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Lecture 5 UNDERSTANDING EXCHANGE RATES (2) Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 1 A typical trading desk for spot forex Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 2 Volatility USD/EUR, tick chart Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 3 Exchange rates in the short run • The theory of the long-run behavior of exchange rates cannot explain the large changes of current (spot) exchange rates. • In order to understand the short-run behavior, we have to recognize that the exchange rate reflects the price of domestic bank deposits (in €) denominated in terms of foreign bank deposits (in $). Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 4 Comparing expected returns across nations • We consider Euroland the “home country”, and the domestic currency €. • The USA are the “foreign country” with the foreign currency $. Euro deposits bear an interest rate i€. Dollar deposits bear an interest rate i$. How does Hans, the European, compare the return on dollar deposits abroad with the return on domestic investments in € ? Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 5 Comparing expected returns across nations • If Hans invests in the USA, he must realize that his return in terms of € is not i$. He must adjust the return for any expected appreciation/depreciation of the $ against the €. • If $-deposits bring an interest rate of i$ =5% p.a., and the dollar is expected to depreciate by 10% p.a. (w = $/€ ), the expected return in € is 5% - 10% = -5%. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 6 Comparing expected returns across nations • More formally RET $(€) i $ w i i € $ w t 1 t 1 wt wt Differential RET e e (€) e w t 1 w t € $ i (i ) wt wt wt Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 7 Comparing expected returns across nations • If Bill invests in Euroland, he must realize that his return in terms of $ is not i€. He must adjust the return for any expected appreciation/depreciation of the € against the $. • If €-deposits bring an interest rate of i€ =3% p.a., and the euro is expected to appreciate by 10% p.a. (w = $/€ ), then the expected return is 3% + 10% = 13%. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 8 Comparing expected returns across nations • More formally RET €($) w i € i i $ € w t 1 t 1 wt wt Differential RET e e ($) i (i $ € w e t 1 wt wt ) wt wt Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 9 The key point: RET$ and RET€ are symmetrical (with opposite sign) e w t 1 w t (€) € $ Differential RET i i wt e w t 1 w t ($) $ € -Differential RET i i wt e w t 1 w t € $ i i wt As the relative expected return on €-deposits increases, both domestic and foreign residents respond in the same way: they want to hold more €-deposits and fewer deposits in $. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 10 Interest parity condition • At present, international capital markets are relatively open. There are few impediments to the flow of capital, and $ and € have similar liquidity and risk. • When capital is mobile and bank deposits are perfect substitutes, the expected return must become identical: i i € $ Paul Bernd Spahn, Goethe-Universität Frankfurt/Main w e t 1 wt wt 11 Why? Arbitrage and liquidity trading • Whenever there emerge small differences between interest rates and/or changes of expectations on the exchange rate, there will be arbitrage in international money markets that evens out the differential between domestic and foreign returns denominated in one currency => Interest parity condition Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 12 Market adjustment: Examples We assume: i$ = 10%, and wet+1 = 1 $/€. • When wt = 1.0 $/€, the expected appreciation/ depreciation of the € = 0% and the expected return in € is then equal to i$ = 10% (Point B). • When wt = 0.95 $/€, wet = 0.052 =5.2%, and the expected return in € = 4.8% (Point A). • When wt = 1.05 $/€, wet = -0.048 =-4.8%, and the expected return in € = 14.8% (Point C). Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 13 Equilibrium in forex markets RET€ wt ($/€) E 1.05 C 1.00 0.95 RET$ B A D 5.2% 10% 14.8% Expected return (€) Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 14 What happens in disequilibrium • When w ≠ 1.0, there is a market reaction: – w > 1: People will try to sell € and buy $. => “Selling €” and “buying $” – But no one holding $ will sell at that price, there is “excess supply” of euros; i.e. the price of €-deposits relative to $-deposits must fall. – The amount of dollars per euro falls, the euro depreciates. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 15 What happens in disequilibrium • When : – w < 1: People will try to sell $ and buy €. => “Selling $” and “buying €” – But no one holding € will sell at that price, there is “excess supply” of dollars; i.e. the price of $-deposits relative to €-deposits must fall. – The amount of dollars per euro increases, the euro appreciates. