a report on international finance

8/14/2019 A Report on International Finance

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INTERNATIONAL FINANCE

Evolution of International Trade

By : Anup Mahesh Savale



Initial trade among communities

• Communities grew in centers favorable for life

• Initial trade among communities was for luxuries

• Trade resulted in

– Specialization

– Increased scale: enhanced productivity

– De-risking

– Spread of technology



Resulting in Explosive growth in humanWealth

Origin of Wealth:

Eric Beinhocker



International trade accelerated this further

Origin of Wealth:

Eric Beinhocker



Why International trade ?

• Mercantilism

• Theory of Absolute advantage

• Theory of Comparative advantage

• Factor endowment theory

• International Product life cycle theory

• Internationalization of Firm



India’s Foreign Exchange reserves

March 31, $ billion1992 1,799

1993 9,832

1994 19,254

1995 25,186

1996 21,687

1997 26,423

1998 29,367

1999 32,490

2000 38,0362001 42,281

2002 54,106

2003 75,428

In December 2003, Indian FX reserves crossed $100 bgrowth from 2 billion to 100 billion a base for examining Global trade



Mercantilism• Prevailed in 17th and 18th century, Europe

• Mercantilism replaced feudalism

– Feudalism emphasis on local economy, self sufficiency andagriculture

– Political change – From Feudalism to nationalism – Cultural change –From Salvation to Happiness of man on earth

• Mercantilism: “Fear of goods; hunger for money”

• Foreign trade as a means to accumulate treasure and increase the power of thestate

• Treasure in the form of gold and silver to increase the power of the king and the

state• Policy advocated “restricted trade”:

- Restrict imports

- Encourage exports, especially manufactured goods

- Encourage re-export of goods

- Achieve full employment of both human and natural resources

Similar situation in India in 1991Imports restricted and exports promoted

As India faced an FX crisisImport surcharge, LC margins



Theory of Absolute Advantage

• Propounded by Adam Smith in Wealth of Nations (1776)

• Advocated free trade from ‘restricted’ trade

• Export a commodity that can be produced at a lower costcompared to the importing country

• Import a commodity that is produced by another country ata lower cost

• Free trade increases the wealth of a country

• Wealth of a country is the wealth of all its citizens not

just the king

Tax benefits and Software Technology Parks created in 1994

An application of theory of absolute advantage?



Absolute Advantage illustrated

Country Cost of Production Domestic barter

rateWine Cloth

Portugal 100(a1) 50(b1) 1 wine = 2 cloth

England 50(a2) 100(b2) 1 wine = .5 cloth

Cost ratio 100/50

2.0

50/100

0.5

•England has absolute cost advantage in wine

• Portugal has absolute advantage in cloth• England will export wine and import Cloth• Portugal will export cloth and import wine

Perfect conditions for Internationaltrade



Theory of Comparative Advantage

• Propounded by David Ricardo, On the theory of PoliticalEconomy and taxation (1817)

• Identified fundamental difference between Domestic tradeand international trade

- Factors of production perfectly mobile within a country butimmobile among countries

- Goods perfectly mobile within and outside the country

• Export goods at which it is comparatively more efficientand import goods at which it is comparatively less efficient

Development of Auto ancillary industry in India



Theory of Comparative advantageCost of

Proudction for one unit

Wine Cloth Exchange rate Exchange rate

Domestic rates

Portugal 80 90I wine = 0.89 cloth 1 cloth =1.125 wine

England 120 1001 wine = 01.20 cloth 1 cloth = 0.83 wine

Portugal has lower cost of production than England for both wine & Cloth

Cloth costs more than wine in Portugal

Wine cost more than cloth in England

Therefore, Portugal will export wine and England will export cloth

Exchange rate for Portugal wine and English cloth will be

England will pay for a unit of wine a maximum of 1.20 cloth

Portugal will want for a unit of wine a minimum of 0.89 cloth

Trade will take place at a price between max. 1.2 cloth to a min. of 0.89 cloth at

which both countries benefit from international trade.



Factor Endowment Theory

• Propounded by HECKSCHER – OHLIN (early 20th century)

• A country should export goods that uses its mostabundant factor of production most intensively

• A country should import goods that uses its mostscarce factor of production most intensively

• Countries with low interest rates and abundantcapital will have capital intensive industries meetingglobal demand

• Countries with large labor pool will have labor intensive industries meeting global demand

International division of LaborChina for manufacturing & India for

Services



Leontief paradox

• Leontief won the noble price for his Input-Output analysis, which formed the

basis for testing Factor Endowment theory

• Leontief analyzed the 1947 US data based on 50 industries

- 38 industries had international trade

- Aggregated factors into two –Capital and labor

- US had more capital employed per worker

- As per Factor endowment theory US should have exported capital intensive

goods and imported labor intensive goods

- For 1947, US imported goods that had 30% more Capital intensity

- Second test of 1951 indicated 6% higher capital intensity in imports

- In 1971 third test indicated 27% higher capital intensity in imports compared to

goods exported



Leontief paradox -2- for 1959, data for Japan was tested, Japan was labor intensive but on its

total exported capital intensive goods

- A split into exports to developed countries 25% and less developedcountries 75%revealed that, Japan exports to US followed the Factor endowment theory

- 1962 data for India tested, Indian exports were labor intensive, but Indianexports to US were capital intensive

- Leontief Paradox partially explained by Factor Intensity Reversal

- For e.g.. if agriculture is traded between India and US, in India agricultureis labor intensive, and in US it is capital intensive.

