Economics of International Finance Econ 315 Chapter 2

Economics of International Finance Econ. 315 Chapter 2 Foreign Exchange Markets and Exchange Rates Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

The Foreign Exchange Market The market in which individuals, firms, and banks buy and sell foreign currencies (foreign exchange). § § § Examples: London, Paris, Zurich, Frankfurt, Singapore, Hong Kong, Tokyo and New York. These centers form a single international foreign exchange market. They are connected electronically and are in constant contact with each other What are the major world currencies? . § The world have what is called a vehicle currency, i. e. , the US Dollar which is used to pay for the transactions that do not involve USA. § Note that the Euro is also growing as a world vehicle currency. China and Russia are asking now for a new vehicle currency. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

Figure 1: Daily Turnover of global foreign exchange transactions (Billions of US $) BIS “Triennial Central Bank Survey” Foreign exchange turnover in April 2013: preliminary global results Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

Currency distribution of global foreign exchange market turnover (Billions of US $) BIS “Triennial Central Bank Survey” Foreign exchange turnover in April 2013: preliminary global results Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

Global foreign exchange market turnover by instrument (Billions of US $) BIS “Triennial Central Bank Survey” Foreign exchange turnover in April 2013: preliminary global results Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

Major foreign exchange centers (by size) are: 1. 2. 3. 4. London (about 40% of daily transactions) New York Tokyo Singapore Functions of the Foreign Exchange Markets: 1. The principle function is to transfer funds or purchasing power from one nation or currency into another. How it is done: § If we need foreign exchange we usually go to a bank. A domestic bank will instruct its correspondent in a foreign monetary center to pay the specified amount of its local currency (foreign exchange) to a person, firm or an account. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

§ This is Usually accomplished by electronic transfers (the internet). Why we need foreign exchange (demand) Source of demand foreign exchange: § Imports of goods from abroad § Imports of services, e. g. , travel abroad § Invest abroad Note that we also receive foreign exchange (supply) Source of supply of foreign exchange: § Exports of goods to abroad § Exports of services, e. g. , insurance § Investments at home Note: these items are all recorded in the country’s BOP Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

§ All these transactions are mainly made through commercial banks which function as a clearinghouse for the foreign exchange. Banks may end up having: § Oversupply of foreign exchange (will sell it to other banks) through a broker. § Excess demand of foreign exchange (will buy it from other banks) through a broker. In general: § A country pays for its imports, investments. . etc. with its foreign exchange earnings from exports, services. . etc. § What happens if the nation’s demand foreign exchange exceeds the supply, or if the supply of foreign exchange exceeds demand? Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

If exchange rate is flexible; the exchange rate will have to change to equilibrate supply and demand. § What if changes in exchange rates are not allowed? (exchange rate is fixed), there will either be: § Excess demand - banks will borrow foreign exchange from the central bank (lender of the last resort). - The central bank will draw down its foreign reserves (a BOP deficit) Excess Supply - Banks will sell foreign exchange to the central bank (exchange the surplus into domestic currency) - Foreign reserves in the CB will accumulate (a BOP surplus). Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

There are four levels of participants in the foreign exchange market that can be identified: 4 th level the central bank: seller or buyer of the last resort when the nations earnings and expenditures of foreign exchange are unequal, draw down its foreign reserves or adds to them 3 rd level foreign exchange brokers (wholesale market) 2 nd level commercial banks (clearing house between users and earners) 1 st level traditional users: tourists, importers, exporters (immediate users of foreign exchange) Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

2. Another function is the credit function. International transactions involve credit facilities, e. g. , § An importer is usually given time to resell his imports and make the payments. § What the exporter do is to discount the “importer’s obligations to pay” at his bank, i. e. , the exporter receives payments. § The bank eventually collects the payments from the importer when due. 3. A third function is to provide facilities for hedging and speculation (explained later) Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

Foreign exchange rates § Equilibrium foreign exchange rates: Flexible exchange rates: Consider the following case (the Dollar and the Euro) Rate $/€ Demand (daily) Supply (daily) 0. 5 350 50 The euro is cheap 1 200 Equilibrium Rate 1. 5 100 300 The euro is expensive 2 50 350 The euro is expensive Economics of International Finance Prof. M. El-Saqqa Note CBA. Kuwait University

