1、What is a countrys balance of payment?A systematic account of all the exchanges of value between residents of that country and the rest of the world during a given time period Tow flows in any transaction: double-entry bookkeepingA credit is a flow for which the country is paidA debit is a flow for

2、which the country must pay1Six categories of flowsMerchandise trade flowsService flowsIncome flowsUnilateral transfersPrivate capital flowsOfficial international reserve flows2Six balancesMerchandise (goods) trade balance Goods and service balance (trade balance)Goods, service, and income balance Cu

3、rrent balance (net foreign investment)Financial account balanceOverall balance (official settlement balance)3Some examples:Exports and imports of goodsExpenditures of foreign visitorsStudy abroad interests and dividend received International migrants remittances Lending to (borrowings from) foreigne

4、rDirect investments and international portfolio investment4The statistic discrepancy itemSomething was under-measured A net results of errors and omissions5The macro meaning of current account balanceFinancing and international financial flows: Net foreign investment (If). CA = If National saving (S

5、) versus domestic investment (Id). S = Id + If, so that CA = S IdDomestic production (Y) versus national expenditure (E). Y = C + Id + G +(X M), E = C + Id + G, and CA = (X M) approximately, so that CA = Y E6The macro meaning of the overall balanceThe official settlement balance:B = CA + FAB + OR =

6、0The international investment positionA statement of the stocks of a nations international assets and foreign liabilities at a point in timeFlow vs. stock (lender or borrower vs. creditor or debtor)7Homework: Prepare Chinas BOP according to the format in figure 2.1 in Pugel (page 15) for 1999-2008,

7、and analyze the trends (goods and service balances, current account balances, official settlement balances, etc.)http:/ is foreign exchange?Dynamic conceptStatic conceptDemand and supply for foreign exchangeCurrent accountFinancial account9Floating exchange ratesDownward-sloping demand curveEquilibr

8、ium exchange rateShift in demand and supply curvesFixed exchange ratesPar value and the narrow bandSupply and demand gapGovernment intervention10Foreign exchange quotationDirect quotation: the amount of DC required to purchase one unit of FCIndirect quotation: the amount of FC required to purchase o

9、ne unit of DCBid price: the exchange rate at which the dealer is willing to buy a currencyAsk (offer) price: the exchange rate at which the dealer is willing to sell a currency11The dealer need to earn a profit, so she always “buy low and sell high”!Bid-ask spread: the difference between the bid pri

10、ce and the ask price (can be in percentage) Factors affecting the bid-ask spreadsMarket conditionDealer positionLiquiditymidpoint price: the average of the bid price and the ask pricebasic point: usually 0.0001 (0.01 for JPY) or 0.01%Some examples:$/ = 1.6543 1.6547 (direct quote in US)/$ = 0.6043 0

11、.6045 (indirect quote in the US)Note that the DC/FC direct bid (ask) exchange rate is the reciprocal of the indirect ask (bid) exchange rateThe bid-ask spread is 0.0004 (3bp, direct), or 0.0002 (2bp, indirect)The percentage bid-ask spread is 0.0004/1.6547=0.0242% (2.42bp, direct), or 0.0002/0.6045=0

12、.0331% (3.31bp, indirect) The midpoint exchange rate is 1.6545 (direct), or 0.6044 (indirect)Questions:1. Suppose you want to convert US dollar into pound, and get three different quotes ($/): A: 1.6432/38 B: 1.6433/36C: 1.6434/37, from which dealer would you buy pound?2. The interbank quotes for US

13、 dollar and pound are $/=1.6433/36. If bank A want to earn 2bp profit, what quotes should it give to its retail customers? Cross-rate calculations with bid-ask spreadsExample 2.1: consider the following quotes involving the dollar, pound, and the euro.$/:0.9836/39/: 1.5473/1.5480Compute the effectiv

14、e $/ bid and ask cross-rates, as well as the /$ bid and ask cross-rates?15Solution 1:($/)bid = ($/)bid*(/)bid = 0.9836*1.5473 = 1.5219 dollar per pound bid rate($/)ask = ($/)ask*(/)ask = 0.9839*1.5480 = 1.5231 dollar per pound ask rate(/$)bid = (/)bid*(/$)bid = 1/(/)ask*1/($/)ask = (1/1.5480)*(1/0.9

