International economics 6th edition phần 7 pps

If, for example, a country’s local rate of inflation was 8 percent whereas its trading partners had only 3percent inflation, a fixed nominal effective exchange rate would imply a 5 percent

Pakistanis employed in the United Kingdom who need to send money to their families Theyearn sterling, but their families want rupees If there are people in Pakistan with rupees whowant sterling in the United Kingdom, the possibilities for an informal exchange systembecome apparent Participants in the system gather sterling from the workers in the London,and promise to deliver rupees to their families in Karachi The rupees of those desiring to getmoney out of Pakistan are used to pay the families, and the sterling gathered in Londonbecomes available to them for whatever use they prefer.

All that is required is a communications route making it possible for those in Karachi

to know which families are to be paid how many rupees That might be done in coded form

by phone, email, or courier If the communications mechanism can be kept confidential and the exchange process in London and Karachi informal, there is no obvious way for the Pakistani or the British government to know what is going on Hawala banking is notonly a way to evade exchange controls, but is widely believed to be used by criminalenterprises and by terrorists to move funds from the Middle East and South Asia to indus-trialized countries September 11 greatly increased the attention given to hawala banking

by the US and European governments, and a few such operations have reportedly beenclosed

The attractions of a regulated exchange market for a developing country facing paymentsdeficits are obvious, but the record of such control systems is poor Enforcement is difficultand frequently produces a decline in respect for law Increasing volumes of export receipts(particularly from remittances and tourism) are diverted to an illegal market, so the avail-ability of foreign exchange for important purposes stagnates or declines Economics is abouthow rational economic agents maximize their self-interest, which means that it is aboutavarice and ingenuity Few situations bring out the unattractive aspects of such maximizingbehavior more quickly than a system of foreign exchange market controls that denies peoplethe opportunity to purchase foreign exchange legally, thereby driving them to illegalalternatives Such systems almost guarantee widespread lawbreaking and thereby underminerespect for the legal system Despite the arguments of economists and a poor historicalrecord, these systems of exchange market controls remain common in the developing world

It ought to be noted that not just hawala banking, but all of the techniques for evadingforeign exchange controls discussed above, are useful for criminals or terrorists seeking tomove funds in forms that are difficult to trace in order to finance their activities SinceSeptember 11, 2001 law enforcement agencies in many countries have become far moreinterested in finding ways to trace, and to stop, such transfers This will not be an easy task

Exchange market intervention with floating exchange rates

In theory, a flexible exchange rate system means that no central bank intervenes in theexchange market and that rates are determined the way prices of common stocks are settled:through shifts in supply and demand without official stabilization In a clean or pure float,the exchange rate rises and falls with shifts in international payments flows, and theseexchange rate movements keep the balance of payments in constant equilibrium (i.e theofficial reserve transactions balance = 0) If the balance of payments and the exchangemarket were in equilibrium when a large surge of imports occurred, the local currency woulddepreciate to a level at which offsetting transactions were encouraged and the market againcleared, which is analogous to what happens to the price of General Motors stock if a suddenwave of selling hits the market The price falls until enough buyers are attracted to clear themarket In a clean float, the exchange market operates in the same way, but countries do not

13 – Markets for foreign exchange 299

maintain clean floats Large or rapid exchange rate movements are seen as so disruptive thatcentral banks instead operate dirty or managed flexible exchange rates.

There is no defense of a fixed parity, but instead discretionary intervention takes placewhenever the market is moving in a direction or at a speed that the central bank orgovernment wishes to avoid If, for example, the yen were depreciating beyond the wishes

of Tokyo, the Bank of Japan would purchase yen and sell foreign currencies in an attempt

to slow that movement Such purchases might be coordinated with similar actions by centralbanks in Europe and North America, creating a stronger effect on the market Since the mid-1980s such intervention has increased, and more of it is being coordinated among the centralbanks of the major industrialized countries

Many economists remain skeptical that such intervention can have more than temporaryeffects on exchange rates unless it is accompanied by changes in national monetary policies.Purchases of yen by the Bank of Japan may temporarily slow a depreciation, but a reduction

in the total yen money supply, that is, a tighter Japanese monetary policy, would have a morelasting impact Despite such doubts among economists, the central banks of countries withflexible exchange rates have become more active in exchange markets in recent years Theresult seems to be some reduction in exchange rate volatility.4

Exchange market institutions

The foreign exchange market is maintained by major commercial banks in financial centerssuch as New York, London, Frankfurt, Singapore, and Tokyo It is not like the New YorkStock Exchange where trading occurs at a single location, but instead it is a “telephonemarket” in which traders are located in the various banks and trade electronically Althoughtrading occurs in other cities, the vast majority of the US market is in New York, where

it includes New York banks, foreign banks with US subsidiaries or branches, and banks fromother states that are allowed to do only international banking in New York The bankstypically maintain trading rooms that are staffed by at least one trader for each majorcurrency.5

Orders come to the traders from large businesses that have established ties to that bankand from smaller banks around the country that have a correspondent banking relationshipwith that institution The banks maintain inventories of each of the currencies which theytrade in the form of deposits at foreign banks If, for example, Citibank purchases yen from

a customer, those funds will be placed in its account in Tokyo, and sales of yen by Citibankwill come out of that account Because these inventories rise and fall as trading proceeds,the banks take risks by frequently having net exposures in various currencies If, for example,Citibank has sold yen heavily and consequently retains yen assets that are less than yen

liabilities, the bank will have a short position in yen, and will lose if the yen appreciates

and gain if it falls Some banks try to impose strict limitations on such exposure by buyingcurrencies to offset any emerging short or long positions, whereas others view such exposure

as a way to seek speculative profits

Currencies such as the Canadian dollar or the euro would normally be quoted inhundredths of a cent or basis points, with bid-asked spreads usually being about five basispoints or one-twentieth of a cent for large transactions The Canadian dollar, for example,might be quoted at 64.42–47 US cents, meaning that the banks are prepared to purchase itfor 64.42 cents or sell it for 64.47 cents Before the advent of flexible exchange rates in the early 1970s, bid-asked spreads were narrower, because exchange rate volatility and riskwere smaller The spreads widened to about ten basis points in the 1970s and narrowed to

300 International economics

the current range of about five points in the 1980s Spreads are sometimes narrower for sets

of currencies that are very heavily traded and for which the bilateral exchange rate has beenparticularly stable

These narrow spreads are for very large transactions for banks’ best customers, and theywiden when that circumstance does not prevail When tourists exchange money at airportbanks or similar institutions, the spreads are much wider because the institutions need tocover their costs and make a profit on small transactions.6

The spread of about five basis points also operates in what is known as the “interbankmarket,” in which the banks trade among themselves If, for example, Chase Manhattan hadbought a large volume of Canadian dollars over a period of a few minutes and the traders

became uncomfortable with the resulting long position, they would sell the excess Canadian

funds in the interbank market, perhaps using a broker as an intermediary or perhaps dealingdirectly with another bank to save a brokerage fee Information on interbank rates andspreads is provided electronically, primarily by Reuters, which supplies television monitorswith the current rates for the major currencies Reuters gathers information on current tradesand on the willingness of banks to trade various currencies The resulting spreads appear

on its screens both in the major banks and in major industrial firms that have extensiveinternational business dealings As a result, everyone in the market should have the sameinformation as to what rates are available Bank traders have said, however, that Reuters and competing services can sometimes lag the market by 30 to 45 seconds when trading isparticularly active, and that trading with customers at “screen rates” can therefore becomerisky In such situations, traders are often in direct phone contact with other trading rooms

to try to find out what the most current rates are

Reduced cost and increased speed for international communications mean that duringoverlapping business hours, the European and New York markets are really a single market.Early in the day, New York banks can trade as easily in London or Frankfurt as in New York.Thus differences in exchange rates among these cities are arbitraged away almost instantly.Chicago and San Francisco continue trading after New York, and then Tokyo and HongKong open for business, so trading is going on somewhere in the world around the clock.Some New York banks are reportedly maintaining two shifts of traders, with one grouparriving at 3 a.m when London and Frankfurt open and the other group trading very late atnight until Tokyo opens The large New York banks have branches or subsidiaries in Tokyo,Frankfurt, and London; therefore these banks are trading somewhere all the time duringbusiness days