§ The exchange rate is determined just like the price of any other good. § If the rate of the Euro is $ 0. 5, the quantity of euros demanded will exceed the quantity supplied the rate will bid up towards the equilibrium rate § If the rate of the Euro is $ 1. 5, the quantity of euros supplied will exceed the quantity demanded the rate will fall towards the equilibrium rate § What if the rate is fixed (fixed exchange rate system). In case of excess demand the central bank (Fed) will either: - set restrictions on the demand for euro, or - fill the gap between demand supply out of its international reserves Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

Free rates. What if the rate is not free? § Fill the gap, or § Set restrictions D€ 1 depreciation Eq. rate Demand shift appreciation Demand shift D€ 2 FIGURE 3 The Exchange Rate Under a Flexible Exchange Rate System. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

Why the demand is negatively slopped? (note that the demand foreign exchange is a derived demand) - At lower rates the demand for the euro increases: why? The lower the rate, the lower is the quantity of dollars required to buy one euro the cheaper it is for Americans to import and to invest in Europe the greater is the demand for euros. Why the supply is positively slopped? - At higher rates, European residents will receive more dollar for each euro they will find American goods and investments cheaper and more attractive they will spend more in USA and the supply of euro will increase Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

Changes in demand supply of foreign exchange § If the American demand for euros shifted up, e. g. , as a result of increased US tastes for European goods and the US quantity supplied for euros increased at point G in figure 3, the euro rate will be 1. 5 and the equilibrium daily quantity will be € 300 mn. § It requires now $ 1. 5 (instead of $ 1) to buy one euro. This is a depreciation of the US $, which is an increase in the domestic price (US) of the foreign currency (euro). § If the American demand for euros shifted down to so as to intersect the US supply at point H in figure 3, the equilibrium exchange rate of the euro would fall to $ 0. 5 and the daily equilibrium quantity would be € 50 mn. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

§ It requires now fewer dollars to buy one euro, this is an appreciation of the $ US, which is a decline in § the domestic price (US) of the euro. § Note that changes in supply of euros would similarly affect the equilibrium exchange rate and quantity of euros. § Another Definition of the Exchange Rate: § The exchange rate can be defined as the foreign currency price of a unit of domestic currency. If the Dollar price of the euro is $1. 5 = € 1 then the euro price of the dollar is (1/1. 5) =. 667, i. e. , it takes 0. 667 euros to buy one dollar. § note: the conventional definition (no of domestic currency units to buy one unit of foreign currency) is (R), hence the other definition is (1/R)). Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

§ Cross Exchange rates: There are rates between the dollar and other currencies, i. e. , between the dollar and the euro, the dollar and the Sterling…etc. once the rate between the dollar and other two currencies is determined, the exchange rate between them (cross) can easily be calculated. e. g. , if the rate between the dollar and the Sterling is $ 2 = £ 1 and the rate between the dollar and the euro is $ 1. 25 = € 1, then the cross exchange rate between the sterling and the euro is 1. 60. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

§ R = €/£ = ($ value of the £)/(($ value of the €) = 2/1. 25 = 1. 6 i. e. , it takes € 1. 6 to purchase £ 1. Mathematical form § If you need the €/£, and you have the $/£ and $/€. You need to manipulate these two rates such that you ended up with € in the numerator and £ in the denominator § Divide $/£ by $/€ $/£ ÷ $/€ the $ cancels out and you end up with €/£. Note that if you start with $/€ ÷ $/£ you would end up with £/€. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

Effective Exchange Rate: § A weighted average of the rate between the domestic currency and the nations most important trade partners, with weights given by the relative importance of the nation’s trade with each of these partners. § Nominal and Real Exchange Rates: § Nominal exchange rate is the domestic price of the foreign currency (direct or indirect rate). § The real exchange rate is the nominal exchange rate divided by the ratio of the consumer price indices in the two countries. § e. g. , the real exchange rate between the dollar and the Sterling is: § ($/£)/(PUSA/PUK) = ($/£)(PUK/PUSA) Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

