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Comprised of
$1.005 trillion $2.076 trillion in derivatives, ie $362 billion in outright forwards $1.714 trillion in forex swaps
Currency Turnover
Exchange Rates Spot versus forward exchange rates Nominal exchange rate A forward contract refers to a transaction for delivery of foreign exchange at some specified date in the future.
Used to hedge currency risk
Forward premium
Forward versus futures Forwards sold by commercial banks, otc Futures sold in organized exchanges
Originated in 1972 in the Merc Clearinghouse, currencies need not be delivered
Contracts settled in cash Forward markets larger but futures markets more liquid
Options
Right to buy or sell at set price (strike price)
or
Ft et i i* = et 1 + i*
If not equal there are arbitrage profits to be made Thus, a positive interest differential implies a forward premium Interest must compensate for capital loss
Ft et et
C B -0.04 -0.04 0
i i * 1 +i *
0.04
PU
Ft et et
C B -0.04 -0.04 0
i i * 1 +i *
0.04
Uncovered Interest Parity Suppose we do not hedge our investment Again we invest one dollar
Let be the expected future spot rate In 3 months we earn Arbitrage requires UIPC, thus
Market Efficiency
Testing for UIPC We have data on F but not on Rational expectations implies that forecast errors are unbiased
Then should be an unbiased predictor of
et +1
Ft
I should find That is, all the information valuable et +1 for predicting is incorporated in Ft the market price,
Testing UIPC Typically one actually regresses changes, so With null hypotheses
Notice this is a joint test
REH and UIPC So rejection could mean either
Expectations are not rational UIPC does not hold (perhaps agents are not risk neutral)
We are testing a joint hypothesis If marginal agents are risk averse ignoring this could explain the forward puzzle If income is volatile perhaps risk premium varies Or it could be Central Bank Behavior
Forward discount is larger in floating rate regimes Forward discount larger at shorter horizons
Interesting because CBs can only move e over short periods Less risk at longer horizons
Longer Horizons
Risk Premium
But time varying risk premia hard to observe
To explain< than
1 2
Why would this be the case (assertion, see notes for explanation)?
DXY Index
With payoff
So if
my profit would be
Carry Trade
Suppose we did this via dollar-yen
September 1993 till August 2003
Bet once a month for ten years, we have 120 observations We would earn money, average profits positive = . 0041 .6 to 1.1 Profits are volatile Sharpe ratio = 0.12 < than for S&P 500
Example
Example
Example: Japanese yen and Australian dollar
2001: steady increase in profits from carry trades. Despite several months of positive carry profits, the yen did not sufficiently appreciate against the Australian dollar to offset these profits.
Price Pressure
Bid-ask spreads reduce size of profits Large amounts of speculation needed to earn money Speculator who be one pound on an equally-weighted portfolio of carry-trade strategies (across the USA, Canada, Belgium, France, Germany, Japan, Netherlands, Switzerland and the euro) from 1976 to 2005 would earn an monthly payoff of 0.0025 pounds. To earn an average annual payoff of 1 million pounds would require a bet of 33.33 million pounds per month. Is there an effect of such large trades? Would they survive such speculation? Prices rise with order flow Could eat profits You could break up trades, but this chews up profits as well The marginal expected payoff can be zero, even when the average payoff is positive Speculators make profits but no money is left on the table
Risk versus Reward Idea: Examine traders strategies and other finance theories to study tradeoff between risk and return.
Data: Positive 1% interest differential is associated with only a 0.23% appreciation in the currency, implying a 0.77% profit. Problem: despite the existence of profits:
Profits do not rise/fall linearly, line is a poor fit for the data. At higher differentials, variance in return higher. Variance around the line is high in general,
Limits of Arbitrage
Returns positive for currencies Very high volatility of returns Sharpe ratios < 1
Equal to 0.5 0.6 for market portfolio of currencies Differs little from stock market
Predictability and Nonlinearity Linear model may be the problem Nonlinear models reveal that low interest differentials are associated with very low profits.
At high differentials, investors engage in carry trades, bidding up the currency, sometimes causing reversals (and losses). At the extreme ends, arbitrage appears to work, so what is happening for moderate interest differentials?
Investors are willing to take on some risk, if
Peso Problems
Suppose e = 20c, and investors are 95% sure it will stay With prob = .05 they believe it will fall to 10c. Then,
So each period for which there is no change the forecast error is positive: Casual observer might assume irrationality
Example
Suppose peso is pegged to dollar
Let iUS = .05 Then UIPC implies
Market predicts depreciation; each period the peg holds UIPC is violated
But does not mean market is inefficient Agents are calculating the small risk of a big depreciation When the market corrects, losses are large Argentina, Hong Kong
Volatility Puzzle
Real Interest Parity We have been looking at nominal returns, what about real returns?
