia.doe.gov/dnav/pet/pet_pri_spt_s1_d.htm
Slide 16
Supply of the USD Imports to the US Goods (trade) Services
(tourism) US investment abroad Foreign Financial Markets Direct
investment abroad Central Banks Speculation Demand for the USD US
Exports Goods Services (tourism) Foreign Investment into US US
Financial markets Direct investment Central Banks Speculation The
ForEx Market
Slide 17
The Interesting 90s 1991-92: Collapse of the USSR Block,
beginning of the Transitional Recession in Eastern Europe 1994
Mexican Currency Crisis 1991(2)-95 The Balkan Wars 1998 Recession
in Japan 1997 (July) Beginning of the Asian Financial Crisis 1998
major Rouble Crisis US ECONOMY average % rates 1992- 2000 2001-
2004 Real GDP3.72.5 Gross Domestic Private Investment8.71.8
Non-Residential Investment9.10.2
Slide 18
The market for USD in the 90s DS Influx of investment
stimulated Demand Increase in imports stimulated Supply Demand
Effect Dominated (thus positively effecting consumers standard of
living) P of USD
Slide 19
The post 90s era United Europe 10 New Countries Entered the
Union on May 1 st of 2004, bringing the total number of member
states to 25, with combined population of over 430 million (US
population is 293 million). Growth in Russia and China nearing
double digits Emerging Economies of Brazil and India Threat of
Terrorism to the US Continuous Growth in US Trade Deficit
Slide 20
The market for USD in the post 90s era DS Supply effect appears
to be dominating The demand effect P of USD
Slide 21
The BIG picture Rise in Imports Increase in Supply Depreciation
Rise in Exports Increase in Demand Appreciation Influx of
Investment Increase in Demand Appreciation Outflow of Investment
Increase in Supply Depreciation COMMODITY PRICES AND CURRENCY
BEHAVIOR Wheat and the Australian Dollar Oil and the Russian
Ruble
Forwards The transaction takes place at a future time period
based on the previously specified terms (value and price) Forwards
can be used to predict future spot rates as they reflect
expectations of currency traders Forward premium versus forward
discount
Slide 24
Implications of forecasting and the forward transactions
Consider that R25 = USD1 today A 6 month forward rate is R25 = USD1
Forecast 1 predicts the future spot rate: R24 = USD1 in 6 months
Forecast 2 predicts the future spot rate: R25.20 = USD1 in 6 months
If our firm owes a payment to a Russian trading partner in 6 months
from now then these two forecasts become confusing: Based on
Forecast 1 we should either purchase the ruble now Based on
Forecast 2 we should wait for 6 months and purchase the ruble then
If after 6 months the spot rate happens to be R24.9 = $1, the First
forecaster proves to be the best in terms of policy recommendation,
even though that forecaster has a much greater error.
Slide 25
swaps A swap usually is a trade that includes a spot and a
forward transaction into one. Some forward-forward swaps are also
being used (both transactions are forward) Frequently used between
banks (including Central Banks) Consider two banks: Citibank (US)
and Lloyds (UK) If Citibank needs pounds, it can agree to exchange
dollars for pounds with Lloyds today and also agree to a reverse
transaction at a future date For example, if the spot rate is 2 USD
per pound and the agreed forward rate is 2.10 dollars per pound
than this constitutes a swap In this case the pound is traded at a
forward premium of $0.1, or 1000 basis points (a basis point is
1/100 of 1 %) in the forward market A percent conversion can also
be made: $0.10/$2.00 = 5%, if the swap is for 6 months, then this
is equivalent to 10% rate of return for Lloyds
Slide 26
Futures Limited selection of currencies Specified quantities
Traded on exchanges
Slide 27
options Call versus put Expiration Volatility and risk premium
Option use as a hedging tool (proper hedging) Option use as an
income source (improper use) Option Pricing the Black-Scholes model
Scholes won the Nobel Prize. Was a co-founder of the LTC venture
along with another Nobel Prize winner Merton and a number of other
prominent economists (from the FED, Salomon Brothers). The LTC
venture was one of the largest in history financial disasters when
it collapsed in 1999, losing 5 billion dollars in about 4 months.
