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The Economics of Foreign Exchange and Global Finance
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The Economics of Foreign Exchange
and Global Finance
Second Edition
Peijie Wang
The Economics of Foreign
Exchange and Global Finance
Second Edition
123
Professor Peijie Wang
University of Hull
Business School
Cottingham Road
Hull HU6 7RX
United Kingdom
ISBN 978-3-642-00106-2 e-ISBN 978-3-642-00100-0
DOI 10.1007/978-3-642-00100-0
Library of Congress Control Number: 2009922087
c Springer-Verlag Berlin Heidelberg 2005, 2009
This work is subject to copyright. All rights are reserved, whether the whole or part of the material is
concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting,
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Cover design: WMX Design, Heidelberg
In memory of my beloved parents
Preface to the Second Edition
The book is designed to integrate the theory of foreign exchange rate determination and the practice of global finance in a single volume, which demonstrates
how theory guides practice, and practice motivates theory, in this important area
of scholarly work and commercial operation in an era when the global market has
become increasingly integrated.
The book presents all major subjects in international monetary theory, foreign
exchange markets, international financial management and investment analysis.
The book is relevant to real world problems in the sense that it provides guidance
on how to solve policy issues as well as practical management tasks. This in turn
helps the reader to gain an understanding of the theory and refines the framework.
This new edition of the book incorporates two new chapters, together with updating most chapters in the first edition, integrating new materials, data, and/or the
recent developments in the areas. A new chapter on the portfolio balance approach
to exchange rate determination is included, in addition to the major models included in the first edition: the Mundell-Fleming model, the flexible price monetary
model, the sticky price monetary model featured by the Dornbusch model and the
real interest rate differential model. This makes the book inclusive in exchange
rate theories. A second new chapter included is on issues in balance of payments
or international transactions and their interactions with exchange rates, changes in
exchange rates and exchange rate policies. Rather than presenting the rival approaches alone, the pertinent literature attempting to synthesise them is offered
also. Moreover, the approaches arising from the need to address balance of payments issues in a changed international investment environment are developed in
the chapter.
Various topics are interlinked so the book adopts a systematic treatment of integrated materials relating different theories under various circumstances and
combining theory with practice. The text examines issues in international monetary policy and financial management in a practical way, focusing on the identification of the factors and players in foreign exchange markets and the international
finance arena.
The book can be used in graduate and advanced undergraduate programmes in
international finance or global finance, international monetary economics, and international financial management. It can also be used as doctorate research methodology materials and by individual researchers interested in international finance
viii Preface to the Second Edition
or global finance, foreign exchange markets and foreign exchange rate determination, foreign exchange risk management, and international investment analysis.
Peijie Wang, December 2008
Preface to the First Edition
The book is designed to integrate the theory of foreign exchange rate determination and the practice of global finance in a single volume, which demonstrates
how theory guides practice, and practice motivates theory, in this important area
of scholarly work and commercial operation in an era when the global market has
become increasingly integrated.
The book presents all major subjects in international monetary theory, foreign
exchange markets, international financial management and investment analysis.
The book is relevant to real world problems in the sense that it provides guidance
on how to solve policy issues as well as practical management tasks. This in turn
helps the reader to gain an understanding of the theory and refines the framework.
Various topics are interlinked so the book adopts a systematic treatment of integrated materials relating different theories under various circumstances and
combining theory with practice. The text examines issues in international monetary policy and financial management in a practical way, focusing on the identification of the factors and players in foreign exchange markets and the international
finance arena.
The book can be used in graduate and advanced undergraduate programmes in
international finance or global finance, international monetary economics, and international financial management. It can also be used as doctorate research methodology materials and by individual researchers interested in international finance
or global finance, foreign exchange markets and foreign exchange rate determination, foreign exchange risk management, and international investment analysis.
