part 5 paris - forum nexus finance class summer 2011

Forum-NexusWelcome to France

Brian David ButlerProfessor of international finance and global entrepreneurship with Forum-Nexus Study Abroad. Guest lecturer with the IQS Business School of the Ramon Llull University in Barcelona, and the Catholic University of Milan. Previously, Brian taught finance, economics and global trade courses at Thunderbird’s Global MBA program in Miami, and worked as a research analyst with the Columbia Business School in New York City. Brian currently lives in Recife, Brazil where he is teaching classes on “Global Entrepreneurship” at the university FBV.

A global citizen, Brian was born in Canada, raised in Switzerland (where he attended international British school), educated through university in the U.S., started his career with a Japanese company, moved to New York to work as an analyst, married a Brazilian, and has traveled extensively in Latin America, Asia, Europe and North America.

[email protected]

LinkedIn/briandbutler

Skype: briandbutler

Find my slides:

www.slideshare.net/briandbutler

Expectations:

▫Attend classes – exams will be from lectures, from assigned readings and from guest lecturers/ professional visits

▫Turn in assignments before class ▫Be prepared for class discussions – lots of small

group assignments during class▫Contribute to group assignment (team grading /

peer review)▫No sleeping, no laptops, no phones (sorry) ▫If your tired… standup, go get a drink, come back

Required books

•Required Textbook▫'An Introduction to Global Financial

Markets', by Stephen Valdez, Palgrave Macmillan, 5th Edition, 2006

▫'Fixing Global Finance', by Martin Wolf Yale University Press, updated 2010

Assigned Readings

•Martin Wolf book

▫Final chapter (ch 8) “From Imbalances to the Subprime Financial Crisis”

▫Recommended: First four Chapters

• Finance book▫ Chapter 9 – foreign

exchange ▫ Chapter 11 - European

Economic and Monetary Union

▫ Switzerland – p 288▫ Euro – p 289, p304

• Optional additional reading▫ Chapter 2 – banking

background p30-38▫ Chapter 6 – the money and

bond markets▫ Chapter 12 – traded options▫ Chapter 13 - Futures

Book: Martin Wolf, “Fixing Global Finance”

Martin Wolf is chief economics commentator at the Financial Times (online FT.com)

review

GROUP PROJECT

Group Project•Introduction:•Teams will be made up of 3-4 students each. •There are THREE sections to this project.

Within each section there are multiple questions.

•Each team paper must include THREE sections. Suggestion – have team of 4 with 3 people working on one section each, and final person putting paper together (flow, content, organization)

Group Project

•Introduction:•388 - Undergrad: The project report

should be between 6 and 8 pages long •688 - Grad: The project report should be

between 8 and 11 pages long•(Font: Arial, 12; Line Spacing: 1.5).•The project must include the following

sections

Part 1. Euro & the Crisis▫Team must answer (most) of the following

questions:•Will the Euro still exist (in its current form,

with current members) in 6 months? How about in 6 years? Why?

•For a country like Spain or Greece, what would be the benefits / drawbacks of an exit from the Euro-zone? How about Germany?

• If a country like Greece were to try and regain their “competitiveness” in global markets, but did NOT consider a currency devaluation as an option, what OTHER choices might they have (to become more competitive)?

Part 2. Fixed vs. Floating currencies▫Team must answer (most) of the following questions:

•Do we currently live in an age of “fixed” or “floating” international exchange rates?

•Why do many countries fear “floating” exchange rates?

•What is the “dollar bloc”?•During the past two crises (financial crisis

2008, and the Euro-zone fiscal debt crisis 2010-11), what are the advantages / disadvantages to having a fixed system of international exchange rates? What are the advantages / disadvantages to having a floating system of international exchange rates?

Part 2. Fixed vs. Floating currencies▫Team must answer (most) of the

following questions:•Ten years from now, make a prediction: do you think the major currencies in the world (US dollar, Euro, Yen, Pound, Swiss Franc) will be in a system of “fixed” or “floating” international exchange rates? Why?

