Exchange Rates

Document Sample
Exchange Rates Powered By Docstoc
					        Foreign Exchange


Professor Christian T. Lundblad
  http://public.kenan-flagler.unc.edu/faculty/lundblac/napoli/




                                                                 1
                                   The Rise of the
                              Multinational Corporation
                  Trade and Financial Regulatory Openness
      Note
1.0   Open Capital Account, Investable Equity, Trade Openness are CS averages for countries in segmentation study
      Open Equity Market is CS average for all 95 countries with data


0.8


0.6


0.4

                                                                              Financial Openness
0.2
                                                                              Trade Openness

0.0
                The Rise of the
           Multinational Corporation
World’s Top Non-financial MNC by Foreign Assets (2005)
                  (millions of dollars and number of employees)




                                                                  Source:
                The Rise of the MNCs
               … in the Emerging World
World’s Top Non-financial MNC from Developing Countries
                by Foreign Assets (2005)
                   (millions of dollars and number of employees)




                                                                   Source:


        These are world class firms: serious competitors
            AND places for significant opportunity
                                       The Rise of the
                                  Multinational Corporation
       Billions of U.S. Dollars
3000
                            U.S. DI Overseas   FDI in the U.S.
2500

2000

1500

1000

 500

   0


                                                                 Source: BEA
                                   The Rise of the
                              Multinational Corporation
                                          World M&A Activity                                            10000
1400
                       M & A (Billions USD)                                 No. of Deals (right-axis)
1200                                                                                                    8000

1000
                                                                                                        6000
800

600                                                                                                     4000

400
                                                                                                        2000
200

    0                                                                                                   0



The data cover deals involving the acquisition of an equity stake of more than 10%.      Source:
                          The Rise of the
                     Multinational Corporation
Cross-Border Merger and Acquisition Activity by
         Buyer and Seller, 1990- 2006
                                         (in millions of U.S. Dollars)

                                      1990                                     2006
                                By Buyer By Seller                       By Buyer By Seller
  World Total                        150576                                   880457

  Developed
  Countries                       143553           135761                 752482         727955

  Europe                           92567            67596                 483637         451288
  North America                    30766            60427                 208302         242680

  Developing
  Countries                         6698            14757                 122941         127372

  Africa                             146              485                  11208         17569
  Latin America                     1114            10199                  31944         37562
  Asia                              5438             4073                  79789         72240
 The data cover deals involving the acquisition of an equity stake of more than 10%.   Source:
The Foreign Exchange Rate




                            8
FX Trading Statistics




                        9
FX Trading Statistics




                        10
                               Trade-Weighted USD Exchange Rate

       150



       125



       100



         75



         50


The index is a weighted average of the foreign exchange values of the U.S. dollar against other major
currencies. The index weights, which change over time, are derived from U.S. export shares. The index is
calculated in indirect terms so higher values imply a stronger USD.
                                                                                                           11
How Significant Are
  Currency Risks?




                      12
Exchange Rate Regimes




                        13
Exchange Rate Regimes




                        14
                                                         The Argentine peso
                                                    Source: http://fx.sauder.ca/

                    1.2

$-peg instituted in April 1991 by Cavallo
under President Menem’s term in office                                    Dual exchange rate system in December 2001;
                                                                          Preferential exchange rate for exports
                     1


                                            $ appreciation              Argentine peso was devalued in January 2002;
                                                                        $-peg was abandoned
                    0.8
            $/ARS




                    0.6




                    0.4

           Brazil’s real currency crisis of 1999;
           Presidential elections in Dec.1999
                    0.2




                     0
                            9




                            0




                            1




                            2




                            3




                            4




                            5
                    O 9




                    O 0




                    O 1




                    O 2




                    O 3




                    O 4




                    O 5
                    Ap 9




                    Ap 0




                    Ap 1




                    Ap 2




                    Ap 3




                    Ap 4




                    Ap 5
                    Ja 9




                    Ja 0




                    Ja 1




                    Ja 2




                    Ja 3




                    Ja 4




                           5
                        l-9




                        l-0




                        l-0




                        l-0




                        l-0




                        l-0




                        l-0
                       r-9




                       r-0




                       r-0




                       r-0




                       r-0




                       r-0




                       r-0
                          9




                          0




                          0




                          0




                          0




                          0




                          0
                        -9




                        -0




                        -0




                        -0




                        -0




                        -0




                        -0
                       n-




                       n-




                       n-




                       n-




                       n-




                       n-




                       n-
                     Ju




                     Ju




                     Ju




                     Ju




                     Ju




                     Ju




                     Ju
                      ct




                      ct




                      ct




                      ct




                      ct




                      ct




                      ct
                    Ja
                                                    The Turkish lira
                                         source:http://ft.sauder.ca/