Recent behavior by some hedge funds
Slide 28
Option value strikeAsset price Intrinsic value Option value
Risk premium = time value Option value = time value + intrinsic
value Intrinsic value >0, otherwise no exercise
Slide 29
Characteristics of hedge funds Unrestricted in their behavior
May assume short positions Trade options/features May assume
leverage (the Carlyle Capital hedge fund operated at a multiple of
32
http://dealbook.blogs.nytimes.com/2008/03/14/in-carlyle-collapse-a-lesson-for-bear-stearns/
the Bear group operated with a 34 times equity leverage)
http://dealbook.blogs.nytimes.com/2008/03/14/in-carlyle-collapse-a-lesson-for-bear-stearns/
Note, not all hedge funds leverage themselves, after all, hedging
is a protective tool, not a speculative tool
Slide 30
Basic option strategies Options can be purchased or written
(sold short) Hedging use of options for insurance purposes Covered
call (hedging) Covered put (hedging) Naked call (infinite risk)
Naked put (limited risk) Spread (risk depends on the structure)
Straddle (market movement)
Slide 31
Leveraging the inappropriate behavior Obtain investment Magnify
it by using it as a collateral to borrow money in a low interest
rate environment (say Japan) Magnify the funds further by issuing
naked puts (possibly calls) Use the funds to go into relatively
safe investment vehicles that earn income US Treasury bonds (short
term will typically require 5 - 10% margin requirement only)
Slide 32
What if markets dont behave the way you expected? If you are
leveraged - CRASH The Carlyle group in March of 2008 Can the
markets behave in an unpredictable way? BSC stock moved from $159
on 4/25/07 to $2.84 3/17/08, could that have been predicted from
the past distribution of prices of BSC? The LTC venture The Asian
Crisis The Rouble Crisis Could the full extend of these crises have
been predicted in advance? The Carlyle Group The US housing market
(see the next slide)
Slide 33
The Housing Market Home Sales in the US decreased from
6,380,000 in 2006 to 4,890,000 in 2007, suggesting that the
quantity decreased along with the price characteristics of a demand
pull back (
http://www.realtor.org/Research.nsf/files/MSAPRICESF.xls/$FILE/MSAPRICESF.xls
)
http://www.realtor.org/Research.nsf/files/MSAPRICESF.xls/$FILE/MSAPRICESF.xls
Slide 34
Revisiting the ForEx Market Nominal exchange rates versus Real
exchange rate Real Exchange rate Er = En * (Pd)/(Pf) Law of one
price Undervalued versus overvalued exchange Real exchange rate
must be equal to one Economic agents respond to real changes
Redistribution of wealth within the country Appreciating dollar in
the 1990s and the impact on the rust belt of the US Appreciating
Canadian Dollar and the redistribution of wealth across the
Canadian provinces Prices act as signals of information Frequent
changes may produce incorrect signals
Slide 35
Purchasing Price Parity Absolute Internationally traded goods
Limited trade restrictions (natural and artificial) The law of one
price: Pd = E * Pf The Big Mac index Commodity prices Cross-border
trade with Canada International trade as the corrective mechanism
Implications: Nominal exchange rates change to offset changes in
the price levels, but the real exchange rate remains constant
Relative Role of inflation International trade as the corrective
mechanism Nominal exchange rate movement as the differential in the
inflation rates Deviations from PPP Non-tradable goods
Heterogeneity of goods and consumer demand Trade restrictions
Current export restrictions on grain (Kazakhstan) Russian Export
tariffs Import tariffs
Slide 36
Relative prices and the exchange rate Rise in the price of a
heavily consumed product can lead to currency appreciation Rise in
the price of a product that is being exported (and the foreign
demand is inelastic), can lead to currency appreciation
Slide 37
Fixed Exchange Rate Overvalued Current account deficit
Possibility of currency attack Loss of reserves Russia, 1998
Undervalued Current account surplus Accumulation of reserves
Effectively, monetary expansion is caused at the forex window of
the CB
Slide 38
Capital Movements and the ForEx market Interest Rate Parity
Money follows the highest risk adjusted rate of return, thus a rise
in the interest rate will cause an influx of foreign investment,
all else held constant Recent depreciation of the USD Canadian
Central Bank behavior in light of US rate reductions Uncovered
interest rate parity No forward market cover transaction Ex:
2006-2007 US hedge funds borrowing in Japan Covered interest rate
parity Covered with a forward transaction to exit the currency
Slide 39
Uncovered interest rate parity USJapan interest ratei$iY
starting balanceAA*Ex Ex = Yen per USD balance after
investingA*(1+i$)A*Ex*(1+iY) in equilibrium, the returns should be
the same A*(1+i$) = A*Ex(1+iY) (1+i$)/(1+iY) = Ex taking natural