Peijie Wang, May 2005
Contents
1 Foreign Exchange Markets and Foreign Exchange Rates..................................1
1.1 Foreign Exchange Rate Quotations and Arbitrage.....................................2
1.1.1 Foreign Exchange Quotations..........................................................2
1.1.2 Cross Rates and Arbitrage ...............................................................3
1.2 Foreign Exchange Transactions.................................................................5
1.2.1 The Bid-Ask Spread.........................................................................5
1.2.2 Transaction Costs and Arbitrage Opportunities...............................7
1.3 Spot and Forward Exchange Rates ..........................................................10
1.4 Effective Exchange Rates ........................................................................12
1.5 Other Currency Markets ..........................................................................14
2 Exchange Rate Regimes and International Monetary Systems........................17
2.1 Exchange Rate Regimes ..........................................................................17
2.2 A Brief History of International Monetary Systems ................................21
2.3 The European Single Currency ................................................................25
3 International Parity Conditions........................................................................31
3.1 Purchasing Power Parity ..........................................................................31
3.1.1 Absolute Purchasing Power Parity.................................................32
3.1.2 Real Exchange Rates .....................................................................36
3.1.3 Relative Purchasing Power Parity..................................................37
3.1.4 Factors Contributing to the Departure from PPP ...........................39
3.1.5 Empirical Tests and Evidence on PPP ...........................................42
3.2 Interest Rate Parities ................................................................................49
3.2.1 Covered Interest Rate Parity ..........................................................50
3.2.2 CIRP and Arbitrage in the Presence of Transaction Costs.............55
3.2.3 Uncovered Interest Rate Parity ......................................................56
3.3 International Fisher Effect .......................................................................59
3.4 Links Between the Parities: a Summary ..................................................61
4 Balance of Payments and International Investment Positions .........................63
4.1 Balance of Payments................................................................................64
4.1.1 Balance of Payments Accounts and Classification ........................65
Contents xii
4.1.2 Balance of Payments Entries and Recording.................................69
4.1.3 The Balance of Payment Identity...................................................80
4.2 International Investment Position Statements and Analysis ....................81
5 Open Economy Macroeconomics....................................................................91
5.1 The Balance of Payments, National Accounts
and International Economic Linkages......................................................91
5.1.1 National Accounts with an External Sector...................................91
5.1.2 International Economic Linkages ..................................................93
5.2 IS–LM in Open Economy Macroeconomics ...........................................95
5.2.1 IS–LM Analysis.............................................................................95
5.2.2 IS–LM–BP Analysis....................................................................101
5.3 Aggregate Supply and Assumptions on Price Attributes.......................105
6 Balance of Payments Issues and Exchange Rate Movements .......................109
6.1 The Elasticity Approach ........................................................................109
6.2 The Absorption Approach .....................................................................118
6.3 The Monetary Approach........................................................................121
6.4 DIPI Analysis and DIDI Analysis..........................................................127
7 The Mundell-Fleming Model ........................................................................139
7.1 Effects and Effectiveness of Monetary Policy and Fiscal Policy
– Perfect Capital Mobility .....................................................................139
7.1.1 Monetary Expansion - Perfect Capital Mobility,
Flexible Exchange Rates..............................................................140
7.1.2 Fiscal Expansion - Perfect Capital Mobility,
Flexible Exchange Rates..............................................................143
7.1.3 Monetary Expansion - Perfect Capital Mobility,
Fixed Exchange Rates..................................................................145
7.1.4 Fiscal Expansion - Perfect Capital Mobility,
Fixed Exchange Rates..................................................................147
7.2 Effects and Effectiveness of Monetary Policy and Fiscal Policy
– Imperfect Capital Mobility..................................................................150
7.2.1 Monetary Expansion - Imperfect Capital Mobility,
Flexible Exchange Rates..............................................................151
7.2.2 Fiscal Expansion - Imperfect Capital Mobility,
Flexible Exchange Rates..............................................................155
7.2.3 Monetary Expansion - Imperfect Capital Mobility,
Fixed Exchange Rates..................................................................157
7.2.4 Fiscal Expansion - Imperfect Capital Mobility,
Fixed Exchange Rates..................................................................160
7.3 Monetary Policy Versus Fiscal Policy...................................................163
7.3.1 Effect on Income .........................................................................163
7.3.2 Effects on the Exchange Rate and Official Reserves...................165
7.3.3 Effect on the Balance of Payments Current Account ..................165
Contents xiii
8 The Flexible Price Monetary Model ..............................................................167
8.1 Demand for Money in Two Countries and Foreign Exchange Rate
Determination ........................................................................................168
8.2 Expectations, Fundamentals, and the Exchange Rate ............................174
8.3 Rational Bubbles and Tests for
the Forward-Looking Monetary Model .................................................176
8.4 Empirical Evidence on the Validity of the Monetary Model .................180
9 The Dornbusch Model ...................................................................................185
9.1 The Building Blocks of the Model and the Evolution Paths of the
Exchange Rate and the Price..................................................................185
9.2 Adjustments of the Exchange Rate and the Price and Overshooting