- If US exports to India, US exports capital intensive goods in line withtheory; but India imports labor intensive goods

- If India exports to US, India exports labor intensive goods in line withtheory; but US imports capital intensive goods

Factor Intensity Reversal explains Leontief

paradoxFactor Endowment theory explains trade



International Product Lifecycle Theory

• Propounded by Raymond Vernon (1960’s)

• Product life cycle: Introduction, Growth, Maturity, decline

• Introduction: Manufacture for home market & exports

begin• Growth: Foreign production starts

• Maturity: Foreign producers become competitive in their local markets

• Decline: Foreign producers enter home market

Shift of semi-conductor manufacturing from

United States to Asia



Internationalization of firms

Stages of Firms evolution

I stage No regular exports

II stage Export via overseas agentsIII stage Establishment of overseas Subsidiary

IV stage Overseas Production

Can we see a parallel in India

Companies acquiring companies globally



A major factor influencing trade now:Technology and Wealth Creation

• Wealth = Value in exchange

• Capital + Labor + Technology = Wealth or Economic Growth

• Capital and Labor are subject to the principle of marginal diminishing return, whereastechnology can hold marginal diminishing return

• Growth can be led by Technology calledInspiration led growth or by labor / capital calledPerspiration led growth



Technology and Growth

Capital deepening = assets used in businessroduction = used commercially in manufactu

In Usage = retail consumption

Source: Solomon, Smith




Evolution of Global

Foreign Exchange Markets

J Shankar IISc, MBA –Second Semester January 2007



Evolution of international Forex markets

• Trade & trade practices

• Why study evolution of FX markets

• Milestones of evolution• Gold standard or Mint parity theory

• Gold exchange standard

• Bretton woods or Exchange rates linked toUS$

• Floating rate / market determined



Trade & trade practices

Type of trade Movement of Goods

Payment inCurrency

Local National Local currency

Deemed Exports National Foreign currency

Aided Sale International Local currency

Export International Foreign currency



Why study evolution of FX Markets

• Often, History repeats itself, especially in moments

of crisis or points of inflections

• Inferences can be drawn from history for e.g.

1. Venue of meeting and power tilts

2. Impact / response of wars / economic

upheavals

3. Policy responses to crisis

• Study of history is fascinating in itself

Look out for color code as we go along



Milestones of Evolution

• Pre 1870 - Barter sales of luxuries

• 1870 - Gold Standard / Mint parity

• 1922 (Genoa) - Gold exchange standard

• 1944 (Bretton Woods) - IMF / US$ base

• 1967 (Rio de Janeiro) - Introduction of SDR

• 1971 (Washington DC) - US$-Gold link breaks

• 1973 (OPEC induced) - Market based



Export trade Pre 1870’s

• Pre historic*

– Initial trade between communities was normally for luxuries

not indispensable, through barter trade

• Trade in ancient India (Arthashastra)

– Profit margin allowed on imported goods is 10%

– Foreign merchants shall not be sued in money disputes

unless they are legal persons in the country; their local

partners can however be sued

• Trade till 19th century

– Mainly through travelling merchants, who sold the goods they carried and

bought back with them local goods that could be used in their native land

* What happened in History, Gordon Childe



1870 -Gold Standard / Mint theory

• Britain -1819 - Resumption Act – After Napoleonic wars (1793-1815) gold conversion resumed

– Currency notes exchanged to gold at fixed rates

– Simultaneously repealed restrictions on export of gold coins and

bullions from Britain• Followed by Europe 1870’s, USA -1879

• Exchange rate based on underlying gold

• Principles of Gold standard

1. Currency value fixed w.r.t gold;

2. Currency issue backed by gold

3. Free trade in gold;



Gold Standard –Theoretical basis

Trade deficit

Export Gold

ReduceMoney Supply

ReductionIn price

More exportsLess Imports

Leads to

Trade Surplus

ImportsGold

IncreasesMoney supply

Increase inPrices

Less exportsMore imports

Leads to



1870 -Gold Standard / Mint theory

• Positives – free world trade;

– stable price / exchange / economic growth & peace

• Negatives – volatile economy / depression -1890 1907,

reduction in money supply leads to recession, lower

price does not lead to higher purchases

• 1914 - I World War, gold conversion

suspended in Europe, USA continues Gold

conversion



1922 - Genoa Agreement

Background –

• Genoa a town in Italy attended by Britain, France, Italy and Japan

• Convertibility to gold stopped in 1914;

• Fiduciary money gains acceptance;

• Gold as settlement currency withdrawn & partial gold standard introduced

•I WW result - High inflation / shortages

Reasons cited for withdrawal of Mint parity -gold production decline; save freight & storage cost

- UK economy grew by 5% in 19th century, gold production increased only by3-4%

Results in –

• Currency not backed by gold; for international trade gold as settlementcurrency continues, not for domestic conversion

• Sterling as world currency,

• London as World trade centre

II World War brings this system to a halt



Movement from barter to Gold

Barter Money Metals

Gold standard

Paper money

Coinage

For Domestic trade For export trade



1944 - Breton Woods

Background –• US the only country on gold standard;

• Left in 1933 at $20.67 and returned in 1934 at $35

• II WW financed by paper money;

• Results in high inflation & shortages• 44 countries meet in the town in New Hampshire in US

• Harry Dexter White of US Treasury and Lord Keynes of UK present plans

Accepted – • Keynesian plan -promote full employment & stable

exchange rates,

• Central banks to co-operation & aid nations in crisis



International Monetary Fund

IMF formed with 44 member nations –

• Fix gold parity for US$ -$35 for 1 troy ounce ; other

currency rates fixed w.r.t. US$,

• Capital flows can be controlled,

• All countries to reach Capital Account Convertibility as

soon as possible to promote free trade

– US and Canadian $ convertible from 1945

– Europe 1958 - 61, Japan 1964• Change in parity only for fundamental disequilibrium

• Countries with convertible currency cannot change

exchange rate

Conditions for IMF membership



International Monetary Fund

• IMF facility to correct disequilibrium

– Quota contributed by members -25% in gold; 75% in

their own currency

-Credit facility 125% of quota

-Extended facility 140% of quota

-Standby facility -IMF guarantee for 3-5 year borrowing

- General Agreement to borrow -1962

– Agreement for IMF to borrow from Industralised nations for lending to countries in disequilibrium

- Currency swap arrangement -1962

Benefits for IMF members



Triffin’s paradox predictsCollapse of Breton Woods system

• 1960’s –Theory “More the US$ is

accepted as international currency of

settlement, sure is the failure of this

system”

–US$ earns interest; gold does not; but exchange rateis fixed



1967 - Rio de Janeiro

• Impetus - declining International liquidity

• 1958-60 - US$ 2b gold shifts from US to Europe

• 1960 -1967 12 b gold shifts out of US

• March 1968 two tier price for gold announced

– Price for Central banks fixed at $35

– Open market price of 44.36 in Paris

• Introduced SDR or Special Drawing Rights



SDR –Special Drawing Rights

• SDR’s allocated to members based on the global needs to supplement existingreserve assets for liquidity

