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Global Financial Markets - Update |
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PART 1: A FRAMEWORK FOR INTERNATIONAL FINANCE
| Contents | Chapter 1 | Chapter 2 | Chapter 3 | Chapter 4 | Chapter 5 |
New: self-test problems on the foreign-exchange and Eurocurrency markets.
This document contains updates to my book, Global Financial Markets (Houghton Mifflin, 1994). It also contains information on developments and research in the international financial markets that might be of interest to students and professionals.
Contents
Chapter 1: An Introduction to the World of International Finance
The changing role of the World Bank; The international financial system
Chapter 2: The Foreign-Exchange and Eurocurrency Markets
Foreign exchange dealing volume; Foreign exchange in the electronic age; Bid-ask spreads in the foreign exchange market; New research results
Chapter 3: Interest Rates in the Global Money Market
Chapter 4: Exchange-Rate Systems
Exchange-Rate Arrangements; New national accounts; Hong Kong versus ERM; The European Monetary System
Chapter 5: Exchange Rates, Interest Rates, and Inflation Rates: An Integrated Framework
Forward rate bias and expected inflation
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Chapter 1: An Introduction to the World of International Finance
The changing role of the World Bank
In July 1994, the World Bank issued a report that charted a new course for the organization: Learning from the Past, Embracing the Future. The report was in part a response to pressures for the bank to become leaner and more responsive to a changing international financial order. For example, the Bretton Woods Commission, a group headed by ex-Fed chairman Paul Volcker, had pressed for significant staff cuts at the bank, on the grounds that larger private capital flows to emerging markets have rendered some of the World Bank's tasks obsolete. (In the past five years, flows of private capital to developing countries have quadrupled to $120 billion. In contrast World Bank lending has declined, to a level of about $20 billion in 1994.)
The report identified five key development challenges:
- the promotion of economic reforms likely to help the poor
- increased investment in people, notably through education, health care and family planning
- protection of the environment
- stimulation of private sector development
- public sector reform to create an environment where private enterprise could flourish.
The bank set out six principles to guide its future. It would try
- to be more selective in the tasks it undertook
- to rely more on partnership with other institutions
- to be more responsive to clients' needs
- to put more emphasis on the results of projects
- to save resources by improving its cost-effectiveness
- to strive to maintain its high standing as a borrower on global capital markets.
The report is available from the World Bank Group, 1818 H Street, NW, Washington, DC 20433, USA.
The international financial system
A key issue in international finance is the debate, practical and academic, between advocates of fixed and of floating rates. Developments and strains in the European Monetary System, particularly since a speculative onslaught forced the bands to be expanded to 15 percent in 1993, offers a good focus for a discussion of the advantages and disadvantages of exchange-rate systems.
Years ago, much of the substance of international finance, particularly from the business viewpoint, was how to understand and avoid exchange and capital controls. This is less important now that most developed countries have dismantled controls. Yet the issue is not dead:
(1) Some countries, such as France and Ireland, have used informal as well as administrative tools at their disposal to quell speculative flows when their currencies came under pressure.
(2) Some policymakers and even academics have begun to advocate taxes, deposit requirements, and other penalties on those who hold open currency positions.
The on-line article, A View of International Finance, provides a thoughtful view of some of these issues.
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Chapter 2: The Foreign-Exchange and Eurocurrency Markets
Foreign exchange dealing volume
In April, 1993, the Bank for International Settlements in Basle reported that turnover in foreign exchange increased 42 per cent between 1989 and 1992 to an estimated $880 billion each business day. The table below gives turnover by country.
Daily currency market turnover ($ billion)
Net of local double-counting; no adjustment for cross-border double-counting
| Country | April 1989 | April 1992 |
| UK US Japan Singapore Switzerland Hong Kong Germany France |
187 129 115 55 57 49 - 26 |
300 192 126 76 68 61 57 36 |
Foreign exchange in the electronic age
An important development in the foreign exchange markets is the growth of technology and software to facilitate electronic payments, trading and foreign exchange risk management. The following items, excerpted from International Treasurer, illustrate these trends.
1. Financial Electronic Data Exchange
This term refers to an arrangement whereby a company's customers remit payment, and the accompanying documentation, electronically. In a multinational company, such a system requires (1) a means of combining payments and data electronically, (2) a computer format that can be understood by the company, by its counterparties, and by the banks and clearing systems of the countries in question.