Arbitrage § The purchase of a currency from the monetary center where it is cheaper for immediate resale in the monetary center where it is more expensive in order to make a profit. § Arbitrage keeps the exchange rate between two currencies the same in different monetary centers. Two point arbitrage New York § $ 1. 99 = £ 1 London $ 2. 01 = £ 1 * Buy here * sell here § Arbitrageur profit = 2. 01 -1. 99 = $. 02 per £ 1 (minus transactions cost) § As arbitrage continues, the exchange rate between the two currencies equalizes. e. g. , § $ 2. 00 = £ 1 § Eliminating thus the profitability of further arbitrage. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

Three point (triangular) arbitrage § New York London Frankfurt § $2 = £ 1 £. 625 = € 1 €. 8 = $1 Note: the cross rates are consistent because: $2 £ 1 € 1. 6 $2 Why: R = €/£ = ($ value of the £)/(($ value of the €) = 2/1. 25 = 1. 6 If this is the case there will be no profit out of arbitrage. To make sure lets start in New York using $2 to buy £ 1, take the pound to London and exchange it for (1/. 625) = € 1. 6. Now if we take the euro to Frankfurt to exchange it into dollars we get (1. 6/. 8) = $2, which is exactly what we started arbitrage with. But if: § New York London Frankfurt § $1. 96 = £ 1 £. 625 = € 1 €. 8 = $1 Again use $ 1. 96 to buy £ 1 in New York to buy € 1. 6 in London and exchange them for $ 2 in Frankfurt, or The arbitrage profit is = $ 2 – $ 1. 96 = $. 04. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

Now given the following information: New York London Frankfurt $2. 04 = £ 1 £. 625 = € 1 €. 8 = $1 What would you do: (remember if you start in New York you would lose $ 0. 4 for each two dollars you use in arbitrage!, how? : Use $ 2. 04 to buy £ 1 in New York, to be exchanged for € 1. 6 in London and again to be exchanged into $ 2 in Frankfurt. Arbitrage profit = 2. 04 – 2 = -. 04) Hence, to be profitable you should start the arbitrage in Frankfurt using $ 2 to buy € 1. 6, exchange them for £ 1 in London. Sell the £ 1 in New York for $ 2. 04. Therefore; The arbitrage profit is = $ 2. 04 – $ 2 = + $. 04. Arbitrage increases the demand for currencies where they are cheaper and increases supply in the center where they are expensive and quickly eliminates inconsistent cross rates. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

The Exchange rate and the BOP § § Look at figure 4 and note the following: D€ arises from imports of goods and services from and investment in Europe. S€ arises from exports of goods and services to Europe and European investments in US Both are autonomous Equilibrium exchange rate is $1 = € 1. and the equilibrium quantity is 200 million. If demand for € increases to D€’ the effect will depend on the exchange rate system Fixed Exchange rate system § If US wants to keep the euro rate at $1, it would have to satisfy the excess demand TE (€ 250), out of official reserves, i. e. purchase $ and sell €. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

Figure 4. : Disequilibrium under a fixed and flexible exchange rate Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

§ Flexible Exchange Rate system § The rate would rise to $1. 5 to equilibrate demand supply for €. § Use of reserves is unnecessary because the depreciation of the $ would eliminate excess demand for €. Managed Floating system § Monetary authorities intervene in the market to moderate depreciation of the $ to only $1. 25 = € 1. This can be done by supplying the market by WZ § Part of the deficit is financed by loss of official reserves, § The other part is eliminated by the depreciation of the $. § Loss of reserves indicates the degree of intervention Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

§ Spot and forward, swaps, futures and options. § Spot and Forward Rate: § A spot transaction involves the payment and receipt of foreign exchange within two days after the day of transaction is agreed upon. The rate is called spot rate. § Forward Exchange Rate: § A forward transaction involves an agreement to buy or sell a specified amount of foreign exchange at a specified future date, at a rate agreed upon today (forward rate). § The contract is for one, three or six months. Three months is the most common. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

§ Equilibrium forward rate is determined at the intersection of the market demand supply of foreign exchange for future delivery § This demand is derived in the course of hedging from foreign exchange speculation and from covered interest arbitrage (will explained later). § If the forward rate < the present spot rate, the foreign currency is said to be at a forward discount. § If the forward rate > the present rate, foreign currency is said to be at a forward premium. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