Part 3. Global Reserve Currency:▫Team must answer (most) of the following

questions:•In 10 years, will the US dollar still be the dominant international currency?

•Why might the US dollar be challenged? •What must the US do to retain the role of the US dollar in the international system?

•What benefits does the US gain from having its currency used as the basis for international trade, commerce, global reserves?

Part 3. Global Reserve Currency:▫Team must answer (most) of the following

questions:•Which other currencies in the world

might challenge the role of the US dollar? (and assume the role of the global reserve currency). What challenges do those currencies face (in their bid to challenge the dollar for global reserve currency status?

•If some countries were to leave, would the Euro still be a challenger to the US dollar as a potential “global reserve currency”?

Part 3. Global Reserve Currency:▫Team must answer (most) of the

following questions:•Extra credit (2 points):

▫If you were to invest your life savings (preparing for retirement in 30 years), in which country would you invest that money today? (considering just likely appreciation / depreciation) why?

review

•Discussion

Observations of France / Euro… ?

•volunteers - tell one thing about French economy (or about the Euro, Greece, etc) they noticed so far + class discuss

•Note: observations should come from reading (wall street journal, etc)… any other sources?

Themes – 3 dangers

1. Danger in borrowing abroad in foreign currencies

2. Danger in relying on short term finance – especially when foreign capital involved

3. Danger in changing rules of finance

* Solution: be aware, and hedge to protect!

Borrowing $$ abroad in foreign currency = RISKY

Question: how does this relate to crises? (ex: SE Asia ‘97, Argentina ‘02)

Discussion - Questions

•Q: He said that monetary policy set in Germany might not be appropriate for Spain (one suit jacket for all body sizes). Why is this a problem?

Discussion - Questions

•Q: He said that (for Spain, Greece, etc)… “the Euro is the problem”. Why?

Currencies and interest rates

•Last week we discussed HEDGING examples

•We will show more…•But first…

24

1.

2.

3.

Foreign Exchange Market

Domestic FinancialMarkets in OtherCountries—Short-Term

Domestic FinancialMarkets in OtherCountries—Long-Term

Deposits, Cash, Forwards, Futures

T-Bills, Deposits,Commercial Paper,Money Market Funds

Bonds, Stocks,ADRs, Deposits, CMOs

Banks, Companies, Brokers

Banks, Companies,Brokers

Banks, Companies,Brokers

International Financial Markets

MARKET

INSTRUMENTS PARTICIPANTS

25

4.

5.

6.

7.

Euro-Currency Market

Euro-Bond Market

International MonetarySystem (IMF)

The Real Sector

Deposits, Euro CPEuroloans

Eurobonds, FloatingRate Notes,Euro-Equities

SDRs, $US, [Gold],Position in the Fund

Banks, Clients

Investment Banks Companies, Brokers

Central Banks,The Fund

International Financial Markets (cont.)

MARKET

INSTRUMENTS PARTICIPANTS

Goods & Services

Consumers & Firms

International money markets

Arbitrage + international money markets

Borrowing in Foreign Currencies….Where would you prefer to borrow?You have a factory in Brazil, and want to

borrow money to expand. You could…1.Borrow money locally at 10%2.Borrow money abroad (in US) at 5%

•Which would you choose?

Note: fictional data based on current loan rates Brazil…• LIBOR + 1.5% for US = 2.5+1.5 = 4%• CDI + 2% for Brazil = 9.75 +2 = 11.75%

Borrowing in Foreign Currencies….Where would you prefer to borrow?You have a factory in Brazil, and want to

borrow money to expand. You could…1.Borrow money locally at 10%2.Borrow money abroad (in US) at 5%

•Which would you choose?•What is the risk of borrowing abroad (in the US)? – general comment 20 words or less

•Details…

Questions:

1. Assume you want to borrow R$2mm for 1 year, and assume exchange rate is 2:1 today

2. Which is better? By how much?3. How much will you owe in 1 year

(in local currency)? –simple interest

▫ Local borrow (Brazil)? ▫ Foreign borrow (US)? ▫ Compute (teams)

1. Borrow money locally (BRL) at 10%2. Borrow money abroad (in US) at 5%

How much will you owe in 1 year (in local currency)?• Local Brazil = R$2.2 mm• Foreign USA = $1.05 mm = R$2.1 mm• Difference = $50,000 USD (100,000R$)

• Which would you choose?


