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Financial Markets: Direct allocation of capital and distribution of funds from surplus sources to targets where funds
Financial Industry: include such lender-savers as individuals, institutions, governments, and foreigners.
Financial Governance: include such borrower-spenders as households, firms, public sectors, and foreigners.
Financial Intelligence: Securities as financial instruments to channel funds serve as assets to lenders but as liabilities.
Direct allocation of capital and distribution of funds from surplus sources to targets where funds are deficient.
2) The surplus sources of funds include such lender-savers as individuals, institutions, governments, and foreigners.
3) The deficit targets of funds include such borrower-spenders as households, firms, public sectors, and foreigners.
4) Securities as financial instruments to channel funds serve as assets to lenders but as liabilities to borrowers.
5) Financial markets thus:
Perform the essential function of channeling funds from economic players that have saved surplus funds to those
that have a shortage of funds;
Promote economic efficiency by producing an efficient allocation of capital, which increases production;
Improve the well-being of consumers by allowing them to time purchases better.
2)
3)
4)
2)
Money-market Instruments
Treasury Bills (T-Bills)
Negotiable Certificates of Deposits (CDs)
Commercial Papers (CPs)
Repurchase Agreements (Repos)
Federal Funds (Fed funds)
Capital-market Instruments
Common Stocks
Securitized Loans: Asset/Mortgage-backed Securities (ABS/MBS), Collateralized Debt Obligations (CDOs)
Corporate Bonds
Government Securities
Government Agency Securities
Local Government Bonds
Tax-exempt Municipality Bonds (Munis)
Commercial and Consumer Loans
2)
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2)
3)
4)
Transaction-cost Reduction
Economies of scale
Liquidity services
Risk Sharing and Reduction
Asset transformation
Diversification
Asymmetric-information Alleviation
Adverse Selection (before the transaction) more likely to select risky borrower
Moral Hazard (after the transaction) less likely borrower will repay loan
Economy-of-scope Provision
Multiple financial services to lower the cost of information production for each service by applying one information
resource to many different services.
Benefits of multiple financial services must be weighed against their potential cost of conflict of interest in which
those services may lead an institution to conceal information or disseminate misleading information.
2)
3)
Depository Institutions
Commercial Banks
Thrift Institutions
Credit Unions
Contractual Savings Institutions
Life Insurance Companies
Property and Casualty Insurance Companies
Pension and Government Retirement Funds
Investment Institutions
Investment Banks
Mutual Funds
Money-market Mutual Funds
Finance Companies
2)
2)
3)
4)
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2)
3)
4)
5)
2)
3)
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Costs:
4)
2)
3)
4)
2)
Bank Assets
Reserves (per requirements from a central bank)
Cash Items in Process of Collection
Deposits at Other Banks (e.g., interbank lending as borrowed reserves)
Securities (of national, state, provincial, and local government agencies)
Loans (e.g., commercial, industrial, consumer, and mortgage loans)
Other Assets (e.g., long-lived tangible and intangible assets)
Bank Liabilities
Checkable Deposits (i.e., non-interest-bearing demand deposits)
Non-transaction Deposits (e.g., saving and time deposits)
Borrowings (from other banks, non-bank firms, and a central bank)
Bank Capital (i.e., shareholders equity, minority interests, preferred stocks, etc.)
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2)
Assets
Reserves
+$100
3)
+$100
Making Profit
A bank transforms its assets by selling liabilities with one set of characteristics and using the proceeds to buy assets
with a different set of characteristics. In this process, the bank borrows short and lends long.
First National Bank
Assets
Liabilities
Required reserves +$100 Checkable deposits +$100
Excess reserves
+$90
+$100
Liquidity Management
Excess Reserve: If a bank has excess reserves, a deposit outflow need not change other parts of its balance sheet.
Assets
Reserves
Loans
Securities
$20M
$80M
$10M
Liabilities
Deposits
$100M
Bank Capital
$10M
Assets
Reserves
Loans
Securities
$10M
$80M
$10M
Liabilities
Deposits
$90M
Bank Capital
$10M
Shortfall Reserve: Reserves are a legal requirement and the shortfall must be eliminated. Excess reserves are
insurance against the costs associated with deposit outflows.
Assets
Reserves
Loans
Securities
$20M
$80M
$10M
Liabilities
Deposits
$100M
Bank Capital
$10M
Assets
Reserves
Loans
Securities
$10M
$80M
$10M
Liabilities
Deposits
$90M
Bank Capital
$10M
Borrowed Reserve: incurs cost in terms of the interest rate paid on the borrowed funds.