Fisher effect tells us that So If PPP holds, then
so
RIPC
So, using the Fisher equation we obtain:
This implies that real interest differentials are equal to expected changes in Q Suppose people expect > 0 Q e Implies real value of the dollar will decline
Investors will demand a premium to hold US assets
Does this mean there are profits that are not arbitraged?
No
Differences in real returns are not on the same asset They are returns on different bundles of goods
RIPC Interpreted
Real interest differentials reflect nominal rates ' s deflated by over different consumption baskets
If agents were identical => PPP, so differences equalized Because people in different countries consume different baskets of goods, there is no way for them to arbitrage away any difference.
Implies that we cannot look at real interest Q e > 0 differentials to study whether capital markets are integrated Capital markets can be perfect, but if large US CA deficits lead to expectations of then real returns on US assets would have to exceed those in the rest of the world
Exchange Rate Regimes Two polar cases and many in the middle
Fixed exchange rates
CB buys or sells reserves to maintain a set price of foreign exchange
If internal prices were as flexible as exchange rates, it would make little economic difference whether adjustments were brought about by changes in exchange rates or by equivalent changes in internal prices. The argument for flexible exchange rates is, strange to say, very nearly identical with the argument for daylight savings time. Isnt it absurd to change the clock in summer when exactly the same result could be achieved by having each individual change his habits? All that is required is that everyone decide to come to his office an hour earlier, have lunch an hour earlier, etc. But obviously it is much simpler to change the clock that guides all than to have each individual separately change his pattern of reaction to the clock, even though all want to do so. The situation is exactly the same in the exchange market. It is far simpler to allow one price to change, namely, the price of foreign exchange, than to rely upon
Foreign Exchange If CB does not intervene, then market price of foreign exchange is Suppose demand for foreign exchange increases
Then if CB does nothing, e must rise To keep e fixed CB must sell foreign exchange
So international reserves fall
Thus,
where is the fixed exchange rate Notice that exchange rate can also be affected by policy
Fixed Rates and Reserve Accumulation If the exchange rate is fixed, then reserves adjust as demand and supply shifts
The peg is sustainable if these shocks offset Peg is unsustainable if shocks are biased But there is asymmetry
Easier to accumulate foreign exchange You cannot print it if you are running out!
% e
Implies that e will jump at that date, t Implies capital gain at date t 1 So people will sell at t -1, implies capital gain, so e collapses at t 1 Implies e collapses at t 2,
Collapse
Exchange rate collapses before reserves run out
Nobody wants to be the last person to exit If agents are forward looking they anticipate capital losses
So currency cannot collapse and then jump to shadow rate
In practice we see that currency collapses before reserves run out Key is when CB is no longer willing to pay the cost of maintaining the exchange rate
CB could always repurchase the MB
Problem is the cost of doing so No longer lender of last resort, interest rates may skyrocket External versus internal balance
Fixing the Exchange Rate Under fixed rates IR is changing to offset any excess demand for foreign exchange
When there is ED > 0 the CB sells reserves, so If ED < 0, the opposite takes place
No Sterilization
The assets of the CB, IR + DS = MB The money supply just depends on the MB, so
Thus when reserves fall the money supply contracts, and vice versa Fixing the exchange rate means giving up control over the supply of money
1. purchase from foreign banks or central banks via changes in the foreign banks deposit at the Fed.
In this case, once the bank uses this deposit to purchase some interest-bearing security from a domestic bank, bank reserves will rise.
Sterilization
Sterilization occurs when the CB moves to insulate the domestic economy from foreign reserve transactions
Typically an open market operation: if inflows of foreign exchange are swelling the money supply then the CB sells bonds to soak it up, e.g., Notice that to persist in sterilization requires large stocks of both foreign reserves and domestic securities. obviously difficult for debtor, what about for surplus case? Need to keep selling DS, but how much will the public buy?
Depends on how financially developed the economy Interest cost of sterilization can be large
M P 1
I R P
i0
i1
L(Y, i)
M/ P
Impossible Trinity
We see that a country cannot simultaneously have:
Independent monetary policy Fixed exchange rate Capital mobility
With fixed e you interest rates cannot diverge from i* Conflict between internal and external balance Chinas advantage
China does not have open capital account
So it can sterilize current account surpluses Lack of capital mobility depresses local interest rates, reduces costs of sterilization
Time of Collapse
Reserve Flow