15、839) = 0.6566 pound per dollar bid rate(/$)ask = (/)ask*(/$)ask = 1/(/)bid*1/($/)bid = (1/1.5473)*(1/0.9836) = 0.6571 pound per dollar ask rateSo, the effective $/ bid and ask cross-rates is $/=1.5219/31, and the effective /$ bid and ask cross-rates is /$=0.6566/71 Solution 2: Imaging you want to co

16、nvert dollar into pound: using dollar to buy euro first (1$ =1/0.9839), and then using the euro to buy pound (1=1/1.5480). The resulting cross-rate is 1$ =0.6566 , or 1= 1.5231$If you want to convert pound into dollar: using pound to buy euro first (1 =1.5473), and then using the euro to buy dollar

17、(1=0.9836 $). The resulting cross-rate is 1 =1.5219$, or 1$ =0.6571.So, the effective $/ bid and ask cross-rates is $/=1.5219/31, and the effective /$ bid and ask cross-rates is /$=0.6566/7117Arbitrage “Pay nothing for something,” or “get something for noting”“there is not such thing as a free lunch

18、”Any deviation from “the law of one price” will present an arbitraging opportunity! Basic strategy: “buy low, sell high”!An arbitraging strategy is risk-free. In contrast, a speculative strategy is always associated with some degree of risk18Bilateral arbitrage with bid-ask spreadsNo-arbitrage condi

19、tion:(FC/DC)bid*(DC/FC)bid 1, or (FC/DC)ask*(DC/FC)ask 1, Example 2.2: DC/FC = 0.80025/0.80041, FC/DC = 1.2498/1.2503; Is there an arbitrage opportunity? If so, what is the arbitraging strategy? What about DC/FC = 0.8003/0.8005, and FC/DC = 1.2484/1.2490?Note that when the rates are misquoted, the d

20、irect bid (ask) of one currency is not the reciprocal of its indirect ask (bid).19Triangular arbitrage with bid-ask spreadsNo-arbitrage condition: the implied cross-rate is consistent with the actual cross-rateExample 2.3: FC1/DC=0.9836/39;FC1/FC2=1.5373/80; DC/FC2=1.5219/31; Is there an arbitrage o

21、pportunity? If so, what is the arbitraging strategy? 20Forward foreign exchange rateA forward forex contract is an agreement to exchange one currency for another on a specified date in the future at a rate set now (the forward exchange rate)A spot rate is the prevailing rate in the marketThe forward

22、 rate is not the same as the future spot rate!21Trading involving forward exchange rateOpen positionLong positionShort positionHedging: offsetting a long (short) position in a foreign currency, or covering the open positionSpeculating: deliberately establishing a net position (long or short) in a fo

23、reign currencyHedging eliminates risk exposure, whereas speculation increases risk exposure22Forward premium (discount): the proportionate difference between the current forward exchange rate and current spot exchange ratef = (forward rate spot rate) / spot rate (under indirect quotation)Note: the q

24、uotation convention (direct or indirect) affects the sign of forward premium! One alternative is to convert the direct quote into indirect quote, and then calculate the premiumAnnualized forward premium 23Some examples:A US exporter signs a contract with a French importer for 1 million euro of goods

25、, to be delivered in three months. The current spot rate is /$=0.7125, and the 3-months forward rate is /$=0.7225The US exporter has an open (long) position of 1 million euro If the US exporter also signs a forward contract to sell 1 million euro in three months, she eliminates her exposure to excha

26、nge rate risk (hedging)If, instead, the US exporter expects the euro will appreciate against the dollar, she signs a forward contract to buy 1 million euro in 3 months. She increases her exposure to exchange rate risk (speculation)Some symbolsCurrent spot rate between domestic currency and foreign c

27、urrency is FC/DC = S; One-year forward exchange rate is FC/DC = F;One-year domestic interest rate is rD;One-year foreign interest rate is rF;One-year domestic inflation rate is ID;One-year foreign inflation rate is IF;One-year forward premium is f = (FS)/S;Domestic price level PD; foreign price leve

28、l PFInterest rate parity (covered interest parity)with 1 unit of domestic currency, you can invest either in the domestic market or in the foreign market;If you invest in the domestic market, you will get (1+ rD) unit of domestic currency in one year;If you invest in the foreign market, you will get