How much will you owe in 1 year (in local currency)?• Local Brazil = R$2.2 mm• Foreign USA = $1.05 mm = R$2.1 mm• Difference = $50,000 USD (100,000R$)

• Tempting to borrow abroad…But…▫ What if FX rate goes from 2:1 to 4:1…

▫ How much will you owe (in local currency)?


Where would you prefer to borrow?

• Local Brazil = $1.1 mm = R$2.2 mm• Foreign USA = $1.05 mm = R$2.1 mm• Difference = $50,000 USD (100,000R$)• (tempting to borrow abroad• But, What if FX rate goes from 2:1 to 4:1…• How much will you owe (in local currency)?

Answer:• Locally – still just owe R2.2mm• But Foreign – would owe R4.2mm ….

Double

• Conclusion:• Borrowing Abroad = MUCH more RISK

International Financial Decisions•Finance projects in 3 basic ways:

1. Raise cash in home country and export finance to the foreign project

2. Raise cash by borrowing in the foreign country where the project is located

3. Borrow cash in 3rd country where the cost of debt is lowest

Ross/Westerfield/Jaffe - McGraw-Hill 7th edition – Corporate Finance Ch 31

Risks:1. Borrow locally for foreign investment: FX

risk of borrowing in “foreign” currency▫If a US firm raises cash for foreign project

by borrowing money in the US, it has FX risk

▫Hedge risk – sell foreign exchange forward▫But difficult beyond 1 year

2. Borrow in foreign for foreign investment▫Might be higher price of money, but less

risk FX


New problem…

Question:

If you were a US based investor, with dollars to invest for 12 months…..where would you choose to deposit your money (to make the most return)?

Note: You can assume you have an account with a bank in London (HSBC, etc)… and its easy to switch from one account to the other (click of a button)

International Money Market Rates (Bid Side)

United Statesdollar

Englandsterling

Europeeuro

Switzerlandfranc

Japanyen

Eurocurrency Rate

LIBOR 12 months

3.2% 6.0% 5.3% 3.2% 1.1%

Where would you invest??


United Statesdollar

Englandsterling

Europeeuro

Switzerlandfranc

Japanyen

Eurocurrency Rate

LIBOR 12 months

3.2% 6.0% 5.3% 3.2% 1.1%

Right?? … maybe not!!

Need to consider….

•You might be temped to choose the England (sterling) option of 6% because it’s the highest…

•but that currency might be expected to lose value (depreciate) over the next year…wiping out the expected gains.

Need to consider….

•Answer: it DEPENDS not just on the interest rate, but also on the expected change in foreign exchange rate as well.


United Statesdollar

Englandsterling

Europeeuro

Switzerlandfranc

Japanyen

Eurocurrency Rate

LIBOR 12 months 3% 6.0% 5% 3.5% 1.1%

Expected appreciation /

depreciation vs. US Dollar to EQUATE

choices…

x -3% -2% -0.5% +1.9%

Which would you choose now??

Answer…

•You wouldn’t care (all investment options would appear neutral)

•Foreign exchange markets are in “equilibrium”

Themes to cover:

1.Banking Business Model –today

2.Pyramid of Promises - next class

Commercial Banking (business model)

•Commercial Banking business model:• “Borrow short, lend long”

•Who can explain what this means?

Borrow Short

•Deposits are LIABILITIES for banks•They are BORROWING money from

clients•But, deposits can be withdrawn at any

time

•So… their Liabilities are short term (might owe money tomorrow)

Lend Long

•Banks invest in Long term Assets•Mortgages, for example… 30 years

duration

•So, money is borrowed short (term), but lent out long (term)

•What is the risk?

