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International Finance FINA 5331 Lecture 9:

International Finance FINA 5331 Lecture 9: Exchange rate regimes and financial crises. Hedging currency risk Read: Chapters 2, Chapter 5 (125-129) Aaron Smallwood Ph.D. Major currency crises. EMS crises of 1992-93.

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International Finance FINA 5331 Lecture 9:

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  1. International Finance FINA 5331 Lecture 9: Exchange rate regimes and financial crises. Hedging currency risk Read: Chapters 2, Chapter 5 (125-129) Aaron Smallwood Ph.D.

  2. Major currency crises EMS crises of 1992-93. Following German re-unification contractionary monetary policy caused the currencies of German trading partners to become overvalued. Mexican peso crisis 1994-95. An overvalued exchange rate, policy mistakes, and political turmoil led to collapse of the peso, a severe recession and inflation before an IMF and US led bailout. Asian currency crisis (1997-98) Contagion Argentina (2001-02) Failure to use fiscal restraint and inflexibility in labor markets led to the collapse in this board system.

  3. Overvalued/Undervalued? How would we know if a currency was overvalued or undervalued? Most economists use “real exchange rates”. According to the law of the one price:

  4. Real Exchange Rate The real exchange rate is defined as: Take Mexico as an example: Suppose St is relatively stable but, PtMexincreases much more rapidly than PtUS. The result, Rt increases. The Mexican peso appreciates in real terms.

  5. Real Exchange rate If a country’s real exchange rate rises, some combination of the following three are occurring: The nominal exchange rate is appreciating Domestic prices are rising rapidly Foreign prices are falling. ALL THREE LIKELY LEAD TO A DECLINE IN THE DEMAND FOR EXPORTS

  6. The Asian currency crisis On July 2, 1997, Thai Baht is devalued. July 11 Philippines devalues the peso July 14: Malaysia floats the ringgit July 17: Singapore devalues August 14: Thailand moves to a float October 14: Taiwan devalues November 14: Korea floats August 17, 1998: Russia abandons its peg Hong Kong: At one point, Hong Kong monetary authority raises rates to 500%.

  7. Asian currency preview: The causes Liberalization of capital markets in a weak domestic financial environment. Crony capitalism Surge in risky real estate investment Maturity mismatch Secondary cause: Over-valued real exchange rates.

  8. Asian currency crisis Crony capitalism: A very close connection between government leaders and private enterprise, “lending decisions were often influenced by political considerations” (page 49, Eun and Resnick). Violation of the trillema Maturity mismatch: Given capital inflow, Asian economies become reliant on short term debt instruments. Aftermath: Average economic growth of Indonesia, Korea, Malaysia, Philippines, and Thailand (source: Krugman and Obstfeld, 6th Edition): 1996: 7.0% 1997: 4.5% 1998: -8.1%

  9. Financial Crisis Overview: In an era of lax monetary policy and rising home prices (a “housing boom”) with questionable mortgage underwriting practices, banks originated loans that were securitized. When housing prices stabilized, interest rates rose, defaults rose, and mortgage backed securities, held by many investment banks, dramatically lost their value.

  10. Housing Prices

  11. US Monetary Policy

  12. Additional Background From Sept 2002 – Aug 2004, the targeted Fed Funds rate was no higher than 1.25% Under Bush administration, expansionary fiscal policy is used. As seen in the graph, housing prices steadily rose from 1995-2004. Subprime loans grow: • In June 2004, 40% of conventional single family mortgages were “ARMs.”

  13. The subprime issue According to Demyanyk and Hermet: “Rapid appreciation in housing prices masked the deterioration in the subprime mortgage market and thus the true riskiness of subprime loans.” St Louis Federal Reserve Working paper.

  14. Regulatory Background “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief,” Alan Greenspan (speaking before Congress on Oct 23). A new banking model: In a largely unregulated environment, banks are encouraged to originate loans. The loans are then “securitized.” The securitized share of the sub-prime market was 75% in 2006 as compared to 54% in 2001 (Demyanyk and Hemert, 2008, St Louis Fed working paper).

  15. A new banking model: Originate to Distribute MBS: Mortgage backed securities. Investment banks demand is high for MBS: they are also poorly leveraged. Investment banks borrow to acquire MBS. CDS: Credit default swaps: Buyer makes regular payments and receives a payoff if an underlying credit instrument (like an MBS) goes into default.

  16. The bubble bursts In 2005, housing prices stabilize and begin to fall. ARMs begin to reset…Defaults and foreclosures are up. According to Realty Trac, foreclosures were up 79% in 2007 from 2006. Almost instantly, liquidity freezes. Credit ratings of several investment banks and insurance companies come under scrutiny.