Foreign exchange transactions in the spot market are typically completed or cleared with

a 2-day lag, so that transactions agreed to on Monday will result in payments being made

on Wednesday This lag is partially the result of differences in time zones and is required toallow paperwork to be completed Canadian/US dollar business is normally cleared in 1 daybecause New York and Toronto are in the same time zone

Payment is made by electronic transfer through a “cable transfer,” which is simply an

electronic message to a bank instructing it to transfer funds from one account to another If,for example, General Motors bought DM 2 million from Chase Manhattan on Tuesday,Chase would send such a cable transfer to its subsidiary or branch instructing it to transferthe funds from its account to that of General Motors on Thursday, and General Motorswould transfer the required amount of dollars from its US account to Chase Manhattan Thetransaction that had been arranged on Tuesday would then be complete For the majorindustrialized countries, the cable transfers are handled through a system known as the

Society for Worldwide Interbank Financial Telecommunications (SWIFT), which began

13 – Markets for foreign exchange 301

operations in 1987 The electronic system through which foreign exchange transfers are

made in New York is known as the Clearing House International Payments System (CHIPS), which was reportedly handling over $600 billion per day in the late 1990s, much

of which was for trades made outside the United States Worldwide foreign exchange tradingwas about $1,200 billion per day in 2002, with well in excess of 90 percent of the tradingbeing for capital rather than current account transactions Although most foreign exchangetrading involves the dollar, London remains the largest foreign exchange market at about

$500 billion per day, followed by New York ($250 billion), Tokyo ($150 billion), andSingapore ($140 billion)

The revolution that the Internet has introduced to common stock trading in the UnitedStates is beginning to extend to the foreign exchange market Internet trading in foreignexchange has begun, and is expected to grow rapidly at the expense of the trading rooms

in the large commercial banks Internet and other electronic trading systems are particularlyattractive for relatively small transactions, where bid/asked spreads are wider than thosedescribed above for large transactions Some market participants expect 50 percent of foreignexchange transactions to be done without the involvement of a commercial bank tradingroom within a few years

The major commercial banks have recently created a new transactions clearing systemwhich will reduce or eliminate default risks in the case of a bank failure This problem canarise because European banks are operating 6 hours ahead of US banks, so a transaction may

be completed in Europe before New York is open for business This means that a few hourshave existed in which one half of the transaction is complete and the other is not When

a German bank, Herstatt, failed in 1974, a number of other commercial banks absorbedlosses on transactions with Herstatt which were only half completed The new system,operating under the name CLS (Continuous Linked Settlement) Bank first nets out trans-actions in the opposite between pairs of banks, so that only one net payment is made It thenschedules such payments during hours when both banks are open for the booking of trans-actions The netting out of opposite transactions greatly reduces the volume of payments to

be made For one day in October 2002, for example, the gross transactions were $395 billion,but only $17 billion in net payments had to be made

Alternative definitions of exchange rates

In the past, exchange rates were measured only bilaterally and as the local price of foreignmoney The US exchange rate in terms of sterling might be $1.65 or whatever This practicehad two disadvantages: (1) it did not provide any way of measuring the average exchangerate for a currency relative to a number of its major trading partners; and (2) it meant that

if a currency fell in value or depreciated, its exchange rate would rise A decline of the dollarwould mean an increased US cost of purchasing sterling and an increase in the US exchangerate Because this practice was found to be confusing, informal usage has now changed

An exchange rate now means the foreign price of the currency in question, or the number

of foreign currency units required to purchase the currency in question The exchange ratefor the US dollar in terms of sterling might be 0.6042 That is, just over one-half of a pound

is required to purchase a dollar The newspaper table shown in Exhibit 13.1 presents bilateralexchange rates in both forms With the new usage, reading that the exchange rate for the dollar fell tells us that the dollar declined in value relative to foreign currencies Thusless foreign money is required to purchase a dollar, but more US money is needed to buyforeign currencies

302 International economics

The nominal effective exchange rate

We still have to resolve the problem of how to measure the exchange rate for the dollarrelative to the currencies of a number of countries with which the United States tradesextensively The nominal effective exchange rate is an index number of the weightedaverage of bilateral exchange rates for a number of countries, where trade shares are typicallyused as the weights An effective exchange rate might be calculated for the dollar, forexample, using January 1973 as the base, by calculating how much the dollar had risen

or fallen since that time relative to the currencies of a number of other countries, as can beseen in Figure 13.2 If 20 percent of US trade with that group was carried on with Canada,the Canadian dollar would get a 20 percent weight in that average; if 8 percent of that tradewas with the UK, then sterling would get an 8 percent weight Either US or world tradeshares could be used as weights, and published indices sometimes appear in both forms UStrade shares would give the Canadian dollar the largest weight, whereas world trade shareswould put the euro or the yen in that position

13 – Markets for foreign exchange 303

EXHIBIT 13.1 EXCHANGE RATES

Source: The Wall Street Journal Republished by permission of Dow Jones, Inc via Copyright Clearance Center, Inc.

© 2003

Effective exchange rate indices can sometimes give an incomplete image of a currency’sbehavior if too few foreign currencies are included Some of the early effective exchange rateindices for the dollar, for example, only included nine currencies of major industrializedcountries Although the majority of US trade is still with those countries, the role of anumber of developing countries, particularly the NICs, has grown rapidly A moderatelyrepresentative index for the dollar would now have to include the currencies of China, SouthKorea, Taiwan, Hong Kong, Mexico, and Brazil, and an ideal index would include everycountry with which the United States has significant trade

The real effective exchange rate

In the latter part of the twentieth century a new exchange rate index was developed whichwas designed to measure changes in a country’s cost or price competitiveness in worldmarkets Such an index would begin with the nominal effective exchange rate but would beadjusted for inflation in the domestic economy and in the rest of the world If, for example,

a country’s local rate of inflation was 8 percent whereas its trading partners had only 3percent inflation, a fixed nominal effective exchange rate would imply a 5 percent realappreciation of its currency and a deterioration of its competitive position in world markets

of that amount If the currency depreciated by 5 percent in nominal terms, just offsetting thedifference in rates of inflation, the competitive position of the country would remain

unchanged The index of the real effective exchange rate is constructed as follows:

XRn⫻ Pdom

XRr=

Prowwhere XRris the real effective exchange rate; XRnis the nominal effective exchange rate,

measured as the foreign price of local money; P is the domestic price level, usually

Figure 13.2 Nominal effective exchange rate for the dollar (1970–2003) The dollar experienced an

enormous appreciation between 1981 and early 1985, followed by a slightly largerdepreciation in the 1985–7 period It traded in a narrow range through the early 1990s,and appreciated modestly late in the decade and at the beginning of the next decade,before declining moderately during 2002

Source: Morgan Guaranty Trust Company of New York and the IMF, International Financial Statistics.