Lend Long

•Risk= profitable bank may not have money on hand to meet short term liabilities (withdrawals)

•This is called “Liquidity” crisis

Bank Run

http://michaelcorey.ntirety.com/Blog

Overcoming Banking Weakness of Liquidity

Question – what do governments do to overcome the fundamental weakness of LIQUIDITY (inherent in banking business models?)

http://globotrends.pbworks.com/Commercial-Banking

Overcoming Banking Weakness of Liquidity

Federal Insurance• As a result of this inherent weakness, banks

are offered federal insurance for the deposits. The government is forced to federally protect (guarantee) depositors that their money will be there if they want it. Or else, people would not trust the banks, and would not deposit their money. FDIC

Question – And, with insurance… what comes NEXT?


Overcoming Banking Weakness of Liquidity Regulation• In exchange for this federal guarantee (that they

receive), the banks (give up) are subject to stiff regulation. One of the main requirements for deposit-taking banks is that they have to maintain a certain level of money on reserve at the (Federal Reserve). In the US, this reserve requirement is 10%.

•But, anywhere you see Regulation… what do you typically see NEXT?


Getting around Regulations….Innovation•Wherever you see regulation, you will see

innovation (to get around the regulation). Banks are some of the most creative organizations when it comes to developing products to get around regulation. For example, there has been massive Innovation in the financial sector when it comes to the securitization of mortgages (which partly is to blame for the subprime lending crisis).


Moral Hazard

•Group Question:

•“Does regulation + bank guarantees… result in making the banking system more, or less risky?▫Ie. Do you think government guarantees

encourage risky behavior?

Moral Hazard

•Law of unintended consequences•Moral Hazard

▫Ex: fire insurance… less likely to smoke? Health insurance…. Less likely to be safe?

•“Moral hazard: One of two main sorts of MARKET FAILURE often associated with the provision of INSURANCE. The other is ADVERSE SELECTION. Moral hazard means that people with insurance may take greater risks than they would do without it because they know they are protected, so the insurer may get more claims than it bargained for.

The Economist.com

Solvency v Liquidity – QUIZ (extra credit)•Extra credit – 1 point in final grade

•In 20 words or less – what is a “Solvency” problem (for banks)

•In 20 words or less – what is a “Liquidity” problem (for banks)

•* think of the business model

Solvent: not Solvent•Ok NOT OK

ASSETS-Include home mortgages-subprime

Liabilities (Borrowing, debt)

Equity



Equity

Solvency v Liquidity• Insolvent: liabilities > assets (equity = 0)

▫Person: I owe more than Im worth▫Bank: assets loose value (subprime mortgages)▫Country: cant pay debts…default

• Illiquidity: long term asset, short term liability▫ I owe money NOW, but have money tied up in my

house, car, etc…▫Bank: lend long term, borrow short term▫Country: cant access credit markets to pay

imports

“The country's problems were adjudged to be ones of illiquidity. They were not. Greece was insolvent. All that has happened since is that Greece's debt burden has risen.”

From day one, immense challenges faced the coalition of international institutions that opted for a liquidity approach to address Greece’s debt solvency problems.

PIMCO CEO Mohamed El-Erian

Response: “Almost all independent observers of Greece have stressed from the beginning that Greece was facing a solvency, not a liquidity problem. This was also the case 10 years ago with Argentina; a country that had achieved financial stability by entering into a “quasi” monetary union using the US dollar and which had privatised every available public asset.


“the Greek government is losing control of the streets. As protests turn increasingly ugly, the pursuit of a national political consensus becomes even more elusive. This is especially true if all Mr Papandreou, or another leader, can offer is a step back to a discredited approach that involves sacrifices with no evidence of lasting benefits.”


Solvency v Liquidity

•How does this relate to the Global Financial Crisis?

▫Anyone?