log and differentiating gives us the relationship between the
exchange rate and the interest rate
Slide 40
Covered interest rate parity USJapan interest ratei$iY starting
balanceAA*Ex Ex = Yen per USD balance after
investingA*(1+i$)A*Ex*(1+iY) Balance after covered
exitA*(1+i$)A*Ex*(1+iY)*(1/Fx) Fx = forward rate, Yen per USD in
equilibrium, the returns should be the same A*(1+i$) =
A*Ex(1+iY)(1/Fx) (1+i$)/(1+iY) = Ex/Fx to simplify the equation,
subtract 1 from each side (i$-iY)/(1+iY) = (Ex - Fx)/Fx
Slide 41
Interest Rate Parity Movements of the government bond rates
Actions of the Central Banks Expected future return and the real
interest rate (investment into Russia today, due to commodity
pricing)
Slide 42
Balance Of Payments Summary of all international transactions
Current Account US trade deficit and the outflow of foreign
exchange (dollar is the international reserves currency) Financial
Account US borrowing from overseas and the inflow of foreing
exchange Paying for trade deficit, the US style Reserves Account
Choice of exchange rate regime
Slide 43
Balance of Payments and the Choice of the Exchange Rate Regime
Float USA (trade deficit) Fixed Russia, 1998 (Currency Crisis)
Slide 44
Economic Stabilization Policies and the choice of the exchange
rate regime Monetary Policy Fiscal Policy
Slide 45
Monetary Side of Economy
Slide 46
Money Properties of Money Store of Value Unit of Account Medium
of Exchange Fiat money versus Commodity Based money Gold
Standard
Slide 47
Supply of Money How to measure money? Defining supply of money
based on liquidity M1 most liquid assets (in Dec of 2007 - 1364.2
billion $) Cash Demand deposits (all forms of checking accounts)
Travelers checks M2 less liquid than M1 (in Dec of 2007 - 7447.0
billion $) M1 Retail money market mutual fund balances Savings
accounts Money market accounts Small time deposits (CDs) M3 M2
Large time deposits (CDs in excess of 100K) Repurchase agreements
Eurodollars Institution-only money market mutual fund balances
Statistical Source:
http://www.federalreserve.gov/releases/h6/Current/http://www.federalreserve.gov/releases/h6/Current/
Slide 48
Demand for Money Transaction demand Function of income
Opportunity cost of holding money Function of the interest
rate
Slide 49
Quantity theory of Money the long-run role of money Money x
Velocity = Prices x Transactions Noting that transactions are based
on the level of real GDP, we can rewrite the above: M x V = P x
Real GDP Assuming constant velocity of money: Inflation = money
supply growth real output growth The above provides us with the
fundamental look at inflation Examples: Russia in 1990s Germany in
the post WWI era
Slide 50
Other Causes of Inflation Resource supply shock USA and the oil
price today Reduced supply of cheap foreign labor and the US
inflation today Demand driven overheating Operating at unemployment
rates below the natural unemployment rate USA in 2000 Expectations
of future price increases
Slide 51
Impact of inflation unexpected versus fully anticipated
inflation COSTS Menu cost Uncertainty Ability of inflation to
reduce forward looking financial arraignments Redistribution of
wealth Impact of inflation on banks: Banks are short-term
borrowers, long-term lenders. Rise in inflation increases borrowing
costs (recall the Fisher equation) BENEFITS Reduced real wages
(effectively enables fixed [sticky] wages to become flexible, the
long-run adjustment)
Slide 52
Hyperinflation Really high Russia 1990-1995 Sources Typically:
Monetary Expansion Effects May lead to dollarization
Slide 53
Modern Banking System and Money Creation Fractional Reserve
System Required Reserves Excess Reserves Money Creation Process
Multiplication Potential money multiplier Actual money multiplier
Reserve Requirements as a monetary policy instrument
Slide 54
Monetary Policy Today US example Central Bank FEDERAL RESERVE
FOMC Policy Making Body Meets typically 8 times a year Policy
Objectives Economic stability and growth Real GDP, Employment,
Inflation Policy Mechanism Interest Rate Real GDP is a function of
the Interest rate Investment is a function of the Interest Rate
Consumption is a function of the Interest Rate Interest Rate is a
function of the Supply of Money Market for Loanable Funds Interest
Rate as the price of Money
Slide 55
Monetary Policy In Action Reserve Requirements Ratio Current
structure based on size of liabilities
http://www.federalreserve.gov/monetarypolicy/reservereq.htm
Discount Rate Open Market Operations Federal Funds Rate Term
Auction Facility (introduced in 2007)
Slide 56
Policy Impact Domestic response in the GDP Consumption Spending
Investment Spending (2001-2003 and the housing market)
International response Currency depreciation in the case of
expansionary monetary policy (USA today) Response of
exports/imports to currency depreciation impact on the GDP Impact
on Prices