            3.5

          Hyperinflation

             3




            2.5

                           IMF forces Turkey to adopt a crawling peg against the $ and the €;
                           Slow depreciation until 2003 was the idea…
             2
$/TLira




                                            Interbank lending rates 5,000%

            1.5

                                              02/22/2001 crawling-peg abandoned;
                                              Turkish Lira depreciates > 30%; ultimately > 40%
             1




            0.5




             0
                  9




                  0




                  1




                  2




                  3




                  4




                  5
          O 9




          O 0




          O 1




          O 2




          O 3




          O 4




          O 5
          Ap 9




          Ap 0




          Ap 1




          Ap 2




          Ap 3




          Ap 4




          Ap 5
          Ja 9




          Ja 0




          Ja 1




          Ja 2




          Ja 3




          Ja 4




                 5
              l-9




              l-0




              l-0




              l-0




              l-0




              l-0




              l-0
             r-9




             r-0




             r-0




             r-0




             r-0




             r-0




             r-0
                9




                0




                0




                0




                0




                0




                0
              -9




              -0




              -0




              -0




              -0




              -0




              -0
             n-




             n-




             n-




             n-




             n-




             n-




             n-
           Ju




           Ju




           Ju




           Ju




           Ju




           Ju




           Ju
            ct




            ct




            ct




            ct




            ct




            ct




            ct
          Ja
                    NDFs on the Chinese Yuan
                             Today…
 8



7.5



 7    One-month

      Six-months

6.5   One-year

      Official Exchange Rate
 6
How Significant Are
  Currency Risks?




                      18
                                         What drives exchange rates?

   Band wagon Eff ect/                                                                                                                                      Purchasing Power Parity
Trend -Following Behav ior


  Inv estor Positioning                                                                                                                                          Net Foreign Assets



                               Short-Run                                                                              Long-Run                                   Productiv ity Trends
   Inv estor Sentiment
                              Determinants                         Exchange Rate                                     Determinants

                                                                                                                                                                 Sav ings/inv estment
      Risk Appetite
                                                                                                                                                                  Balance Tre nds
                                                          Medium-Run Determinants
                                                                                                                                                                 Persistent Trend in
   FX Options Market                                                                                                                                              Terms-of -Trade
      Positioning


                                              Real                    Current                              Capital
                                        Interest-Rate                 Account                              Flows
                                         Diff erentials               Trends

                             Monetary                     Fiscal                      Relativ e                            Portf olio-
                              Policy                      Policy                     Economic                              Balance
                                                                                      Growth                             Considerations
                                                                          Michael R. Rosenberg, Exchange Rate Determination: Models and Strategies for Exchange-Rate Forecasting. McGraw Hill, 2003.




                                                                                                                                                                                                       19
                Arbitrage and the Law of One
                            Price
Five Parity Conditions Result From Arbitrage Activities
 1. Purchasing Power Parity (PPP)
 2. The Fisher Effect (FE)
 3. The International Fisher Effect (IFE)
 4. Interest Rate Parity (IRP)
 5. Unbiased Forward Rate (UFR)
Arbitrage and the Law of One
            Price
               Arbitrage and the Law of One
                           Price

The Law of One Price
Identical goods sell for the same price worldwide

Theoretical Basis
If the prices after exchange-rate adjustment were not
     equal, arbitrageurs would take profit opportunities

Link for Five Parity Conditions
The adjustment of rates and prices to inflation
                     The Law of One Price

• We can write an equation for the law of one
  price as,
             PiLC = PiFC * S
  where
      PiLC is the local currency price of good i
      PiFC is the foreign currency price of good i
      S is the dollar to euro exchange rate

• Or we can rearrange the equation to get
          S = PiLC / PiFC

                                                     23
Big Mac Index (from July 2007)

             Invented in 1986 as a light-hearted guide to
         whether currencies are at their “correct” level,
         burgernomics is based on the theory of purchasing-
         power parity (PPP). This says that, in the long run,
         exchange rates should move toward rates that would
         equalise the prices of an identical basket of goods
         and services in any two countries. To put it simply: a
         dollar should buy the same everywhere. Our basket
         is a McDonald's Big Mac, produced locally to roughly
         the same recipe in 118 countries. The Big Mac PPP
         is the exchange rate that would leave burgers
         costing the same as in America. Comparing the PPP
         with the actual rate is one test of whether a currency
         is undervalued or overvalued.
             The first column of the table shows local-currency
         prices of a Big Mac. The second converts them into
         dollars. The average price of a Big Mac in four
         American cities is $3.41. The cheapest burgers are
         in China ($1.45); the dearest are in Switzerland
         ($5.20). In other words, the yuan is the most
         undervalued currency, the Swiss franc the most
         overvalued. The third column calculates Big Mac
         PPPs. Dividing the local Chinese price by the
         American price gives a dollar PPP of 3.23 yuan. The
         actual exchange rate is 7.60 yuan, implying that the
         Chinese currency is undervalued by 58% against the
         dollar.
                                                              24
                               Relative PPP