Solvency v Liquidity Timeline

•2007 – September 2008▫Problem = Solvency▫Mortgages (assets on

Banks balance sheet) worth less than anticipated… write down

▫Results: Hedge funds Funds go under (Bear Stearns)

▫Bankruptcy threat



Equity

Credit bubble led to housing bubble, led to bust…

http://www.abc.net.au/reslib/200802/r220644_867185.jpg

Credit Crisis timeline – key dates in SeptemberSeptember 7, 2008: Federal takeover of Fannie Mae and Freddie Mac

[25][26] September 14, 2008: Merrill Lynch sold to Bank of America amidst

fears of a liquidity crisis and Lehman Brothers collapse[27] September 15, 2008: Lehman Brothers files for bankruptcy

protection[28] September 16, 2008: Moody's and Standard and Poor's downgrade

ratings on AIG's credit on concerns over continuing losses to mortgage-backed securities, sending the company into fears of insolvency.[29][30]

September 17, 2008: The US Federal Reserve loans $85 billion to American International Group (AIG) to avoid bankruptcy.

September 19, 2008: Paulson financial rescue plan unveiled after a volatile week in stock and debt markets.

September 25, 2008: Washington Mutual was seized by the Federal Deposit Insurance Corporation, and it's banking assets were sold to JP MorganChase for $1.9bn.


•September 2008 – 09▫Crisis CHANGED▫No longer just a SOLVENCY CRISIS▫Became a MIXED crisis of BOTH solvency

and liquidity▫How? Why? What does that mean?

▫Someone tell me again…what is “liquidity”?

Questions:

•Question: if a bank is having a SOLVENCY trouble… should the government come to their rescue?

• (clue – remember the discussion on “moral hazard”)



Equity


•Answer: NO! (probably not) *

•* but, gets complicated by worries about systemic risk, and interconnectedness, and “too big to fail” banks



Equity

How about a “Liquidity” crisis?

•Should the government step in to help a bank facing a “liquidity” crisis?

How about a “Liquidity” crisis?

•YES!!•To help banks bridge the gap between short term liabilities and long term assets

•* this is exactly why the FDIC, insurance was offered.

The trouble during the crisis…

•… after September 2008… it was difficult to tell which banks faced “liquidity” crisis (and should be helped), and those that faced “solvency” crisis, and should be allowed to fail (to avoid “moral hazard” from saving them)

2. Professional visit review

•Banco Sabadell; most important in Catalonia

Quotes for discussion:

•When talking about the banking model... he said …“deposits are not yours… its not your money. You loan it out, but might need to repay quickly… equity is small, question of risk”

•Q. Do these comments make sense now? (hope so!)

Quotes for discussion:

•When talking about the risks of global markets, he said …“money responds to fear… When political turmoil occurs… money disappears”

•Q. How does this relate to our discussion of the “dangers of international finance”? Of “portfolio money”?

•PYRAMID OF PROMISES

International Finance

Pyramid of promises

What “promises”?• Financial assets represents “promises of

future, often contingent, receipts in return for current payments”

• Bonds▫Represent PROMISES of fixed payment (in

time), plus PROMISE of regular payments in between

• Equity (stocks)▫Represent PROMISES a share in future

corporate profits• Pensions

▫Represent PROMISES for a stream of income in retirement

Martin Wolf, “Fixing Global Finance”… based on McKinsey “Mapping Global Capital Markets”, 2005

What “promises”?• Life Insurance Policy

▫Represent PROMISES of payment after some fixed date or death

• Accident / Health Insurance Policy▫Represent PROMISES of payment if something

happens• Mutual Fund

▫Promises to return to investors the proceeds from mutual funds purchase of promises from corporations

• Options▫Is a promise to hand over a claim to a certain

promise under specific conditionsMartin Wolf, “Fixing Global Finance”… based on

McKinsey “Mapping Global Capital Markets”, 2005

Remember 2 dangers of international finance…

1. Currency might devalue2. Foreign governments might default (less

obligation to foreigners, not to voters)

* Promises based on trust

Pyramid of Promises

•“Central feature of the financial system: it is a Pyramid of promises- often promises of long or even indefinite duration. This makes it remarkable that sophisticated finance systems exist”

•Promises may not be kept•Interest of those who make promises NOT

to keep them


Pyramid of “promises”?

•“As the financial system grows more complex… it piles PROMISES on PROMISES”.


Just how big is the MOUNTAIN of promises…?

