chapter 4 international capital markets, interest … alogoskoufis, international macroeconomics...

George Alogoskoufis, International Macroeconomics

Chapter 4 International Capital Markets, Interest Parity Conditions and Exchange Rate Determination

This chapter examines the role and structure of the international capital and financial markets, and the relationship between interest rates and exchange rates in open economies.

The level of international interest rates is determined in the international capital and financial markets. Exchange rates are determined on the foreign exchange market, which is an important part of international financial markets.

The major agents operating in these markets are commercial banks, non-bank financial institutions, multinational corporations, central banks and governments.

International capital and financial markets are actually a network of closely related markets in various countries, where securities denominated in various currencies and coming from different countries, such as stocks, bonds, derivatives, loans and bank deposits are created and exchanged.

We can distinguish between the international bond market, the international stock market and the international money market, a significant part of which is the international foreign exchange market. Transactions in these markets take place in global financial centers linked through advanced telecommunication systems.

4.1 The Structure of International and Financial Markets

Because of externalities and historical circumstances, the main international financial centers are located in New York, London, Frankfurt, Hong Kong and Tokyo.

The international network of capital and financial markets exchanges securities denominated in various currencies, 24 hours a day. However, due to the development of telecommunication systems, much of the trading is done electronically now, even outside these international financial centers.

The various instruments, denominated in different currencies are bought and sold through dealers located in major international bank and non-bank financial institutions.

Dealers exchange securities at their disposal, either on behalf of clients or on behalf of the financial institution they represent. Their aim is to make profit by buying cheaply and selling dearly. These markets are characterized by high liquidity and volatility. The volume of transactions is huge, much larger than the volume of transactions needed to finance international trade in goods and services.

George Alogoskoufis, International Macroeconomics Ch. 4

This is because the majority of transactions are made for reasons related to portfolio investment and not the financing of international trade or foreign direct investment.

Negotiators in international capital markets are usually specialized in one of the markets or sub-markets, such as buying bonds, equities, currencies and derivatives. With their collective behavior, and the behavior of their clients they influence, if not determine, international interest rates and the exchange rates of currencies.

What is the exact role of the various actors involved in the international capital and financial markets?

4.1.1 Commercial Banks

Commercial banks are at the center of international capital financial markets, and play a central role in the international payments system, engaging in a wide range of financial activities.

Their liabilities include deposits of different terms, as well as loans from other banks and non-bank financial institutions, via the interbank market.

Their assets include loans (to households, businesses and governments), deposits in other banks and bonds and shares.

Large multinational banks undertake other activities such as underwriting new stock and bond issues, mediating in mergers and acquisitions, and portfolio management for large customers.

One of the main features of international banking is that banks are often able to undertake activities in international markets which they are not allowed to carry out in their domestic market. This asymmetry in banking regulations and supervision between countries was one of the reasons for the large increase in international banking in the last fifty years.

4.1.2 Non-Bank Financial Institutions

Non-bank financial institutions such as insurance companies, pension funds, mutual funds and hedge funds, have flourished in recent years. These, have been active in international capital and financial markets in order to diversify their portfolios.

Important among them are investment banks, such as Goldman Sachs, Morgan Stanley and Lazard, which differ from commercial banks in that they specialize in underwriting securities such as shares, bonds and derivatives, securitization of loans, stocks and bonds, trading in derivatives and organizing mergers and acquisitions. They do this for their customers, businesses and governments, but also for their own account. The rise of international investment banks took place because in 1993 the US banned commercial banks from undertaking these activities, because of the risks involved. It is characteristic that the international financial crisis of 2007 and 2008 became worse because of the collapse of two investment banks, Bear Stearns and Lehman Brothers. The ban on commercial banks to undertaking investment banking activities in the US was partially lifted in 1999. In any case, because the ban did not apply to international activities of US commercial banks, large commercial banks such as Citi, and J.P. Morgan Chase display intense international

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investment banking activity, competing with purely investment banks. Today, the distinction between commercial and investment banks has eased, as very few purely investment banks remain.

The importance for the international capital markets of non-bank financial institutions is illustrated by the recent international financial crisis. Apart from the collapse of Bear Stearns and Lehman Brothers, one huge insurance company AIG (American International Group), with more than $ 1 trillion in assets, faced extreme difficulties, and the same happened with a number of other mutual and hedge funds.

