fletcher school, tufts university › 2016 › 11 › ...transactions costs, risk sharing and...

George Alogoskoufis, The Economics of the European Union

Fletcher School, Tufts University

11. International Capital and Financial Markets, and the Determination of Exchange Rates

Prof. George Alogoskoufis


The Role of Finance and Financial Markets

Financial markets perform the essential economic function of channeling funds from households, firms and governments that have surplus funds by spending less than their income, to those that have a shortage of funds because they wish to spend more than their income.

Finance can be either direct, or indirect.

In direct finance, borrowers borrow funds directly from lenders in financial markets, by selling them securities (also called financial instruments), which are claims on the borrower’s future income or assets. Securities are assets for the lender, but liabilities (IOUs) for the borrower.

Securities take the form of either bonds or stocks.

Bonds are debt securities that promise to make periodic payments for a specified period of time.

Stocks are securities that entitle the owner to a share of a company’s profits or assets.

In indirect finance this exchange of securities takes place through financial intermediaries, usually banks.

Financial markets allow funds to move from those who lack productive investment opportunities to those who have such opportunities, and thus contribute to an efficient allocation of capital that increases economic welfare.

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Debt versus Equity MarketsA borrower can obtain funds in financial markets in two ways:

A. Through issuing a debt instrument, such as a bond or a mortgage. This is a contractual agreement by the borrower to pay the holder of the instrument fixed dollar amounts at regular intervals (interest and principal payments), until a specified date (the maturity date), when a final payment is made. The maturity of a debt instrument is the number of years (term) until the instruments expiration date. A debt instrument is short term if its maturity term is less than a year, and long term, if its maturity term is ten years or longer. Debt instruments with a maturity term between one and ten years are said to be intermediate term.

B. Through issuing equities, such as common stock, which are claims to share in the net income and the assets of a business firm. Equities often make periodic payments (dividends) to their holders and are considered long-term securities because they do not have a maturity date. Owing common stock means that you own a portion of the firm and gives you the right to vote on issues important to the firm and the election of its directors.

Disadvantage of being an equity holder is that you are a residual claimant, i.e the corporation must satisfy debt holders before equity holders. As an equity holder you benefit from an increase in the firms profitability but also you lose from a decrease in the firms profitability. Bond holders receive fixed amounts. In the USA the bond market is larger than the equity market. At the end of 2013 the value of bonds was about $42 trillion, versus $21 trillion for the value of equities.

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Primary versus Secondary MarketsA. A primary market is a financial market in which new issues of a security, such as a

bond or a stock, are sold to initial buyers by the corporation or government agency borrowing the funds.

B. A secondary market is a financial market in which securities that have been previously issued can be resold.

Primary markets are dominated by investment banks which underwrite a corporation’s or a government’s securities and then sell them in the secondary market.

Secondary markets are important because they make financial instruments more liquid, thus increasing their attractiveness to investors. They are also important for the determination of the price of securities and thus affect the pricing of securities in the primary market as well. Conditions in secondary markets are therefore the most relevant for corporations and governments issuing securities.

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Exchanges and Over the Counter Markets

Secondary markets are organized in one of two ways:

A. Exchanges, where buyers and sellers of securities (or their agents or brokers) meet in one central location to conduct trades. The New York Stock Exchange (NYSE) and the Chicago Board of Trade for commodities are examples of such organized exchanges.

B. Over the Counter Markets (OTC). Dealers in different locations stand ready to buy and sell securities “over the counter”. The OTC market relies on electronic communication systems, trades and prices are known to everybody, and is thus very competitive.

Many stocks are traded OTC but the majority of the large corporations have their shares traded at organized stock exchanges. The US government bond market, with a trading volume larger than NYSE is entirely OTC. There are about forty dealers who establish the market in US government securities, standing ready to buy or sell. Other types of securities such as negotiable securities of deposit, federal funds and foreign exchange are also traded in OTC markets.

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Money and Capital MarketsAnother distinguishing characteristic of financial markets is the maturity term of the securities traded.

The money market is a financial market in which only short term debt instruments are traded, i.e those with original maturity terms of less than one year.

The capital market is the market in which longer term debt instruments and equity instruments are traded.