• SDR’s initially fixed in terms of gold via US$, later through a basket of

currencies

• SDR’s can be used by the member country to buy foreign currencies for their international trade

• IMF allocates SDRs to members in proportion to their quotas

– Interest is paid to the member if the SDR held by member is higher than original

allotment

– Interest is paid by member if the SDR held by the member is lower than original

allotment

• http://fx.sauder.ubc.ca/SDR.html• http://www.imf.org/external/np/exr/facts/sdr.HTM

http://fx.sauder.ubc.ca/SDR.html

http://fx.sauder.ubc.ca/SDR.html



Beginning of the collapse 1967 - Riode Janeiro

• Special Drawing Rights (SDRs) -Paper gold upto 3 times their own

SDRs

• SDRs are used in transactions between central banks

• Value 1970 -1 SDR = 1 US$

1974 -linked to 16 currencies 1980 -linked to 5

currencies

• SDR history 1970 US$ 3.4 b 1971 US$ 2.95 b 1972

US$ 2.95 b

• SDR introduced - 1.5% interest on SDRs increased to 5% in 1975



Triffin’s paradox in action:Collapse of Breton Woods

• US gold reserve1944 26 b of total global stock of 33 b1958 23 b1971 10 b

• Between 1967-68 20% of gold reserve wastaken out of US; price of gold $44.36 per ouncevs.$35

• US gold reserve as % of $ held by other centralbanks -1963 -100%; 1970 -50%; 1971 -22%

• Bundesbank held 18 b $ in 1972, more than theentire US gold reserve



1971 -US stops gold conversion

• US budget deficit1958 -71 US$ 56 b1971-73 US$ 60 b

• 1958 -71 US had BOP deficit due to-higher return outside US leading to capital outflows

-Vietnam war & military commitments• Measures- 1963 -Interest Equilization tax

1965-Voluntary Credit restrain 1968 -Mandatory Credit restrain

1971 –US had $10 b of Gold;UK wanted to convert $3 b of $ it held for gold

• August 15, 1971 –US stopped gold convertibility – 10% import surcharge on imports introduced

– 90 days wage and price freeze



1971 - Smithsonian Agreement

• Group of 10 formed in 1962 meet

• Temporary regime -2.25% range

•US devalues 8.57%;

• Yen 17%, Mark 13.5%, FF & UKP 9% up in 1971

• US devalues 11% in 1973

• Arrangement fails due to oil price hike by OPEC in

1974 of 400%



Post 1973 -OPEC influence

• Organisation of Petroleum Exporting Countries

• 1973 oil price hike 400%;

• 1978 another increase

• Approach to oil price hike -Japan - hikes local price

-surplus BoP

US -prevents price hike - deficit BoP

• Creates market fiction and total market determined rates



Market determined prices

• G 7 -US, UK, WG, Japan, France, Italy, Canada

• US$ exchange rate

75 80 85 90 95 98

DM 2.3 1.7 3.3 1.7 1.4 1.6795

UKP 2.0 2.3 1.1 1.7 1.6 1.6627

Yen 305 250 255 148 100 114

• Upto 1980’s trade dominates exchange market

• Post 1980’s capital flows influences market



Market determined prices

• Capital flows influenced by Interest rates

• Trade flows influenced by Tariffs / trade agreements

• Economic sequence or vicious circle

Economic activity-> Money quantity ->Interest rates

->Exchange rates ->Economic activity




Evolution of Indian

Foreign Exchange Markets

J Shankar IISc, MBA –Second Semester

January 2007



Evolution of Indian Rupee

• Indian Currency: Arcot rupee, started by Nawab of Arcot, later adopted byEuropeans and was known as English, French and Dutch arcots; Englishused them in Madras, Calcutta and Dacca: 171-177 grains of pure silver

• Sonaut rupee: used in United Provinces; also refers to coins minted threeyears and older

• Sicca rupee: used by East India Company from 1793 in Bengal 176 grains of

pure silver and total weight of 192 grains• Company rupee: introduced by East India Company after 1835

• 1835 Act of Imperial Government: standard rupee for all part of Indiaunder British control: 180 grains of metal; 165 silver

• Paper currency Act of 1861: a legal tender paper currency: notes of Rs.10, 20,50,100, 500, 1000 and 10,000 declared unlimited legal tender in their circles

• 5 rupee note in 1891, 1 rupee note in 1940• 1903: Rs.10 and higher notes declared universal legal tender

• 1935 Reserve Bank of India set up as central bank

• 1947 India joins IMF: Indian rupee = 30.225 cents of US$

• April 1957, decimal coinage system introduced



Evolution of Indian FX markets

• Founder-member of IMF

• 1947 INR -US$ = 3.31; INR-UKP =13.33

• 1949 INR-US$ = 4.75; INR -UKP =13.33

– 75% of Commonwealth countries followed devaluation – Pakistan did not devalue; India stopped payment; Pak

followed devaluation in 1955

• Wars in 1962 & 1965-666.6.66 -57.5% devaluation; US$ =7.5, UKP 21

• 1967 -US$ 7.5; UKP =18 (Pound re-valued)

• 1971 -Pegged to UKP in a band of 2.25% range

E l ti f I di FX



Evolution of Indian FXMarkets

• 1975 - INR pegged to basket of currencies

• 1978 -banks permitted intra day positions

• 1979 -RBI ups margin to 5% from 2.25%• 1981 -Reuters services permitted in India

• 1987 -RBI sells US$ as well as Rupee; till 1987, pound

was the only currency• 1991 -LC Margins (200%), devaluation & Exim scripts for

export subsidies



Evolution of Indian FX Markets

• 1992 -LERMS (Exim scripts withdrawn & dual

rate introduce) Official $ rate Rs.26

• US$ replaces UKP as intervening currency

• 1993 -Unified exchange rate introduced;