§ e. g. , if R is $2 = £ 1, and the three month forward rate $1. 98 = £ 1 § The £ is at a forward discount of 2 cents (or 1% (2/200), or the annual forward discount is 4% (8/200)). Same forward premium if the three month forward rate is $ 2. 02. § Hence, the annual forward discount or premium is calculated (for a three month contract) as: FD or FP = ((SFR – SR)/SR)× 4 × 100 i. e. , § FD = ((1. 98 -2)/2) × 4 × 100 = -4% and § FP = ((2. 02 -2)/2) × 4 × 100 = 4% Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

§ Currency Swaps (combination of spot and forward) § A currency swap refers to the spot sale of a currency combined with a forward purchase of the same currency - as part of a single transaction. e. g. , suppose that NBK receives a payment of $ 1 mn today that it will need in three month but it wants to invest the sum in Sterling. It will swap the dollars into pounds with a British bank in a single transaction. § This is cheaper (in terms of brokerage fees) than selling the dollars in the spot market today and at the same time repurchasing dollars in the forward market for delivery in three month (two separate transactions) § The swap rate is the difference between the spot and forward rate in the currency swap. § The foreign exchange market is currently dominated by swaps, about 50% of foreign exchange contracts. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

§ Foreign Exchange Futures and Options. § Foreign exchange future is a forward contract for a standardized currency amounts and selected calendar dates traded in an organized market. § e. g. , in the International Monetary Market (IMM) in Chicago trading is done of standard size. - £ 62500 - Four dates of the year are available, the third Wednesday of : March June September December 1. The IMM imposes a daily limit on exchange rate fluctuations 2. Buyers have to pay a brokerage commission 3. Buyers are required to post a security deposit (margin) of 4% of the contract. C$ 100000 ¥ 12. 5 million € 125000 _____________________________ * C$ = the Canadian Dollar Economics of International Finance ¥ = the Japanese Yen Prof. M. El-Saqqa CBA. Kuwait University

§ Futures market differs from the forward market. - In the futures market: only few currencies are traded: Trades occur in standardized contracts only For a few specific delivery dates Subject to limits on exchange rate fluctuations Trading takes place only in a few geographical locations (Chicago, New York, London, Frankfurt, France and Singapore). - Future contracts are usually for smaller amounts than forward and thus useful for smaller companies, but more expensive. - Futures can be sold in any organized futures market until maturity. Forward contracts can not be sold. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

§ Options § A foreign exchange option is a contract giving the purchaser the right, but not the obligation, to buy (a call option) or to sell (a put option) a standard amount of traded currency on a stated date (the European option) or at any time (the American option), and at a stated price (the strike or exercise price). § They are in standard sizes equal to those of futures IMM contracts. § The buyer of the option has the right to purchase or forego the purchase if it turns out to be unprofitable. § The seller of the option, however, must fulfill the contract if the buyer desires so. § For this privilege, the buyer must pay the seller a premium (option price) ranging from 1 to 5% of the value of the contract. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

Foreign Exchange Risk, Hedging and Speculation Foreign Exchange Risk Over time demand supply foreign exchange shifts due to changes in tastes, differences in inflation, changes in relative interest rates, changing expectations. . etc • Increasing demand (tastes) by Kuwaitis for American goods raises the US $ rate (depreciation of KD) • If domestic inflation in Kuwait decreases relative to US inflation the US $ depreciates relative to the KD. • If interest rates on domestic currency (KD) deposits are greater than the rate on US $ deposits, the KD will appreciate. • If expectations of a stronger KD increases, the KD appreciates relative to US $. • Fluctuations in exchange rates impose risks on individuals, firms, and banks that have to make or receive payments in the future denominated in foreign exchange. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

e. g. , • A local importer purchases $ 100, 000 of goods to be paid in 3 month time. • If the KD/$ rate is 0. 300, He will have to pay KD 30, 000 in three month time. • In 3 month time the rate could e. g. , be 0. 330, He will pay 33, 000 (extra KD 3000). • The rate could e. g. , also be 0. 270/1, He will only pay KD 27, 000 (KD 3000 less) Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

The exporter and investor may face the same situation. § Both the importer and exporter will have to insure against the increase in the rates in 3 months. § In general, whenever a future payment must be made in a foreign currency, a foreign currency risk, or the so called open position, occurs because the spot rate changes overtime. Most business people are risk averse. Sources: The foreign exchange risk arises from: 1. A transaction involving future payments or receipts in a foreign currency (transaction exposure) 2. A need to value inventories or assets abroad in local currency for inclusion in the firms consolidated balance sheet (the translation or accounting exposure) 3. Estimation of the domestic currency value of the future profitability of the firm (economic exposure). Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