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 16 Change in the foreign interest rate • If the foreign interest rate increases, the expected return RET$ also increases. • This leads to a depreciation of the euro. • The same is true if the expected return on dollar deposits increases (at the original equilibrium exchange rate). Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 17 Equilibrium in forex markets wt ($/€) RET€ RET$ RET$ wB B wC C iD Expected return (€) Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 18 Change in the domestic interest rate • An increase in the domestic interest rate raises the expected return on euro deposits, shifts the RET€ schedule to the right, and leads to a rise in the exchange rate. • It creates an excess demand for €-deposits at the original exchange rate, and this leads to an appreciation of the €. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 19 Equilibrium in forex markets wt ($/€) RET€ RET€ RET$ wC C wB B i€B Paul Bernd Spahn, Goethe-Universität Frankfurt/Main i€C Expected return (€) 20 What about inflation ? • If we assume that rational investors ask for a compensation for the erosion of a nominal value due to inflation, i.e. the “Fisher equation” holds, we have to be more specific • Expected inflation-rate differentials are embedded in nominal interest rates, and hence in the nominal exchange rate. • On top of the inflation-rate differential, the exchange rate reacts to differentials in the “real interest” rate. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 21 Factors that affect the exchange rate Change in variable Exchange rate change Domestic interest rate Foreign interest rate Price expectations (D/F) Expected import demand Expected export demand Expected productivity (D/F) Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 22 The analysis of forex markets Euro Euro Paul Bernd Spahn Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 23 Volume of forex transactions, in bill.$ Share of financial innovations Daily, month of April Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 24 Forex turnover by currency pairs (in per cent) $ € € 30 ¥ 20 3 £ 11 2 SFr 5 1 Other 25 2 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main Other 2 25 Forex transactions by market place (April 2001) Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 26 Actors in forex markets Bill. US dollars per day Volume of trading by groups of actors With traders With other financial institutions With non-financial institutions Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 27 The forex market is highly concentrated Citygroup Deutsche Bank Goldman Sachs JP Morgan Chase Manhattan Bank Credit Suisse First Boston UBS Warburg State Street Bank & Trust Bank of America Morgan Stanley Dean Witter Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 9,74 9,08 7,09 5,22 4,69 4,10 3,55 2,99 2,99 2,87 28 And will be concentrated even more … • Since September 2002 the forex market has changed: The CLS Bank started operating. It highly concentrates forex dealings due to a new technology. • On October 29th, the CLS Bank settled 15,200 transactions, totaling $395 billion, which required only $17 billion of payments between member banks, a 95% reduction. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 29 Short and long run: the $/DEM-market Zur Anzeige wird der QuickTime™ Dekompressor „TIFF (LZW)“ benötigt. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 30 Short and long run: the $/£-market Zur Anzeige wird der QuickTime™ Dekompressor „TIFF (LZW)“ benötigt. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 31 Pound sterling during the 1992 crisis • Mastertextformat bearbeiten – Zweite Ebene • Dritte Ebene – Vierte Ebene • Fünfte Ebene Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 32 The Asian crisis 1997-98 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 33 The crisis of the Argentinian peso Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 34 Systemic stability of the financial sector Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 35 Factors driving the financial sector • The financial system is in a continuing flux driven by transactions costs motives. • The developments of forex markets demonstrate the importance of cost reduction. • The strategies are – – – – Bundling of funds (economies of scale) Risk reduction through diversification Explicit Hedging Expertise (legal, technological) Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 36 Information inefficiencies • Market participants can have insufficient information about their counterparts (asymmetric information). It leads to – Adverse selection. This is an information problem occurring before the transaction: Potential bad credit risks are those who seek loans most actively. – Moral hazard. This occurs after the transaction: Borrowers may take on big risks. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 37 Adverse selection: The ‘lemons problem’ • A ‘lemon’ is a bad car purchased second hand. • Akerlof studied the usedcar market and found an asymmetric information problem: – Potential buyers can’t tell a ‘lemon’ from a good car. – They offer an average price, between the value of a lemon and a good car. