Foreign Exchange Markets - University of Nevada, Reno · different currencies, forex futures, forex...
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Foreign Exchange Markets
The Forex Market, the J-curve and capital flows
�The Spot Market, the Forward Market, and Interest Rate Parity
�Derivatives Markets, Futures, and Options
The Spot Market
� Direct Forex Price = E
� Demand: imports + foreign savings outflows
� Supply: exports + foreign savings inflows.
� For major currencies, foreign savings flows are the vast majority of transactions.
Assuming we export X and import Y,
NX = Px(Qx-Dx) – EPy*(Dy-Qy).
If E rises, Dx rises and Dy falls, but EPy* rises so effect on NX uncertain.
If NX ≈ 0 and |εX| + |εY| > 1, then ∂NX/ ∂E > 0.
Elasticities become more elastic over time.
In short run, currency depreciation can make the trade deficit larger. Surprise!
With foreign savings flows, however, the slope of Forex demand would still be downward-sloping.
� Market makers: a dozen U.K. banks, ten banks in U.S., nine in Japan.
� Priced in bid/offer spreads, depending on transaction size, strength of banking customer relationship.
� Arbitrage: prices are forced to equality across firms, triangular rates always equal. ($/€)=($/£)(£/¥)(¥/€)
� Major Banks are Market Makers, with forward contracts arranged for customers.
� Quoted in bid/offer forward prices, or forward premiums.
� Price is set by the market like a sports book, with Ef the median price.
� Ef is not the mean, and not the forecast of E. It is the median of what people think E will be, weighted by the money on each side.
Interest Rate Parity (IRP)
For similar assets:
[(1+i)/(1+i*)]n = Ef/E
If n is not too different from one, and i ≈ i* so that Ef ≈ E, then an approximation is:
n(i - i*) ≈ (Ef/E – 1), the forward premium.
and i = i* + (Ef/E – 1) is the IRP equation.
Risk in Foreign Exchange
� Arbitrage – taking advantage of price differences to make money, without incurring much risk.
� Hedging – making a transaction to reduce risk.� Speculation – intentionally taking risk in the hope
of earning a higher return.� The same transaction can be either, depending on
whether your position is open or closed, long or short.
� The risk-return tradeoff.� Leveraging – using debt to increase risk and
return.� Diversification and pooling – strategies to reduce
� Firms use real assets to produce goods and services and generate income.
� Financial assets are a (usually transferable) claim on that income.
� Debt has predetermined income, higher priority, less risk, and no control. Loans, bonds.
� Equity has residual income, with rights of control. Shares of stock.
� Derivatives are financial assets with a value derived from other financial assets.
What are Derivatives?
A derivative is a financial asset whose value is derived from other financial assets (e.g., futures, options, swaps).
� A derivative is financial insurance against price changes: a risk-averse person pays another party to take their risk from them.
� The most common type of derivative is an interest rate swap, but there are more types of derivatives than bets in a casino.
Most Common Derivatives
� Asset-backed Securities (ABSs), such as Mortgage-backed Securities (MBSs) or Collateralized Debt Obligations (CDOs).
� Interest Rate Swaps: principal is basis of notional value, average spread between fixed and variable rates the market value.
� Credit Default Swaps (CDSs): essentially an insurance policy on financial assets.
� Commodity Price Futures.
� Option Contracts.
� Foreign Exchange Contracts: Interest Rate Swaps in different currencies, forex futures, forex options.
Fundamentals vs. Bubbles
� In theory, future asset fundamentals determine the asset price, where Price = net present discounted value of future earnings stream.� For stocks, P = Earnings/(i-g+σ).
� For a safe discount bond, P = Face/(1+i)n
� For a house, P = Rent/(i-πR+δ)
� When buyers look at past prices instead of future fundamentals due to incomplete information, a speculative bubble can occur.� Biggest fool theory.
Why are Derivatives a Problem?
� Insurance markets are regulated to make sure the insurer has adequate capital. Derivative markets are not.
� You don’t have to own the asset to buy insurance on it. This can leads to pyramiding of side bets. There are also often multiple generations far removed from the asset.
� Derivative markets can be complex, and traders on both sides may not realize what they are doing.
� Derivatives are not transparent, off-book, and huge.
� All insurance markets have problems of moral hazard.
