Transcript and credit and lyonnais

International Finance
FINA 5331
Lecture 2: Foreign Currency Markets
Continued: Introduction to
Balance of Payments
Read: Chapters 3&5
Aaron Smallwood Ph.D.
Review
• The spot market is an exchange market for
delivery of currencies on the “spot.”
• Direct quotations for currency x from currency’s
y perspective: S(y/x).
• Banks buy currencies at the bid price and sell at
the ask price:
– Ex. In the market for ¥ relative to €, suppose we get
the quote:
€0.00770-75. How much to purchase
¥ 1,000,000?=
– ¥ 1,000,000*0.00775= €7,750.
Review Cont
• Arbitrage: The act of simultaneously
buying and selling to make a profit
• Triangular arbitrage involves three
markets.
– Take two markets, calculate the implied price
in the third. If implied quote doesn’t match,
there is an opportunity for arbitrage.
Review: Triangular Arbitrage
Suppose we
observe these
banks posting
these exchange
rates.
$
Barclays
Credit
Lyonnais
S(¥/$)=120
S(£/$)=1.50
First calculate the
implied cross
rates to see if an
arbitrage exists.
¥
Credit Agricole
S(¥/£)=85
£
Review: Triangular Arbitrage
The implied S(¥/£)
cross rate is S(¥/£) = 80
Credit Agricole has
posted a quote of
S(¥/£)=85 so there is an
arbitrage opportunity.
$
Barclays
Credit Lyonnais
S(¥/$)=120
S(£/$)=1.50
¥
Credit Agricole
S(¥/£)=85
So, how can we make money?
Buy the £ @ ¥80; sell @ ¥85. Then trade yen for dollars.
£
Review: Triangular Arbitrage
As easy as 1 – 2 – 3:
$
1. Sell $ for £,
Barclays
2. Sell £ for ¥,
S(¥/$)=120
3
3. Sell ¥ for $.
Credit
Lyonnais
1
S(£/$)=1.50
2
¥
Credit Agricole
S(¥/£)=85
£
Review: Triangular Arbitrage
Sell $100,000 for £ at S(£/$) = 1.50
receive £150,000
Sell our £ 150,000 for ¥ at S(¥/£) = 85
receive ¥12,750,000
Sell ¥ 12,750,000 for $ at S(¥/$) = 120
receive $106,250
profit per round trip = $ 106,250- $100,000 = $6,250
Cross Currency Exchange Rates with BidAsk Spreads
• Consider the example on page 122
– Suppose, relative to the US $, we are given the bid
ask spread in the market for pounds (e.g. $/£).
What then is the bid ask spread in the market for
$?
• Bid price is the inverse of the ask price.
• If bid-ask spread in the market for pounds is: $1.9712-17,
the bid price in the market for $=
St
£/$
 1 / 1.9717  0.5072
– Can show that the ask price is 0.5073
Triangular Arbitrage
• Previous triangular arbitrage is unrealistic since
traders face no transactions costs.
• We want to consider examples with bid-ask
spreads.
• See example on pages 122-123, with the
following quotes:
– Market for pounds: $1.9712-17
– Market for euros: $1.4739-44
– Market for pounds: €1.3305-10
• Implied price in the third market is 1.3370-77. POUND
UNDERVALED!
Exploit the arbitrage opportunity
• Suppose we start with $1,000,000
• First, we need to get euros so we can buy
pounds in the 3rd market.
– Start by selling dollars for euros:
• We receive: $1,000,000/1.4744 = €678,242.00
– Sell euros for pounds:
• We receive: €678,242.00/1.3310 = £509,573.25
– Finally, sell pounds for dollars
• We receive: £509,573.25*1.9712 = $1,004,470.79
• PROFIT: $4,470.79.
Balance of Payments Accounting
• The Balance of Payments is the statistical
record of a country’s international
transactions over a certain period of time
presented in the form of double-entry
bookkeeping.
credit “positive” entries
debit “negative entries”
Balance of Payments Example
• Suppose that Maplewood Bicycle in
Maplewood, Missouri, USA imports
$100,000 worth of bicycle frames from
Mercian Bicycles in Darby England.
• There will exist a $100,000 credit recorded
by Mercian that offsets a $100,000 debit at
Maplewood’s bank account.
• This will lead to a rise in the supply of
dollars and the demand for British pounds.
Balance of Payments Accounts
• The balance of payments accounts are those
that record all transactions between the
residents of a country and residents of all foreign
nations.
• They are composed of the following:
–
–
–
–
The Current Account
The Financial Account
The Official Reserves Account
Statistical Discrepancy
The Current Account
• Includes all imports and exports of goods and
services (invisible trade).
• Includes unilateral transfers of foreign aid.
• If the debits exceed the credits, then a
country is running a trade deficit.
• If the credits exceed the debits, then a
country is running a trade surplus.
• It is thought that the CA responds to changes
in income and the exchange rate.
The Current Account
• A credit on the current account results in
foreign reserves flowing in (fixed exchange
rate) or an increase in the demand for
domestic currency in the FOREX market
(flexible exchange rate).
• A debit on the current account results in
foreign reserves flowing out of the domestic
economy (fixed exchange rate) or an
increase in the supply of domestic currency in
the FOREX market (flexible exchange rate).
The Current Account
• When a domestic company sells goods or services to
a foreign resident, there will be a credit recorded on
the current account.
• When a domestic resident buys goods or services
from a foreign firm, there will be a debit recorded on
the current account.
• When a foreign asset pays interest to a domestic
resident, or a domestic resident earns income in the
foreign economy, there will be a credit recorded on the
current account.
• When a domestic asset pays interest to a foreign
resident, or a foreign resident earns income in the
domestic economy, there will be a debit recorded on
the current account.
J-curve Effect
What conditions are necessary for J-curve effect?
εIM is the import demand elasticity = %Δimports divided by %ΔSt.
When εIM is greater than one (in absolute value), a domestic depreciation will lead
to a fall in the dollar value of imports. Import demand is said to be elastic.
When εIM is equal to one (in absolute value), a domestic depreciation will not
change the dollar value of imports.
When εIM is less than one (in absolute value), a domestic depreciation will lead to a
rise in the dollar value of imports. Import demand is inelastic.
The J-curve can only occur when import demand elasticities are inelastic.
Algebra of Import Demand Elasticities
$ value of imports  St  Qimports
% $ value of imports  % St  % Qimports
%$ value of imports
%St %Qimports