Direct quote instead of indirect quote

• 1994 -August, current account convertibility

• 1995 -Sodhani committee report

• 1997 -Tarapore committee report



Sodhani committee recommendations-1995

• To develop FX markets in India

• Forward Covers based on Projections

• Banks overnight currency limits of Rs.15 cr. to be

replaced

• Interbank borrowing to be excluded for reserve

requirements

• RBI to act through both spot and swap markets

• Corporates to be permitted to sell options



Sodhani committee recommendations -1995

• Accounting norms for derivatives, both for dealers and

end-users

• Corporates to have Board approved Exchange Risk

Policy and authorisation levels

C



Tarapore Committee recommendations-1997

• June 1997, Road map for Capital Account Convertibility

• Pre-requisites to be achieved by 2000:

– Gross Fiscal deficit to 3.5% from 4.5%,

currently around 5%

– Inflation at 3%-5%, currently in 4-6%

– NPA in banks at 5%,

– CRR at 3%

T itt d ti



Tarapore committee recommendations-1997

• Balance of Payment, minimum -6 months import

cover $22b -3 month import + 1 month export

+3 month debt service $24b -short term debt + portfolio

money at 60%, any increase to be

held in reserve $31b -NFE assets to Currency ratio

at 70% (current level) min 40% $26b



Role of RBI in CAC environment

• NREER as indicator for intervention Neutral

Real Effective Exchange Rate

• Intervention to maintain +/- 5% of REERDirect -purchase / sale in FX market Indirect

-Interest rate signalling Noise level -

Pronouncement / Direction indication /Recommendatory



1998 -Back to regulated market

• Backdrop: Asian currency crisis

• January 16, 98 INR-US$ touches 40.40

– RBI announces:

– REPO rates 7% to 9%

– CRR increase 10% to 10.5%

– Banks -square /near square position – Import surcharge increased 15% -30%

Rupee drops to 37.70 vs. US$Rupee drops to 37.70 vs. US$



1998 -Back to regulated market

• August 19, 98 INR-US$ touches 43.60

– RBI announces:

– CRR rates increased 10% to 11%

– Repo rates from 5% to 8%

– Forward contracts on imports cancellation and

rebooking banned

–Banks to report peak intra day position

Dec 16, 1997 forward cover for loans

could not be cancelled & rebooked



2003 and onwards - Problems of Plenty

• Options in Indian rupee introduced

• Norms for forward covers liberalized

• Permission given for covers in excess of documentary evidence based on specific

RBI approvals

• Norms for Acquisition liberalized,

acquisition upto net worth permitted

S d T C itt F ll



Second Tarapore Committee on Fuller Capital Account Convertibility

• Five year time table 2006-11, in 3 phase• First phase 2006-07, Second 2001-09, third phase 2009-11

• For Individuals:

– Freely remit up to $50,000 in P-1, and $200,000 in P-3

– Residents can have foreign currency accounts overseas

– Foregin individuals can invest in stocks through PMS & MF

– Retention of 100% of inward remittance in EEFC a/c for all exchange earners

• For Business

– MF can invest up to $3 b in P-1, and $5 b in P-3

– PMS to be allowed to invest in Overseas market – ECB upper limit to be raised gradually, end use restriction to be removed

– No ceiling on long term or rupee denominated ECB’s

– Companies can invest up to 4 times their capital in overseas subsidiaries / JV in P-

3

Second Tarapore Committee on F ller



Second Tarapore Committee on Fuller Capital Account Convertibility

• For Banks:

– P-3 can raise up to 100% of their capital through ECB

– RBI to evolve policies to allow on case by case Industrial houses to hold equity in Indian

banks or promote new banks

– Encouragement to Institutions to set up private banks

– Government holding in state owned banks to 33%

– A single banking law for all banks including PSU banks• Conditions

– Ban on participatory notes

– Non residents to access FNCR (B), NR (E) RA deposits

– FIIs to set aside reserves in volatile times

–Banks must consolidate

– PSU’s must reign in borrowing

– Reign in Small savings and unfunded pensions

– Center and State should graduate from the present system of computing financial deficit to a

new measure of public sector borrowing requirements (PSBR)




Theories of

Exchange rate determination


January 2007



Forecasting can be for different time



Forecasting can be for different timehorizons

All three factors are present in all markets,

They are more critical in Foreign exchange markets

Time horizon Dominant force Analytical tool used

Short time –intraday

Technical /Speculative

Sentiment factors /

Technical views

Medium term –days to months

Cyclical Technical factors /

Fundamental views

Long term –beyond 3/6months

Structural Fundamental views



Topics we will cover in this class

• Basic Economic concepts

• Exchange rate theories

– Purchasing Power Parity

– Balance of Payment

– Interest rate differentials

– Real Interest rate differentials



Price -Volume relationship

Price

Volume

Demand

Supply

Law of diminishing marginal utility



Interest - Money relationship

Interest

Volume of Money

Investments

Savings

Domestic currency value -Volume of



Domestic currency value Volume of business relationship

DomesticCurrency

Volume of Business

Exports

Imports

Appreciates

Depreciates

Decrease Increase

What determines domestic currency value?



PURCHASING POWER PARITY –Stage 1

• Origin -16th century Spain, 1920 GustavCassel

• Concept - One price for one commodity

UndervaluedD C

ExportsIncrease

Correctionin Value

OvervaluedDC

ImportsIncrease

Concept originally came up in 16th Century in Europe

One price for one commodity -some



One price for one commodity someconditions

• Commodity under question tradable

• There are no trade barriers to arbitrage and

trade

• There are no transaction cost

• The goods traded are homogenous



Big Mac theory and PPP

Innovative and Imaginative use by Economist

Big MAC in practice



Big MAC in practice

• Big Mac theory (in 1986)

– 66 countries; only local items used;

– Has not reflected current exchange rate

– Robert Cumby (1993) researched that 70% gapbridged in 1 year

Country DC Price PPP Ex rate %• US 2.53 - - -

• India 47 18.5 37.7 (57)

• Indonesia 4600 1818 3605 (50)

• S. Korea 2300 909 1060 (14)• Singapore 3.00 1.19 1.58 (25)November 21, 1997 (during Asian Currency crisis)

PPP St 2



PPP -Stage 2

• Evolution in PPP concepts

Law of One price

Basket of commodities

Inflation differentials -REER



Problems in PPP



Problems in PPP

• Calculate PPP -CPI, WPI, Wage index, Export PI,

• Basket of Currency -Europe -Mortgage

• Base Period -International – 1973 –floating exchange rate,

1980 –US current account in balance, 1999 –

formation of Euro

– National -1991, 1995, 1996, 1998, 2001

• Elasticity of demand - Price Income

Food low high Industrial RM low high Mfg.