EXHIBIT 13.2 REAL EFFECTIVE EXCHANGE RATE INDICES Source

measured as consumer or wholesale prices Unit labor costs may be used as an alternative to

wholesale prices; Prowis the price level for the rest of the world, using the country’s majortrading partners as a proxy Trade shares are used as weights Unit labor costs may be used

as an alternative to the price level

If the real exchange rate (XRr) rises, the country’s cost-competitive position has rated because it has experienced more inflation than its trading partners after allowance forchanges in the nominal exchange rate Such a deterioration implies greater difficulty inselling exports and an increased volume of imports Real exchange rate indices, calculatedusing prices and unit labor costs, can be found in the IMF, International Financial StatisticsYearbook (See Exhibit 13.2.)

deterio-306 International economics

Box 13.1 The Big Mac index

An amusing but insightful attempt to determine the extent to which market exchange

rates misvalue currencies has been provided by The Economist magazine in the form of

its Big Mac index A problem in determining misvaluation has always been to find abasket of the same goods and services that are consumed in both, or all, countries

through which to make the purchasing power parity comparison The Economist begins

by assuming that McDonald’s sees to it that its Big Mac sandwich is exactly the same

in all countries in which it is sold, and then allows the Big Mac to be its universal goodfor the purposes of determining under- or overvaluations of currencies relative to thedollar

It is important that the raw materials and labor used for producing a Big Mac arelocally produced, making a Big Mac a nontradable good If the product being used forprice comparison were a tradable, prices would be much more likely to be the same, or

at least close to the same, in various countries despite many currencies being over or

undervalued Using a nontradable good for the comparison means that The Economist

really is comparing the relative costs of doing business in each country through currentexchange rates Translating local currency prices of a Big Mac into dollars at the marketexchange rate and comparing them to the average price of a Big Mac in the UnitedStates leads to the conclusion that, as of the end of 2002, most currencies were

undervalued relative to the dollar, that is, that the dollar was overvalued (See The Economist, January 18, 2003, p 98.) A few currencies, however, were overvalued,

relative to the dollar The Swiss franc was the most overvalued, at 72 percent, followed

by Sweden (31 percent, the United Kingdom (20 percent), and the euro area (8percent) More currencies were undervalued, including Argentina (55 percent), all ofthe 1997–9 Asian debt crisis countries except South Korea, Russia (52 percent), China

(55 percent), and Japan (16 percent) In the past The Economist has suggested that the

Big Mac index has produced useful information as to how exchange rates are likely tomove in the short- to medium-term future, with undervalued currencies rising relative

to the dollar, and overvalued currencies falling, but no data were provided to support

this conclusion The dollar, which The Economist said was badly overvalued in early

2002 according to this index, did depreciate from spring 2002 to the end of the yearand during the first half of 2003

An alternative definition of the real effective exchange rate is the ratio of the domesticprice of nontradable goods and services to the domestic price of tradables; that is:

PNT

PT

These two definitions of the real effective exchange rate look entirely different, but thesecond can be derived from the first with a few assumptions.7The common sense of thesecond definition of the real exchange rate is that when this ratio is too high domestic firmsare encouraged to produce nontradables rather than tradables, whereas domestic consumersare encouraged to consume tradables rather than nontradables, thereby generating a tradedeficit

Different elements within the consumer price index are sometimes used as proxies for theprices of nontradables and tradables for the purpose of estimating the real effective exchangerate; services are used for non-tradables and goods are used for tradables The wage rate might

be used as the price of non-tradables, or an index of unit labor costs might be even better.Unit labor cost over the price of goods provides a clear index of the competitiveness of thiseconomy as a place to produce for international markets; if that index rises, the countrybecomes an increasingly unattractive location for manufacturing, and vice versa

Alternative views of equilibrium nominal exchange rates

Economists have had a variety of opinions as to how nominal exchange rates are determined,

and the oldest of those views is implicit in the index of a real exchange rate The purchasing power parity (PPP) view is that nominal rates should move to just offset differing rates of

inflation, that is, that the real exchange rate ought to be constant.8In a regime of floatingexchange rates it was widely expected that the workings of the exchange market wouldproduce that result, in that nominal exchange rates would naturally follow differences inrates of inflation That has not been the case since 1973, and changes in real exchange rateswere quite large during the 1980s but were somewhat smaller in the 1990s.9The US dollarappreciated by approximately 40 percent in real terms between 1981 and 1985, and thendepreciated by a similar amount in the following four years Some developing countries havehad modest success with a “purchasing power parity crawl” in that they have adjustedotherwise fixed exchange rates by small amounts every month or so to offset the differencebetween local and foreign inflation If, for example, Brazil was experiencing 40 percentinflation when the rest of the world had 4 percent inflation, a 3 percent devaluation of thereal per month would maintain the ability of Brazilian firms to compete in world markets.The purchasing power parity view of equilibrium exchange rates is entirely tied tointernational trade in that it makes no allowance for capital account transactions asdeterminants of the exchange rate In recent years exchange rates for the industrializedcountries have frequently been modeled in an “asset market” context.10Since capital flowtransactions have increasingly dominated the exchange markets in such countries, theequilibrium exchange rate is that which allows international markets for financial assets toclear Borrowers and lenders are assumed to operate in both domestic and local markets, andtherefore to move funds through the exchange market The exchange rate then becomes anelement in supply and demand functions for such assets, and the equilibrium exchange rate

is determined by the clearing of these financial markets This approach has the problem of

13 – Markets for foreign exchange 307

ignoring trade Although a majority of exchange market transactions is for capital accounts,

it does seem a bit extreme to determine an equilibrium exchange rate without reference todiffering rates of inflation or other factors affecting trade flows

Finally, there is the somewhat tautological view that the equilibrium exchange rate is thatwhich produces a zero official reserve transactions account balance It is therefore the ratethat would be observed in a regime of clean floating exchange rates Such a view implieslittle permanence and instead a great deal of volatility Large swings in short-term capitalflows, in part driven by speculation, have produced large and frequently reversed changes inexchange rates during recent years This approach therefore implies that the equilibriumexchange rate is likely to change from one month to another for reasons as ephemeral asspeculative moods As will be seen in Chapter 20, econometric attempts to explain short-

to medium-term movements of floating exchange rates on the basis of economic or financialfundamentals, including purchasing power parity, have met with a decided lack of success

Summary of key concepts

1 Minus transactions in a country’s balance of payments accounts generate a domesticdemand for foreign exchange, and vice versa The exchange market is the institutionalarrangement in which these supplies and demands are accommodated

2 If private transactions are out of balance, the exchange market can clear only throughofficial intervention, which is normally carried out by the central bank A paymentsdeficit requires that the central bank sell foreign exchange, thereby reducing its foreignexchange reserves, and buy its own currency in the exchange market

3 Many developing countries try to protect scarce foreign exchange reserves from lossesthrough such intervention by maintaining systems of exchange market control,particularly seeking to prohibit capital outflows from the country Such control systemsseldom succeed for long, because there are numerous ways to cheat on them, transferpricing perhaps being the most important

4 Although theoretically unnecessary, official intervention is quite common for countriesthat maintain floating exchange rates, with such intervention typically intended toproduce a less volatile exchange rate than would otherwise exist

5 The nominal effective exchange rate is a trade-weighted average of bilateral rates Thereal effective exchange rate is the nominal effective rate, adjusted for inflation in thehome country and abroad It is therefore an index of this country’s price and costcompetitiveness in world markets

308 International economics

Suggested further reading

• Aliber, Robert, The New International Money Game, 6th edn, Chicago: University of

Chicago Press, 2002

• Broadus, J and M Goodfriend, “Foreign Exchange Operations and the Federal Reserve,”

Federal Reserve Bank of Richmond Quarterly, Winter 1996, pp 1–19.

• Campbell, T., and J O’Brien, “Foreign Exchange Trading Practices: The Interbank

Market,” in A George and I Giddy, eds, International Finance Handbook, New York: John

Wiley & Sons, 1983

• Chrystal, K Alec, “A Guide to Foreign Exchange Markets,” Federal Reserve Bank of St Louis Review, March 1984, pp 5–18.

• Giddy, I., Global Financial Markets, Lexington, MA: D.C Heath, 1994

• Kubarych, Roger M., Foreign Exchange Markets in the United States, rev edn, Federal

Reserve Bank of New York, 1983

• Pauls, B Diane, “US Exchange Rate Policy: Bretton Woods to Present,” Federal Reserve Bulletin, November 1990, pp 891–908.

• Poniachek, Harvey, ed., Cases in International Finance, New York: John Wiley & Sons,

13 – Markets for foreign exchange 309

Questions for study and review

1 Where does one look in a nation’s balance of payments for items that give rise to

a demand for foreign exchange? For a supply of foreign exchange?