• We can write an equation for Relative PPP as

        E[et] = E[(St - St-1)/St-1] ≈ pLC,t – pFC,t

where
  pi,t is the inflation rate in country i between time t-1
     and t
  et is the rate of change in exchange rate between time
     t-1 and t


                                                             25
          Purchasing Power Parity (PPP)

PPP in the Extreme: German Hyperinflation
                                                                                          Empirical Evidence on PPP
                                                 1-Year Interval: Low Inflation                                                                  1-Year Interval: High Inflation




                                                                                                                            250
                                                                                                                            200
                                                                 Inflation Differential
              10 20




                                                                                                                            150
                              0
        -20 -10




                                                                                                                            100
                                                                                                                                50
                                                                                                                                  0
                                           -40   -20       0                              20          40       60                      0         50           100     150          200   250
                                                 Exchange Rate (% change)                                                                        Exchange Rate (% change)


In the short-run, PPP does not do a good job of describing exchange
     rate fluctuations (somewhat better in inflationary settings)
  Rather, PPP appears to be a statement about the (very) long-run:
                                                                                                                    24-Year Interval
                  Inflation Differential




                                                                    100 150 200
                                                                                  50
                                                                                          0
                                                                    -50




                                                                                               -100        0              100              200          300
                                                                                                           Exchange Rate (% change)
                                                                                                                                                                                               27
                     Empirical Evidence on PPP


           Market Exchange Rates vs. PPP

                                    300
2.4
      US$/UK£                             JP¥/US$
2.2                                 250
 2
                                    200
1.8
1.6                                 150
1.4
                                    100
1.2
       Market Exchange Rate   PPP         Market Exchange Rate        PPP
 1                                  50




                                                                 Source: OECD
                                         What drives exchange rates?
   Band wagon Eff ect/                                                                                                                                      Purchasing Power Parity
Trend -Following Behav ior


  Inv estor Positioning                                                                                                                                          Net Foreign Assets



                               Short-Run                                                                              Long-Run                                   Productiv ity Trends
   Inv estor Sentiment
                              Determinants                         Exchange Rate                                     Determinants

                                                                                                                                                                 Sav ings/inv estment
      Risk Appetite
                                                                                                                                                                  Balance Tre nds
                                                          Medium-Run Determinants
                                                                                                                                                                 Persistent Trend in
   FX Options Market                                                                                                                                              Terms-of -Trade
      Positioning


                                              Real                    Current                              Capital
                                        Interest-Rate                 Account                              Flows
                                         Diff erentials               Trends

                             Monetary                     Fiscal                      Relativ e                            Portf olio-
                              Policy                      Policy                     Economic                              Balance
                                                                                      Growth                             Considerations



                                                                          Michael R. Rosenberg, Exchange Rate Determination: Models and Strategies for Exchange-Rate Forecasting. McGraw Hill, 2003.




                                                                                                                                                                                                       29
                  Current Account and National Savings


• National Savings (S) is defined as the portion of
  national income not devoted to consumption or
  government expenditures. So,

    S=Y-C-G

    S = (C + I + G + EX - IM) - C - G

    S = I + EX – IM

    S = I + CA


                                                         30
Evolving Trade Dynamics




                          31
                      What about the U.S.?


Is this
sustainable?                             Canary in the
So long as the $ is                      coal mine? The
the world’s                              state of the $.
reserve                                  Rubin: “I think I
currency…                                was right,
                                         probabilistically”




                                                        32
                                   Global Current Account Imbalances

                 Major Net Exporters and Importers of Capital




Sum of all CA balances does not sum to zero                            33
                     Rising importance of Euro

                      Further facts
Reserve currencies    • Dollar share of holdings by OPEC countries
      EURO Dollar         •2001: 75.0%
                          •2004: 61.5%
1999 17.9% 70.9%

2002 24.2% 66.5%      • International bonds denominated in EURO
2005 24.3% 66.4%          •1999: 21.7%
                          •2003: 33.0%
Source: ECB
                          •2007: >45%

                          Source: International Capital Market Association
                  The International Fisher
                        Effect (IFE)
Fisher postulated
  – Real interest rates tend toward equality through
    arbitrage
  – The nominal interest rate differential reflects the
    inflation rate differential
  – With no government interference, nominal rates
    vary by inflation differential or
             iLC,t – iFC,t ≈ pLC,t – pFC,t
IFE states
  – The spot rate adjusts to the interest rate
    differential between two countries.