Money market securities are usually more widely traded than longer term securities, making them more liquid. They also tend to have smaller fluctuations in prices, making them safer instruments. Such instruments are US Treasury Bills, negotiable certificates of deposit, commercial paper, repurchase agreements (repos) and Federal Funds. Capital market instruments are corporate stocks, residential mortgages, corporate bonds, US government bonds, state and local government bonds, bank commercial loans, consumer loans and commercial and farm mortgages.

Money markets are used by banks and corporations to earn interest on surplus short term funds, while capital market instruments are held by insurance companies and pension funds which have long term liabilities.

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Financial IntermediariesFinancial intermediaries stand between lenders-savers and borrowers-spenders and help transfer funds from one to the other. This is called indirect finance.

In fact, financial intermediation is the main route for moving funds from lenders to borrowers, and is mainly conducted by depository institutions (commercial banks, savings and loans associations, mutual savings banks and credit unions), by contractual savings institutions (life insurance companies, pension funds and government retirement funds), and by investment intermediaries (finance companies, mutual funds, hedge funds and investment banks).

To understand the role and significance of financial intermediation one must understand the roles of transaction costs, risk sharing and information costs in financial markets.

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Transactions Costs, Risk Sharing and Financial Intermediation

Financial intermediation implies lower transaction costs because of specialization, economies of scale and the provision of liquidity services.

In addition, because of the scale of their operations, financial intermediaries can reduce the risk of lending, by pooling different types of risk. Thus, they turn individually risky assets into safer composite assets, through diversification (“You should not put all your eggs in one basket”).

By holding a larger and safer portfolio of risky assets, financial intermediaries are thus able to offer savers a safer menu of assets at a lower cost than if savers tried to do the same at a smaller scale.

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Asymmetric Information: Adverse Selection and Moral Hazard

Another reason for the importance of financial intermediation is asymmetric information. Borrowers usually have better information than lenders about the risk and return of the investment they are about to undertake, and in addition, lenders cannot usually monitor the behavior of borrowers after they have lent them the money.

Asymmetric information creates two types of problems. Adverse selection and moral hazard.

Adverse selection is the problem created by asymmetric information before the transaction takes place. Adverse selection occurs when the riskier borrowers, the more likely to produce an adverse outcome, are the ones more actively trying to secure a loan. Because of adverse selection, lenders may decide not to make any loans, although good credit risks exist.

Moral hazard is the problem created by asymmetric information after the transaction occurs. It is the risk (hazard) that the borrower might ex post engage in activities that are undesirable (immoral) from the view point of the lender, because they reduce the probability that the loan might be re-paid. Hence, again, borrowing and lending may break down because of this risk.

With financial intermediation, small savers can deposit their funds with the financial intermediary who, because of the specialization and the scale of their operations, have better means to address asymmetric information, by screening aspiring borrowers and monitoring the behavior of borrowers ex post. Thus, financial intermediaries can mitigate the problems of asymmetric information and expand the market.

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Economies of Scope and Conflicts of Interest

Most financial intermediaries provide a range of financial services to their customers. Banks take in deposits, offer loans, provide liquidity services through checking accounts, insurance services and so on. Thus, financial intermediation also implies economies of scope.

Economies of scope create the potential for conflicts of interest, a type of moral hazard problem that arises when an agent has multiple objectives (interests) some of which conflict with each other. Conflicts of interest are more likely to occur when a financial institution provides multiple services.

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The Risks of Financial IntermediationFinancial intermediation increases the efficiency of the financial system, but is not without risks.

For a start, the problem of asymmetric information remain. Intermediaries have better information about risks than their lenders and worse information than their borrowers. Hence, the need for government regulation to reduce the problems of asymmetric information.

In addition, financial markets are vulnerable to systemic risks. A negative systemic shock can destabilize them, especially as there is a discrepancy between the maturity structure of the liabilities and the assets of financial intermediaries. The liabilities of financial intermediaries are typically safe short term securities (e.g. checking accounts), while their assets are riskier and longer term (e.g. long term loans and bonds). If there is a shock that reduces the return of their assets and at the same time shakes the confidence of lenders-savers, leading them to withdraw their deposits, financial intermediaries may run into liquidity or solvency problems. Again, the possibility of such systemic risks creates the need for regulation.

