Lecture 3:The Foreign Exchange Market

An Empirical Analysis of the Impact of Foreign Exchange Regimes on Exchange Rates

Where is this International Financial Center?

Relationship of Exchange Rate Volatility to Exchange Rate Regime Question: Given the spectrum of exchange

rate regimes (noted in Lecture 2) which can confront both global firms and global investors, an important question is whether there is a difference in exchange rate volatility from one regime to another. An additional question: what happens to volatility

when regimes change?

Measured Volatility (Standard Deviations of % Changes) Against the U.S. Dollar Using monthly data from January 1990 –

August 2011 Floating Currencies:

British Pound: 2.31% Japanese Yen: 2.30% Australian Dollar: 3.22% Euro: 2.59%

Managed Currencies: Singapore Dollar: 1.20%

Pegged Currencies (“Crawling Peg): Chinese Yuan: 0.42% (since July 2005)

Pegged Currencies (Fixed Rate): Hong Kong Dollar: 0.12% (peg at 7.8 since Oct 1983)

Volatility of 3 Exchange Rate Regimes (Monthly Data, Jan 1990 – Aug 2011)

Measured Volatility (Standard Deviations of % Changes) Against the U.S. Dollar Using weekly data from August 2008 – August

2011 Floating Currencies:

British Pound: 1.55% Japanese Yen: 1.26% Australian Dollar: 2.17% Euro: 1.55%

Managed Currencies: Singapore Dollar: 0.73%

Pegged Currencies (“Crawling Peg): Chinese Yuan: 0.16%

Pegged Currencies (Fixed Rate): Hong Kong Dollar: 0.07%

Measured Volatility (Standard Deviations of % Changes) Against the U.S. Dollar Using daily data from August 2008 – August

2011 Floating Currencies:

British Pound: 0.77% Japanese Yen: 0.80% Australian Dollar: 1.30% Euro: 0.82%

Managed Currencies: Singapore Dollar: 0.41%

Pegged Currencies (“Crawling Peg): Chinese Yuan: 0.11%

Pegged Currencies (Fixed Rate): Hong Kong Dollar: 0.04%

Intermediate and Long Term Trend Changes by RegimeGBP: Floating Rate Currency SGD: Managed Currency

Intermediate and Long Term Trend ChangesCNY Crawling Peg Currency (since July 2005)

HKD: Pegged Currency (since Oct 1983 at 7.8)

Issues of Floating Currencies Floating currencies present the greatest ongoing risk for

global firms and global investors. Data showed that these currencies are very volatile over the

short term (e.g., Monthly, weekly and daily basis). Complicates doing business or investing on an ongoing basis

for: Exporters, importers, global asset managers, global commercial banks,

overseas sales and manufacturing subsidiaries. What will be the costs and returns associated with different markets

and different investments?

Thus, global firms and global investors need to pay close attention to their floating currency exposures and utilize appropriate risk management tools. Issue: How easy is it to forecast a floating rate currency’s price?

Managed Currencies (Dirty Float) Under this regime, governments manage their

currency to offset (i.e., counteract) market forces. They do this when market demand factors or supply factors

are seen as creating undesirable exchange rate moves. They do this as a monetary policy target to achieve inflation

target (e.g., Singapore). As a result, over the short term, these currencies are not as

volatile as floating currencies. Exchange rate management may occur on

A regular basis or when governments feel conditions warrant.

Management involves either intervention action (buying or selling currencies) or interest rate adjustments (to affect demand/capital flows).

Pegged Currency Regimes Under a pegged currency regime, governments link their national

currency to a key international currency (usually the U.S. dollar or the euro or some “market basket” of currencies).

Why do governments peg their currencies? A peg is seen as a necessary condition to promote confidence in the

currency and in the country and promoting economic growth. May encourage foreign direct investment or long term capital inflows. Or by pegging the currency at an undervalued currency this may support the

country’s export sector.

Pegs can either be at a fixed rate (e.g., Hong Kong dollar) or in relation to a trend (i.e., a crawling peg).

As long as the peg is maintained, the exchange rate risk is negligible (recall there is some potential daily variation).

Peg is maintained through market intervention (buying and selling)

Hong Kong Dollar: Pegged to a Fixed Rate (7.8HKD = 1 USD)

Daily Volatility of the Hong Kong Dollar Over the Last 6 Months

Saudi Arabia Riyal

Issues with Pegged Currencies As long as the peg is maintained, this regime presents

the smallest risk to global firms; however there is the potential for enormous risk, when: Governments either (1) abandon the peg for another foreign

currency regime or (2) adjust to a new peg. These changes occur either by

An orderly change adopted by the government (China from a fixed peg to a crawling peg on July 21, 2005 with more changes which followed and to be discussed in a later slide).