Hedging § Avoidance of “foreign exchange risk” or the covering of an “open position”. § How it is done? A- In the spot market § An importer purchases $100, 000 goods. The importer could borrow domestic currency equals to the $100, 000 and exchange it at the present spot rate, and leave the sum on deposit in a bank for 3 months, when the payment is due. This way the importer avoids the risk. § The cost of insuring against the foreign exchange risk is the positive difference between the interest rate he pays on the loan and the interest rate he earns on his deposit. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

§ An exporter exports $100, 000 goods. The exporter who expects the rate to go down could also borrow the $100, 000 (in foreign exchange) he expects to receive, exchange them into KDs, and deposit the sum in a bank for 3 month. After 3 months, he will repay the loan using the payment he receives. § The cost of avoiding the risk is the difference between the borrowing and deposit interest rate. § The problem with coverage of exchange risk in the spot market is that the exporter (importer) has to tie his funds for three months. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

B- In the forward market § The importer could buy the $100, 000 forward for delivery in three months at today’s 3 month forward rate. § If e. g. , the 3 month forward premium is 4%, he would have to pay ((100000 +(100000 × 0. 04)/4) = $101000. § The exporter could also sell his $ 100, 000 forward for delivery in 3 months. If e. g. , the 3 month forward discount is 4%, the exporter will get only $ 99 000. C- In the futures or options market. § Another alternative for the importer is to buy an option to purchase the amount in three month at option and pay now the premium 1% (KD 300) on the $100 000 option. If the 3 month spot rate is 0. 296/1. The importer could let the option expires unexercised and get the $100 000 at a cost of KD 29600 on the spot market. The 300 premium can be considered as the insurance policy and the importer will save KD 100 over the forward contract. § The option contract is better here than the forward contract Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

§ Ability of traders and investors to hedge greatly facilitates the international flow of trade and investments. § Note that multinationals have to make and receive a large number of transactions need only to hedge their net open position. § Similarly banks have an open position only in the net balance of contracted future payments and receipts in each foreign currency at each future date. Speculation § Opposite of hedging. A speculator accepts and even seeks out a foreign exchange risk, or an open position in the hope of making a profit. § A speculator can make profit or incurs a loss. § Speculation can take place in spot, forward, futures and option markets. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

A- Speculation in the spot market If a currency is believed to rise in three months, the speculator will § buy the currency at the spot rate now. § deposit the currency in a bank § In the future if the rate is higher, he will sell it at the spot rate and earns profit. If a currency is believed to fall in three months, the speculator will: § borrow the currency and exchange it for domestic currency at the spot rate, § deposit the domestic currency in a bank for three months. § After three months, if the rate is lower, he will purchase the currency at the sport rate and repay the loan. Note: For a speculation to be profitable, the difference between the two spot rates should be higher than the difference between the interest rates on the domestic and foreign currency Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

B- Speculation In the forward and options market § The problem with speculation in the spot market is that the speculator has to tie his funds or to borrow to speculate. To avoid this speculation takes place in the forward market. Speculation in the forward market If a currency is believed e. g. , to be higher than its present forward rate in three months, the speculator will: § Buy the currency forward for delivery in three months. § After three months he receives the foreign currency at the lower agreed upon (forward) rate and sells it immediately in the spot market. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

§ Speculation in the options market As an alternative, if the speculator believes that a currency will depreciate (e. g. , the dollar to fall form KD 0. 300 (current forward rate) to KD 0. 295) in three months, he could: § purchase an option to sell a specific amount of the currency in three months at KD 0. 300. § If the speculator was right (after 3 months the spot rate is KD 0. 295), he will exercise the option to make a profit of KD 0. 005 for each dollar). § If the speculator is wrong, he will let the option expire unexercised and incurs only the option’s price. § Long position: if a speculator purchase a foreign currency in the expectation of reselling it at a higher future spot rate. § Short position: if the speculator borrows or sells forward a currency on the expectation of buying it at a future lower rate to repay a foreign exchange loan or honor a forward sale contract or option. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