Assets
Reserves
Loans
Securities
Liabilities
$9M
$90M
$10M
Deposits
Borrowing
Bank Capital
$90M
$9M
$10M
Securities Sale: The cost of selling securities is the brokerage and other transaction costs.
Assets
Reserves
Loans
Securities
Liabilities
$9M
$90M
$1M
Deposits
$90M
Bank Capital
$10M
Central Bank Borrowing: incurs interest payments based on the discount rate.
Assets
Reserves
Loans
Securities
Liabilities
$9M
$90M
$10M
Deposits
Borrowing
Bank Capital
$90M
$9M
$10M
Loans Reduction: is the most costly way of acquiring reserves. But, calling back in loans antagonizes customers
while other banks may only agree to purchase loans at a substantial discount.
Assets
Reserves
Loans
Securities
2)
3)
Liabilities
$9M
$81M
$10M
Deposits
$90M
Bank Capital
$10M
Asset Management
Three Goals: 1) to seek the highest possible returns on loans and securities; 2) to reduce risk; and 3) to have
adequate liquidity.
Four Tools: 1) Find borrowers who will pay high interest rates and have low possibility of defaulting; 2) Purchase
securities with high returns and low risk; 3) Lower risk by diversifying; and 4) Balance need for liquidity against
increased returns from less liquid assets.
Liability Management
Recent phenomenon due to rise of money center banks.
Expansion of overnight loan markets and new financial instruments (such as negotiable CDs).
Checkable deposits have decreased in importance as source of bank funds.
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4)
High-capital Bank
Liabilities
$10M
Deposits
$90M
$90M
Bank Capital
$10M
High-capital Bank
Liabilities
$10M
Deposits
$90M
$85M
Bank Capital
$5M
Assets
Reserves
Loans
Assets
Reserves
Loans
Low-capital Bank
Liabilities
$10M
Deposits
$96M
$90M
Bank Capital
$4M
Low-capital Bank
Liabilities
$10M
Deposits
$96M
$85M
Bank Capital
-$1M
The amount of capital affects return for the owners (equity holders) of the bank
1. Return on Asset (RoA) = Net Profit / Assets
2. Return on Equity (RoE) = Net Profit / Assets * Assets / Equity
Regulatory requirement for bank capital as self-insured buffer for safety
1. Benefits the owners of a bank by making their investment safe
2. Costly to owners of a bank because the higher the bank capital, the lower the return on equity
3. Choice depends on the state of the economy and levels of confidence
HOW DOES A BANK MANAGE ITS CREDIT RISK?
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Gap Analysis
Deals with an impact on net interest margin (NIM) from changes in interest-rate sensitive assets and liabilities
Positive gaps indicate a potential increase in NIM due to a change in market interest rates
Negative gaps indicate a potential decrease in NIM due to a change in market interest rates
Maturity bucket approach measures the gap for several maturities to calculate rate impacts over a multiyear period
Standardized gap approach measures different degrees of sensitivity for different rate-sensitive assets and liabilities
Duration Analysis
Deals with an impact on market value (MV) of rate-sensitive assets and liabilities to movements in interest rates
The Macaulay Duration (D) measures the average lifetime of a cash-flow stream of an asset or a liability
A modified Duration (MD) measures the sensitivity of MV of an asset or a liability to changes in an interest rate
2)
3)
4)
Loan Sales
Also called secondary loan participation to sell all or part of the cash stream from a specific loan
Lenders could earn immediate profits from sale of quality loans while readjusting their balance-sheet diversification
Lenders could realize immediate losses from sale of troubled loans while removing their risks from balance sheets
Fee-income Generation
Specialized financial services, e.g., currency exchanges, payment transfers, stand-by credit lines, debt guarantees
Standby credit lines include note issuance facilities (NIF) and revolving underwriting facilities (RUF) for Euronotes
Debt guarantees serve as a put-option contract for the buyers to let the lenders bear default risk of their behalf
Structured investment vehicles (SIV) are securitized instruments that lenders enhance liquidity for their borrowers
Trading Activities
Lenders trades derivatives (futures, options, forwards, swaps) on exchanges or OTC to facilitate their businesses
Lenders often try to outguess the markets and engage in speculation that is risky and could lead to insolvencies
Risk Management Techniques
Lenders also trades derivatives to hedge their market risk rather than speculating or arbitraging market movements
Lenders need to employ reliable risk-quantification methods to accurately measure and properly manage their risks
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The Wall Street Reform and Consumer Protection Act of 2010 (aka the Dodd-Frank Act)
Objectives: The Dodd-Frank Act aims at
1. Promoting the financial stability of the US by improving accountability and transparency in the financial system
2. Ending the Too Big To Fail doctrine
3. Protecting the American taxpayer by ending bailouts
4. Protecting consumers from abusive financial services practices, and for other purposes
Suppositions: The Dodd-Frank Act purports to