2 When a nation chooses to peg its currency at a give exchange rate vis-à-vis another

currency, what exactly must its central bank do if a gold standard exists? Under theBretton Woods system?

3 Explain how the elasticity of demand for foreign exchange is influenced by theelasticity of home demand for imports and by the elasticity of home supply ofimport-competing goods

4 Malaysia has just imposed exchange controls which are designed to make itimpossible to move capital out of the country What would you expect to happen

to Malaysia’s recorded current account results in the next year or so? Why?

5 If you are working in a developing country and only have access to local data, howwould you estimate a “rough and ready” version of a real effective exchange ratetime series for this country?

6 If the gold standard were again operating, why would you expect the “gold points”

to be wider for the sterling/yen exchange rate than for the sterling/euro rate? Ifsilver were substituted for gold in this fixed exchange rate regime, what wouldhappen to the band within which exchange rates could move? Why?

1 For a discussion of gold points, see Leland Yeager, International Monetary Relations: Theory and

Policy, 2nd edn (New York: Harper and Row, 1976), pp 20–1 and 317–18.

2 An extensive discussion of the Bretton Woods intervention system can be found in Yeager, op

cit., chs 20 and 21 See also Robert Solomon, The International Monetary System: 1945–1976: An

Insider’s View (New York: Harper and Row, 1977), chs 5–7, for a discussion of the problems which

the Bretton Woods system faced during the late 1960s See also B Diane Pauls, “US Exchange

Rate Policy: Bretton Woods to Present,” Federal Reserve Bulletin, November 1990, pp 891–908.

3 The problems of such exchange control regimes are discussed in J.N Bhagwati, The Anatomy and

Consequences of Exchange Control Regimes (Cambridge, MA: Ballinger, 1978) See Dunn, R.M.

“The Misguided Attractions of Foreign Exchange Controls,” Challenge, Sept./Oct 2002, pp 98–111 See IMF, Annual Report on Exchange Arrangements and Exchange Controls (Washington,

DC: IMF), for information on practices being maintained by various countries

4 For a discussion of official intervention in a regime of flexible exchange rates, see K Dominguez

and J Frankel, Does Foreign Exchange Market Intervention Work? (Washington, DC: Institute for

International Economics, 1993) See also R Dunn, Jr., “The Many Disappointments of Flexible

Exchange Rates,” Princeton Essays in International Finance, no 154, December 1983, pp 13–15.

5 The institutional arrangements through which foreign exchange is traded are covered in M

Melvin, International Money and Finance (New York: Harper and Row, 1989), and in R Kubarych,

Foreign Exchange Markets in the United States (New York: Federal Reserve Bank of New York, 1983).

See also, K.A Chrystal, “A Guide to Foreign Exchange Markets,” Federal Reserve Bank of St Louis

Review, March 1984, pp 4–18 For a discussion of recent developments in foreign exchange

trading, see The Financial Times, June 5, 1998, special survey on foreign exchange See also “Do It Yourself Forex Deals,” The Financial Times, July 9, 1998, p 8.

6 Purchasing a local currency for dollars at an airport “bank” or other money exchange can beextremely expensive and the costs are often unclear to customers The exchange office may offer

an attractive exchange rate in large letters, but then place a notice in very small letters at thebottom of the sign which states the commission, which can be as high as 9.75 percent You willgenerally get better rates at a commercial bank, but that is of little help on weekends or at night

If you are registered at a hotel, it may be possible to change money there without a commission,but often at a very unattractive exchange rate It is a good idea to ask what the commission isbefore handing over your traveler’s check or cash Credit card transactions are usually processedwithin a percentage point or two of the interbank rate, which can save you considerable amounts

of money ATM machines also process transactions at, or close to, the interbank rate, usually with

a fixed fee of about $2.50 per transaction Using credit cards for most costs and ATM cards for cashneeds (keeping each ATM transaction fairly large) can minimize costs, although you may want tocheck with your bank and credit card company before traveling to find out exactly how close tothe interbank rate your transactions will be processed See Robert M Dunn, Jr., “Retail Foreign

Exchange Trading in Prague: Are Tourists Rational?,” Journal of Socio-Economics 26, no 5, 1997,

for a discussion of the apparently less-than-rational behavior of travelers in deciding where toexchange money

7 If perfect competition prevails in markets for tradables, the law of one price holds and the domesticprice of tradables equals the foreign price divided by the nominal exchange rate This is simply anarbitrage condition With domestic prices of tradables fixed by the nominal exchange rate and byforeign prices, the relevant price level for the measurement of domestic competitiveness is theprice of nontradables, so the following conditions hold:

Since the real effective exchange rate is:

8 The history of the purchasing power parity approach to exchange rate determination begins with

G Cassel, “Abnormal Deviations in International Exchanges,” Economic Journal, September 1918 See also B Belassa, “The Purchasing Power Parity Doctrine: A Reappraisal,” Journal of Political

Economy, December 1964, and K Froot and K Rogoff, “Perspectives on PPP and Long Run Real

Exchange Rates,” ch 32 in G Grossman and K Rogoff, eds, Handbook of International Economics,

Vol III (Amsterdam: Elsevier, 1995)

9 The failure of nominal exchange rates to follow purchasing power parity in the short-to-mediumterm is analyzed in P Kortweg, “Exchange Rate Policy, Monetary Policy, and Real Exchange RateVariability,” Princeton Essays in International Finance, no 140, December 1980, and in J Frenkel,

“The Collapse of Purchasing Power Parities in the 1970s,” European Economic Review, May 1981,

pp 145–65

10 For a discussion of the asset market approach to exchange rate determination, see W Branson,

“Asset Markets and Relative Prices in Exchange Rate Determination,” Reprints in International

Finance, 20, 1980 See also Polly Allen and Peter Kenen, Asset Markets, Exchange Rates, and Economic Integration (New York: Cambridge University Press, 1980) For a discussion of empirical

tests of alternative models of exchange rate determination, see R Levich, “Empirical Studies ofExchange Rates: Price Behavior, Rate Determination, and Market Efficiency,” in R Jones and

P Kenen, eds, Handbook of International Economics, Vol II (Amsterdam: North-Holland, 1985),

ch 19 See also J Frankel and A Rose, “Empirical Research on Nominal Exchange Rates,” in

Grossman and Rogoff, eds, Handbook of International Economics, Vol III, ch 33.

13 – Markets for foreign exchange 311

or the existence of a liability, and therefore do not typically appear on a balance sheet, butnevertheless do create the opportunity for speculative gains or losses Many domesticfinancial derivatives have become quite controversial, due to large losses being suffered onsuch contracts by hedge funds (Long Term Capital Management), nonfinancial corporations(Procter & Gamble), and even local governments (Orange County, California) in recentyears Our concern, however, is only with international derivatives, such as foreign exchangeforwards, futures, and options.

Forward exchange markets

Forward exchange markets allow the purchase or sale of foreign exchange today for delivery

and payment at a fixed date in the future Contracts typically have maturities of 30, 60, or

90 days to match payment dates for export sales and the maturities of short-term moneymarket assets such as Treasury bills, commercial paper, and certificates of deposits (CDs) If,for example, a US importer is committed to pay euro 500,000 for German exports in 90 days,

Learning objectives

By the end of this chapter you should be able to understand:

• how forward foreign exchange contracts are used to hedge risks arising from foreigntrade or investment transactions, and how these contracts can be used byspeculators;

• the interest parity theory of forward rate determination, the forward rate asexpected spot rate theory, and how the two can be reconciled;

• the difference between a forward contract and a foreign exchange futures contract;

• foreign exchange options: who buys puts or calls, who is willing to sell or writethem, and the nature of the price or premium on such contracts; the large risks thatcan result from selling or writing uncovered options;

• how the premium or price of a foreign exchange option is determined;

• circumstances in which a company would use an international interest rate swap

a forward purchase of euro is a convenient way to avoid the possibility that the currency mayappreciate over that time, which would impose higher dollar costs on the importer.