•Amazing….

data from McKinsey report 2005, "Mapping the global capital market" and http://www.federalreserve.gov/releases/


Size of Finance…

•“What is amazing is that the financial sector ballooned to the size that it has...with a worldwide total of $140 trillion in promises outstanding in 2005”


Size of Finance…

•Of that total, the US was the prime holder of promises (assets).

•The US household sector held about $39 trillion (28% of world total), and with the US as a whole holding nearly $52 trillion (37% of all world financial assets, or promises).


Size of Finance…


“PYRAMID of Promises”


•Modern economies depend on pyramids of promises far more impressive and complex than those of stone constructed almost 5 thousand years ago”

“PYRAMID of Promises”


•But, the system is extremely FRAGILE

•Confidence that sustains them could be misplaced

•People could end up with promises NOT WORTH the paper (they used to be) printed upon

Underneath that “PYRAMID”


•The “Foundation” of all of these PROMISES is = title to real assets▫Housing, land, property, factories,

machines, etc

▫Need to BELIEVE the original owner really ownes what they say they own.

▫So, key = property rights, law, institutions – for trust, and development of financial system

Law of Un-Intended ConsequencesAnd… “Moral Hazard”

NY times article 1999…•Fannie Mae Eases Credit To Aid

Mortgage LendingBy STEVEN A. HOLMESPublished: Thursday, September 30, 1999

•“In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders.”

NY Times, “Fannie Mae Eases Credit To Aid Mortgage Lending”, By STEVEN A. HOLMES, September 30, 1999

NY times article 1999…

•“The action…will encourage those banks to extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans.”



•“Fannie Mae…has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people

•… and felt pressure from stock holders to maintain its phenomenal growth in profits.”


NY times article 1999…• In addition, banks, thrift institutions and

mortgage companies have been pressing Fannie Mae to help them make more loans to so-called subprime borrowers.

• These borrowers whose incomes, credit ratings and savings are not good enough to qualify for conventional loans, can only get loans from finance companies that charge much higher interest rates -- anywhere from three to four percentage points higher than conventional loans.


NY times article 1999…• In moving into this new area of lending, Fannie

Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980's.

• ''If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.''



•“By expanding the type of loans that it will buy, Fannie Mae is hoping to spur banks to make more loans to people with less-than-stellar credit ratings.

•Fannie Mae officials …add that the move is intended in part to increase the number of minority and low income home owners who tend to have worse credit ratings ...


Dr. Kishore Dash, January 20, 2007

Exchange Rate Practices

•Pegging

•Floating

Exchange Rate Options

OfficialDollarization

CurrencyBoard

Free Float

Peg

More Flexible Less Flexible

Crawling Peg

BandDirtyFloat

Source: Rafael Barraza


Review

Concepts from last class

review

•Anglo Saxon vs Continental model of banking

•What is the difference?

Review -- Series of Crises

This is NOT the first one!!

quotes

•“the age of financial liberalization became the age of crisis”

•What does this mean?

Martin Wolf

History of Crises (series)

What happened around1945?

What happened around1973?

http://mohammedfikri.files.wordpress.com/2010/02/bretton_woods_sign.jpg

Note timing•1945 – end WW2

▫Stability, fixed rates▫Bretton Woods▫only 38 financial crisies between 1945 and

1971

•Early 1970 – end Bretton Woods▫Crises, flexible rates▫Enter age of Liberalization of finance▫139 financial crises between 1973 and 1997

Martin Wolf book, “Fixing Global Finance”

Series of Crises – 1990’s• Japanese recession - 1990 to 2003, collapse of a real estate bubble

and more fundamental problems halts Japan's once astronomical growth, “lost decade”

• United Kingdom - 1992 - devaluation of currency, "broke the bank of England“, currency speculating against the European currency unit peg

• Mexico crisis 1994 ”tequila crisis” - currency devaluation, debt crisis

• Asian Crisis 1997: SE Asia Crisis - 1997 & 1998 - currency devaluation, debt crisis

• South Korea - 1998 • Russia - 1998 • USA - Long term capital management - hedge fund meltdown - 1998

- causes were SE Asia Crisis of 1997, and Russia crisis of 1998• Brazil - 1999 - currency Real was pegged to US dollar, then forced

to float – currency crisis

http://globotrends.pbworks.com/history-of-economic-crisis-and-currency-devaluations

Fixed, Floating

FX discussion…

Fixed vs. Flexible exchange rates

• Fixed exchange rates▫Any examples?