1. Provide rigorous supervisory standards to protect the American economy, consumers, investors, and businesses
2. End taxpayer-funded bailouts of financial institutions and financial services firms
3. Provide for an advanced warning system on the stability of the economy
4. Create rules on executive compensation and corporate governance
5. Eliminate some loopholes that led to the 2008 economic recession
Regulators: The Dodd-Frank Act affects the following regulatory agencies
1. Financial Stability Oversight Council (FSOC) newly established
2. The Federal Reserve System (Fed)
3. Federal Deposit Insurance Corporation (FDIC)
4. Federal Insurance Office (FIO)
5. Federal Housing Finance Agency (FHFA)
6. National Credit Union Administration Board (NCUAB)
7. Office of the Comptroller of the Currency (OCC)
8. Office of Credit Ratings (OCR)
9. Office of Thrift Supervision (OTS) eliminated
10. Office of Financial Research (OFS) newly established
11. Securities and Exchange Commission (SEC)
12. Commodity Futures Trading Commission (CFTC)
13. Securities Investor Protection Corporation (SIPC)
14. Bureau of Consumer Financial Protection (BCFP) newly established
Systemic Risk Regulation: The Dodd-Frank Act enables FSOC to
1. Monitor markets for asset price bubbles and the buildup of systemic risk.
2. Designate which firms are systemically important financial institutions (SIFIs) who pose a risk to the overall
financial system because their failure would cause widespread damage, e.g., bank holding companies.
3. Subject SIFIs to additional regulation, including higher capital standards, stricter liquidity requirements, and a
requirement to draw up a plan for orderly liquidation of the firm gets into financial difficulties.
Resolution Authority: The Dodd-Frank Act enables FDIC to
1. Seize assets of failing SIFIs and wind them down in an orderly manner.
2. Levy fees on financial institutions with more than $50 billion in assets to recoup any losses.
Consumer Protection: The Dodd-Frank Act authorizes BCFP to
1. Examine and enforce regulations for issuers of residential mortgage products having over $10 billion in assets.
2. Examine and enforce regulations for issuers of other financial products marketed to low income people.
3. Require lenders to verify borrowers ability to repay loans based on their income, credit history, and job status.
4. Ban payments to brokers for pushing borrowers into higher-priced loans (i.e., predatory loans).
5. Allow states to impose stricter consumer protection laws on national banks.
6. Give state attorney-general power to enforce certain rules issued by BCFP.
7. Increase the level of federal deposit insurance to $250,000 permanently.
The Volcker Rule: The Dodd-Frank Act improves upon the Bank Holding Company Act of 1956 as follows
1. Banking entity, including insured depository institution and bank holding company, would be limited in the
extent of its proprietary trading and allowed to own a small percentage of hedge fund and private equity fund.
2. The rule limits banking entities to own no more in a hedge/private-equity fund than 3% of total ownership. The
total of all of the entitys interests in hedge/private-equity funds cannot exceed 3% of the entitys tier-1 capital.
3. No bank that has a direct or indirect relationship with a hedge fund or private equity fund may enter into a
transaction with the fund or its subsidiaries without disclosing the full extent of the relationship to the regulators
and assuring that there are no conflicts of interest.
4. Banking entity must comply with the Act within two years of its passing, although it may apply for time
extensions.
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2)
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Stocks are not the most important source of external financing for businesses
Stock markets accounted for only a small fraction of the external financing of businesses in advanced economies during
1970-2000: 12% in Canada, 11% in the US, 8% in Germany, and 5% in Japan.
Issuing debt and equity securities is not the primary way to finance businesses
Debts represented a higher portion of businesses external financing in advanced economies than stocks during 19702000: 15% in Canada, 32% in the US, 7% in Germany, and 9% in Japan.
Indirect finance through intermediaries is more important than direct finance through financial markets
Within those relatively smaller-sized direct-financing markets, less than 5% of newly issued debt securities and 33% of
equity securities have been sold directly to individual investors with the balances being bought by institutional investors.
Financial intermediaries are the more important sources of external funds for businesses
Loans from depository institutions (banks) and financial-services firms (non-banks) took up the larger slices in
businesses financing in advanced economies: 73% in Canada, 57% in the US, 85% in Germany, and 86% in Japan.
The financial system is among the most heavily regulated sectors of the economy
Governments regulate financial markets and intermediaries primarily to promote the provision of information and to
ensure the soundness and stability of the financial system.