Specialised low high Non specialisedHigh High

• Tradable and non tradable goods

B l f P t th



Balance of Payment theory

• Conceived in 1930’s by Joan Robinson

• Long run equilibrium exchange rate is rate at

which internal & external balance is achieved

• Internal balance -full employment

• External balance -targeted level for current

account balance

Equilibrium Exchange rate



Equilibrium Exchange rate

• Long term equilibrium exchange rate

– Attainment of internal and external balance

– Internal balance = attainment of full employment

• Full employment = Strong demand for goods producedin economy

– External balance = attainment of some targeted level

for the current account balance

• External balance = Long term balance in current

account, a result of exchange rate led trade flows



Logical movements



Logical movements

Trade inflows or exports

Less Trade outflows or imports

Equals Current account balance

• Appreciating currency decreases exports and increases

imports resulting in net outflows:

– Appreciating currency = net trade outflows

Logical movements



Logical movements

• Internal balance = full employment• To reach Full employment = there must be

demand for Domestic output – Domestic output = Local demand + Exports

• Domestic currency value can be used toreach full employment

• How?• How does Domestic currency value affect

employment?

Some observations



Some observations

• Internal balance and external balance can be

achieved at a point of time;

• During most occasions: the position will be tilting

towards either Internal balance or external

balance

IB & EB E ilib i t



IB & EB Equilibrium rate

DCValue

Real domestic demand

Weak demandCA deficit

Strong demandCA deficit

EB

IB

Strong demandCA surplus

Weak demandCA Surplus

DOMESTIC OUTPUT = LOCAL + FOREIGN DEMAND

AB

C

D

AppreciatesCA deficit

DepreciatesCA Surplus

Weak demand Strong demand

Evolution of BOP theory



Evolution of BOP theory

• Initial concept - Balance of Trade -Current Account Focus

• Current concept - Balance of Payment: both trade &

capital flows

• Sustained Current account deficit not feasible due to debttrap

Tradedeficit

CAdeficit

Externaldebt

Debt service



Real interest rate differentials

• Components of interest

Incentive + Risk premium + inflation

• Risk premium eliminated by Sovereign risk; but country

risk cannot be eliminated

• High inflation indicates domestic competitiveness weak,

weak currency

• Exchange rate movement = Real interest rate

differentials

Interest rate differentials



Interest rate differentials

• Zero Capital mobility Income = Savings + Consumption

Savings = Investment Current Account balance = Nil

• Capital account mobility Income = Savings +

Consumption Savings is not equal to Investment

Current Account balance = Capital flow

Interest rate differentials 2



Interest rate differentials -2

• Current Account balance

Negative = Capital Inflow into economy

Surplus =Capital outflow from economy

• Capital flows influenced by Interest rates

• With free flow of capital, interest rate differentials bridged

by capital flows

If you were the decision makes, whatt f ld lik f



type of currency would you like for your country?

• An appreciating currency or

• A depreciating currency

And why?




Fiscal and Monetary policies:

A look at Mundell Fleming models


January 2007

Mundell Fleming Model



Mundell-Fleming Model

• Robert Mundell (1963) & J Marcus Fleming (1962)

• Analyze impact of Fiscal / Monetary policy on exchange rates

• Importance of capital mobility

• Classification of economy

Capital mobility -nil, low, high, perfect

Exchange rate -Fixed, Floating

Mundell-Fleming Model -assumptions



Mundell-Fleming Model -assumptions

• MF model is based on an open economy this is too small to

influence the interest rate in the rest of the world

• Price is assumed to be fixed in the short run and equilibrium

level of output is below full employment level

• Model assumes exports /imports will rise in response to a

change in value of the domestic currency

M F transmission mechanism



M-F transmission mechanism

Inc.In Money

Supply

Inc. in Dom.Economic

Activity

Trade balance

Deficit

Decline in

Dom. InterestRate

CapitalOutflow

Dom.Currency

depreciation

Impact of expansionary Monetary policy




Fixed Exchange rate• Money Increase = Domestic demand =Imports attractive

due to fixed Ex. Rate

• Foreign exchange reserves are drained; fastest where

there is perfect mobility and slowest with zero mobility,• Capital moves out in anticipation of currency depreciation

Capital Mobility FE Res. D.Prdn D Int.• Zero Modest loss No change No

change

• Low large loss No change No change

• High extensive loss No change Nochange

• Perfect Infinite loss No change. No change

Only trade led drain to trade deficit + capital outflow




p p y y p y

Floating exchange rate• Money Increase = Interest rate decline =Capital outflow=Currency depreciation = higher exports

• Higher freedom for capital flow, faster the currencydepreciates, faster it depreciates higher the domestic

production increaseMobility D.Cur D.Prdn D Int.

• Zero Small dep. Small inc.

Large dec.

• Low large dep. large inc. Small dec.

• High larger dep. larger inc.smaller dec.

• Perfect largest dep. Largest inc. No change

Trade and capital flows balance to some extent

M-F transmission mechanism



M F transmission mechanism

Inc.In Govt.

Spending/Investment

Inc. in Dom.Economic

Activity

Trade balance

Deficit

Increase in

Dom. InterestRate

Capitalinflow

ImpactOn

Balance of Payment*

*If trade dominates, currency depreciatesIf capital inflows dominate currency appreciates

• Fiscal policy is the policy with regard to Government spending

Impact of Expansionary fiscal Policy



Fixed Exchange rateZero mobility• Increased govt. investment met by imports• Increase in Interest rate does not translate to capital inflows due to Zero

mobility• Hence, no impact on domestic production

In Perfect mobility• Domestic expansion financed by capital inflows; output has multiplier

impact of investment; no change in interest rate as increased demandmet by foreign inflows

Capital Mobility FE Res. D.Prdn D Int.•

Zerolarge loss No change large inc.