In the absence of regulation, adverse shocks may lead to a destabilization of the financial system and a financial crisis.

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Internationalization of Financial Markets

The internationalization of financial markets is the result of globalization, the deregulation of foreign financial markets and the existence of large pools of savings in Asia and elsewhere.

Foreign bonds, Eurobonds and Eurocurrencies are the main financial instruments exchanged in international financial markets. Foreign bonds are bonds sold in a foreign country, but denominated in its currency. Eurobonds are bonds denominated in a currency other than the one of the country in which they are sold. Eurocurrencies are foreign currencies deposited in banks outside their home country.

The foreign exchange market is by far the most important international financial market, but stock and bond markets have become internationalized as well.

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Methods of Financing Deficits in the Current Account

1. Foreign Exchange Reserves (short term)

2. International Bond Issues

3. International Bank Loans

4. Official Borrowing (IMF, World Bank, other governments)

5. Foreign Direct Investment

6. International Portfolio Investment

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2. International Bond Issues

Bond issues are the main method of financing for advanced economies. It used to be the main method of financing for less developed economies until 1914, and in the inter-war period. Bond issues by less developed economies have staged a comeback after 1990, with the liberalization of the financial systems of developing economies.

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3. International Bank Lending

Since the end of the 1970s, and until the end of the 1980s this was the main method of financing for less developed economies. In the beginning of the 1980s bank lending corresponded to the whole of the current account deficits of less developed economies. Since then, the importance of international bank lending has diminished, although it remains one of the most important methods of finance.

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4. Official Lending

These loans may be concessionary, or at market interest rates. Before the 2008-09 crisis, official lending had been very low, used for very poor economies, such as those of sub-Saharan Africa. Official lending has made a comeback after the recent crisis, and is mainly used by countries which have agreed an adjustment program with the IMF.

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5. Foreign Direct Investment

Financing the creation or development of subsidiaries of multinational enterprises. For example, a loan or a capital injections from Microsoft or Unilever in its greek subsidiary constitutes foreign direct investment in Greece, and helps finance the current account deficit of Greece.

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6. International Portfolio Investment

If a US insurance fund were to buy shares of a Greek company, or Greek sovereign or corporate bonds, this is an international portfolio investment, and helps finance the deficit of the current account in Greece. This trend is often reinforced by privatization initiatives in various countries.

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Finance through Debt and Other Securities

❖ International bonds, international bank loans and official lending constitute debt, whereas foreign direct investment and international portfolio investment in shares does not constitute debt.

❖ The difference between the two methods of financing is that in debt contracts, the borrower agrees to repay in specific installments (interest and amortization) to the lender, irrespective of conditions, while in the case of equity investment, the investor shares in the profits of firms only if the firm makes profits.

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Differences between Advanced and Less Developed Economies

❖ The problem with less developed economies is that a large part of the financing of their current account deficits is through external debt, and in particular debt denominated in foreign currencies. International investors refrain from assuming the currency risk associated with a peripheral currency, even if they assume the country risk.

❖ On the other hand, the major advanced economies, whose currencies are widely traded internationally, almost always borrow in their own currency. Thus, the US borrows in US dollars, the Euro Area economies in euro’s, Japan in Japanese yen, Britain in sterling. Even Switzerland, due to the international acceptance of the Swiss franc, borrows in its own currency.

❖ A country that can borrow in its own currency has significant advantages over countries which cannot do this. It can continue servicing its loans, even if it has to resort to issuing money in order to pay its creditors. So it does not run the risk of default. This option is not available to developing economies which borrow in foreign currency.

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The Original Sin and the Exorbitant Privilege

❖ The inability of less developed economies to borrow in their own currency, is often called the original sin. On the other hand, the ability of the US to borrow in dollars, and in this way to reduce the real value of its international obligations, is often referred to as the exorbitant privilege of the US.

❖ It is also worth noting that, as shown by the recent crisis in the peripheral economies of the Euro Area, participation in a single currency area like the euro area does not ultimately absolve a less developed economy from the original sin.