29、 S*(1+ rF)/F unit of domestic currency in one year;No-arbitrage condition implies that (1+ rD) = S*(1+ rF)/F, or F/S = (1+rF ) / (1+ rD), or (FS)/S = (rF rD) / (1+ rD) The linear approximation is: f rF rD, which states that the forward premium (in percentage) is approximately the interest rate diffe

30、rential This parity relation seems to be counterintuitive. After all, if interest rate increase in foreign market, capital will flow out of the domestic market, which should lead to the depreciation of domestic currency?The key to understand the interest rate parity is the expected future exchange r

31、ate. Specifically, higher foreign interest rate should indeed lead to the outflow of domestic currency in the spot market. Consequently, on the one hand, the decreasing money supply in domestic market (due to money outflow) should lead to higher domestic interest rate, which increases the rate of re

32、turn in domestic market. At the mean time, the rate of return in foreign market should decreases due to money inflow. On the other hand, the need for hedging should increase the demand for domestic currency in the future. Both effects lead to the expectation that domestic currency will appreciate in

33、 the future higher expected future spot rate for domestic currency. Since forward exchange rate is the unbiased predictor of future spot exchange rate, forward exchange rate should be at premium. Uncovered interest rate parityThe expected one-year spot rate is E(S1)Using the same strategy as in cove

34、red interest rate parity, except that you decide not to cover your position using forward contractIn equilibrium, we have: (1+rD)=S0*(1+rF)/E(S1), or E(S1)/S0= (1+rF)/(1+rD), or approximately, E(s) rF rD, which states that the expected exchange rate appreciation should be approximately the interest

35、rate differential.28Absolute purchasing power parity (PPP)With one unit of domestic currency, you can buy 1/PD unit of goods in domestic marketYou can also buy S/PF unit of the same goods in foreign marketThe law of one price implies that: PD = PF/S, or S= PF/PDRelative PPP (Expected future PPP)By t

36、he same reasoning, at the end of the period, 1/PD*1+E(ID) = E(S1)/PF*1+E(IF)PD*1+E(ID) = PF 1+E(IF)/E(S1), or E(S1)/S0 = 1+E(IF) / 1+E(ID), The linear approximation: s=E(S1)/S01E(IF)E(ID), which states that the exchange rate variation is approximately the inflation rate differential 30Combining rela

37、tive PPP, covered interest rate parity, and uncovered interest rate parity, we have: E(S1)/S0=F/S=(1+rF)/(1+rD)=1+E(IF)/1+E(ID),or approximately, Expected appreciation of DC = premium on forward DC= difference between foreign and domestic interest rates = expected difference between foreign and dome

38、stic inflation rates31Real interest rate equilibriumFrom (1+rF)/(1+rD)=1+E(IF)/1+E(ID), we have:(1+rF)/(1+E(IF)=(1+rD)/1+E(ID), or approximately: rF E(IF) rD E(ID), which states that the real interest rate should be approximately equal internationally 32International Fisher relationDomestic Fisher r

39、elation: (1+r) = (1+p)*1+E(I), or approximately rp+E(I). Assuming that the real interest rate p is constant over time, the fluctuation in nominal interest rates are caused by revision in inflationary expectation.Applying to the international setting, and assuming that the real interest rates are equ

40、al globally, we have: (1+rF)/(1+rD)=1+E(IF)/1+E(ID), or approximately: rFC rDC E(IF)E(ID), which states that the nominal interest rate differential is approximately the inflationary expectation differential 33Foreign exchange expectation relationF = E(S1)Or, (FS0)/S0 = E(S1) S0/S0 Which states that

41、the forward premium (discount) is equal to the expected exchange rate movement.34Empirical evidence on international paritiesKeep in mind that the various international parity relations hold under some strict assumptions, such as:lNot transaction and/or transportation costslNot capital controllFloat

42、ing exchange regimeslNot import tax and restriction, not export subsidieslInvestors are risk-natural35Interest rate parity holds very well both in the short run and long run, except for some developing countries with capital control and taxesUncovered interest rate parity does not hold well in real

43、world, particularly in the short run. Possible explanations include (1) measuring error in expected future spot rate; (2) risk premium PPP performs poorly in the short run, but is supported in the long run. Possible explanations include (1) measuring error in inflation rate; (2) barriers on internat