Properly done, such systems produce information generated by payments receipts that arrives simultaneously in every department that needs access to it--the operating departments, such as sales, purchasing and production, as well as the finance functions--accounting, credit and treasury.
Electronic data interchange of this kind can cut costs by allowing better and more rapid controls. For example, the European Treasury Center of Merck (a U.S. pharmaceuticals company) has set up controls for its electronic payments in Europe that enhance oversight at the parent-subsidiary level. With a large volume of payments and a small staff of three persons, the treasury center uses the remote authorization capabilities of its electronic banking system to allow the Group Treasury in the US to review the payment requests and provide final authorization.
2. Corporate Access to SWIFT?
Corporations that wish to make payments to one another must rely on banks that are members of SWIFT, the international payments exchange network. Through bank intermediaries, corporates can initiate electronic payments to one another via the SWIFT network using electronic banking systems sold to the by member banks. They cannot, however, transmit the accompanying information concerning each transaction through the same network. Some companies are seeking to change this. They want two things:
- They want SWIFT, a system designed for interbank transactions, to accommodate transactions and information of a non-banking variety.
- They want to have direct access to the network.
So far, banks have successfully resisted corporate membership of SWIFT. Electronic payment processing services are a lucrative business. If non-banks have access to SWIFT, third-party processing centers may gain a share of the market. Moreover, corporate in-house treasury centers and finance subsidiaries could gain more capabilities--such as electronic funds transfer--that would allow them to compete with banks for other banking business, e.g. cash management, of their customers and suppliers.
3. On-Line Foreign Exchange Trading
Some US banks allow retail as well as corporate clients to execute payments on-line through their personal computers. Some brokerage firms enable their customers to conduct stock trades from PCS. Now Citicorp, through its wholly-owned subsidiary CrossMar, is offering corporations a service for dial-in foreign-exchange trading and confirmation and settlement.
1. FXLink, for FX trading, gives firm quotes for over 90 currencies. Spot, forward and swap trades can all be executed electronically. Once done, transaction information goes straight to a trade blotter at a Citibank dealer's desk and to the back office.
2. FXMatch helps bring the back-office on-line. It allows a corporate treasury department to auto-match and confirm FX transactions and provide delivery instructions electronically. It offers the convenience of sorting transactions by trade or value date, counterparty, legal entity. Trades can be listed by currency codes indicating whether they await payment instructions or bank confirmation. All are time-stamped for a detailed audit trail.
At present, such a system is probably most useful for the execution of smaller transactions, perhaps by less experienced staff. Larger trades should be shopped around by experienced FX managers.
Bid-ask spreads in the foreign exchange market
Corporate treasurers complain about the cost of trading in foreign exchange, especially the higher bid-ask spreads in smaller or odd-lot trades, or trades in "exotic" currencies. Tourists complain even more bitterly about the differences between buying and selling rates. What justifies these differences in spreads?
Demsetz (1968) has described the bid-ask spread as the cost of obtaining "immediacy," the right to transact without significant delay. In his 1989 synthesis, Stoll argued that bid-ask spreads must cover three costs incurred by providers of immediacy: order-processing costs, asymmetric-information costs, and inventory-carrying costs. Research in the currency markets report that spreads widen (i) with recent volatility [Boothe (1987)], (ii) with measures of trading volume [Glassman (1987)], and (iii) on Fridays [Glassman (1987) and Bossaerts and Hillion (1991)].
More recently, Bessembinder's 1994 study showed that spreads also widen with forecasts of inventory price risk, with liquidity costs, and before weekends and holidays. He demonstrated that the increase in spreads can be fully explained by increased sensitivity of spreads to risk and liquidity costs over intervals of thin or nonexistent trading. Despite the fact that there are no predetermined constraints on pricing in the major FX markets, Bessembinder found that there was considerable clustering in quotations. For example, an average of 53% of the quoted bid-offer spreads quoted on Reuters for pounds, marks, yen and French francs take on the value of 10. Another 23% take on values of 5, 15 or 20.
The study also provides some new evidence on the interaction between FX trading volume (as proxied by futures trading volume) and spreads. When time series of volume were decomposed into forecastable and unexpected components, the effects of the two volume components on spreads were found to differ considerably. Estimates indicated that spreads decline with the expected component of volume (perhaps because traders perceived increased liquidity), but increase with volume surprises.
References
Hendrik Bessembinder, Bid-Ask Spreads in the Interbank Foreign Exchange Markets," Journal of Financial Economics, Vol. 35, 1994, 317-348.