 1   IM
%St
%St
%St
Since  IM  0 and % St  0,
  0 if unit elasticity 
% $ value of imports 


0
if
elastic


% St
  0 if inelastic 


Will a depreciation increase your company’s
exports?
• That depends on the elasticity of demand for your product.
• A domestic depreciation will make your products less expensive to
foreign residents.
• The law of demand tells us that quantity demanded will be higher.
• But if the price falls by more than the quantity rises (inelastic
demand), total sales will be less.
• An inelastic export demand will lead to lower sales. Your company
would be better off with a domestic appreciation!
• To determine the effect on company export sales of a change in St,
one needs to know the foreign demand elasticity.
The Financial Account
• The financial account measures the difference
between U.S. sales of assets to foreigners and
U.S. purchases of foreign assets.
• The financial account is composed of Foreign
Direct Investment (FDI), portfolio investments
and other investments.
The Financial Account
• A credit on the financial account results in
foreign reserves flowing in (fixed exchange
rate) or an increase in the demand for
domestic currency in the FOREX market
(flexible exchange rate).
• A debit on the financial account results in
foreign reserves flowing out of the domestic
economy (fixed exchange rate) or an
increase in the supply of domestic currency in
the FOREX market (flexible exchange rate).
The Financial Account
• When a domestic entity (firm or individual)
sells an asset to a foreign resident, there will
be a credit recorded on the financial account.
• When a domestic resident buys an asset from
a foreign entity, there will be a debit recorded
on the financial account.
• Note – income earned on these assets is
recorded on the current account, not the
financial account.
The Balance of Payments Identity
BCA + BFA + BRA = 0
where
BCA = balance on current account
BFA = balance on financial account
BRA = balance on the reserves account
• Note: When a country experiences a currency
crisis, we typically see BRA>0 (and HUGE)
Under a pure flexible exchange rate regime,
BCA + BFA = 0
Because BRA = 0
Balance of Payments Trends
• Since 1982 the U.S. has experienced
continuous deficits on the current account
and continuous surpluses on the financial
account.
• During the same period, China has
experienced the opposite.
Balances on the Current (BCA) and Capital (BKA)
Accounts of the United States
United States
800
Balances in Billions of US dollars
600
Current Account Balance
Capital and Financial Account Balance
400
200
0
-200
-400
-600
-800
-1000
1981
1986
1991
1996
2001
2006
2011
Balances on the Current (BCA) and Capital (BKA)
Accounts of United Kingdom
United Kingdom
80
Balances in Billions of US dollars
60
Current Account Balance
Financial Account Balance
40
20
0
-20
-40
-60
-80
-100
1981
1986
1991
1996
2001
2006
2011
Balances on the Current (BCA) and Capital (BKA)
Accounts of Japan
JAPAN
250
Current Account Balance
Capital and Financial Account Balance
200
Trade in Billions of US dollars
150
100
50
0
-50
-100
-150
-200
-250
1984
1989
1994
1999
2004
2009
Balances on the Current (BCA) and Capital (BKA)
Accounts of China
CHINA
500
400
Current Account Balance
Financial and Capital Account Balance
300
Balances in Billions of US Dollars
200
100
0
-100
-200
-300
-400
-500
1982
1987
1992
1997
2002
2007
2011
Balance of Payments and National Income
Accounting
•
•
•
•
1.
2.
3.
4.
GNP = Y = C + I + G + X – M
Y=C+S+T
X – M = (S- I) + (T- G)
If a developing economy experiences large
trade deficits (X-M <0), the remedies are:
Savings must increase, S↑
Investment must fall, I↓
Government spending must fall, G↓
Taxes must rise, T↑