Transcript 2 - Goethe-Universität

Lecture 5
UNDERSTANDING
EXCHANGE RATES (2)
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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A typical trading desk for spot forex
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Volatility USD/EUR, tick chart
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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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
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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
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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
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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
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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
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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
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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 $/€, wet = -0.048 =-4.8%, and
the expected return in € = 14.8% (Point C).
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Equilibrium in forex markets
RET€
wt ($/€)
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
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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
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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 $-deposits
relative to €-deposits must fall.
– The amount of dollars per euro increases,
the euro appreciates.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Change in the foreign interest rate
• If the foreign interest rate increases, the
expected return RET$ 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
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Equilibrium in forex markets
wt ($/€)
RET€
RET$
RET$
wB
B
wC
C
iD
Expected return (€)
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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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
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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
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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
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The analysis of forex markets
Euro
Euro
Paul Bernd Spahn
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Volume of forex transactions, in bill.$
Share of
financial innovations
Daily, month of April
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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
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Forex transactions by market place (April 2001)
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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
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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
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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
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Short and long run: the $/DEM-market
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Short and long run: the $/£-market
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Pound sterling during the 1992 crisis
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– Zweite Ebene
• Dritte Ebene
– Vierte Ebene
• Fünfte Ebene
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The Asian crisis 1997-98
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The crisis of the Argentinian peso
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Systemic stability of the financial sector
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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
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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
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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.
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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
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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
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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
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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
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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
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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
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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
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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
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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)
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The tulip boom
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• 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
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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
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Financial crisis:The US stock market 1871-1914
Financial
crises have
been frequent
and persistent
throughout
economic
history
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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
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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
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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
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Development of Stock Market Index
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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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
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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
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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
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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
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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 ………..
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Our leaders are much brighter !!
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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
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…and it did!
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The 1920s and 30s
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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?
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