Chapter 2 International Financial Mgmt Eun, et.al. 3460.03 notes: A.P. Palasvirta, PhD.

Chapter 2 International Financial Mgmt Eun, et.al.

3460.03 notes: A.P. Palasvirta, PhD

When CBs execute a monetary policydiscipline of the gold standard is goneafter WWII governments ran inflationary

policies interest rate policies employment policies inflation sometimes running at 200% or more

Exchange rates fluctuatecreating uncertainty for trade

April 19, 20233460.03 int'l money notes a.p. palasvirta, ph.d. 2

Dollarization Currency boards

http://users.erols.com/kurrency/ Managed exchange rate

PeggedBanded pegCrawling peg

Floating exchange rate Currency unification



Markets and/or individuals in a country use a foreign currency without formal government approval Individuals wealth denominated in foreign currency

Notes, bonds, bank deposits in domestic or foreign banks

Protect against domestic inflation Markets accept or prefer the use of a foreign

currency Grey and black markets

Foreigners hold from 55 to 70% of the U.S. Dollars currently in circulation

U.S. Dollar, Euro, and Yen are the primary currencies held


Government adopts a foreign currency as a predominant or exclusive legal tender Panama, Ecuador

No currency board, no central bank Benefits

Dollar inflation Low interest rates No exchange rate risk (transaction, translation, & operating

exposure) Loss of sovereignty

No independent monetary policy Loses the power of seignorage

http://users.erols.com/kurrency/basicsup.htm


Currency board issues notes & coin convertible into foreign currency at a fixed exchange rate on demand100% to 110% in foreign reserves

General t-bills denominated in the foreign currency Has no discretionary power

Inflation and interest rates are approximately in line with the foreign currency

Cannot be a lender of last resort

http://users.erols.com/kurrency/intro.htm

Gold, silver

Foreign exchange

U.S. dollar assets (T-bills)

Domestic coinage and cash

Commercial Bank deposits


Assets Liabilities

Create money Mandate reserve ratios Mandate capital ratios Control bank rate Operate in t-bill market Operate in exchange markets

Bank of Canada Report


AdvantagesNo exchange rate risk (transaction,

operating and translation exposure is zero)Maintain artificially low prices for one’s

products Disadvantages

Lack of monetary policy independence Imbalances in international financial

markets continue and grow Eventually sudden large adjustments in

exchange rates


PeggedA fixed peg maintained by the central bank

Banded pegCentral bank intervenes if the exchange

rate increases or decreases by more than a given percentage

Crawling pegCentral bank fixes to an exchange rate, but

changes the fixed value it defends periodically China


China (Yuan)CB of China will supply enough Yuan to

satisfy the demand for the Yuan due to Balance of Payments surplus Causes money supply to increase (inflationary

pressure)CB of China is moving to a managed float

Will allow the Yuan to appreciate but is not announcing how or when it is allowing the Yuan to appreciate


Brazilian Stock market take a hit Government borrowing in dollars

have to pay back in higher valued currencyoften leading to re-negotiation of terms

operating exposure (change in real exchange rate)on exporters on importers


Inflation targets Bank tries to increase supply of money just

enough to accommodate demand Assume demand increases by 5% per year If bank is targeting 2 – 3 % inflation rate, supply will

be increased by about 8% Interest rate targets

Low interest rates tend to increase capital investment

Keep growth in the economy positive Exchange rate targets

Fixing exchange rates reduces transaction risk and keeps international prices in one’s favor


Floating exchange rate regimeDoes not try to affect trend

To affect trend it would have to either buy or sell foreign exchange in large quantities

Bank’s policy is directed at an inflation target2 – 3% inflation per year

Will jump into the market to affect volatility Over the year this means that the net sales and

purchase of foreign exchange is approximately zero

http://www.bankofcanada.ca/en/annual/2007/ar2007.html


Control moneyOpen market operationsBank rate

Manage banking systemReduce liquidity risk

Reserve ratios Deposit insurance

Reduce default risk Capital ratios Lender of last resort

Bank of Canada balance sheet


Central banks order coin and currency which is stored in the vault

Money is created when the central bank buys something with that coin and currencyGold and silverForeign exchange