Trading in forward contracts is carried on by the same banks and traders that do the spottrading described in the previous chapter The arrangements are similar to those for spottrading, except that settlement takes place in 30, 60, or 90 days rather than in 2 days For afew major currencies trading is common at 180- and 360-day maturities, and longer contractsare sometimes done on a negotiated basis Forward contracts are binding in that someonebuying forward sterling is required to complete that purchase at maturity, even if the spotexchange rate has moved to a level that makes doing so unprofitable In contrast, a buyer

of an option, may choose to complete or not to complete the transaction, depending on howthe spot exchange rate has moved Foreign exchange options will be discussed later in thischapter Forward exchange rates for a number of currencies, along with the prevailing spotrates, can be found in Exhibit 14.1

As can be seen, forward rates frequently differ from prevailing spot rates If a currency isworth less in the forward than in the spot market, it is said to be at a “forward discount.” Aforward premium exists in the opposite situation Although those involved in these markets

on a day-to-day basis frequently quote such discounts or premiums in terms of cents,economists usually refer to annual percentages This is done to make such discounts orpremiums directly comparable to annual interest rates If, for example, sterling were trading

at $2.00 in the spot market and

at $2.01 in the 90-day forwardmarket, the premium wouldappear to be one-half percent(1/200), but that is for only

90 days or one-quarter of a year The premium measured as

an annual rate is four times half percent, which is 2 percent.The reasons for using annualrates rather than monetary units

one-to measure this premium willbecome more apparent when

we discuss the factors mining forward rates

deter-The forward market is similar

to the futures market for modities, where it is possible tobuy or sell for future delivery at

com-a price determined now Thereare, however, small differencesbetween the two types ofarrangements All futures con-tracts close on the same day

of the month, whereas forwardcontracts close a fixed number ofdays after they are signed, whichcan be any day of the month.Futures contracts are relatively

14 – International derivatives 313

EXHIBIT 14.1 EXCHANGE RATES: SPOT AND

FORWARD

Source: The Wall Street Journal Republished by permission of Dow

Jones, Inc via Copyright Clearance Center, Inc © 2003 Dow Jones

and Company, Inc All Rights Reserved Worldwide.

liquid, in that they can be resold in commodity exchanges before maturity, whereas forwardcontracts usually have to be held to maturity Although forward contracts are traded bybanks in large transactions, futures are traded in commodity exchanges such as the ChicagoBoard of Trade in smaller transactions and with sizable brokerage commissions.

A futures market for foreign currencies exists as the International Monetary Market

(IMM) in Chicago (data for which can be found in Exhibit 14.2) where trading is carried

on just as it would be for commodities such as copper or wheat It is used both to hedge risksarising from relatively small trade transactions and to provide a vehicle for speculation.1

Reasons for forward trading

The forward exchange market has three separate, but related, roles in internationalcommercial and financial transactions First, it is a way of hedging risks arising from typicalcredit terms on export/import business In the first half of this book it was assumed that tradetook the form of barter, or that if money was involved, payment was immediate It is actuallyfar more common for exports to be sold under credit terms which create a period of timebefore payment is due This creates an exchange rate risk

If, for example, Harrods agrees to pay 50 million yen for television sets to be sold from its

UK stores, it will not make that payment when it becomes committed to the transaction oreven when the sets are delivered It will normally have 30-, 60-, or 90-day payment terms.Consequently, it faces the risk that the yen may appreciate during that period, resulting inhigher sterling costs for the television sets The yen might, of course, fall instead, whichwould save Harrods money, but if the company does not view itself as being in the business

of speculating on the future exchange rate for the Japanese currency, a forward contract topurchase yen becomes a convenient way to avoid any uncertainty as to the cost of the sets

in pounds sterling As soon as the commitment to purchase the television sets is binding,

314 International economics

EXHIBIT 14.2 EXCHANGE RATE FUTURES

Source: Fnancial Times, 3 January 2003.

the immediate purchase of 50 million yen in the forward market means that Harrods hashedged or covered the exchange risk arising from its delayed payment to the Japanesemanufacturer.

When fixed parities existed under the Bretton Woods system and market exchange ratesfluctuated only within a narrow band, many firms did not worry about such risks, and theyfrequently left accounts payable or receivable denominated in a foreign currency uncovered.The introduction of flexible exchange rates in the early 1970s greatly increased the perceivedrisk of such behavior and reportedly resulted in a sharp increase in the volume of forwardcontracts being traded as firms sought to eliminate such exposure

It is worth noting that forward contracts are not the only way to cover risks arising fromaccounts payable or receivable that are denominated in foreign exchange Changing theinvoicing of another transaction is an alternative for large firms that undertake many exportand import transactions every day If, for example, Unilever in the United Kingdompurchases French goods worth 10 million euros with 90-day payment terms, it could coverthis risk by invoicing its next sale to an EU country that was for about the same value ineuros If, within a short time after the agreement to purchase the French goods becamebinding, Unilever received an order for about 10 euro worth of goods from a German firm,

it could offer to invoice that sale in euros rather than sterling The German firm could

be expected to agree, because it would be relieved of the need to cover a sterling accountpayable If Unilever has both an account payable and an account receivable for 10 millioneuros with the same 90-day maturities, it is fully hedged Some large multinational firms,which have many transactions in each currency every day, are reported to undertake suchoffsets frequently, and to use the forward market only for whatever exposure is left over,thereby saving bid-asked spreads and commissions on forward contracts

The same result could be obtained by altering where one borrows or lends to offset aforeign exchange exposure Returning to Unilever’s 10 million euro account payable, if thatfirm also had about that sum in UK treasury bills, it could switch those funds to the euroequivalent of such bills for the 90-day period If Unilever has both a 10 million euro accountpayable and 10 million euros in short-term paper, it is fully hedged The cost to Unilever ofthis latter approach would be the difference between the interest income which it wouldearn on that sum in the United Kingdom and what it earns on euro paper That cost would,

of course, be negative if interest rates in euro exceed those in the United Kingdom.Returning to forwards, the second major role of such contracts is to cover risks arising frominternational capital movements When banks or other financial institutions seek to takeadvantage of higher interest rates available in foreign markets, they typically seek to avoid

the risk that the currency in which they invest may depreciate Undertaking a “swap” in

which a currency is simultaneously bought spot and sold forward is a way of covering suchrisk New York banks, for example, might hope to observe the following situation:

UK Treasury bill yield 14 percent

US Treasury bill yield 10 percent

Uncovered differential 4 percent favoring the UK

Forward discount on sterling 2 percent

Covered differential 2 percent favoring the UK

UK interest rates are 4 percentage points above those in New York, but switching intosterling for 90 days involves a sizable risk that the currency could depreciate by enough (or

14 – International derivatives 315

more than enough) to destroy the transaction’s profitability If, however, sterling is bought

in the spot market (in order to purchase the 14 percent bills) and simultaneously soldforward, the cost is only 2 percent (measured as an annual rate), leaving a net profit of 2percent For reasons that will be discussed soon, this situation would be extremely unlikely,and banks would normally face a situation such as the following:

UK Treasury bill yield 14 percent

US Treasury bill yield 10 percent

Uncovered differential 4 percent favoring the UK

Forward discount on sterling 4 percent

Covered differential 0

Finally, forward contracts can be used to take on risk rather than to avoid it If speculatorsbelieve that a currency will depreciate during the next 90 days to a level below the existingforward exchange rate, a forward sale of that currency is a convenient way to gamble on thatoutcome without investing large sums of money If the exchange rate for sterling was $1.86

in the New York spot market and $1.85 in the 90-day forward market when a speculatorbelieved that a depreciation of the spot rate of considerably more than 1 cent was likelyduring the next 3 months, he or she could sell forward sterling at $1.85 and wait If theexchange rate was, for example, $1.83 at the end of the contract, the speculator wouldpurchase the currency spot at that rate and deliver it on the forward contract, for a net profit

of 2 cents times the number of pounds sterling in the contract If, of course, sterling were