Peg coming under successful market attack (e.g., British pound in 1992; Argentina, February 11, 2002; Mexico from a crawling peg to a float on December 22, 1994; Some Asian currencies in 1997).

These changes can have substantial impacts on global firms and global investors. Especially if the firm or investor did not take advanced steps to

protect itself. Thus, global firms and global investors must be on the alert for

exchange rate regime changes.

China Policy Decision: From a Fixed Peg to a Crawling Peg to a Fixed Peg to a Crawling Peg

Currency Regime Changes Due to “Currency Attacks” Another situation that changes currency

regimes occurs when a peg comes under attack by the market. Attacks occur because the market is convinced

that the peg is unrealistic and unsustainable (ie., the government doesn’t have the political will or resources in the form of hard currency to defend the peg.

British Pound: Driven Out of the Exchange Rate Mechanism in 1992Background In 1990, the U.K. joined Europe’s

exchange rate mechanism (ERM). Under this arrangement the U.K. agreed to

peg the pound to the German mark at a rate of 1:2.95 (+- 3%).

During the next two years, the German economy surged and the U.K. economy fell into recession.

By 1992, Germany had raised interest rates and the U.K. was forced to follow.

In September 1992, George Soros decided to bet against the pound (he felt it was overvalued) and his hedge fund started selling pounds short.

The U.K. responded by buying pounds and selling U.S. dollars and by raising interest rates twice in one day (to 12 and then 15%)

On September 17, the U.K. government announced they were leaving the ERM

GBP-D

Mexican Peso Crawling Peg (with a Floor of 3.0512): Abandoned Dec 1994

Philippine Peso During the Asian Currency Crisis, 1997

Implications of the 1997 Asian Currency Crisis for Regional Economic Growth: Average GDP Growth

Impact of Asian Currency Crisis for Global Investors

Argentina: Abandoning a Fixed Peg: Moving to a Floating Regime, Jan 2002

Percent Change in ARS-USD Daily Data, Jan 1, 2000 – Dec 31, 2001

Percent Change in ARS-USD Daily Data, Jan 1, 2003– Jan 1, 2005

Response of Currencies to Dropping a Peg Regime

Abandoning a Pegged Rate and the Currency Weakens: RISKS for Global Firms and Investors As noted, changes in exchange rate regimes pose

potential risks for global firms. Using the Argentina example, discuss the following:

What do you think happened to foreign multinationals located in and selling in Argentina after the peso weakened? For Example: McDonalds’ U.S. dollar profits in Argentina?

What do you think happened to foreign multinationals exporting to Argentina after the peso weakened? For example: Boeing ability to export airplanes to Argentina?

What do you think happened to the portfolios of investors holding Argentina stocks and bonds?

Abandoning a Pegged Rate and the Currency Weakens: OPPORTUNITIES for Global Firms However, changes in exchange rate regimes also

offer potential opportunities for global firms. Again, using the Argentina example:

What do you think happened to foreign multinationals importing from Argentina after the peso weakened? For Example: Wal-Mart’s U.S. dollar cost associated with

importing goods from Argentina? What do you think happened to foreign multinationals

considering expanding FDI into Argentina after the peso weakened? For Example: The new U.S. dollar cost to Ford Motor

Company considering setting up a production facility in Argentina?

Potential Costs to Holding a Peg If market forces push a pegged currency above

its peg (i.e., the currency becomes “too strong” or “overvalued”) this happens because: The market is buying the currency, then

Government management involves either selling the pegged currency on foreign exchange markets (thus, buying hard currency) or reducing domestic interest rates.

Issues: If the government sells its currency this created to potential for expansion of its domestic money supply and hence inflationary pressures.

On the other hand, lowering domestic interest rates can also stimulate domestic investment and economic activity which may lead to inflationary pressures.

Potential Costs to Holding a Peg If market forces push a pegged currency below its

peg (i.e., the currency becomes “too weak” or “undervalued”) this happens because: The market is selling the currency, then Government management involves either buying the

pegged currency on foreign exchange markets (thus, selling hard currency or raising domestic interest rates. Issues: Does the government want to give up its hard

currency (does it have potentially better uses for this (e.g., buying oil or paying off international debts)

On the other hand, raising domestic interest rates can dampen economic activity and lead to rising unemployment.

Note: These last two slides summarize one reason (i.e., the costs) why major central banks have probably gotten out of the currency management business.

Appendix 1: Monitoring FX Intervention

Most major central banks provide timely information regarding their intervention activities in foreign exchange markets.

As on example see: http://www.ny.frb.org/markets/foreignex.html

This site provides a quarterly report on both the U.S. dollar and intervention activities on behalf of the dollar.

Go to archives, July 30, 1998 to view intervention activity.