❖ The governments of a small open economies participating in the Euro Area cannot rely on the European Central Bank (ECB) to lend them euros to service their euro denominated debts, or the debts of their banks. This is because of the ECB's political independence and the prohibition of monetary financing of budget deficits in the Euro Area. In essence, the statutes of the ECB do not allow it to function effectively as a lender of last resort to Euro Area governments, in contrast to the central banks in the US, Britain or Japan who do in fact act as lenders of last resort.

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The International Foreign Exchange Market

❖ An International Network of Traders in Currencies

❖ Vehicle currency, the US dollar

❖ Exchange rates

❖ Spot Transactions

❖ Swap transactions

❖ Forward Transactions

❖ Eurodeposits and Eurocurrencies

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Structure of the Foreign Exchange Market

❖ The different currencies are bought and sold through dealers located in major international banks and financial institutions.

❖ Dealers hold currency reserves, and their goal is to make profits by buying cheaply and selling expensively.

❖ The foreign exchange market is characterized by high liquidity and the trading volume is huge.

❖ The volume of foreign exchange transactions is much greater than the volume of transactions necessary for financing international trade.

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Major Financial Centers

❖ New York❖ London❖ Frankfurt❖ Hong Kong❖ Tokyo


Exchange Rates❖ The price of the dollar in foreign currency (ie 0.91 euros

per dollar) is called the exchange rate (in European terms).

❖ The reverse, ie a currency value in dollars (eg $ 1.1 per euro) is the exchange rate in US terms.

❖ An increase in the exchange rate in European terms means that the currency has depreciated against the dollar, while a rise in the exchange rate in US terms means that the currency has appreciated against the dollar (i.e the dollar has depreciated).

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Alternative Definitions of Exchange Rates

❖ We shall define the exchange rate in European terms as S.

❖ This means that an increase in the exchange rate S constitutes a depreciation of the Euro and an appreciation of the dollar, since more euros are required in order to buy one dollar.

❖ We shall define the exchange rate in US terms as E.

❖ This means that an increase in the exchange rate E constitutes an appreciation of the euro and a depreciation of the dollar, since it takes more dollars to buy one euro.

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The Euro Dollar Exchange Rate €/$

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The Euro Dollar Exchange Rate $/€

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The US Dollar and Triangular Transactions

❖ The US dollar is considered as a vehicle currency for transactions in the foreign exchange market.

❖ For example, to convert sterling into yen usually requires two transactions. One to convert sterling to dollars, and one to convert dollars to yen.

❖ Because of the depth (high trading volume) in the dollar market, the cost of this triangular transaction is usually less than the direct exchange of sterling for yen.

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Arbitrage and Exchange Rates

In the foreign exchange market, because of arbitrage, there are no potential profits from triangular transactions in different currencies.

For example, if E1 is the sterling dollar exchange rate, E2 the euro dollar exchange rate, and E3 the sterling euro exchange rate, and transactions have no cost, in equilibrium it can only be the case that,

E1=E3 x E2

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Transaction Categories in the Foreign Exchange Market

❖ Spot transactions, where the transaction closes immediately (in fact within two days). These determine spot exchange rates.

❖ Swap transactions, in which the currency is bought (sold) today and resold (re-bought) at a future date. The value of both the spot and the forward exchange rate is determined today.

❖ Forward transactions. These are current agreements for future purchase or sale of a currency. The price, quantity and the date of the transaction are determined today.

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Spot, Swap and Forward Transactions❖ The swap rate is the difference between the repurchase

rate (repo) and the spot exchange rate. The spot exchange rate and the swap rate determine the forward exchange rate.

❖ Swap and forward transactions take place for 1 and 2 weeks, and for 1, 3, 6 and 12 months.

❖ We say that a currency trades at a premium when the forward exchange rate is higher than the spot rate (on the US definition). Otherwise it trades at a discount.

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The Structure of Transactions in the Foreign Exchange Market

❖ The vast volume of transactions in the foreign exchange market are spot transactions between dealers. Swap transactions constitute about 1/3 of the total volume. Forward transactions constitute a very small percentage of the total volume.

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Eurodeposits and Eurocurrencies❖ A Eurocurrency deposit, or a Eurodeposit, is a deposit in

foreign currency outside the country issuing the currency.