44、ional trade; (3) factors other than inflation rate may influence exchange rates A test of international Fisher relation is actually a test of whether the real interest rates are constant internationally. The evidence is unsupported in the short run, but is supported in the long run. Possible explana

45、tions: (1) unsynchronized business cycle in the short run; (2) economic integration in the long runEmpirical evidence on foreign exchange expectation relation shows that, in the short run, the exchange rate is too volatile to be explained by the interest rate differential; however, over the long run

46、, there seems to be a risk premium in the future spot exchange rateA history of exchange rates since the start of floating exchange rate regime The long-term trendsThe medium-term trendsThe short-term variabilityAn analytical frameworkAsset market approach to exchange rates in the short run (portfol

47、io repositioning)Monetary approach to exchange rates in the long run (economic fundamental) Exchange rates in the short runThe uncovered interest rate parity states that: E(s) rF rDTherefore, change in any of the other three factors should lead to change in spot exchange rateExample 1: domestic inte

48、rest rate increase in favor of bond denominated in DC increasing demand for DC DC appreciate in spot market FC is expected to appreciate in the future39Example 2: expected future spot rate of FC appreciate in favor of bond denominated in FC increasing demand for FC DC depreciate in spot market FC is

49、 expected to appreciate in the futureSelf-fulfilling expectation: act on expectationSelf-fulfilling expectation can have either stabilizing effect or destabilizing effect on exchange rates, depending on whether the expectation is consistent with economic fundamental40Exchange rates in the long runPP

50、P implies that exchange rates are closely related to the levels of prices for products in different countries, at least in the long runThe price levels in different countries is affected by the money supplies in these countriesThus, in the long run, exchange rates are links to relative money supplie

51、s in different countries41PPP:S= PF/PDThe quantity theory of money supply and demand:Thus, we have:Assuming that the Ks are constant, the equation states that DC will appreciate if (1) the growth of domestic money supply is relatively slower; (2) the growth of domestic real output is relatively fast

52、er42YPKM*)/(*)/(*)/(/DFDFSFSDFDYYKKMMPP)/(*)/(*)/(/FDFDSDSFDFYYKKMMPPSExample 1: Money supplies and exchange rate cut in domestic money supply credit tightening by domestic banks decreasing domestic aggregate demand, output, job, and product prices the purchasing power of DC should rise DC appreciat

53、eExample 2; Real incomes and exchange ratereal domestic income increase due to supply-side reasons more demand for money (transaction demand) if the money supply is unchanged, the purchasing power of DC should rise DC appreciate 43Exchange rate overshootingIn the short run, the actual exchange rate

54、overshoot its long-run value and then revert back toward itDomestic money supply unexpectedly jumps the foreign currency is expected to appreciate because product prices are sticky, domestic interest rate is driven down, leading to the appreciation of foreign currency The combination of the two effe

55、cts will drive up the exchange rate of foreign currency to exceed it long-run value in the short run44Why does government want to intervene the foreign exchange market?Reducing exchange rate volatilityEconomic reasonsPolitical reasonsTwo types of government interventionPolicies directly applying to

56、the exchange rate itselfExchange control45Floating exchange rate Clean floatManaged float (or dirty float)Fixed exchange rate (pegged exchange rate)What to fix to?When to change the fixed rate?How to defend a fixed exchange rateuofficial intervention in the foreign exchange marketuExchange controluA

57、ltering domestic interest rateuAdjusting the countrys whole macroeconomic positionusurrender46Defending through official interventionDefending against depreciationuBuying DC and selling FCDefending against appreciationuBuying FC and selling DCTemporary disequilibriumuMay be socially desirableDisequi

58、librium that is not temporaryuGenerally unsustainable, calling for adjustment47Exchange controlA public auction model (page 110112 in Pugel ) exchange control will certainly lead to social losses 48International currency experienceThe gold standard era (18701914, fixed rates)Interwar instability The

59、 Bretton Woods era (1944-1971, adjustable pegged rates)The current system (not system)49A model for well-behaved international lendingTow nations: one with abundant capital but less attractive investment opportunities; another with less capital but abundant investment opportunitiesAssuming declining

60、 marginal-product-of capital curves (MPK) for both nationsIn the absence of international lending, each nation must use all of its capital to finance its domestic investment opportunities. 50As a result, lenders in capital-abundant nation have to accept a lower rate of return, whereas borrowers in c