Paul Boothe, "Exchange Rate Risk and the Bid-Ask Spread: a Seven Country Comparison," Economic Inquiry, 1987, 485-492.
Peter Bossaerts and Pierre Hillion, "Market Microstructure Effects of Government Intervention in the Foreign Exchange Markets," Review of Financial Studies, Vol. 4, 1991, 513-541.
Harold Demsetz, "The Cost of Transacting," Quarterly Journal of Economics, Vol. 82, 1968, 33-53.
Debra Glassman, "Exchange Rate Risk and Transactions Costs: Evidence from Bid-Ask Spreads," Journal of International Money and Finance, Vol. 6, 1987, 479-490.
Hans Stoll, "Inferring the Components of the Bid-Ask Spread: Theory and Empirical Tests," Journal of Finance Vol 44, 1989, 115-134.
New research results
"An Empirical Measure of Asset Liquidity" (August 1994)
BY: MARK HOOKER and MEIR KOHN
CONTACT: MARK HOOKER
E-MAIL: Mark.A.Hooker@Dartmouth.edu
POSTAL: Department of Economics, Dartmouth College, Hanover, NH 03755-3514
PHONE: (603) 646-2943
FAX: (603) 646-2122
REF: WPS94-344
We develop an operational empirical measure of liquidity consistent with the definition first suggested by Keynes: An asset is more liquid if it is "more certainly realizable at short notice without loss." We define this loss as the difference between the value realizable from optimal sale (with no time constraint) and the value realizable from immediate sale. We estimate the former by treating optimal sale as a search problem: the seller faces a sequence of prices over time and must decide when to accept.
Implications of our definition include
(1) market efficiency implies perfect liquidity,
(2) liquidity is forward-looking and depends on the expected future path of prices rather than current or past prices,
(3) liquidity applies to buyers as well as sellers, and
any inference about the liquidity of an asset is necessarily model-dependent.
We illustrate the use of our measure by applying it to Los Angeles real estate and to investment in Canadian dollars and in pounds sterling.
"Tests of Microstructural Hypotheses in the Foreign Exchange
Market" (August 1994)
BY: RICHARD K. LYONS
CONTACT: Richard K. Lyons
E-MAIL: lyons@haas.berkeley.edu
POSTAL: 350 Barrows Hall, U.C. Berkeley, Berkeley, CA 94707
PHONE: (510) 642-1059
FAX: (510) 642-2826
REF: WPS94-349
This paper introduces a transactions dataset to test microstructural hypotheses in the spot foreign exchange market. The dataset reflects all the trading activity of a dealer whose average daily volume is over $1 billion over the five-day sample. We use the data to test for effects of trading volume on prices through the two channels stressed in the literature: the information channel and the inventory-control channel. We find that trades have both a strong information effect and a strong inventory-control effect, providing support for both branches of microstructure theory. The strong inventory-control effect arises despite the fact that foreign exchange dealers have an additional means of inventory control that a specialist does not, namely trading on another dealer's prices.
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Chapter 3: Interest Rates in the Global Money Market
No update, but see the supplementary self-test problems.
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Chapter 4: Exchange-Rate Systems
Exchange-Rate Arrangements
New national accounts
A new, internationally-agreed system of national accounts will henceforth be implemented by government statisticians around the world. The table below gives a simplified picture of what the SNA is trying to achieve. Its aim is to record the nature of stocks and flows that are part of the economic system, applying the same concepts, definitions and classifications to all accounts and sub-accounts. It is rooted in the market system, where goods and services are produced and traded for a price.
The New System of National Accounts:
How it Tracks National Output and Wealth
| Type of account | Main items reported |
| Opening balance sheet | National wealth in terms of assets, liabilities and net worth. |
| Production | GDP, value added. Industrial, sector accounts show outputs and inputs. |
| Income and its use | National disposable income, consumption, saving: includes types of income and their redistribution. |
| Capital | Capital formation. Includes changes in net worth due to saving and net capital transfers. |
| Financial | Acquisition of financial assets, liabilities, net lending and borrowing. |
| Revaluation | Changes in net worth due to changed prices of assets and liabilities. |
| Other changes in assets | Covers items such as new discoveries of natural resources, catastrophic losses, and uncompensated seizures. |
| Closing balance sheets | National wealth, net worth, reflecting above items. |
Hong Kong versus ERM
Under the Exchange Rate Mechanism of the European Union, central banks in effect promised to fix their exchange rates to one another, but the promises proved to be little more than a promise to intervene in the FX markets until resources or resolve were depleted.