❖ A deposit in US dollars in a London bank is a Eurodollar deposit, while a deposit in yen at a bank in New York is a Euroyen deposit.

❖ Most eurodeposits are fixed rate deposits with terms reflecting those available for swap and forward currency transactions.

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LIBOR and EURIBOR❖ LIBOR (London Interbank Offered Rate) is the rate at which banks are

willing to lend dollars or pounds to the most reliable banks and non-bank enterprises that participate in the London interbank market. Loans to less reliable banks and enterprises have a higher rate than LIBOR (premium).

❖ The EURIBOR (Euro Interbank Offer Rate) is the rate at which banks are willing to lend euros to the most reliable banks and non-bank enterprises, participating in the euro area interbank market. Loans to less reliable banks and enterprises have a higher interest rate than EURIBOR (premium).

❖ The LIBOR and the EURIBOR vary depending on the loan term (from one week to 12 months).

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Dollar and Euro 3-month LIBOR

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-1.00000

0.00000

1.00000

2.00000

3.00000

4.00000

5.00000

6.00000

7.00000

8.00000

1999-01-04

2000-01-04

2001-01-04

2002-01-04

2003-01-04

2004-01-04

2005-01-04

2006-01-04

2007-01-04

2008-01-04

2009-01-04

2010-01-04

2011-01-04

2012-01-04

2013-01-04

2014-01-04

2015-01-04

2016-01-04

$LIBOR €LIBOR


The EURIBOR (1 month, 2 months, 3 months)

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Comparing Rates of Return in Different Currencies The Rate of Return of a Deposit in Euros, Measured in Dollars

❖ Suppose you are a bank or a money market fund and have 1 million $ to invest for a year.

❖ If you invest in a dollar deposit, at the end of the year you will get 1+i$

❖ If you invest in a euro deposit, you must first convert your $ million into euros. Thus you will invest S times one million, where S is the spot euro/dollar exchange rate.

❖ At the end of the year, you will earn (1+i€)S in euros.

❖ At the same time as you make the spot transaction buying the equivalent of $1m in euros, you can make a forward transaction, selling (1+i€)S million euros in the forward market, and buying back dollars at the forward exchange rate F.

❖ Thus, at the end of the year you will use your (1+i€)S euros to fulfill your forward contract, and you will be left with (1+i€)(S/F) dollars.

❖ Thus, the rate of return in dollars of your euro deposit is certain and equal to (1+i€)(S/F).

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Equilibrium in the Swap Foreign Exchange Market Covered Interest Parity

Forex traders in the swap market, will be buying and selling the two currencies until the rate of return of a dollar deposit is equal to the rate of return of a euro deposit, adjusted by the swap rate of a euro deposit when the euros are covered back to dollars.

This means that they will be buying and selling currencies, changing the spot and the forward exchange rate, until,

(1+i$) = (1+i€)(S/F)

This equilibrium condition, is called covered interest parity.

If this condition is violated, expected profits can be made by borrowing in one currency and lending in the other. These expected profits will lead to arbitrage, i.e equilibrating trades, until the condition is satisfied and no incentives for further equilibrating trades exist. Given the speed of transactions in forex markets, the condition will be satisfied almost continuously.

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What Determines the Future Exchange Rate: Expected Future Spot Rates and Uncovered Interest Parity

The profit from a swap or forward transaction in the foreign exchange market is the difference of the forward rate from the spot rate, at the end of the term of the transaction. Consequently, at the time of agreement to the forward transaction, with the assumption of risk neutrality, it should apply that,

F=Se

where Se is the expected future spot rate at the end of the term of the forward transaction.

Hence, under the assumption that traders are risk neutral, the forward rate is equal to the expected future spot rate. Substituting in the covered interest parity condition we get that,

(1+i$) = (1+i€)(S/Se)

This equilibrium condition, is called uncovered interest parity.

In fact, a risk neutral forex trader may not use the swap market at all and concentrate on the spot market.

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Comparing Rates of Return in Different Currencies The Expected Rate of Return of a Deposit in Euros, Measured in Dollars

❖ Suppose you are a forex trader for a bank or a money market fund and have 1 million $ to invest for a year.