4.1.3 Large Corporations

Large corporations are the third major player in the international capital and financial markets. Especially large multinationals such as Exxon Mobil, Apple, Coca Cola, IBM, Nike, Toyota, Nestlé, Unilever and others. Such corporations use both bank loans and international bonds denominated in different currencies, engage in international portfolio investment of their reserves, and are very active in mergers and acquisitions.

The activity of multinational enterprises, especially trade and foreign direct investment is also financed through the international capital and financial markets.

4.1.4 Central Banks and Governments

Central banks and governments is the last major category of participants in the international capital and financial markets. Central banks systematically intervene in financial markets, in order to affect the short-term interest rates, and in foreign exchange markets, while many governments and public sector entities in different countries often borrow from the international capital markets and major international banks.

But what exactly is the role of international capital and financial markets?

4.2 The Role of International Capital and Financial Markets

We have three categories of transactions in international capital and financial markets. All three require the mediation of banks and non-bank financial institutions engaged in international capital and financial markets.

The first category of transactions relates to the financing of international trade in goods and services, namely the exchange of goods and services produced in a country, for goods and services produced in another country. As known from the theory of international trade, such transactions entail benefits for all countries, as different countries can specialize in the production of goods and services at which they are relatively more effective, and to import goods and services in the production of which they are relatively less effective. Because the payment of both exports and imports are in terms of money, these transactions are made through banks, which in turn participate in international financial markets, especially in the foreign exchange market.

The second category relates to inter-temporal international trade, i.e the exchange of goods and services today, for goods and services at a later time. Inter-temporal trade also entails additional benefits for all the countries concerned, as it allows an economy to smooth out the time path of

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consumption more effectively, achieving a higher level of prosperity. When a country's income is temporarily high, the current account moves to a surplus, as national savings exceed domestic investment. On the other hand, when investment is temporary high, the current account moves into deficit, as domestic investment exceed national savings. As inter-temporal trade involves deficits and surpluses in the current account, an issue arises regarding the financing of deficits or investing the surpluses. In this, the intermediation of international capital and financial markets is crucial.

Thus, a country which has a deficit in the current account, because its savings are lower than investment, should reduce its net assets to the rest of the world to finance its deficit. This can be done by partly increasing private and public external debt, partly by reducing its net foreign exchange reserves, and partly by selling securities and other assets owned by residents of the country. Whichever way a country chooses to finance its deficit, this will be done through transactions in the international capital market, like bonds, shares or foreign currency, depending on the nature of the shock which causes an imbalance in the current account.

A country which has a surplus in the current account, because its savings are greater than investment will increase its net assets towards the rest of the world. This will either lead to a reduction in private and public external debt, or an increase in foreign exchange reserves, or to a net acquisition of foreign assets by residents of the country. These transactions will be concluded through the international capital and financial markets. Consequently, the mediation of the international capital and financial markets is crucial for the financing of imbalances in balance of payments of different countries.

The third category of transactions made via the international capital and financial markets are international portfolio investments. When savers choose where to place their savings, an important factor is the return of their assets and a second is the risk. In general, investors are characterized by risk aversion. Risk aversion means that investors will require a higher return from investments that are characterized by higher risk. It also means that they will want to diversify their portfolios in order to reduce risk, even if it means lower expected returns. The basic idea is that "you do not want to put all your eggs in one basket.”. Optimal portfolio selection involves a diversified portfolio, which contains securities with different risk-return characteristics.

To the extent that the securities associated with different countries entail different risks for investors, portfolio investment will be allocated among the securities of different countries and securities denominated in different currencies, with the aim of optimizing the risk return combination. Riskier securities will have a higher return, but to the extent that risks are not highly correlated across countries, a diversified portfolio containing assets linked to different countries will be in the interests of investors. The international diversification of portfolios is therefore one of the main roles of international financial markets, together with the financing of international and inter-temporal trade. Portfolio investment is perhaps the largest part of transactions in international capital and financial markets.

We next turn to the international foreign exchange market, as this market plays a central role in exchange rate determination.

4.3 The International Foreign Exchange Market

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Banks have a central role in the foreign exchange market, by facilitating the exchange of bank deposits in different currencies. The bulk of transactions in this market is the exchange of securities, mainly bank deposits, denominated in different currencies.