• Low small loss small inc. Small inc.

• High small gain large inc.Smaller inc.

• Perfect large gain larger inc. No change

p p y y

Impact of Expansionary fiscal Policy



p p y y

Floating exchange rate

• In Zero mobility, policy induced demand is met by imports, BOP deficit leads tocurrency depreciation leading to higher exports; high interest rates does not attractcapital inflows due to no mobility

• In perfect mobility, policy induced demand brings in capital inflows leading to exchangerate appreciation and reduces export competitiveness

Capital Mobility D.Cur D.Prdn D Int.

• Zero large dep. large inc. Large inc.

• Low small dep. small inc. Small inc.

• High small app. smaller inc.smaller inc.

• Perfect large app. No change No change

Combined impact of Monetary / Fiscal policy



p y p y

ExpansionaryMonetary Policy

RestrictiveMonetary Policy

Expansionary

Fiscal Policy

Ambiguous Domestic Currency

Appreciates

Restrictive

Fiscal Policy

Domestic Currency

Depreciates

Ambiguous

In situations of high capital mobility

• Restrictive fiscal policy = policy inducted demand reduction leads to

capital outflows leading to DC depreciation

• Expansionary monetary policy = increased imports & capital outflows

• Expansionary monetary policy negates Expansionary fiscal policy




Euro: the birth of a new currency

J Shankar

IISc, MBA –Second Semester January 2007

EURO seen as it happened



EURO seen as it happened

Genesis of Euro

What is Euro

Global implications of Euro

Genesis of Euro



Genesis of Euro

1958, Treaty of RomeBalanced development of economic

activity, created European Investment Bank

1972, Bale agreement, “The Snake”

Currency fluctuation 2.25%

1973, European Monetary Co-op Fund

1979, European Monetary System

European Currency Unit (ECU)



Genesis of Euro 3



Genesis of Euro -3

May 1, 1998 Participating countries fixed

Exchange rate between them fixed

Jan 1, 1999 Euro & Domestic Currency co-exist,

Euro = 1.1740 US$

1999-2001 No compulsion no prohibition

Jan 1, 2002 Euro replaces DC as legal tender

What is Euro?



What is Euro?

Eligibility criteria for joining Euro

Inflation <1.5% of average of lowestthree countries

Budget deficit <3% of GDPTotal public debt <60% of GDP

LT interest rates <2% of the average of lowest threecountries

Currency stability within EMS band for 2 years



What does it mean?



What does it mean?

Domestic currency -> Euro

Euro effective from January 4, 1999

Euro & Domestic Currency co-exist

“No compulsion, no prohibition”

Upto January 3, 2002

After January 3, 2002 only Euro

Immediate Implications



Immediate Implications

In the 11 countries, who are part of Euroland

One currency will exist

One interest rate

One exchange rate -w.r.t Foreign Currencies

Central banks give their Monetary powers toEuropean Central Bank

Global Implications of Euro



Global Implications of Euro

US Japan Euro

GDP in US$t 8.1 4.0 6.3

Population in m 270 140 290

Unemployment 5% 3.5% 11.75%

Debt market US$ t 5 3.3 5

Savings rate 4% 12% 9.8%

Global % Exports 12.2% -

15.6%Balance of trade -ve +ve

+ve

Euro vs US$



Euro vs. US$

EURO balance sheet

+ Trade surplus

+ Higher unemployment

+ Higher savings

+ Larger market

- Cultural barriers

- Survival of Euro a ?- Capital markets

- Technology & innovation

Conclusion



• European Monetary Union

Tarapore Committee report

• Basis for the two

PPP = Inflation & REER

BoP = Budgetary deficit, Reserve levels

IRD = Interest rate range & inflation




Market convention: Forex Markets

J Shankar




Contract of Sale Some key concepts



Contract of Sale -Some key concepts

• Price -currency value of commodity

• Factors affecting the price, independent of the

market conditions

- Delivery schedule- Terms of Payment

• Price in any market denotes a delivery schedule

& terms of payment defined by convention or Law

What are FX market practices

Market quotes available



Market quotes available

• Business Line, February 9, 2007

– Money and Banking page

• Inter-bank rate on February 8th:Thursday

– US$ Opened 44.13/1350, close 44.12/1250, previous close 44.12

• Traveler Rates issued by Thomas Cook on 7th:

– US$ Buying rate: 44.75, Selling rate 48.05

• Exchange rates of SBI on 7th

– US$ Export or buying rate: 44.08, Import or selling rate: 44.17What are these different rates?

FX Markets



• Works from Monday to Friday

• INR-US$ market

– 9.00 AM to 4.30 PM; 5.00 PM for banks

• Cross currencies

– Round the clock market (Monday to Friday); due to trading

across the globe

– Hong Kong – Frankfurt –New York –San Francisco

• Market convention is “Two way quotes”

• Spread (difference between buying rate and selling rate) also called

bid –ask rate reflects the liquidity of the market

A typical market quote



A typical market quoteMarket Quotes at 5.00 PM on 08/02/2007

Currency EXPORT RATES IMPORT RATES

SPOT RATES 1 m 3 m SPOT RATES 1 m 3 m

TT Bill TT Bill

US$ 44.08 44.07 44.18 44.57 44.17 44.20 44.37 44.74

Euro 57.26 57.25 57.33 57.90 57.40 57.44 57.74 58.37

UKP 86.67 86.55 86.80 87.55 86.86 86.92 87.25 87.94

Yen (100) 36.35 36.34 36.40 36.86 36.44 36.46 36.74 37.35

Sing $ 28.74 28.73 28.76 29.06 28.81 28.83 28.98 29.32

Inter US$ bank rate –Rs. 44.13

FX Markets –Some more practices



p

• Inter-bank rate, Customer rate, card rate – Inter bank rate – for trade between banks

– Customer rate – a spread over inter bank rate(based on volume, credit risk, size of

transaction and relationship) – Card rate – fixed rate for the day for small value

transactions; say below $10,000

– An area for negotiation;