of the Exchange Rate .............................................................................190
9.3 A Tale of Reverse Shooting and the Sensitivity of Exchange Rate
Behaviour...............................................................................................201
9.4 The Real Interest Rate Differential Model.............................................206
9.5 Empirical Evidence on the Dornbusch Model and Some Related
Developments ........................................................................................208
10 The Portfolio Balance Approach to Exchange Rate Determination...............215
10.1 Three Assets and Market Equilibria.......................................................215
10.2 Effects of Monetary Policy under the Portfolio Balance Approach.......219
10.3 Effects of Changing Economic Environments and Risk Perceptions ....229
10.4 Theoretical and Empirical Research and Developments in the
Portfolio Balance Framework ...............................................................236
11 Global Derivatives Markets ...........................................................................241
11.1 Global Use of Derivatives –
Current State, Trends and Changing Patterns ........................................241
11.2 Organised Derivatives Exchanges,
Contract Specifications and Trading......................................................256
11.3 Use of Derivatives Shapes Investor Behaviour, Risk Management
Concept and Risk Management Methods ..............................................269
12 Currency Futures ...........................................................................................271
12.1 Futures Contracts and Trading...............................................................271
12.2 Futures Quotes .......................................................................................275
12.3 Pricing of Futures Products....................................................................278
13 Currency Options...........................................................................................287
13.1 Option Basics.........................................................................................287
13.2 Option Terminology and Quotes............................................................297
13.3 Currency Options...................................................................................301
13.4 Option Pricing – the Binomial Tree Approach.......................................307
13.5 Option Pricing – the Black-Scholes Model ............................................321
Contents xiv
14 Currency Swaps.............................................................................................331
14.1 Basics of Swaps .....................................................................................331
14.2 Currency Swaps.....................................................................................335
14.3 Swapnotes..............................................................................................339
15 Transaction Exposure ....................................................................................345
15.1 Introduction to Transaction Exposure and Its Management ..................345
15.2 Forward Hedge and Futures Hedge .......................................................347
15.3 Money Market Hedge ............................................................................353
15.4 Option Hedge.........................................................................................357
16 Economic Exposure and Accounting Exposure.............................................361
16.1 Measuring Economic Exposure .............................................................362
16.2 Managing Economic Exposure..............................................................365
16.3 Measuring Accounting Exposure...........................................................367
16.4 Managing Accounting Exposure............................................................372
17 Country Risk and Sovereign Risk Analysis...................................................375
17.1 Factors of Influence on Country Risk....................................................376
17.2 Country Risk Analysis and Ratings .......................................................378
17.3 Sovereign Risk Analysis and Ratings ....................................................389
18 Foreign Direct Investment and International Portfolio Investment ...............395
18.1 Recent Profiles of Foreign Direct Investment........................................395
18.2 FDI Types and Strategies.......................................................................404
18.3 International Portfolio Investment .........................................................409
References...........................................................................................................415
Index....................................................................................................................427
1 Foreign Exchange Markets and Foreign
Exchange Rates
A foreign exchange market is a market where a convertible currency is exchanged
for another convertible currency or other convertible currencies. In the transaction
or execution of conversion, one currency is considered domestic and the other is
regarded as foreign, from a certain geographical or sovereign point of view, so is
the term foreign exchange derived. Foreign exchange markets are not reserved for
traders or finance professionals only but for almost everyone, from multinational
corporations operating in several countries to tourists travelling across two currency zones. As long as national states or blocs of national states that adopt their
own currencies exist, foreign exchange markets will persist to serve business, nonbusiness, and sometimes, political needs of business firms, governments, individuals, and international organizations and institutions.
An exchange rate is the price of one currency in terms of another currency; it is
the relative price of the two currencies. The initial and foremost roles of money
are to function as a common measure of value and the media of exchange to facilitate the exchange of commodities of different attributes. When the values of
commodities of different attributes are readily denominated by certain units of a
currency or a kind of money circulated in a country or region, the relative price, or
the ratio of values, of two commodities can be easily decided. The relative price of
two commodities can be decided without the involvement of money, though less
explicit. So, more important is the role of money as the media of exchange, for it
is the bearer of commonly recognised value, exchangeable for many other commodities then or at a future time. Instead of barter trade where change of hands of
two commodities is one transaction conducted at one place and at one time, people
do not need to sell one commodity in exchange for another commodity or other
commodities directly and immediately, but sell the commodity for certain units of
a currency or a kind of money in which the value of the sold commodity is
“stored” for future use.