  17. Aftermath March 28, 2008 Bear Sterns is acquired by JP Morgan in a deal brokered by the Federal Reserve Bank of New York (for $1.2 billion). On Aug 22, 2008, Freddie Mac and Fannie Mae’s credit rating is reduced by Moody’s. In September, Fannie and Freddie Mac are placed under legal authority of the Federal Housing Finance Agency. On Sept 15, 2008, Lehman Brothers declares bankruptcy. In Sept Merrill Lynch is acquired by Bank of America. Washington Mutual declares bankruptcy. In September, the Federal Reserve bails out AIG, supplying an emergency loan of $85 billion. In exchange, the US government obtains an almost 80% ownership claim in AIG. In Oct, The Emergency Economic Stabilization Act authorizes the Treasury Department to spend up to $700 billion to purchase MBSs.

  18. Review: Terminology • Long vs short: • A trader is long in a currency when they are owed that currency in the future. A trader is short in a currency when they owe that currency in the future. • Hedging • The act of reversing a natural short or long position, such that no net position is taken. • Speculation • The act of intentionally creating a short or long position in an attempt to profit on currency movements. This exposes the trader to risk. • Arbitrage • The act of simultaneously buying and selling an asset, such that no net position remains.

  19. Simple Hedging Strategies

  20. A Little More Sophisticated Hedging Strategies

  21. Hedging FX Risk • Hedging will reduce or eliminate risk. • But it will also eliminate profitable FX movements. Example – If you have a payable due in foreign currency in 90 days, a domestic depreciation will increase your domestic currency costs. But if the domestic currency appreciates over the 90 day period, your costs fall!

  22. Hedging FX Risk Q - So why hedge? If hedging eliminates potential FX gains, why do it? A - Are you in business to sell goods and services or are you a FX market speculator? By not hedging FX risk, you are playing a risky game in a business that might not be your expertise. Stick to what you know best. Leave the FX speculation to the dealers and traders.

  23. Forward contracts • Forward contracts: Allow traders to buy/sell foreign currency for delivery in the future, for a price that is known TODAY. • We will consider here both outright forward contracts and non-deliverable forward contracts (NDFs). • Example: The 3 month forward contract for Swiss Franc: $0.8443. On February 14, 2009, we could buy at sell SF at this price.

  24. Forward contracts • Let’s consider aspects of deliverable forward contracts: • 1. A forward contract is a derivative asset, based off of a spot contract. The forward market is known as an “over the counter” (OTC) market, as compared to futures markets, where trade typically occurs on a centralized exchange. • 2. The terms of a forward contract are negotiated between a bank/dealer and their client. At least in theory, except where capital controls may be present, a forward contract can be written for any currency. • 3. Based on 2, a forward contract can be written for delivery at any point in the future. • 4. Again, based on 2, a forward contract can be written in any “lot size.”

  25. Forward rates • When the forward rate exceeds the spot rate, the foreign currency (currency in the denominator) is trading at a “forward premium.” • Example: S($/SF)= $1.0919…F($/SF)3m=$1.0924, SF is selling at premium. • …When the forward rate is less than the spot, the foreign currency is said to be selling at a “forward discount.” • Example: S($/£)=$1.6321… …F($/£)3m=1.6299, the pound is selling at a discount.

  26. Forward rates • Like spot rates, banks will buy forward foreign currency at one price (the bid price) and sell it forward at another price (the ask price). • When the spot quotation is provided, the dealer will simply quote basis points for the associated forward rates. • For the basis points, the trader will understand that if the first quote exceeds the second, the basis points are subtracted from the spot quotations. • If the first number in the quote is less than the second, the basis points are added. • A basis point is defined as 0.0001.

  27. Example • Suppose we call our dealer and ask for forward quotes relative to the spot rate for Canadian $. Our dealer supplies the following information: • Spot: $1.0480-86 • 1 month forward “12-10” • 3 month forward “14-8” • 6 month forward “16-2” • One month forward rates: $1.0468-$1.0476 • Three month forward rates: $1.0466 - $1.0478 • Six month forward rates: $1.0464 - $1.0484.

  28. Percentage forward premia/discount • In some sense, the premium or discount provides information related to how the value of a currency changes over time. We can express these values in percentage terms. We will typically apply annualization. The calculation: • Where “days” is the number of days until the contract matures.

  29. Example • Suppose the three month forward rate on yen today is $0.011782. The current spot rate $0.011775. Suppose a contract written for yen matures 92 days from now. The yen is trading at a premium: • The yen is selling at 0.233% premium.

  30. Premia/Discount Cont. • If Ft>St, in some sense, this might signal that we expect foreign currency to appreciate in value. • If Ft<St, this might indicate that we expect the foreign currency to depreciate in value.

  31. Readings • “The Mexican peso crisis” by Joseph Whitt: • http://www.frbatlanta.org/filelegacydocs/J_whi811.pdf • “The Mirage of Fixed Exchange Rates” by Maurice Obstfeld and Kenneth Rogoff. • http://www.nber.org/papers/w5191.pdf • “Fear of floating” by Guillermo Calvo and Carmen Reinhart. • http://www.nber.org/papers/w7993.pdf?new_window=1 • “Understanding the subprime mortgage crisis” by Yuliya Demyanyk and Otto Van Hemert • http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1020396

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