Stabilizing speculation: § Refers to the purchase of a foreign currency when the domestic price of it falls, on the expectation that it will rise thus leading to a profit. Or the sale of a currency when its rate rises in the expectation that it will soon fall. (i. e. in opposite direction) § Stabilizing expectations moderates fluctuations in exchange rates over time and performs a useful function Destabilizing speculation: § Refers to the sale of a foreign currency when the exchange rate falls in the expectation that it will fall even more in the future. Or purchase a currency when its rate is rising on the expectation that it will rise even more in the future. (i. e. in the same direction) § Destabilizing speculation magnifies exchange rate fluctuations and can disrupt international flow of trade and investment. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

Other speculation tactics. § Any one who have to make payments in a foreign currency in the future can speculate by speeding up his payments if he expects the currency to rise, or delaying his payments if expects the currency to fall. For example an importer expects exchange rate to rise he can place an order to pay for imports right away (leads). On the other hand, the exporter who expects the foreign exchange to rise will want to delay deliveries and extend longer credit terms to delay payments (lags) Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

Interest arbitrage and efficiency of foreign exchange markets Uncovered interest arbitrage § Suppose that interest rate on 3 month T. B is 6% in New York and 8% in Frankfurt. § The American investor may want to exchange $ for € and purchase EMU TBs, to earn an extra 2%. When the TBs matures the investor exchange back his euros plus interest into dollars. By that time the euro may have depreciated so that he would get fewer dollars than he paid. If the euro depreciates by more than 2% the investor loses. (if the euro appreciates he would get an extra gain from the appreciation of the euro) (this is an uncovered interest arbitrage) Covered interest arbitrage § Investors of short term funds abroad generally want to avoid the foreign exchange risk by covering interest arbitrage. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

§ To do this the investor sells forward the amount of foreign exchange he invested plus interest with the maturity of the investment. § Covered interest arbitrage: refers to the spot purchase of the foreign currency to make the investment and the offsetting simultaneous forward sale of it (swap) to cover the risk. § Since the currency with the higher interest rate is usually at a forward discount (why? ), the net return on investment is roughly the interest differential minus the forward discount. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

covered interest rate arbitrage parity (CIAP). § As covered interest arbitrage continues, the possibility of gains diminishes until it is completely wiped out. This occurs for two reasons: 1. As funds transferred from New York to Frankfurt, the interest rate rises in New York and falls in Frankfurt. Interest differentials diminish. 2. The purchase of euros in the spot market increases the rate and the sale of euro in the forward market reduces the forward rate. The forward discount on the euro rises. - Both reasons cause the net gain to fall until it becomes zero. Then the euro is said to be at covered interest rate arbitrage parity (CIAP). The interest differential in favor of the foreign monetary center is equal to the forward discount on the foreign currency. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

Covered interest arbitrage parity § Look at figure 5, where i = the domestic interest rate and i*= the foreign one. § The vertical axis is interest rate differentials. Negative values indicates that foreign interest rate is higher than the domestic one, and positive indicates that the foreign interest is less than the domestic one. § The horizontal axis measures the forward discount (-) or forward premium (+). § The solid diagonal line indicates all points of covered interest arbitrage parity (CIAP), i. e. , (i-i*=FD) Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

§ At CIAP line, when (i-i*)=-1, the foreign currency is at a forward discount of 1% a year, and a positive differential of 1 indicates a forward premium of 1%, finally when the interest differential is zero, there is neither a forward discount nor a forward premium. § Below the CIAP line, either the negative interest differentials (in favor of the foreign currency) exceeds the forward discount on the foreign currency, or forward premium exceeds the positive interest differentials. In either case there will be a net gain from covered interest arbitrage (CIA) outflow, e. g. , point A. where interest differential is 2, in favor of the foreign currency, while the forward discount is 1% CIA margin is 1% in favor of the foreign nation leading to capital outflow. Similarly point A’ involves a forward premium of 2% on the foreign currency and a positive interest differential of only 1% in favor of the domestic currency investors have an incentive to invest abroad. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

Note CIA ends up here before reaching the CIA line In favor of the nation i-i* = FD (FP) No CIA At B: i-i*>FP -ve CIA At A’: i-i*<FP +ve CIA At B’: i- i*<FD -ve CIA In favor of the foreign nation At A: i-i*>FD +ve CIA Figure 5 Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