The majority of foreign exchange transactions are spot transactions, but a relatively large part consists of swap transactions and forward transactions. On swaps and forward transactions we have agreement between the parties on the future exchange of currencies at a predetermined price. Instead, spot transactions are settled immediately, immediately meaning within two working days. The spot exchange rate is determined by spot transactions, while forward exchange rates are determined through swaps and forward transactions.

As the exchange rate is the relative price of deposits in two currencies, its determination takes place in the same way as the determination of the price of any security. Equilibrium in the foreign exchange market requires equalization of returns of deposits denominated in different currencies, when returns are measured in a common currency. This is the basis of interest rate parity.

4.3.1 The Spot Exchange Rate of the Euro

The price of the dollar in foreign currency (i.e. € 0.91 per dollar) is called the bilateral exchange rate in European terms. The reverse, a currency’s value in US dollars (i.e. $ 1.1 per euro) is the bilateral exchange rate in American terms. An increase in the exchange rate in European terms means that the foreign currency has depreciated against the dollar, while a rise in the exchange rate in American terms means that the foreign currency has appreciated against the dollar. Generally, depreciation of a currency occurs when we need more units of the currency for the purchase of a dollar and appreciation when we need fewer units.

Figure 4.1 depicts the daily evolution of the spot exchange rate of the euro vis-a-vis the US dollar, in American terms, i.e dollars per euro. This means that an increase in the exchange rate implies an appreciation of the euro and a depreciation of the dollar, since more dollars are required per euro.

Figure 4.1 reveals the high daily volatility of the exchange rate and the appreciation and depreciation cycles of the euro. When the euro was created in early 1999, the exchange rate to the dollar was $ 1.179 per euro. For the first two years, the euro depreciated against the dollar, with the bottom on October 26, 2000, when it reached $ 0.825 per euro. Since early 2002, the euro started to appreciate against the dollar, although the appreciation has not been smooth. The first cycle of the appreciation of the euro was completed in late 2004, when the euro reached 1.363 dollars per euro. A second three-year euro appreciation cycle began in early 2006. On September 15, 2008, the day of the collapse of Lehman Brothers and a key date for the international monetary crisis of 2008, the euro was at historically highest point, 1.599 dollars per euro . Within a month the euro exchange rate had collapsed to $ 1.246 per euro (October 27, 2008). Between the end of 2008 and the spring of 2014, the euro dollar exchange rate has been fluctuating in a range between $ 1.5 and $ 1.2 per euro. The latest depreciation cycle of the euro started in April 11, 2014 and lasted for almost a year. The euro exchange rate collapsed from $ 1.3872 per euro on that date, to $ 1.0570 on April 10, 2015. A depreciation of almost 24%. In the last year or so, the euro exchange rate has been hovering around $ 1.1.

4.3.2 Triangular Trades and Arbitrage in the Foreign Exchange Market

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For most of the postwar period, trading for most internationally traded currencies has been taking place through the US dollar. The US dollar is considered a vehicle currency for transactions in the foreign exchange market. For example, to convert sterling for yen usually takes two transactions. One to convert sterling to dollars, and one to convert dollars to yen. Because of the high trading volume in the dollar market (depth of the dollar market), the cost of this triangular transaction is usually less than the cost of a direct transaction of sterling for yen. With the introduction of the euro, there is now a second vehicle currency in the global economy, but the dollar remains the dominant international vehicle currency.

In the currency market, there cannot be non-exploited potential profits from triangular transactions in different currencies. For example, if E1 is the dollar sterling parity, parity of the pound dollar, E2 is dollar euro parity and E3 is the euro sterling parity, and there are no transactions costs, in equilibrium, it can only be the case that,

E1 = E3 x E2 (4.1)

If (4.1) holds, there is no possibility to profit from triangular trades. If it is violated, traders would rush to make profits from triangular transactions. This behavior, arbitrage, will ensure that all profit opportunities will be exploited instantly, and that (4.1) will generally hold. Continuous trading in the foreign exchange market eliminates any profit opportunities from triangular transactions between currencies.

4.3.2 Categories of Transactions in the Foreign Exchange Market

Transactions in the foreign exchange market are divided into three main categories.

The first is spot transactions (spot), where the transaction closes immediately, In fact it is settled within two days. These transactions determine spot exchange rates.

The second category is swap transactions, in which a currency is sold (or bought) today, and repurchased (or resold) at a future date. Both the current and future exchange rate is determined today. The swap rate is the difference between the repurchase rate and the spot exchange rate. The spot exchange rate and the swap rate determine the forward exchange rate.