EP24 The staggering numbers come from the derivatives market, though this is to some extent a measurement problem.Elliott Parker, 7/6/2009
Let’s not forget Hubris.
� Some risks are not diversifiable.
Derivatives played a role in the most recent financial crisis.
First Wave (1950s)
– commercial banks
Second Wave (1980s)
– GSE-guaranteed securities
Third Wave (>2002)
– other mortgage-backed securities
Mortgage debt grew MUCH faster than either income or home ownership
Real estate mortgages seemed like safe investments
Delinquency Rates and Charge-Off Rates
on Loans at Insured Commercial Banks: 1985 to 2006
Real Estate LoanDelinquency
Real Estate Loan Charge-offs
Credit Card Charge-offs
Subprime lending had a much higher default rate, but it was less than ten percent of the mortgage market.
What Caused all this Lending?
� New homebuyers, existing homeowners, and speculators.
� Mortgage brokers and predatory lenders.
� Financial market consolidation.
� Firms competing for highest returns.
� Short-term incentives for financial managers.
� Investment banks, rating agencies, and hedge funds.
Government Sponsored Enterprises
Fannie Mae (Federal National Mortgage Association) & Freddie Mac (Federal Home Loan Mortgage Corp.)� Privately-owned, government-sponsored enterprises
responsible for the mortgage-backed securities market for conforming loans.
� These were latecomers to the subprime debacle, but they reduced conforming loan standards to maintain market share.
� They were big players, and may have influenced government regulators.
� They may have led many mortgage brokers to believe they would guarantee bad loans.
� Because they were big, the cost of bailing them out was very high – though MBSs and CDOs from private investment banks had much higher default rates.
� President Obama has proposed phasing them out.
Federal Reserve Bank
� Monetary policy in reaction to 9/11 recession made cheap credit available, creating incentive for combining short-run borrowing and long-term lending.
� Twelve FRBs are controlled by member banks. They failed to regulate bank involvement in the derivatives markets.
Mortgage Rates had been much more Stable than either Prime or the FFR
The Federal Reserve chose not to regulate derivatives or act to prevent bubbles
Alan Greenspan testified,
� “I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms.”
- Congressional testimony, Oct. 22, 2008
Let’s Not Forget the Federal Government
� Encouraged more people to buy homes, and pushed lenders to devote some portion of their lending for those who would normally not get loans. But most borrowing was not by poor.
� Removed regulations on lending practices and on derivative markets, and negligent in enforcing existing regulations. Pressure to turn a blind eye to emerging problems.
� Allowed financial mergers that made these firms too big to fail.
The role of campaign contributions from financial sector…
Financial Markets are Prone to Market Failure
� Market economies are most efficient when (1) there is competition, (2) everybody knows what they are buying and selling, and (3) external spillover effects are minimal.
� Finance fails on at least two: information and contagion.
� Basic problem: banks are lending somebody else’s money.
� Government insurance (FDIC) and private insurance (CDSs) both lead to moral hazard, excessive risk-taking for short-run profit. Bailouts are just an extreme form of insurance.
� Issued by market makers in large blocks with standardized dates, traded on organized exchanges. Brokers earn commissions, not spreads.
� Speculators put up cash margins to guarantee future price, in hope that forex future appreciates.
� Usually traded OTC, investment banks are the market makers.
� Call is option to buy, Put is option to sell.
� Seller (writer or grantor) puts up cash margin, usually speculating.
� Buyer is holder and has the option, pays premium to grantor based on difference between “strike price” and expected future E.
� At the money, out of the money, in the money.
� American, European, and Bermudan options.
� If you have to sell Forex in future, and think E will be higher than Ef, you might want to not buy the forward contract, but might prefer an put option in case you are wrong.
� A put option with a lower strike price has a cheaper premium. On a call, a lower strike is more expensive.
� Does striking make you better off? It depends. Certainly if you bought it to hedge against bad outcomes, being in the money means the bad outcome happened, but you don’t suffer as much with insurance. Are you better off if your house catches fire?
Foreign Currency Transactions
� Spot market – third of total.
� Forward contracts – eighth of total.
� Spot-Forward Swaps – half of total.
� Futures and Options
� Interest Rate Swaps in different currencies.
� Credit Default Swaps in different currencies.