Only large corporations have easy access to securities markets to finance their businesses
Unlike well-known corporations, small-to-medium enterprises (SMEs) that are not well established are less likely to
raise funds through financial markets but more so from financial intermediaries.
Collateral is a prevalent feature of debt contracts for both households and businesses
As a property pledged to a lender, collateral is used by borrowers to guarantee their payment in the events of default.
Commercial and farm mortgage loans with collateral make up 25% of borrowing by businesses.
Debt contracts are complex legal documents that place substantial restrictions on the borrowers behavior
Debt contracts have a provision called covenants to restrict certain activities in which borrowers can engage. Other
covenants include a requirement for borrowers to maintain sufficient insurance on properties purchased with the loan.
2)
2)
3)
Adverse Selection
Adverse selection occurs before a transaction takes place or a financial contract is entered.
6) Lemons Problem: arises when product-sellers or fund-borrowers are not willing to reveal information that makes
the quality of their products or credit-ratings look worse than they want them to be to that they could sell for the
highest possible price or borrow at the best possible deal.
2) Free-rider Problem: occurs when a majority of market participants take advantage over a minority in bargaining the
transactions by observing the deals best outcomes so that the former need not share the costs with the latter.
Moral Hazard
Moral hazard arises after a transaction took places or a financial contract has been entered.
1) Risk-shifting Problem: occurs when product-buyers pursue their entitlements or privileges under the contracts at
their product-sellers expense or when fund-borrowers unilaterally switch their intents or behavior to utilize fund to
maximize their own self-interest at their fund-lenders risk during the period of their contracts.
2) Cherry-picking Problem: arises when product-sellers or fund-lenders (agents to the contracts) pursue their own
self-interests by conducting hidden or opaque activities that undermine or sub-optimize the interests of their
product-buyers or fund-borrowers (principals to the contracts) during the period of their contracts.
Conflicts of Interest
Conflicts of interest arise when an institution has multiple objectives and conflicts among those objectives.
1) Incentive-related Conflict: As institutions face conflicting objectives, there is a strong incentive for them to distort
one set of information over another thereby reducing in the information quality while increasing its asymmetries.
7) Agency-related Conflict: Within an institution, there are underinvestment and overinvestment problems caused by
conflicts between principals and agents making it unable to channel funds into productive investment
opportunities.
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2)
2)
3)
4)
2)
2)
Public Accounting Return and Investor Protection Act of 2002 (aka the Sarbanes-Oxley Act)
Increases supervisory oversight to monitor and prevent conflicts of interest.
Establishes a Public Company Accounting Oversight Board.
Increases the Securities and Exchange Commissions (SEC) budget.
Illegalizes public accounting firms to provide non-audit service to clients while performing an impermissible audit.
Raises criminal charges for white-collar crime and obstruction of official investigations.
Requires the CEO and CFO to certify that financial statements and disclosures are accurate.
Requires members of the audit committee to be independent.
Global Legal Settlement of 2002
Requires investment banks to sever the link between research and securities underwriting.
Bans spinning.
Imposes $1.4 billion in fines on accused investment banks.
Requires investment banks to make their analysts recommendations public.
Over a 5-year period, investment banks are required to contract with at least 3 independent research firms that
would provide research to their brokerage customers.
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2) He/she helps set the agenda for the Feds meetings and votes first about monetary policy.
3) He/she has the authority to supervise professional economists and economic-policy advisers.
4) He/she has a pivotal role in negotiating with the US Congress and the US President.
2)
2) However, some economists developed the Theory of Bureaucratic Behavior arguing that there are other factors that
influence how the bureaucratic system operates and bureaucrats within it behave.
3) Such a theory claims that the objective of a bureaucracy is to maximize its own welfare relating to power and prestige.
2)
3)
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2)
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Deposits from the public are a major source of funds of a financial industry that are transformed into credit to be
allocated to households and firms.
Creating more deposits would expand credit in a financial system with its resultant MS being utilized for consumption
and investment purposes.
Stakeholders whose roles in deposit-creation include:
Central bank (CB) who formulates monetary policy and supervises financial industry;
Depository institutions (DI) who take deposits from and grant loans to the public;
Depositors who provide insurable funds to depository financial institutions;
Borrowers who receive credit and loans from depository financial institutions.
Both CB and DI directly influence deposit- and credit-creation whereby the former specifies the RR and the latter
allocates credit in markets from ER.
Both depositors and borrowers are the beneficiaries of the central banks RR monetary policy and the depository
institutions ER credit policy as total reserves (TR) have direct impacts on both funding cost and credit quantity.