The third category is pure forward transactions. These are current agreements for future purchase or sale of a currency. The price, quantity and the date of the transaction are determined currently. Such transactions are carried out for 1 to 2 weeks, and 1, 3, 6 and 12 months. We say that a currency trades at a premium when the forward rate is higher than the spot rate (on the American definition). Otherwise it trades at a discount.

The vast majority of transactions in the foreign exchange market are spot transactions between dealers. Swap transactions are about 1/3 of the total volume. Forward trading is a very small percentage of the total volume.

Eurocurrencies play an important role in the foreign exchange market. A Eurocurrency is a foreign currency denominated deposit outside the country where that currency is legal tender. Although called Eurocurrencies for historical reasons, these deposits are not necessarily in Europe. A deposit in US dollars in a London bank is a Eurodollar deposit, while a deposit in yen at a bank in New

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York is a Euroyen deposit. Most eurocurrency deposits are fixed interest time-deposits, with terms reflecting those available for forward foreign exchange transactions.

The LIBOR (London Interbank Offer Rate) is the rate at which banks are willing to lend dollars or sterling to the most reliable banks and corporations participating in the London interbank market. Loans to less reliable banks and corporations have a higher rate than LIBOR (premium).

Correspondingly, the EURIBOR (Euro Interbank Offer Rate) is the rate at which banks in the euro area are prepared to lend euros to the most reliable banks and corporations participating in the Euro interbank market of the Euro (Frankfurt, Paris, Milan and elsewhere). Loans to less reliable banks and corporations have a higher interest rate than the EURIBOR (premium).

The evolution of EURIBOR since 1998 for loans of a week, three months, and twelve months is shown in Figure 4.2.

4.4 Covered Interest Parity

Spot exchange rates, forward exchange rates and eurocurrency interest rates are interdependent through the so called covered interest parity condition.

If i is the interest rate of a Euro deposit for one period t, i* the interest rate for a eurodollar deposit, S the spot exchange rate (dollars per euro) and F the forward exchange rate for one period, the yields of the two deposits must be equal when expressed in a common currency.

Suppose an investor has one million euros to deposit. If he deposits them in a euro denominated deposit, at the end of the period he will receive 1+i million euros. If he converts them into dollars at the spot exchange rate S, deposits the proceeds in a eurodollar deposit, and sells the dollars forward for euros, at the forward rate F, at the end of the period he will receive (1+i*)S/F million euros. If the two returns differ, all investors will try to buy the eurocurrency that offers the higher return, causing its spot exchange rate to appreciate relative to its forward rate, until the two returns are equalized. Thus, arbitrage will ensure that the two returns cannot be different. This means that in equilibrium,

(4.2)

If (4.2) is violated, like in the case of triangular transactions, there are profit opportunities through arbitrage, which will almost immediately ensure that (4.2) is satisfied.

(4.2) is often expressed in terms of its logarithmic approximation,

(4.3)

where f=ln(F), s=ln(S).

4.5 Uncovered Interest Parity

1+ it = (1+ it*) StFt

it ! it* + st − ft

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The profit from a forward transaction in the foreign exchange market is equal to the difference between the forward exchange rate and the spot exchange rate at the end of the forward contract. It thus follows that at the time of the agreement of the forward contract, under the assumption of risk neutrality, it the forward rate must be equal to the expected future spot rate. Thus, it must follow that,

(4.4)

where Ε is the mathematical expectations operator. είναι ο τελεστής µαθηµατικών προσδοκιών. Η (4.4) implies that under risk neutrality, traders must be indifferent between buying a currency spot and selling it forward, or buying a currency spot, holding it, and selling it spot in a period.

Substituting (4.4) in (4.2), we get the so called uncovered interest parity condition.

(4.5)

This condition is often expressed in terms of its logarithmic approximation,

(4.6)

(4.5) and (4.6) imply that the rate of return of a deposit in euros must be equal to the expected rate of return of a deposit in dollars, when the dollars are converted into euros at the end of the term of the deposit. Alternatively, it says that the rate of return of a deposit in dollars should be equal to the expected rate of return of a deposit in euros, when the euros are converted back into dollars at the end of the term. In short, the expected rates of return cannot differ when expressed in a common currency.