Foreign denominated cash and currency Foreign denominated t-bills

Domestically denominated t-billsKeeps purchases sufficiently high to meet

inflation targets


Central bank has large influence in two marketsDomestic t-bill market (largest single entity)Exchange market (largest single entity in

domestic currency in exchange markets) As a large entity it, unlike other

operators in the market, can affect price


Bank rate Interest rate charged member banks for

borrowing to increase reserves Increase the bank rate decreases system

reserves thereby leading to a decrease in the money supply

Decrease the bank rate increases system reserves thereby leading to an increase in the money supply


Commercial banks required to maintain liquid reserves to meet demand of deposit holders demanding redemption

Inverse of reserve ratio is called the money multiplierHow much bank money, base money will

support



Reserves Cash Currency Deposits with CB cd t-bills

Loan Portfolio Lines of Credit Car loans Business Loans Home and Business Mortgages

Checking Accounts

Savings Accounts

GICs

Bank Capital

Reserve Ratio = 10% Money multiplier = 10


Reserves = $1 billion

Loan Portfolio = $9 billion

Checking deposits

Savings Deposits $9.6 billion

GICs

Bank capital = 400 million

Reserve Ratio = 20%, Money multiplier = 5


Reserves = $1 billion

Loan Portfolio = $4 billion

Checking deposits

Savings Deposits $4.8 billion

GICs

Bank capital = 200 million

LeverageMeasured by the debt/equity ratio or debt

ratioMeasure of risk

Manufacturing firms usually D/E = 1 or D/TA = 0.5

Banks D/E = .96/.04 = 24 or D/TA = 0.96The liabilities (deposits) in a bank are

guaranteed (insured) by the governmentBanks can lever quite a bit because of this

CIBC balance sheet


Advantages Purchasing power parity allowed to hold

Trend line reflects relative inflation International prices adjust automatically

Prices more transparent

Allows an independent monetary policy Disadvantages

Exchange rate volatility increases Higher costs due to need to hedge volatility


Gold, foreign exchange

T-bills 70 – 80%

Cash, currency

Commercial bank reserves held at BOC


Assets Liabilities

Independent European Central Bank convergence criteria

nominal inflation < 1.5% above avg of 3 with lowest in previous year

long-term interest < 2.0 % above avg of 3 with lowest in previous year

fiscal deficit no more than 3 % of GDPdebt no more than 60% of GDP


AdvantagesOne monetary policyNo exchange rate risk

Costs of trade much lowerFinancial market integration (money &

capital) Disadvantages

Loss of sovereignty on monetary/fiscal policy

Loss of national currency


Belgium (franc) Germany

(deutschemark) Spain (peseta) France (franc) Ireland (punt) Luxembourg (franc) Italy (lira)

Netherlands (guilder)

Austrian (shilling) Portugal (escudo) Finland (markka) Vatican City (lira) Greece (drachma) Slovenia (tolar)


Bulgaria (Lev) Czech Republic

(Koruna) Denmark (krone) Estonia (Kroon) Hungary (Forint) Latvia (Lats)

Lithuania (Litas) Poland (Zloty) Romania (Leu) Slovakia

(Koruna) Sweden (krona) United Kingdom

(pound)


Price for current deliveryPrice of one currency in terms of anotherDelivery no later than four business days

Price market determinedfluctuates to reflect new information


Current demand for CD by holders of foreign currency foreigners want to buy something Canadian

Current supply from Canadians holding CD demanding foreign exchangeCanadians want to buy something foreign


e0 , Can terms = CD/USD = 1.0004

CD cost of the USD

e0 , us terms = USD/CD = 0.9996

USD cost of the CD

exchange rates


Croatia

Macedonia

Turkey


Deposits held in other than the domestic currencyA usd account at a Chartered Bank is a

eurocurrency deposit Off-balance-sheet account Chartered bank would hold a liability to the

depositor which is matched equally by an asset which is a deposit to an U.S. bank for the same amount


Eurocurrency interest rates PIBOR (Paris), MIBOR (Madrid), SIBOR

(Singapore)Off-balance-sheet lending in currencies

other than home currency Wholesale market

Between multinationalsLarge banksCentral banks

Narrow spreadLow riskLarge amounts ($500,000) or more


Chapter 2 International Financial Mgmt Eun, et.al. 3460.03 notes: A.P. Palasvirta, PhD.

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Transcript of Chapter 2 International Financial Mgmt Eun, et.al. 3460.03 notes: A.P. Palasvirta, PhD.