• Floating exchange rates▫Any examples?

• What system is active today? (globally)

• Important to INTERNATIONAL business managers to pay attention to changes▫why?

Fixed vs. Flexible exchange rates

•What system is Better? Why?

▫Groups of 2-3 students, answer

Brief History – Key points

•Key point: there is NO “best” system•It all depends on what you want to

achieve…•History: Cycle from Fixed to Flexible to

Fixed to Flexible……(future?)

Fixed Fixed

Flexible Flexible

The gold standard (~1850–1914)Fixed exchange rates during the 1920s

Great Depression era

Post WWIIBretton Woods / IMF system (1944–1971)

1970’s –today: since U.S. left the gold/dollar standard

?????

Brief History – Key points

•QUESTION:▫Why change from flexible to fixed? (give 1

reason)▫Why change from fixed to flexible?

Fixed Fixed

Flexible Flexible

The gold standard (~1850–1914)Fixed exchange rates during the 1920s

Inter-war periodGreat Depression era

Post WWIIBretton Woods / IMF system (1944–1971)

1970’s –today: since U.S. left the gold/dollar standard

Brief History – Key points• ANSWER:

▫Why change from flexible to fixed? CONTROL, STABILITY, LOWER INFLATION,

END CHAOS Note: Too chaotic in depression… so fixed for

stability Note: Argentina = fixed to dollar was “brilliant”

at the time…but should have dropped sooner (not just in 2002)

▫Why change from fixed to flexible? EASE ADJUSTMENT PROCESS, IMPROVE

LOCAL MONETARY CONTROL, INCREASE GLOBAL FLOW OF FUNDS

FIXED system…

Painful ADJUSTMENT mechanism:

Example: Under the GOLD Standard:

If exports > imports… build up gold reservesIf imports > exports… run out of gold reserves

KEY QUESTION:

▫ Under a fixed system, how do you increase exports? (to stop burning through gold reserves)?

▫….Group answer

FIXED system…

Answer▫ need to decrease prices, wages ▫ So exports more competitive▫Can’t adjust FX rates, so adjustment has to be painfully with wages, prices

• KEY POINT:▫ adjustment in fixed system is = painful process, slow, very unpopular!▫

Hedging example

Borrowing in Foreign Currencies….Where would you prefer to borrow?You have a factory in Brazil, and want to borrow

money to expand. You could…1.Borrow money locally at 10%2.Borrow money abroad (in US) at 5%

• Which would you choose?• What is the risk of borrowing abroad (in the US)?

– general comment 20 words or less

Note: fictional data based on current loan rates Brazil…• LIBOR + 1.5% for US = 2.5+1.5 = 4%• CDI + 2% for Brazil = 9.75 +2 = 11.75%

•NEXT CLASS

Derivatives - details

•Derivatives

Derivatives•Central point of finance = risk is undesirable• Individuals who choose risky securities only

if the expected return compensated for the risk.

•Firms constantly look for ways to reduce their risk.

•Hedging = use of derivatives to reduce risk exposure

•Speculating = opposite (but if wrong… tools cut deep)


Derivatives•Financial instrument whose payoffs and values

are derived from or depend on something else

•Examples: forwards, futures, swaps, options•Why use derivatives?: change firms risk

exposure•Derivatives are to finance, what scalpels are to

surgery. By using derivatives, the firm can cut away unwanted portions of risk


Types of FX Transactions• Spot

▫Today▫Agreement of FX rate today, for settlement in 2

days• Forward

▫With bank. Agree today about FX rate to use in future

▫Usually 1-52 weeks• Futures

▫Similar to Forward contracts, but traded on exchanges. Set dates, fixed quantities, marked to market

• Swap▫Sale (or purchase) of foreign currency today, with

simultaneous agreement to repurchase (resell) at some point in the future. Difference between 2 rates= swap rate


Forward v Future• A Forward contract – agreement by 2 parties to

sell an item for cash at a later date. The price is set at the time the agreement is signed. Cash changes hands on the date of delivery. Forward contracts generally are not traded on exchanges.