$1.88 at the end of the contract, he or she would absorb a loss of 3 cents per pound.Since this is not an option contract, the speculator is obligated to complete the losingtransaction, and the bank with which he or she did business would normally have requiredthat the speculator provide enough money as “margin” at the beginning of the contract toprotect it against the possibility of an attempt to evade that obligation

Factors determining forward rates: the interest parity theory and the role

of speculators

The determination of forward exchange rates can be viewed in two separate ways, but thedifferences can be more apparent than real The two approaches can be reconciled andfinally regarded as a single approach under reasonable assumptions First, forward rates areset through international capital flows This approach is known as the interest parity theory

of forward rate determination

If New York banks faced the 2 percent covered interest rate spread that appears in the firstset of numbers on page 315, they would purchase spot sterling in enormous volumes, drivingthe currency up, and they would simultaneously sell forward sterling in the same volumes,driving it down The 2 percent forward discount on sterling should widen to 4 percent in thetwinkling of an eye, eliminating the profitability of the swap transaction.2The arbitragingprocess will normally produce the following outcome, when forward rates are measured asannual percentage discounts or premiums:

Sterling forward discount = rUK– rUS

Or, making the same statement for the opposite situation:

Sterling forward premium = r – r

316 International economics

Sterling should trade at a forward discount that equals the difference between British and

US interest rates, and vice versa Any time this is not true, the possibility for arbitrage profitsexists and money can usually be expected to move in sufficient volume to force the forwardrate to the level at which such profits are eliminated or at least reduced to a very low level.This adjustment of the forward rate should be instantaneous

Sometimes financial markets produce data which do not match the interest paritycondition When sizable covered interest arbitrage profits have appeared to exist, it was oftenfor one of the following reasons:

1 The two assets were not of the same perceived risk, so that a risk premium had to bepaid on one of them Commercial paper, for example, may be viewed as having a greaterdefault risk in Canada than in the United Kingdom, resulting in a higher covered yield

in Toronto than in London

2 The possibility of double taxation existed because one country maintained a holding tax on interest payments to foreigners that could not be fully credited againsttaxes due in the investor’s country

with-3 Investors feared the imposition of exchange controls by the country with the highercovered interest rate, meaning that it might not be possible to enforce forward contracts

as they matured in order to get money out of the country

Sometimes the appearance of such profits has been created when interest and exchangerate data were not collected for the exact same times Using average daily interest rates anddaily closing exchange rates, for example, could produce the appearance of arbitrage profitswhen none actually existed

The second approach to the forward rate is that it represents the exchange markets’consensus prediction of what will happen to the spot exchange rate over the period of theforward contract If, for example, spot sterling is trading at $1.86 and the 90-day forward rate

is $1.84, market participants on average expect spot sterling to depreciate by 2 cents duringthe next 3 months If this were not the case, speculators would undertake transactions thatwould move the forward rate to a level that would represent their consensus expectation If,for example, forward sterling were $1.84 when most market participants thought it would be

no lower than $1.86 in 90 days, speculators would buy it heavily at $1.84 in expectation of

a sizable profit The volume of such purchases would be large enough to push the rate to theexpected spot rate, when the buying pressure would end

It is not necessary that everybody has the same expectation, for that is obviouslyimpossible It is only necessary that the average expectation matches the forward rate so thatspeculative purchases and sales roughly match If, for example, 20 percent of the marketparticipants expect the spot rate to be $1.86 in 90 days, whereas 40 percent think it will belower and 40 percent think it will be higher, the forward market should clear at $1.86because the number of people speculating that it will be higher will equal the number

of people betting on the opposite outcome, and the market will clear (For the sake ofsimplicity, this example assumes that each market participant is prepared to gamble the sameamount of money.) To use an inelegant analogy, the forward rate is like the point spread on

a basketball game; it represents the consensus prediction of how the game will end.Otherwise, bets on one team will greatly exceed those on the other, and the spread will bevery quickly adjusted

These two approaches to forward rate determination seem different, but they can bereconciled; both can be shown to result from differences in expected rates of inflation If

14 – International derivatives 317

British interest rates exceed those in the United States by 4 percentage points, this suggeststhat investors expect 4 percentage points more inflation in the United Kingdom than in theUnited States Real interest rates are thought to be arbitraged together because if peopleexpect more inflation in one currency than another, a higher nominal interest rate will berequired to attract them to hold assets in that currency The following statement representsthe arbitraging together of real interest rates:

rUK– rUS= expected UK inflation – expected US inflation

The forward discount on sterling, which superficially reflects differing nominal interestrates, more fundamentally reflects the fact that more inflation is expected in the UnitedKingdom than in the United States

Speculators can be viewed as forming exchange rate expectations on the basis of tionary predictions If national monies are ultimately claims on real goods and services,exchange rates should reflect the relative purchasing powers of those monies, which is to say that they should reflect purchasing power parity, as discussed earlier If speculators expectnominal exchange rates to follow purchasing power parity, indicating that they expect aconstant real exchange rate, they will form expectations of future spot rate behavior on the basis of forecasts of differences in rates of inflation Trading forward sterling at a discount

infla-of 4 percent (annual rate) indicates the speculators’ belief that the United Kingdom willexperience 4 percentage points more inflation than will the United States, and thereforethat spot sterling will have to depreciate at a 4 percent annual rate to maintain purchasingpower parity

Speculation

in the forward market

Expected depreciation

of £, measured

as an annual percentage rate

Expectation that the nominal exchange rate will follow purchasing power parity

Expected inflation

in the UK minus expected inflation

in the US

UNCOVERED INTEREST PARITY

=

Figure 14.1 The determination of the forward discount on sterling The fact that UK inflation is

expected to exceed US inflation causes both an excess of UK nominal interest rates over

US yields and an expectation that sterling will depreciate relative to the dollar Thedifference between UK and US interest rates produces an offsetting forward discount onsterling through covered interest arbitrage The expectation that sterling will depreciatecauses the same forward discount on sterling through speculation in the forward market

Both the interest-arbitrage and the expected-spot-rate approaches to forward ratedetermination can be traced back to the same origins – expectations with regard to relativerates of inflation The following statements summarize this conclusion:

Expected UK inflation – Expected US inflation = rUK– rUS= Forward discount onsterling

Expected UK inflation – Expected US inflation = Expected spot sterling depreciation

= Forward discount sterling

Therefore:

Expected UK inflation – Expected US inflation = Forward discount sterling

This might be visualized more easily as in Figure 14.1 The forward rate reflects bothdifferences in nominal interest rates and expected changes in the spot exchange rate, both of which result from differences in expected rates of inflation The way inflationaryexpectations are formed is a more complex matter It might begin with differences in therates of growth of national money supplies, but that subject is beyond the scope of thischapter

The relationship among expected rates of inflation, nominal interest rates, and forwardexchange markets may be easier to understand with a somewhat more extreme example

If inflation during the next year is expected to be 40 percent in Brazil and 4 percent in theUnited States, nobody is going to be willing to hold fixed-interest assets denominated inBrazilian reals unless they are paid a great deal more than the US interest rate Ignoringtaxes, people will insist on being paid 36 percentage points more on Brazilian debt than theywould be willing to accept on US dollar assets The fact that Brazilian interest rates exceed

US yields by 36 percentage points strongly suggests the expectation of 36 percentage pointsmore inflation in Brazil than in the United States In addition, the fact that inflation isexpected to be so much higher in Brazil than in the United States indicates that the Brazilian

currency will have to be devalued The exact amount of that devaluation or depreciation

cannot be known ahead of time, but a reasonable expectation is about 3 percent per month.That depreciation would just offset the differences in expected rates of inflation, therebymaintaining an unchanging real effective exchange rate for the Brazilian real To summarizethus far, the fact that Brazilian inflation is expected to exceed US inflation by 36 percentper year will mean both that Brazilian interest rates will exceed US yields by 36 percentagepoints and that people will expect the Brazilian real to depreciate by an offsetting amount