The Hong Kong dollar's peg to the U.S. dollar, in contrast, is somewhat more substantial. The Hong Kong Monetary Authority is bound by strict rules to enforce the peg. It does this by guaranteeing to buy U.S. dollars from the 2 (soon 3) commercial banks that are authorized to print Hong Kong dollars. In exchange for the U.S. dollars, the banks receive certificates of indebtedness. With these they can print the equivalent amount of Hong Kong dollars at the official exchange rate of HK$7.8 to the U.S. dollar. If the banks have a surfeit of local currency, they can use them to redeem their certificates of indebtedness in exchange for U.S. dollars, again at the official rate.
The monetary authority thus has no direct control over the money supply. It does, however, maintain an iron grip on the exchange rate by raising or lowering interest rates. The exchange rate has remained fixed since the system was set in place in 1983. In the long run, Hong Kong rates are determined by U.S. rates--inevitable under a fixed-rate system.
Since overseas money has poured into Hong Kong and China, the exchange fund is presently flush with U.S. money. At $43 billion, Hong Kong has the world's sixth-largest reserves, equivalent to about twice Hong Kong's monetary base.
One question is what will happen to the HK dollar once the colony reverts to China, in 1997. The prevailing view seems to be that the currency will remain stable--the Chinese, who already have a great deal of influence in Hong Kong, would not permit an adjustment; moreover China has itself pegged its semi-convertible yuan to the dollar.
Source: The Economist, April 16, 1994.
The European Monetary System
As of 1996, Germany and the other leading members of the European Union still intended to institute a common currency, the "Euro," by 1999. But many observers remain sceptical.
A major setback to plans for monetary union was the series of events in 1992-1993. Following several speculative crises, the pound sterling and the Italian lira dropped out of the ERM, and eventually the remaining currencies adopted wider, 15%, bands (except for the DM and Dutch guilder, which retained the narrow 2 1/4% bands). Far from being merely attributable to a speculative onslaught, it became clear that meeting the 1999 deadline would have been well nigh impossible. The convergence criteria laid out in the Maastricht Treaty were that, to participate in EMU, the country should possess:
- A currency that "shall have respected the normal fluctuation margins provided for by the ERM of the European Monetary System without severe tensions for at least the last two years before the examination";
- "An average nominal long-term interest rate that does not exceed by more than 2 percentage points that of, at most, the three best-performing member states in terms of price stability";
- An average rate of inflation that "does not exceed by more than 1 percentage points that of, at most, the three best-performing member states"; and
- A sustainable government financial position. This is defined, first by "whether the ratio of the planned or actual government deficit to gross domestic product exceeds" 3 percent, "unless either the ratio has declined substantially and continuously and reached a level that comes close to " 3 percent or "the excess...is only exceptional and temporary"; and, second, by "whether the ratio of government debt to GDP exceeds 60 percent, "unless the ratio is sufficiently diminishing and approaching" 60 percent "at a satisfactory pace."
In retrospect, it seems most unlikely that these criteria would be met by the majority of members of the EC. Even Germany currently cannot meet the standards. Whether Europe can still return to the path of monetary union remains the subject of active debate. A number of studies on this subject have been conducted under the auspices of the Centre for Economic Policy Research in London. Two such studies are summarized below.
Michael Artis, "Stage Two: Feasible Transitions to EMU," CEPR Discussion Paper no. 928, March 1994.
Artis notes that the exchange-rate crises of 1992-93 appear to have dealt a severe blow to prospects for EMU. maintaining currencies within the "normal" bands of the ERM for two years had until August 1993 seemed the least difficult of the Maastricht Treaty's convergence criteria. The establishment of the European Monetary Institute in January 1994 did nothing to ameliorate concerns that similar speculative attacks could prevent a transition to full monetary union, since its mission is to consider the instruments and policies the European Central Bank (ECB) will require in Stage Three, not to make policy for Stage Two. While the EMI may "formulate opinions or recommendations on the overall orientation of monetary policy and exchange rate policy," these can have no binding force.
The paper points out that the Maastricht Treaty's wording allows countries participating in the ERM to retain the temporary +/-15% bands simply by agreeing to define these as "normal" and abandon the previous interpretation based on the +/-2.25% narrow bands. The other convergence criteria could then remain intact or even be hardened to compensate for the resulting loss of credibility. This would undermine the entire rationale for introducing the narrow-band convergence criterion, however, which was to provide a "proving ground" in which countries experienced the effects of "monetary disarmament" before making the final commitment to EMU.