§ As arbitrage outflow continues, the net gain diminishes and tends to disappear. Starting from A, the transfer of funds reduces interest differentials in favor of the foreign currency, and increases forward discount on it (e. g. , from 1 – 1. 5), and reduces the premium (say from 2 to 1. 5) so as to reach again the CIAP line. § Above the interest parity line, either the positive interest differential exceeds the forward premium on the foreign currency (point B) or the negative interest differential is smaller than the forward discount on the foreign currency (point B’). In both cases it pays off foreigners to invest in our country an arbitrage inflow. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

§ As arbitrage continues, the gain diminishes and then disappears when the CIAP is reached. § Note that in reality interest arbitrage will come to an end when the net gain reaches about ¼ of 1% a year (white area between dashed line and the diagonal). Covered interest arbitrage margin § CIAP line indicates either that the negative interest differential (in favor of the foreign center) equals the forward discount FD on the foreign currency, or the positive interest differentials (in favor of the domestic center) equals the forward premium FP on the foreign currency, i. e. , Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

i-i* = FD if or; CIAP i-i* = FP § But since FD(FP) = (FR-SR)/SR measures the FD if SR>FR or the FP if SR<FR, the foregoing condition for CIAP can be written as: i-i* = (FR-SR)/SR § The covered interest arbitrage margin CIAM or the margin gain from covered interest arbitrage can be written as CIAM =(i-i*)-FD or FP § More precisely as: CIAM = (i-i*) / (1+i*) – (FR-SR)/SR Where(1+i*) is a weighting factor. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

Example: § If the interest rate on a three month TB is 6% in New York (on an annual basis), and 8% in Frankfurt. § The spot rate of the € is $1/ € 1. § The three month forward rate is $. 99/€ 1 on an annual basis. CIAM = (0. 06 -0. 08)/(1+0. 08)-(0. 99 -1)/1 = (-. 02)/1. 08 -(-. 01)/1 = -. 01852+. 01 = -. 00852 (per year) § The negative sign (in favor of the foreign center) refers to a CIA outflow or investing in Frankfurt. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

§ The extra return per dollar invested in Frankfurt is. 852% per year or. 213% per quarter, i. e. , for a $ 10 million invested in Frankfurt, means an extra return of $21300 for investing in three month EMU TB with the foreign exchange risk covered. § Deduct from that the transactions costs. If these are ¼ % a year (i. e. , 1/16 % per quarter), i. e. 1/16 of 1% i. e. , 0. 000620 times the $10 million which is $6250. § The net gain = $21300 - $6250 = $15050 for three months Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

§ In reality Covered interest arbitrage margins are sometimes observed, not because the covered interest arbitrage does not work, but it may be due to other forces. For example: 1. High tax rate abroad may exceed the CIAM in favor of the foreign monetary center so that no arbitrage outflows takes place 2. Investors may not take advantage of a CIAM in favor of a foreign monetary center if they fear that the foreign government might default or impose restriction on foreign capital repatriation. 3. Large and persistent CIAM may exist because of lack of information on foreign investment opportunities in LDCs’ financial market. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

Efficiency of foreign exchange markets § In general a market is efficient if it reflects all available information. § A foreign exchange market is efficient if forward rates accurately predict the future spot rates. § If forward rates reflect all available information and quickly adjust to any new information so that investors can not earn consistent and unusual profits by utilizing any available information, then the market is efficient. § Tests of efficiency are difficult to formulate and interpret. Economics of International Finance Prof. M. El-Saqqa CBA. Kuwait University

Key Terms Appreciation Covered interest arbitrage parity (CIAP) Currency swaps Destabilizing speculation Efficiency of foreign exchange markets Foreign exchange futures Foreign exchange options Forward discount Offshore deposits Hedging Speculation Stabilizing speculation Vehicle currency Economics of International Finance Arbitrage Covered interest arbitrage margin (CIAM) Cross Exchange rate Depreciation Effective exchange rate Exchange rate Foreign exchange market Foreign exchange risk Forward premium Forward rate Interest arbitrage Spot rate Uncovered interest arbitrage Prof. M. El-Saqqa CBA. Kuwait University