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main George Akerlof *1940, Nobel Prize 2001 38 The ‘lemons problem’ • The owner of a used car knows whether the car is good or bad. • If the car is a lemon, he is of course happy to sell at the average price. • If the car is good, the owner has little incentive to sell at average prices. • Transaction volumes are low and the market may even break down. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main • Similar problems arise in the securities markets (bonds, and stocks). • An investor will only pay a price that reflects the average quality of firms. • Bad firms are happy to take loans from investors. • Good firms are not willing to borrow on this market. 39 Moral hazard in equity contract (1) • Equity contracts (shares) are subject to a particular ‘principal-agent problem’. • Stockholders (principals) are not the same as managers (agents). This separation involves moral hazard because managers may act in their own interest. • Example: Steve has an ice-cream shop, and you become his silent partner. The capital is shared at 10:90. Profits are also shared in these proportions. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 40 Moral hazard in equity contract (2) • Option 1: Steve works hard and provides good service, but earns only 10% or the profit. • Option 2: Steve does not provide good service, and uses the capital to buy artwork for his office, a luxury car for business; he thus acquires ‘fringe benefits’ at your expense. • Option 3: Steve is not only a poor manager, but also dishonest. In this case the moral hazard problem may become extreme. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 41 Elimination of asymmetric information (1) • A first solution to the problem is the private production and sale of information. • There are professional rating agencies (Standard and Poor’s, Moody’s, Value Line), and you can set up costly monitoring and auditing (state verification) of the firm. • But there is s ‘free-rider problem’ to this. If you buy a security, people my simply copy your behavior without paying for the information. • This erodes potential extra profits, and you may not have bought the information in the first place. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 42 Elimination of asymmetric information (2) • A second possibility could be to involve the government in regulating the market. • The objective is to make firms reveal honest information by adhering to standard accounting practices and to disclose pertinent information. • Government can also impose stiff criminal penalties to contain fraud. • Government regulation may ease the asymmetric information problems, but it is difficult to eliminate them totally. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 43 Elimination of asymmetric information (3) • A third solution is to involve financial intermediaries as experts in the production of information. • A private loan is not traded, so others cannot watch and imitate (no free rider). • This explains why indirect finance is more important than direct finance. • Larger firms (because they are better known) obtain easier access to capital markets than smaller firms. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 44 Systemic instability and financial crises • Financial crises are characterized by abrupt declines in asset prices and by insolvencies of financial and non-financial firms. • Such crises are reoccurring in many countries. They are caused by a sharp increase in adverse selection and moral hazard problems. • Four categories of factors trigger crises: – – – – Increases in interest rates; Increases in uncertainty; Asset market effects on balance sheets; and (Multiple) bank failures. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 45 Asset market effects on balance sheets • Balance sheets have important repercussions on the financial system: – A deterioration (fall in stock or housing prices) of the balance sheet reduces the ‘net worth’ of a firm. – Lenders are less willing to lend because of reduced collateral. – This induces moral hazard because borrowers take higher risks. – The increase in moral hazard makes lending less attractive … this reduces economic activity. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 46 Typical financial crises Deterioration of a bank’s balance sheet Increase in interest rates Stock market decline Increase in uncertainty Adverse selection and moral hazard problems worsen Economic activity declines Bank panic Adverse selection and moral hazard problems worsen Economic activity declines Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 47 The stock market and speculative frenzies • Stock markets have indeed often created havoc to the economy and to people’s life • Early example: the ‘tulip bubble’ in the Netherlands (approximately 1620 to 1637) Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 48 The tulip boom Zur Anzeige wird der QuickTime™ Dekompressor “Foto - JPEG” benötigt. • The boom involved rare tulips • Bulb prices rose steadily throughout the 1630s, as ever more speculators wedged into the market. • In 1633, a farmhouse in Hoorn changed hands for three bulbs • In 1637 the bubble stretched ……. and burst !! Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 49 Precedents of the crisis • The basis of the bubble was an economic boom caused by shocking “new technologies” (Amsterdam merchants were at the center of the new and lucrative East Indies trade) • But enabling the bubble was leveraged through credit, future contracts, and an innovative climate of Dutch finance (that coined new instruments such as options) Did the burst of the bubble drag down the Dutch economy? Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 50 Financial crisis:The US stock market 1871-1914 Financial crises have been frequent and persistent throughout economic history Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 51 What causes stock market volatility? • Financial crises exhibit a similar pattern: – Promising novel technologies or markets – A psychologically boosted investment frenzy – Financial leverage and concentration of resources into an emerging segment of the economy – Over-expansion of a sector and its bust – Contagion of the overall economy Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 52 Examples • This pattern was typical for – The railway frenzy of the mid-19th century – The initiation of electrical appliances at the turn of the last century But the best analyzed event in economic history is the one following the expansion of the ‘roaring 1920s’ ….. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 53 How do financial bubbles affect activity? The NY stock market crashed on Friday, October 1929, initiating a persistent and long downturn of the economy Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 54 Development of Stock Market Index Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 55 Repercussions on the real economy US Unemployment rate, 1929-1942 25 official series 20 Quelle: M.R. Darby, Three-and-a-half Million Employees Have been mislaid, Journal of political Economy, 1976 15 10 Adjusted series 5 1930 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 1935 1940 56 Impact on people’s lives Top CEOs had a especially hard time ! Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 57 What dragged the economy down? • The impact was then – Increase of personal savings (and hence a reduction of consumer spending) due to a perceived reduction of personal wealth – Change in consumer behavior due to higher unemployment – Credit implosion with an induced reduction of demand, notably fixed investment – Reduction of housing investment due to prior over-investment Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 58 The Great Depression: Further problems • And : – A general loss in consumers’ and investors’ confidence – Change in spending behavior due to insolvencies and bankruptcies – Disintermediation due to a lack of liquidity – Negative impact on public investment due to a fall in tax revenue – Policy failures, e.g. “strategic trade policies” (Smoot-Hawley Act) Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 59 The Great Depression: US imports Monthly data. Imports from 75 Countries (in bill. Gold $) January December 1929 February 1930 1931 November March 1932 November 1933 April October May September August Paul Bernd Spahn, Goethe-Universität Frankfurt/Main July June 60 The Great Depression: Monetary policy • Policy failure of central banking: – Reduction in the supply of money – High real interest rates – Failure of financial institutions Anna Schwartz Milton Friedman Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 61 What have we learned since? • Social protection, especially of the old and the unemployed • Consolidation of financial sector to avoid credit implosion, insolvency and break-downs • Fiscal and monetary management • International institutions to provide international means of payment (IMF) and to protect free trade (WTO) • International cooperation and integration • And in particular ……….. Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 62 Our leaders are much brighter !! Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 63 Today we are technically more advanced and smarter than our grandparents! Paul Bernd Spahn, Goethe-Universität Frankfurt/Main However: “animal spirits” are persistent and remain 64 Irrational exuberance: “A bubble that will burst!” Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 65 …and it did! Zur Anzeige wird der QuickTime™ Dekompressor „TIFF (LZW)“ benötigt. The 1920s and 30s Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 66 The central bank and systemic stability • The health of the economy and the effectiveness of monetary policy depend on a sound financial system. Through supervising and regulating financial institutions, the ECB is better able to make policy decisions. • But should it intervene? • Rescue failing banks? Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 67