             E[et] ≈ iLC,t – iFC,t
                   The International Fisher
                         Effect (IFE)
Implications:
   – Currency with lower interest rate are expected to
     appreciate relative to one with higher rate (monetary
     policy)
                  (Covered) Interest Rate Parity
                              (IRP)
The forward rate (F) differs from the spot rate (S) in
  equilibrium by an amount equal to the interest
  differential (iLC,t – iFC,t ) between two countries

The forward premium or discount equals the interest rate
  differential:
                (Ft – St)/St = (iLC,t – iFC,t )

In equilibrium, risk-free returns on currencies will be the
   same. Should this hold for emerging markets?
                                   (Covered) Interest Rate Parity
                                        (IRP) (1981-2006)




The data are spot rates and 3-month external currency market interest rates and forward rates from Global Insight (1981-2006)
             Relationship between Forward and
                   Future Spot Rate (FEP)
The Forward Rate as a predictor for future
  spot rates? Ft = E[St+1]
  – States that if forward rate is unbiased, then it
    should predict the expected future spot rate.

                                                   It doesn’t!
                                                  popularity
                                                  of the “carry
                                                      trade”
                                                 Caveat: Be very
                                                    cautious!
                                         What drives exchange rates?
   Band wagon Eff ect/                                                                                                                                      Purchasing Power Parity
Trend -Following Behav ior


  Inv estor Positioning                                                                                                                                          Net Foreign Assets



                               Short-Run                                                                              Long-Run                                   Productiv ity Trends
   Inv estor Sentiment
                              Determinants                         Exchange Rate                                     Determinants

                                                                                                                                                                 Sav ings/inv estment
      Risk Appetite
                                                                                                                                                                  Balance Tre nds
                                                          Medium-Run Determinants
                                                                                                                                                                 Persistent Trend in
   FX Options Market                                                                                                                                              Terms-of -Trade
      Positioning


                                              Real                    Current                              Capital
                                        Interest-Rate                 Account                              Flows
                                         Diff erentials               Trends

                             Monetary                     Fiscal                      Relativ e                            Portf olio-
                              Policy                      Policy                     Economic                              Balance
                                                                                      Growth                             Considerations



                                                                          Michael R. Rosenberg, Exchange Rate Determination: Models and Strategies for Exchange-Rate Forecasting. McGraw Hill, 2003.




We clearly do not fully understand why exchange rates fluctuate
 hedging?
                                                                                                                                                                                                       40
                                                                          What drives exchange rates?

                   FX dealers’ perception of the most important factor that
                            explain exchange rate movements

    Select the single most important factor that determines exchange rate movements
on an:
                  Intra-Day Basis Medium-Run Basis             Long-Run Basis
                                   (up to 6 months)            (beyond 6 months)
    Bandwagon Effects                                                    29%                               10%   1%
    Overreaction to News                                                 33%                               1%    0%
    Speculative Forces                                                   25%                               31%   3%
    Economic Fundamentals                                                1%                                31%   83%
    Technical Trading                                                    10%                               26%   11%
    Other                                                                2%                                2%    2%
    Source: Yin-Wong Cheung, Menzie Chinn, and Ian Marsh, International Journal of Finance and Economics




                                                                                                                       41
                            Exchange Rate Forecasting
• Who would want to forecast exchange rates?
   – Investors, corporations, government officials, etc.
   – Forecasts play a fundamental role in nearly all of international finance


• The big debate: Can we do it? (forecast FX rates)
   – While many business and financial decisions depend on FX forecasts,
     there is considerable debate about the possibility of making accurate or
     useful forecasts.
Exchange Rate Forecasting




             From a May 24,1995 WSJ story
Exchange Rate Forecasting
                   Exchange Rate Forecasting

Do Banks Know Better? Performance of Exchange Rate Forecasting




                                          R = MSE(Bank)/MSE(Spot Rate)
                              Should Firms Hedge?
Not everyone agrees that a firm should hedge:
   – May not add to shareholder wealth if the shareholders can manage
     exposure themselves
   – May not reduce the non-diversifiable risk of the firm


In the presence of market imperfections, the firm should
   hedge.
   – Information Asymmetry: The managers may have better information than
     the shareholders
   – Differential Transactions Costs: The firm may be able to hedge at better
     prices than the shareholders
   – Default Cost: Hedging may reduce the firms cost of capital if it reduces
     the probability of default.
   – Taxes: Corporations that face progressive tax rates may find that they
     pay less in taxes if they can manage earnings by hedging than if they
     have “boom and bust” cycles in their earnings stream.
Do Firms Hedge?




       % of firms using derivative
        Bartram, Brown, Fehle
Do Firms Hedge?




             % of firms using derivative
             Bartram, Brown, Fehle (2007)

				
DOCUMENT INFO