– Small value transactions can be bunched

Potential for smart risk less profit in negotiating costs




p

• Spot, TOM, Cash prices

– Spot -2 working days from transaction day or t+2

– TOM – T+1 (NPV of cash flow considering Risk free rate)

– Cash price – T (NPV of cash flow considering Risk free rate)

- Used for Cash flow management / interest cost management

• Quote on Dec 1 (Friday), Spot date Dec 5, TOM date 4

– Spot rate 44.6550

– Cash /Spot discount 00.0065 (for 4 days)

– TOM/Spot discount 00.0015 (for 1 day)

– Call money rate 06.10%• Cash Spot discount % 1.33%

• TOM/Spot discount % 1.23%


FX Markets –Spot, TOM and Cash



FX Settlement volumes February 3rd

2006Trade Type # of US$ INR

TradesMillion Rs.Cr

Cash 55 844 37332TOM 136 1467 64931Spot 1790 3558 157104Forward 32 180 8073

• Imports and exports or trade flows (including services)• Borrowing and lending or financial flows

• Investment flows

• Speculation

Earlier Business Line used to report on FX volumes for the day




p

• Bill rate and TT rate

– Bill rate further processing required in the bank(includes processing charges)

– TT rate –further work required is minimal

– Since the difference is a service charge, can be

negotiated based on the bargaining position of thecustomer

– In the SBI quote, difference between Bill rate and TTrate is

• For exports Re.0.01, for $100,000 you pay Rs.1000

• For imports Re.0.03, for $100,000 you pay Rs.3000 – For transactions where you have forward cover, the forward

cover rate applies and not the bill rate or TT rate


Factors considered in selecting FXbanker



banker

• Trust: will give your the best rate and make your profit from volumes

instead of margin; banks fix spread over inter bank rate

• Infrastructure: Communication facilities, do you have access to your

dealing room, can you execute large value transactions, are you

reachable 25 by 7, 365 days; SBI –Pound sterling Nov 1988

• For cross currencies: Do you have overseas offices, can you execute

overnight orders, keep client informed on markets moves

• Can you innovate new instruments and structures; most foreign banks

• FX banking goes with other banking facilities like borrowing, investments

and Non fund based business; integrated approach; share of fund

businesss

• Provides access to your research views and are able to add value to

customers trading strategy: Most foreign banks get their economist to

visit large clients and discuss their view with the treasury teams

Often the person makes the difference




FX Market Players and Instruments

J Shankar


FX Market Players



• Hedgers

• Speculators

• Arbitrageurs

• Central Bank “as a player”

Hedgers



• Have an exposure• Enter market for risk reduction

• Will take delivery

• Incidental to their primary business• Affected by market liquidity

• May or may not have a view on price

movements• Examples –Consumers & Investors

Need: Price that will be traded in the future

Speculator



Speculator

• Create an exposure• Increases risk; risk-reward critical

• Will not take delivery

• Benefits from low liquidity

• Enters market because of price view• Primary business is market operations• Examples -Hedge Funds, Margin players,• Banks play this role to provide liquidity to their

customers: Difference between inter-bank rate and card

rate is the reward for this

A price that he expects will trade in the future

Arbitrageurs



Arbitrageurs

• No primary exposure• Minimal exposure taken

• Risk-free profits; source of profit market

information• Does not take delivery

• Exist because of illiquidity

•No view on price• Primary Business is market operations

Looks out for differences in Prices in different markets

What is a derivative




• A cost effective method of finding a trade-

able future price

• Derivatives name arises from the fact that

the price is derived from the spot market

• Fundamental basis for derived price is the

cost of holding

Key is cost effective method

Cost of holding



• Spot price+ cost of holding

- interest cost

- holding cost (warehousing cost)

- transaction cost

Methods of finding the futurei D i ti i t t



price or Derivative instruments

• Forward Contract

• Futures

• Swaps

• Options

Forward Contract



o a d Co t act

• A contract for sale or purchase of for delivery andpayment beyond the market norms / conventions

• Difference between spot & forward price isdiscount or premium

• Premium = Forward price minus spot price

• Discount = Spot price minus forward price

• Over the counter market

• Settlement mainly through delivery

• No margin or immediate payment required

Most popular instrument in the Indian FX market

Forward Rate



Forward rate = S ((1+(rdx t)

/(1+rf x t ) ) + C

S = Spot rate

rd = Domestic interest raterf = Foreign currency interest rate

t - the life of the forward contrac

C = transaction cost of bid-ask spread in FX markets

and bid ask spread in Money markets• Since Indian Rupee is not fully convertible, the forward

rate is not determined only by interest rate differential butalso expectation of spot movement

Example of Forward Contracts



Period Forward Price (INR

-US$) (bid rates)

Premium / (discount)

Spot price 1/12/06 44.6550

1 month premium 0.0791 2.09%



Period INR US$ Differential6 month 6.80% 5.33% 1.47%

Interest Rates

Indian Rupee is not a convertible currency

Source: Mecklai Financial & Commercial Services

Example of Forward Contracts



Period Forward Price (US$-Euro) Bid price

Premium / (discount)

Spot price 1/12/06 1.3257




Period Euro US$ Differential6 month 3.74% 5.33% 1.49%

Interest Rates

Euro and US$ are convertible currency

Futures



Futures

• Traded in an Exchange

• Standardised terms

Quantity

Delivery period

Terms of settlement

Trading through membersMargin stipulation



Evolution of Futures Market



• 1919 -Eggs

• 1921 commodities -corn, wheat, oats, rye

• 1947 metals -copper

• 1972 currencies -DM, Yen

• 1975 Gold

•1977 Treasury Bonds

• 1983 Crude oil

Future market in Indian rupee not yet introduced in India

Difference between Forward Contract &Futures



• FEATURE FORWARD FUTURE Size Tailor-made Standard

Delivery -do- -do- Price

OTC Exchange CommissionSpread Broking fee Margin

Optional Mandatory Settlement by

Delivery over 90% <

1%

Where to use Future and Forward



• Forward contract for known cash flows;• For uncertain cash flows Futures

• Futures prices can be different from forward prices due

to

– Credit risk priced in forward contract, risk in futures covered

through margin

– Since forward contract is not marked mark to market, cashflow is not influenced till the date of the expiry