If a forward market for the real exists, that currency should trade at an annual rate forwarddiscount of about 36 percent, both because the difference in interest rates is that wide andbecause of the expected depreciation of the real The forward discount of about 36 percent

on the real, however, ultimately reflects the fact that inflation is expected to be 36 percenthigher in Brazil than in the United States (The expected depreciation and the forwarddiscount will be somewhat less than 36 percent because of the arithmetic problem of usingthe opening number as the base for any percentage change, meaning that the same changeover the same range is a higher percentage if the number rises and a lower percentage if itfalls; if a number rises from 80 to 100, that is 25 percent, but if it falls over the same range

it is only 20 percent If the price level in Brazil rises by 100 percent, that would not imply

a 100 percent depreciation of the real, which would make it worthless, but instead a

14 – International derivatives 319

depreciation of 50 percent The forward discount would also not be 100 percent, implying aworthless currency at maturity, but instead 50 percent If a stockbroker tells you that amutual fund made 100 percent one year, and then lost 50 percent the following year, thatdoes not mean a net gain of 50 percent It means a gain of zero.)

Two phrases have been used here which sound quite similar, but which are in factdifferent Covered interest parity, which is almost always true, says that a currency will trade

at a forward discount which equals the difference between the local and the foreign interestrate If short-term interest rates are 6 percent in the United Kingdom and 4 percent in theUnited States, sterling will trade at a 2 percent forward discount This is the interest paritytheory of forward rate determination Uncovered interest parity says that the differencebetween the local nominal interest rate and that prevailing abroad equals the rate at whichthe local currency is expected to depreciate The difference between London and New Yorkinterest rates just referred to means that sterling is expected to depreciate at an annual rate

of 2 percent This may be the expectation, but as will be seen below it is seldom fulfilled

Problems with the model

As the previous discussion suggests, countries that have high interest rates and thereforeforward discounts, should have depreciating currencies If that were not true, a trading rulecould be devised which would earn profits most of the time Surprising as it may seem, themodel is not supported by the data, and such profits could have been earned in the past In

a total of seventy-five empirical studies, it was found that industrialized countries with highinterest rates usually had appreciating, rather than depreciating, currencies, meaning thatthe expectations implied by uncovered interest parity were badly mistaken.3

Investors could therefore have made sizable profits by always buying fixed-interestsecurities in high-interest-rate, industrialized countries without covering in the forwardmarket On average, they would have received both a higher interest rate and the results of

an appreciation of that currency Buying US dollar assets in 1981, for example, and holdingthem for 4 years would have produced both extremely high nominal interest rates and

a 60 percent appreciation in the nominal effective exchange rate In addition, since theinterest parity condition usually holds in the forward market, currencies with high interestrates typically had forward discounts but did not, in fact, depreciate and instead usuallyappreciated This means that profits could have been earned most of the time by purchasingthe currencies of industrialized countries in the forward market whenever they were at sizablediscounts and simply waiting for maturity If these currencies appreciated rather thandepreciated in the spot market, the forward contracts would have been quite profitable Thesame pattern was repeated in the euro/dollar market in 2002 and early 2003 Interest rateswere higher in Europe than in the United States through a period in which the euroappreciated by 20 percent A decision to replace dollar assets with euro assets, uncovered,would have made a huge profit in 2002 and early 2003

It should be stressed that these are the results of studies of past data and that there is noguarantee, or even likelihood, that such profits will be available in the future Nevertheless,these research results are surprising, and academic economists have not yet produced veryconvincing explanations of why this happened They merely wish that they had knownabout it in the past, so that they could have taken advantage of this situation in the markets.The earlier model, which produced a unified result for the forward rate via interestarbitrage and speculation, required that speculators determine their exchange rate expec-tations solely on the basis of differences in expected rates of inflation; that is, that they firmly

320 International economics

believed in purchasing power parity This, of course, may not be the case Particularly forindustrialized countries for which capital account transactions exceed current accounttransactions by a large multiple, exchange rate expectations may be set in a variety of ways.This creates the possibility that interest arbitragers and speculators will disagree as to whatforward rate ought to prevail, and the actual outcome will depend on their relative numbersand the amounts of money they are prepared to commit In some periods speculative activitymay be modest, and interest arbitragers will dominate the market, producing the outcomepredicted by the interest parity theory In other periods, however, speculators may be soactive as to move the forward rate away from that suggested by interest parity, despite theactivities of arbitragers.4

Foreign exchange options

Futures or forward contracts obligate the holder to complete the transaction at maturity,unless it is sold in the meantime or offset by a contract in the opposite direction A 90-dayforward purchase of sterling, for example, could be canceled after 30 days through a sale of60-day sterling Otherwise the contract goes to maturity, whether or not the outcome isfavorable An option contract, in contrast, provides the opportunity to purchase or sell afixed amount of a currency or a common stock during a fixed period of time at a guaranteed

price (called the strike price), but the holder of the option has the alternative of not

completing the purchase or sale.5A “put” gives the buyer of the contract the right to sell the asset, and a “call” provides the opportunity to buy Because an option is a one-sided bet, an

often sizable premium or price is required to purchase such a contract, as can be seen inExhibit 14.3 Sterling, for which the spot exchange rate was US$1.5978, was available on 2January 2003 as a call with a March 2003 expiration at a strike price of $1.60 The price orpremium on that call is 1.50 cents A March put was available at the same $1.60 strike price

at a premium of 2.90 cents The fact that the premium for the put was considerably higherthan that on the call, despite the fact that the strike price was very close to the current spotexchange rate ($1.60 versus $1.5978) suggests that the put was viewed as being much morelikely to be exercised than was the call, for reasons that will be discussed later

Foreign exchange options are a useful means of covering possible exchange exposure from

a transaction that may not occur If, for example, a US firm were in the midst of negotiating

a contract to purchase a British firm for £1 million sterling, it might want to lock in its USdollar price but not be bound to take delivery of the sterling if the negotiations were to fail.Purchasing sterling calls totaling £1 million will protect the firm against the possibility thatsterling will appreciate before the deal is completed and paid for, but will still give the firm

a means of avoiding purchasing the sterling if the transaction does not occur

Foreign exchange options can also be used to insure a pre-existing financial positionagainst loss without giving up the possibility of a profit If, for example, a firm owned £1million in sterling assets and had no sterling liabilities, it would be worried about a possiblefuture depreciation of sterling, but would profit if the currency appreciated Purchasing £1million in sterling puts would protect the firm against the depreciation without depriving it

of the possibility of making money if sterling rose If the firm had sterling liabilities but

no sterling assets, the same insurance would be provided by purchasing sterling calls In bothcases, however, the insurance comes at the cost of the premium on the option plus brokeragecommissions

Finally, purchasing puts or calls is a means of speculating on the future of the spot exchangerate with a limited risk of loss If, for example, a speculator believed that spot sterling will

14 – International derivatives 321

fall well below $1.60 before the end of March, purchasing a sterling put with a strike price

of $1.60 for 2.90 cents is a way of gambling on that outcome without taking a large risk Theproblem is that sterling will have to fall below $1.5710 for the gamble to be profitablebecause, although the strike price is $1.60, the speculator already has spent 2.90 cents onthe premium or price of the option Since the contract size is £31,250, the total price of theoption is $906.25 plus brokerage charges, which is the maximum loss that the speculator canexperience That will occur if spot sterling never goes below $1.60 before maturity, so it isnever worth exercising This put option is said to be “in the money” (or, sometimes, “abovewater”) whenever the spot exchange rate is below $1.60, but it is only profitable at spotexchange rates below $1.5710

If, for example, spot sterling is $1.58 as the expiration date of the put approaches, theoption is certainly worth exercising at a strike price of $1.60 Two cents is earned per pound,but this does not offset the original cost of the option (2.90 cents per pound), leaving a loss

of 0.9 cent per pound, or $281.25 plus brokerage commissions on the entire contract If,however, sterling had fallen to $1.55 before the maturity of the option, a profit of 2.10 centsper pound, or $656.25 minus brokerage charges on a contract of £31,250, would have

322 International economics

EXHIBIT 14.3 FOREIGN EXCHANGE OPTIONS

Source: Financial Times, 3 January 2003

resulted An option contract is said to be “out of the money” (or underwater) if it is notworth exercising, meaning that its holder will lose the full premium on the option pluscommissions if circumstances do not improve before maturity.