For this to happen, the interest rate differential must reflect the expected change in the exchange rate between the two currencies. If i>i*, then the euro is expected to depreciate against the dollar. If i<i* then the euro is expected to appreciate against the dollar. If the i=i*, then the exchange rate is expected to remain constant.

If (4.5) (or (4.6)) is violated, then there is the possibility of making expected profits, through the strategy to borrowing in one currency and making uncovered loans in another. These expected gains will lead to trades that will lead to the satisfaction of (4.5) and (4.6) through arbitrage.

4.6 Uncovered Interest Parity and Exchange Rate Determination

The condition of uncovered interest parity is widely used in international macroeconomics, as an approximation to the equilibrium conditions in international foreign exchange markets. As such, it can serve as the basis of all theories of exchange rate determination.

From (4.6), the (log of the) spot exchange rate is determined by,

! (4.7)

Ft = Et (St+1)

1+ it = (1+ it*) StEt (St+1)

it ! it* + st − Et (st+1)

st = Etst+1 + it − it*

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The current spot exchange rate depends on the expected future spot exchange rate and the current interest rate differential between the two currencies.

Uncovered interest parity thus suggests that any theory of exchange rate determination must rely on a model of the determination of interest rate differentials between currencies, and it must also rely on a hypothesis about the formation of expectations.

For example, assume that interest rate differentials between the euro and the dollar follow a first order autoregressive process of the form,

! (4.8)

where ρ<1 and εt is a white noise process with zero mean and constant variance.

From (4.8) and (4.7), the (fundamental) rational expectations solution for the current spot rate is given by,

! (4.9)

Thus, according to (4.9) the current spot rate depends positively on the current interest rate differential and the speed of convergence of interest rate differentials.

Even with this assumption, one needs a theory of the determination of interest rate differentials before one can say anything more about exchange rate determination. It is to such theories that we now turn.

4.7 Conclusions

Exchange rates are determined in international markets for foreign exchange. The main participants in such markets are banks, non-bank financial institutions, multinational corporations, governments and central banks.

Banks have a key role by facilitating the exchange of bank deposits in different currencies, which constitute the bulk of transactions in the foreign exchange market. The international foreign exchange market is essentially a unified world market that operates almost 24 hours per day.

The majority of foreign exchange transactions are spot transactions, but about one third constitute transactions in foreign exchange swaps, and a small portion are pure forward transactions. Swap and forward contracts are current agreements between the parties on the future exchange currencies at a predetermined price, for terms from one week to twelve months. Instead, spot transactions are settled immediately.

As the exchange rate is the relative value of financial instruments denominated in different currencies, its determination is related to the determination of the prices of financial instruments. Equilibrium in the foreign exchange market requires the equalization of the returns of deposits denominated in different currencies, when returns are measured in a common currency. This is the basis of interest rate parity conditions, such as covered and uncovered interest parity.

(i − i*)t = ρ(i − i*)t−1 + ε t

st = Et (i − i*)t+s = (i − i*s=0

∞∑ )t ρ ss=0

∞∑ = 11− ρ

(i − i*)t

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For given interest rates on deposits denominated in various currencies, and for given expectations for the future development of the exchange rate, uncovered interest parity determines the current exchange rate. For example, ceteris paribus, an increase in dollar interest rates causes the dollar appreciation. A rise in euro interest rates causes a euro appreciation. Finally, an expected future appreciation (depreciation) of the euro, leading directly to a current appreciation (depreciation) of the euro.

Thus, in order to look at the determinants of exchange rates, one has to consider the determinants of interest rate differentials between different currencies.

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Figure 4.1 The Euro US Dollar Exchange Rate

($ per €)

Source: European Central Bank

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0.8000

0.9000

1.0000

1.1000

1.2000

1.3000

1.4000

1.5000

1.6000

4/1/99 4/1/00 4/1/01 4/1/02 4/1/03 4/1/04 4/1/05 4/1/06 4/1/07 4/1/08 4/1/09 4/1/10 4/1/11 4/1/12 4/1/13 4/1/14 4/1/15 4/1/16


Figure 4.2 EURIBOR 1998-2015

Source: European Money Market Institute. Red (12 month), Blue (3 month), Green (1 week).

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References

Mark N. (2001), International Macroeconomics and Finance, Blackwell, Oxford.

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chapter 4 international capital markets, interest … alogoskoufis, international macroeconomics...

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