Derivative Instruments in FX markets

J Shankar

IISc, MBA –Second Semester February 2007




• A cost effective method of finding a trade-

able future price

• Derivatives name arises from the fact that

the price is derived from the spot market

• Fundamental basis for derived price is the

cost of holding

Key is cost effective method

Cost of holding



• Spot price+ cost of holding

- interest cost

- holding cost (warehousing cost)

- transaction cost

Methods of finding the futureprice or Derivative instruments



price or Derivative instruments

• Forward Contract

• Futures

• Swaps

• Options

Option



p

A contract obtained for a price paid that gives the holder the right but not

the obligation to conduct a trade with the counterparty, on terms

specified in the contract

Writer of option –receives premium and undertakes the obligation

Buyer of option –pays premium and buys the right but not the obligation

Put Option –right to sell

Call option –right to buy

Similar to a general insurance contract

Inputs to Option Pricing



• Current Price or Spot price

• Strike Price or price for exercise

• Tenor or period for which option required

• Interest rate –risk free rate of interest of both

domestic• Dividend yield of the stock, benefit from holding the

asset; for FX options risk free rate of interest of foreign currency

• Volatility –computed as standard deviation of dailypercentage changes in spot prices

Specific components of Option



• Premium –consideration paid to the writer of option• Strike Price – price for exercise at the point of exercise,

• Tenor –life of option

• Exchange traded options are of short duration normally less

than one year

• In Indian markets

- Stock Index Option is an European Option

- Individual stock options are an American Option

- INR options are European Option

Some terminologies explained

Value of an option



• Intrinsic value of an option

– Gain to holder on immediate exercise of option

– = Market price – Exercise price for Call option

– = Exercise price – Market price for Put option

• Does a option have value if it has no intrinsic value?

• Where does this value come from?

– Time value of option• Volatility value

• Interest value or Risk free rate

• Dividends

– Fair value of an option considers both the Intrinsic value + the

time value of an option• Option premium value can never exceed spot price

Classification of options basedon exercise price



on exercise price

Classification based on Intrinsic value• At the Money option

– Exercise price = Spot price

• In the Money option

– Call option: Spot price > Exercise price – Put option: Exercise Price > Spot price

• Out of Money options – Call option: Exercise price > Spot price

– Put option: Spot price > Exercise Price• Zero price options are typically Out of Money

Options

Typical Option quotes for FX



OPTION PRICES (US$/INR)Months 1 month 3 month 6 month 12 month

ATM 44.32 44.59 44.90 44.54

Call 0.21 0.38 0.53 0.74Put 0.21 0.38 0.53 0.74

Quote of Mecklai Financial & Commercial Services Ltd

February 20, 2007

Option specific terms used



• Delta = Change in Option price to change in spot price

– Used by writers of option to determine the amount for hedging in spot market

– Call options have delta in the range 0 to +1

– Put options have delta in the range 0 to -1

– Higher the delta, greater the probability of option expiring ITM

•Gama =rate of change in Delta to change in spot price• Theta =rate of change in Option value w.r.t. time

– For the holder indicates the rate at which option looses valueover time, or decay value; for the writer of the option it isvalue accruing to him;

– theta does not have a linear relationship with time but squareroot of time;

– The loss is more closer to the date of expiration (Slog over)

Option specific terms used



• Lamda :Change in premium to change in volatility

• Volatility is an input that is person dependent

• 3 types of volatility – Historical volatility: computed based on daily price moves

– Forward looking volatility: computed by adjustinghistorical volatility by an amplifier or reducer

– Implied volatility: is worked back from premium

• Writers of Options believe volatility will decrease going

forward compared to implied volatility in their optionpricing model

Benefits of using option



•Cost paid upfront, no further cost involved for buyer of options,hence can be factored in by the hedgers

• Potential for upside not capped, hence benefit unlimited

• Option strategy based on view

- Bullish (believes prices will increase)- buy call option

- Bearish (believes prices will fall) –buy put option

Writer of option has an unlimited liability

Writer benefits only if the option expires without being exercised or the difference between exercise price and spot market on date of

exercise is lower than the premium received by him

Use of a call option or right to buy



• Hedgers will buy call options, if they are- Bullish or expects prices to go up or

wants to cap their costs

• Speculators will write call options, if

- If they are bearish or expects market to

be flat; collects premium upfront for a riskthat he is taking

Uses of a Put option or right to sell



• Hedgers with an uncertain sales price

- Will buy put option to protect against price

drop Speculators will write put option

- if he is bullish or expects price to go up

Forward to Forward (combination of twoforward contracts)



• A simultaneous purchase and sale of forwardcontract for different periods

• To fix the premium without fixing the spot rate,Spot rate fixed before the expiry of first contract

• Used in Indian markets before it was banned in1990’s

• To take a view on interest rate / expectation

down the line without fixing spot rate

Exotic forwards (combination of forwards with Options)



• Range Forwards

defines a range, with high and low

(European)

• Layered Forwards

defines a range, with high and low

(American)

Instrument variants to reduce the forward premium cost

What is a Swap?



• Swap is an exchange of benefits derived fromholding an assets

• Two types of swaps –Currency swap and Interestswaps

•Intermediary –Market maker • Assumes credit risk for a spread

• Swaps are settled by payment / receipt of difference

• Reference to a specific public rate

• Documentation format is ISDA prescribed(International Securities Dealers Association)

The first Swaps



• First Currency swap in 1981 between

World Bank and IBM

– Exchange principal and fixed interest for interestand fixed interest in another currency

– Value of swap priced through interest

– Interest rates used –T Bill, LIBOR, CP rates

Variants



• CAPS –for lender Upside is fixed or for

borrower downside is fixed

• Floors – for lender downside is fixed or for

borrower upside is fixed

• Collar –that has both a Cap and a floor

Pricing for a Swap



• Based on NPV• Initial NPV of a Swap is Zero• Exchange rate is determined by the Yield Curve• If the yield curve is flat, fixed interest will be close

to floating interest rates

• If the yield curve is normal, sloping up left to right,swap rate is fixed such that

- Fixed interest is higher than floating- Steeper the curve, higher the rate fixed

a report on international finance

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