It should be clear why one might be interested in purchasing puts or calls, but the questionthen arises as to why anyone would be willing to sell, or “write,” such contracts The seller

of the option accepts the possibility of a large loss with no offsetting possibility of speculativegain Those who sell options are willing to do so because they receive the premium or price

of the option, which was $906.25 in the example in the previous paragraph Those who sellputs on sterling with a strike price of $1.60 are gambling that sterling will not fall below

$1.5710 before the option expires, so that even if the option is exercised, they will retainsome profit If sterling does not fall below $1.60, the option will be “out of the money” andwill not be exercised In that case, the seller retains the entire $906.25 minus brokeragecharges

The profit and loss outcomes from this put contract, measured as US cents per poundsterling, are illustrated in Figure 14.2 The buyer of the put makes a profit at any spotexchange rate below $1.5710 and loses above that rate, with the maximum loss being 2.90cents if the put is “out of the money” and therefore not worth exercising The writer or seller

of this option faces the mirror-image situation; losses are absorbed if the spot price is below

$1.5710, and a maximum profit of 2.90 cents is earned if the spot rate does not fall below

$1.60

Note that the buyer of the option has an almost unlimited possible profit and a limitedloss, whereas the seller has a limited possible profit and an almost unlimited possible loss.The only reason why there is any limit to the possible profit to the buyer, and loss to theseller, of this put option is that spot sterling cannot go below zero in US funds

The profit and loss outcomes for the previously discussed sterling call, which had a strikeprice of $1.60 and a premium of 1.50 cents, can be found in Figure 14.3 In this case, thebuyer of the call absorbs a maximum loss of 1.50 cents if spot sterling never goes above $1.60,

Figure 14.2 Profits and losses from a put option on sterling A sterling put with a strike price of $1.60

and a premium of 2.90 cents will be profitable for a buyer if the spot price of sterling fallsbelow $1.5710 before the option expires The maximum loss for a buyer, which occurs ifspot sterling does not fall below $1.60, is 2.90 cents per pound The writer or seller of theoption is in the mirror-image situation, facing a loss that rises as sterling falls below

$1.5710 and a profit that is at a maximum of 2.90 cents per pound if spot sterling neverfalls below $1.60 before the option expires

so the option is “out of the money” and not worth exercising Profits begin at $1.6150 andare unlimited as sterling rises beyond that level The seller of the option again faces themirror-image outcomes A maximum profit of 1.50 cents is made if spot sterling never risesabove $1.60 Losses begin at $1.6150 and rise without limit as sterling exceeds that level.Transactions costs are ignored in these graphs, so profits will be slightly smaller and lossesbigger when brokerage commissions are included.

Those who write or sell options often have a cover or hedge; if, for example, someonealready owns £31,250 with no offsetting sterling liabilities, selling a sterling call contract

is not risky If sterling rises sharply and the option is exercised, there is no out-of-pocket loss, but instead merely a loss of what otherwise would have been a capital gain on sterling’sappreciation If, however, someone owns no sterling and sells sterling calls, the risks can

be very large If sterling rises sharply and the option is therefore exercised, the seller of theoption must purchase the necessary sterling at the higher spot exchange rate and absorbwhatever out-of-pocket loss results Writing uncovered or “naked” options is extremelydangerous, as many writers of puts on US common stocks discovered on 19 October 1987when the Dow-Jones Industrial Average declined by over 500 points

Determinants of options prices

The determination of the premiums on foreign exchange options depends on both intrinsicand time value, that latter having a number of determinants Intrinsic value is the extent

to which the option is currently “in the money.” If a sterling call has a strike price of $1.60and the current spot exchange rate is $1.63, the intrinsic value of the option is 3 cents, andthe premium must be at least that amount

Time value results from the possibility of future exchange rate changes that could makethe option worth more than its current intrinsic value Three factors determine an option’stime value: relative interest rates, expected volatility, and the length of time until the optionexpires Relative interest rates determine the forward premium or discount, which in turn

Figure 14.3 Profits and losses from a call option on sterling A sterling call with a strike price of $1.60

and a premium of 1.50 cents will be profitable for a buyer if spot sterling rises above

$1.6150 before the option expires The maximum loss for the buyer, which occurs if spotsterling never exceeds $1.60, is 1.50 cents per pound The seller of the option is in themirror-image situation, making a maximum profit of 1.50 cents per pound if sterling neverexceeds $1.60, and losing money as spot sterling rises above $1.6150 before the optionexpires

represents the expected change in the spot rate If 90-day interest rates in the UnitedKingdom are above those prevailing in the United States, sterling will be at a forwarddiscount in the 90-day market, meaning the market expects spot sterling to depreciate duringthat period This set of circumstances existed at the beginning of 2003 This situation wouldreduce the time value and therefore the premium on a sterling call with a 3-month maturity,because the market views it as unlikely that this option will become more profitable toexercise by the time it matures Higher interest rates in the UK and the resulting forwarddiscount on sterling would, of course, increase the premium on a sterling put with the samematurity, because the market is saying that option is likely to be further in the money, andtherefore more worth exercising, at maturity than it is now This explains the 2.90 centspremium on the sterling put relative to the 1.50 cents premium on the call in the earlierexamples which were drawn from 2 January 2003 data.

The second factor in determining time value is expected volatility, which is likely to bebased on volatility in the recent past Sterling puts and calls with strike prices of $1.60 will

be worth more if the exchange rate for sterling is expected to be quite volatile, perhapsbecause it has been volatile during the last year or two If, however, sterling has not movedabove $1.62 or below $1.58 during that period, and there is no reason to expect that circum-stance to change, both the put and the call will be worth considerably less Purchasingoptions are sometimes referred to as buying price volatility, and the premium is the cost ofthat purchase

The last factor is the amount of time left until an option expires; the longer that period,the greater the opportunity for an exchange rate change that will make the option moreprofitable, and the higher its current premium An option which has a year until maturitywill be considerably more valuable than one which expires in 3 months As maturityapproaches, time value declines rapidly, there being no time value at maturity, when thepremium must be the intrinsic value of the option If a sterling call has a strike price of $1.60and the spot exchange rate is $1.62 when the option expires, its premium must be 2 cents.With the same spot rate, a sterling put with the $1.60 strike price would have a premium ofzero at maturity because it is out of the money by 2 cents

Informal trading in foreign exchange options has existed for some time, but formal trading

on exchanges is fairly recent It began in Amsterdam in 1978 and was extended to Montrealand Philadelphia in 1982 American options can be exercised at any time until maturity,while European options can only be exercised at the maturity date European options can,however, be bought or sold in the secondary market, at the current premium or price, in themeantime

Other international derivatives

The contracts described in the previous pages of this chapter are the most commonly usedinternational derivatives, but there are many others International interest rate swapsinvolve the exchange of interest payments in one currency and maturity for those of anothercurrency and maturity If, for example, a British corporation was borrowing in order toundertake a direct investment in Japan and wished to make its interest payments in yen, butwas unknown to bankers outside the United Kingdom and therefore could not easily borrow

in Tokyo, it could borrow sterling and then use an interest rate swap to solve its problem.Under the interest rate swap it would agree to pay in yen the Japanese short-term interestrate on a nominal amount equal to its UK borrowing, and to receive the UK short-terminterest rate on the same amount in sterling The latter funds would be used to pay interest

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