❖ If you invest in a dollar deposit, at the end of the year you will get 1+i$

❖ If you invest in a euro deposit, you must convert your million into euros. Thus you will invest S times one million, where S is the spot euro/dollar exchange rate.

❖ At the end of the year, you will earn (1+i€)S in euros.

❖ To convert them into dollars, you will need to use the euro/dollar exchange rate in a year’s time, when the euro deposit matures. You do not know what this rate will be, but you can form expectations about it.

❖ Thus, the expected rate of return in dollars of your euro deposit is uncertain, and equal to (1+i€)(S/Se), where Se is the expected future spot euro/dollar exchange rate in a year’s time.

❖ If you are risk neutral, you will forego the swap market, unless the market future rate differs from your expected future spot rate.

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Equilibrium in the Spot Foreign Exchange Market Uncovered Interest Parity

Thus, forex traders in the spot market, if they are risk neutral, will be buying and selling the two currencies in the spot market, until the rate of return of a dollar deposit is equal to the expected rate of return of a euro deposit when the euros are measured in dollar terms.

This means that they will be buying and selling currencies, changing the exchange rate, until,

(1+i$) = (1+i€)(S/Se)

Their behavior will guarantee uncovered interest parity, because if this condition is violated, expected profits can be made by borrowing in one currency and lending in the other. These expected profits will lead to arbitrage, i.e equilibrating trades, until the condition is satisfied and no incentives for further equilibrating trades exist. Given the speed of transactions in forex markets, the condition will be satisfied almost continuously.

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Determining Factors of Spot Exchange Rates

Solving the covered interest parity condition and assuming that future rates as equal to expected future spot rates, we get that,

S=Se((1+i$)/(1+i€))

Three factors determine the spot euro/dollar exchange rate

First,the dollar nominal interest rate. A rise in the dollar nominal interest rate causes the dollar to appreciate against the euro, as S goes up.

Second, the euro (foreign) nominal interest rate. A rise in the euro nominal interest rate causes the dollar to depreciate, as S goes down.

Third, the expected future spot rate. An expected future appreciation of the dollar causes the dollar to appreciate immediately. An expected future depreciation of the dollar causes the dollar to depreciate immediately.

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A Diagrammatic Exposition of Exchange Rate Determination

Uncovered interest parity requires that the return of a deposit in dollars is equal to the expected return in dollars of a deposit in euros. This can be written as,

1+i$=(1+i€)(S/Se)

We can depict this equilibrium condition in a diagram. The left hand side is independent of S, whereas the right hand side is a linear function of S.

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A Rise in US Nominal Interest Rates

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A Diagrammatic Exposition of Exchange Rate Determination

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A Rise in EA Nominal Interest Rates

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An Expected Future Depreciation of the Euro

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International Financial Markets and Exchange Rate Determination

❖ Exchange rates are determined in international financial markets. The main agents participating in these markets are banks, multinational corporations, non-bank financial institutions, governments and central banks.

❖ Banks have a key role by facilitating the exchange of bank deposits in different currencies, which constitutes the bulk of transactions in the foreign exchange market. The international foreign exchange market is essentially a unified world market that operates almost 24 hours each day.

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The Foreign Exchange Market

❖ The bulk of transactions in foreign exchange markets are spot transactions, but a large part consists of swaps and forward transactions.

❖ In swaps and forward transactions there is an agreement between the parties on the future exchange of currencies at a predetermined price. Spot transactions are settled immediately.

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Eurodeposits and Interest Parity❖ Equilibrium in the foreign exchange market requires

equalization of returns of securities that are denominated in different currencies, when the returns are measured in a common currency. This is the basis of of interest rate parity.

❖ For given interest rates on deposits denominated in different currencies, and for given expectations for the future development of the exchange rate, uncovered interest rate parity determines the current exchange rate.

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Exchange Rate Determination

❖ Ceteris paribus, an increase in dollar interest rates causes the dollar appreciation.

❖ Ceteris paribus, an increase in euro interest rates causes the euro appreciation.

❖ Finally, ceteris paribus, an expected future appreciation (depreciation) of the euro, leads immediately to a spot appreciation (depreciation) of the euro.

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fletcher school, tufts university › 2016 › 11 › ...transactions costs, risk sharing and...

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