In international trade, the situation is slightly different from that in domestic
trade in that the value of one commodity is denominated in two or more currencies. In theory it is straightforward to derive the exchange rate between two currencies, which is simply the ratio of the units of one currency required to purchase,
or obtained from selling, the commodity in one country or region to the units of
the other currency required to purchase, or obtained from selling, the same comP. Wang, The Economics of Foreign Exchange and Global Finance,
DOI 10.1007/978-3-642-00100-0_1, © Springer-Verlag Berlin Heidelberg 2009
2 1 Foreign Exchange Markets and Foreign Exchange Rates
modity in the other country or region. Indeed, this is the idea of so called purchasing power parity, or PPP for abbreviation, an important theory and benchmark of
studies in international finance. Unfortunately, this world is not a simple and carefree place. Different countries may not always produce identical products that possess the exactly same attributes, or some countries do not produce certain products
at all, which leads to the needs of international trade on the one hand, and makes
international comparison of commodities and consumptions difficult on the other
hand. Then, transportation and physical movements of export goods incur additional costs, and governments of national states and trade blocs impose tariffs on
imported goods that distort the total costs for the consumption of a wide range of
commodities. Besides, national and regional borders prevent human beings, either
as a factor of production or consumers, capital, technology, natural resources and
other factors of production from moving freely between countries and regions,
which further cause and enlarge differences in income, preference, culture, means
of production and productivity, economic environments and development stages in
different countries and regions. All of these influence exchange rates and are the
determinants of exchange rates to varied extents. Theories incorporating one or
more of these factors and determinants have been developed over the last few decades and will be gradually unfolded and examined in the later chapters of this
book.
1.1 Foreign Exchange Rate Quotations and Arbitrage
Foreign exchange rates can be quoted as the number of units of the home or domestic currency per unit of the foreign currency, or as the number of the foreign
currency units per domestic currency unit. Moreover, since more than one pairs of
currencies are usually transacted on the foreign exchange market, the cross exchange rate or the cross rate arises. The cross rate refers to the exchange rate between two currencies, each of which has an exchange rate quote against a common
currency. When there are discrepancies in different cross rate quotations arbitrage
and arbitrage activities may take place.
1.1.1 Foreign Exchange Quotations
Foreign exchange rates can be quoted directly or indirectly. In a direct quotation,
the exchange rate is expressed as the number of units of the home or domestic currency per unit of the foreign currency. An indirect quotation is one that the exchange rate is expressed as the number of the foreign currency units per domestic
currency unit. For example, the exchange rate between the US dollar and the euro
was quoted on September 19, 2003 in Frankfurt as €0.8788/$ and $1.1380/€. The
former is a direct quotation and the latter is an indirect quotation, from the point of
view of Germany or the euroland as the domestic country.
1.1 Foreign Exchange Rate Quotations and Arbitrage 3
This book adopts direct quotations of foreign exchange rates in all the discussions where relative changes in currency values, e.g., appreciation and depreciation of a currency, are referred and relevant. Using direct quotations, an increase
in the exchange rate indicates depreciation of the domestic currency or appreciation of the foreign currency, since one unit of foreign currency can purchase more
units of the domestic currency. Similarly, a decrease in the exchange rate means
that one unit of the foreign currency can purchase a smaller number of units of the
domestic currency, so the domestic currency appreciates and the foreign currency
depreciates. Table 1.1 is an example of foreign exchange rate quotations. Each of
the rows shows the direct quotations for the country/region and each of the columns shows the indirect quotations for the country/region. e.g., the second to
fourth cells in the first row tell how many units of the US dollar can be exchanged
for one unit of the euro, the British pound and the Japanese yen respectively.
These figures are direct quotations from the point of view of the US as the domestic country. The first, second and fourth cells in the third column report how many
units of the US dollar, the euro and the Japanese yen are required respectively in
exchange for one British pound. These figures are indirect quotations from the
point of view of the UK as the domestic country.
Table 1.1. Foreign exchange rate quotations (September 1, 2008) – matrix illustration of
direct and indirect quotes
US$ Euro€ UK£ JPN¥
US$ 1.4611 1.8017 0.0093
Euro€ 0.6845 1.2331 0.0063
UK£ 0.5550 0.8111 0.0051
JPN¥ 107.96 157.70 194.47
1.1.2 Cross Rates and Arbitrage
It is common that more than two currencies are traded at the same time on the foreign exchange market. The cross exchange rate, or the cross rate, refers to the exchange rate between two currencies, each of which has an exchange rate quote
against a common currency. e.g., if the common currency is the euro, and the exchange rates of the euro vis-à-vis the US dollar and the British pound are available
at €0.6845/$ and €1.2331/£. Then the cross rate refers to the exchange rate between the US dollar and the British pound that should be equal to €1.2331/£ over
€0.6845/$ or $1.8015/£. In the point of view of the euroland as the domestic country, this cross rate is the number of units of one foreign currency, which is the US
dollar in this case, in terms of one unit of another foreign currency, which is the
British pound. It can then be envisaged that there might be discrepancies between
the direct or indirect quotes of the exchange rate and the cross rate for two currencies. In Table 1.1, it is shown that the exchange rate quote for the US dollar vis-àvis the British pound is $1.8017/£ that is unequal to $1.8015/£ derived earlier
from the cross rate calculation.