Artis therefore considers three means of renarrowing the bands to preserve the spirit of the proving ground interpretation while reducing the opportunities for destabilizing speculation. First, the narrow bands could be accompanied by capital controls to protect currencies against speculative onslaughts, but this would provide no incentives for national governments to adopt appropriate macroeconomic policies. Second, more flexible narrow bands--with indexed central rates and soft edges--could deter speculation by removing "safe bets," but this too would likely remove the discipline associated with hard-edged nominal bands.
The author suggests a third path: a return to hard-edged, narrow bands in conjunction with a gradual transition towards a more symmetric European monetary policy. The transition proposed by Maastricht is not transitional: transferring the conduct of policy from national central banks to the ECB at the start of Stage Three entails a "Big Bang." National central banks, Artis argues, should instead continue to conduct monetary policy during Stage Two, following the lead of the Bundesbank, which should itself act on the EMI's recommendations rather than responding solely to German concerns and objectives as its current statutes dictate. He cites research indicating that the aggregate European money supply is now at least as good a predictor of inflation as the domestic money supply in nearly all ERM countries, including Germany.
Peter Bofinger, " Is Europe an Optimum Currency Area?" CEPR Discussion paper no. 915, February 1994.
Academic discussion of European economic and monetary union has been influenced by the theory of optimum currency areas (OCAs), which holds that economies prone to asymmetric real shocks should not form common currency areas. Bofinger argues that this theory's restrictive assumptions bear little relation to European realities.
The use of the exchange rate to adjust relative prices assumes that each country produces only one good, whereas all European Union members have diversified production structures. Moreover, trade unions' increased freedom from money illusion and willingness to accept wage cuts provide an alternate adjustment mechanism. Flexible exchange rates will not always compensate for shocks, and past real exchange rates reflect factors that monetary union will remove and therefore cannot be used to predict their future pattern.
The author develops an alternative approach that emphasizes currency areas' performance in terms of policy credibility, their responses to asymmetric monetary shocks and the efficiency of monetary targeting and other policy instruments. This indicates that with EMU already in place, France and the other low-inflation EU countries could have benefited substantially from the interest-rate reductions achieved in Germany since late 1992. This approach, he says, also improves on the theory of OCAs since it explains why nation states outperform their constituent regions as currency areas: the money demand function is necessarily less stable if currency areas a re smaller than the jurisdictions within which agents are free to shift assets. He concludes that since money demand is more stable at the European than at the national level, so EMU would therefore improve the efficiency of policies based on quantitative monetary targets and monetary policy instruments.
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Chapter 5: Exchange Rates, Interest Rates, and Inflation Rates: An Integrated Framework
Forward rate bias and expected inflation
A number of studies show that the expected return from holding open forward exchange positions is not zero (Froot and Frankel, 1989; Froot and Thaler, 1990). This can be interpreted as the forward rate not being an unbiased predictor of the future spot rate, or as deviations from the international Fisher effect. Investing in currencies with high nominal interest rates, for example, has provided better-than-expected results.
One interpretation lies in the idea that real interest rates differ around the world. The reasoning is that central banks manipulate their countries' short term interest rates in an attempt to control inflation, so that nominal interest rates are often temporarily higher than is justified by anticipated inflation.
A simple hedging rule would be to seek exposure in high-yielding currencies and hedge exposure in currencies with low short term interest rates. An improvement would be to base hedging decisions on estimated real interest rates. This was done in a recent study by Hazuka and Huberts (1994). Using an adaptive expectations model and assuming that a trailing six-month average of actual CPI inflation is a proxy for inflation expectations, they simulated buying currencies with high real interest rates and shorting currencies with low real rates. The strategy returned 3.7% annually over the 228-month test period. It beat an unhedged and a fully hedged benchmark portfolio by a considerable margin (excess returns of 2.5% and 4.6%, respectively). They also found empirical support for a strategy based on purely nominal interest rate differentials, but not a strong as for a real-rate differential based strategy.
References:
K. A. Froot and J.A. Frankel, "Forward Discount Bias: Is it an Exchange Risk Premium?" Quarterly Journal of Economics, February 1989.
K.A. Froot and R.H. Thaler, "Anomalies: Foreign Exchange," Journal of Economic Perspectives, Summer 1990.
T.B. Hazuka and L.C. Huberts, "A Valuation Approach to Currency Hedging," Financial Analysts Journal, March-April 1994, 55-59.
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