• Futures – also agreements for future delivery. ▫Advantages – liquidity. ▫Mark to market: if the price of a futures contract

falls on a particular day, every buyer of the contract must pay money to the clearinghouse. Every seller of the contract receives money from the clearing house. This prevents defaults.


Futures v Forwards…• Futures are publicly traded on exchanges• Futures are traded in blocks. With forwards, its

easier to specify exactly the dollar amount that you want to trade.

• Futures contracts expire at specified times (on the 3rd Wednesday of the quarter - March, June, September, December - and not in between. So, if you are looking to hedge currency exposure till the middle of July, you might not choose to use futures contracts because the contract will expire in June, and would leave you naked (exposed) until July.

• To buy/ trade futures contracts, an individual calls their stockbroker, who will require a "margin account" to insure against losses.

• In forward contracts, the individual calls their bank, and makes a private deal with their banker. No collateral is required, but you must have a bank that trusts you, and is willing to make the deal


Futures v Forwards…• Futures are not traded in every currency. Look on

the Chicago Mercantile exchange to see what is traded. Usually its dollar, euro, yen, and other major currencies. To trade less common currencies, it is sometimes difficult to find futures contracts traded on exchanges. Instead, you will likely need to use a forward.

• The good thing about Futures is that they trade on a very liquid market (easy to net out your position and trade your contract with someone else).

• Futures prices are quoted in daily papers, and online

• There is a middle man, called a "clearing house" in futures contracts

• Futures are "marked to market" on a daily basis, which results in many cash flows (daily), rather than just one big cash flow at the end (like with forward contracts)


Forward with FX• Example: if a company is importing and knows that

they must pay the foreign supplier in foreign currency at a time of 30 days in the future, that company might be afraid of a currency change , which would result in them owing much more money (in their local currency). To mitigate this risk, the company might want to "lock-in" an exchange rate in the future...by using a "forward" exchange. To do this, the importing company would make a deal with their local bank to buy the foreign currency at a specific rate (in 30 days in the future). By agreeing to "sell dollars forward", and to "buy foreign currency forward", the importer has guaranteed that they will have the right amount of foreign currency on hand in the future (to pay the supplier), and they have eliminated the risk. This is like buying insurance against the risk of FX fluctuations.


Forward with FX

•How to buy a forward contract•you need a relationship with a bank•and they have to trust you (there is no

collateral in a forward contract)•unlike a Futures market contract which

you purchase with a stock broker using stock as collateral (margin account)

•


REMINDER - Terms you need to know….•Appreciation:

▫Currency gets STRONGER vs other

▫Team answer (on paper)

▫What is appreciation (numerically)? If current FX rate is 2 US dollars to the 1 Euro… what is one rate that would reflect US dollar Appreciation (give sample rate).

Terms you need to know….

•Appreciation:▫Currency gets STRONGER vs other▫Example:

US Dollar Appreciates Goes from 2.0 USD per Euro to 1.0 USD per

Euro So, it takes LESS US dollars to buy one Euro

Goes from 1 usd buys 0.5 Euro…. Now; 1 usd buys 1 Euro So, it 1 USD buys MORE Euros

Terms you need to know….

•Depreciation:▫Currency gets WEAKER vs other▫Example:

US dollar Depreciates Goes from 1.0 USD per Euro to 2.0 USD per

Euro So, it takes MORE US dollars to buy one Euro


Exchange Rate Practices

•Pegging

•Floating

Exchange Rate Options

OfficialDollarization

CurrencyBoard

Free Float

Peg

More Flexible Less Flexible

Crawling Peg

BandDirtyFloat

Source: Rafael Barraza


part 5 paris - forum nexus finance class summer 2011

Economy & Finance

global markets

global entrepreneurship

global reserves

global citizen

global finance martin

global reserve currency

global financial markets

following questions