2)
3)
4)
5)
ddr
DD / DD = 1
ccr
CC / DD
rrr
RR / DD
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err
ER / DD
2)
Since a central banks assets must equal its liabilities, we could rearrange the equation as follows:
MB =
(NBR + BR) = (CC + TR)
NBR =
CC + TR BR
=
CC + (RR + ER) BR
=
CC + RR + (ER BR)
NBR =
CC + RR + NFR
We could then link MB to MS as follows:
MS =
CC + DD
DD =
MS CC
=
MS MS*(CC/MS)
DD =
MS * (1 h)
RR =
rrr * MS(1 h)
NBR =
(h*MS) + [rrr*MS(1 h)] + NFR
MS =
(NBR NFR) / [h + rrr(1 h)]
write CC in terms of MS
where: h = CC/MS or CC = h*MS
where: RR = rrr*DD
substituting in equation 5 above
rearrange in terms of MS
2)
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2.
3.
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A rise in RR, ER, or CC in financial institutions would cause MS to fall, forcing interest rates to rise.
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2.
3.
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Advantages of DWL
It serves as the lending of last resort for financial institutions to secure their reserves and liquidity in an emergency.
It is a source of reserves outside the banking industry for a central bank to control short-term market interest rates.
Disadvantages of DWL
The decision whether to borrow from a central bank belongs to a bank as it would compare across different sources.
If the discount rate is less competitive than interbank rates or those prevailing in the markets, then the central
banks intent to affect the financial institutions reserves might not be fulfilled.
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3.
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2)
3)
Monetary Tools
Open market operations to affect NBR by controlling stock and flow of reserves.
Discount rates to affect BR by adjusting short-term rate to compete in the market.
Reserve requirements to affect RR and ER by adjusting a money-supply multiplier.
Policy Instruments
Reserve-aggregate targets (NBR, BR, RR, ER, and CC resulting in monetary base)
Interest-rate targets (short-term rate changes resulting in different reserve levels)
Intermediate Targets
Intermediate targets (e.g., medium-term money-supply and interest-rate levels)
Reserve-aggregate and interest-rate targets are incompatible, i.e., a central bank must choose one way or the other.
2)
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4)
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Developments in financial system yield crucial impacts on economic activities than they did earlier.
The zero-lower-bound interest rates can be a problem as negative rates are possible (as an incentive for not to lend).
The cost of cleaning up after a financial crisis is higher than what the public funds (tax-payer money) could cover.
Price and output stability do not always ensure financial stability while misbehavior (e.g., greed and lies) of
financial participants is still rampant.
How should central banks respond to asset price bubbles?
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3)
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5)
Asset-price bubbles: pronounced increase in asset prices that depart from intrinsic values, which eventually burst.
What are the factors that induced asset-price bubbles?
Aggressive/predatory credit extension (e.g., resulting in the subprime crisis)
Irrational exuberance of investors/speculators (e.g., in real-estate markets)
Should central banks respond to bubbles?
Strong argument for not responding to bubbles driven by irrational exuberance.
Bubbles are easier to identify when asset prices and credit volumes are increasing rapidly at the same time.
Monetary policy should not be used to pierce bubbles.
Macropudential Policy
Regulatory policy that reflects what happened and affects what will happen in credit markets at the aggregate level.
Managed Monetary Policy
Central banks and other regulators should not have a laissez-faire attitude and let credit-driven bubbles proceed
without any reaction.
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2.
FX variations are caused by 1) global market mechanisms or 2) domestic interventions by government or central bank.
2) Based on the first source, the FX rate would change according to dynamics in the demand and supply of different
currencies. Based on the second source, authorities in a certain country could intervene to adjust its FX d by actively
trading it in the global markets in order to minimize any undesirable impact on its economic or financial system.
3) A change in FX due to global market mechanisms can lead to two outcomes: 1) FX appreciation or 2) FX depreciation.
If a direct quote is used, an FX appreciation or depreciation would also be direct, e.g., from USD0.16/CNY to
USD0.17/CNY when appreciating and from USD0.16/CNY to USD0.15/CNY when depreciating.
If an indirect quote is used, an FX appreciation or depreciation would also be inverse, e.g., from CNY6.22/USD to
CNY6.21/USD when appreciating and from CNY6.22/USD to CNY6.23/USD when depreciating.
4) An adjustment in FX due to domestic interventions can lead to two outcomes: 1) FX revaluation or 2) FX devaluation.
HOW CAN AN FX CHANGE BE ESTIMATED BY THE PPP?
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A Chinese investor has a choice between buying a local bond that pays domestic interest rate of (id) 3% p.a. and a US
bond that pays foreign interest rate of (if) 4% p.a. Assume that a current FXd today between CNY and USD is
CNY6.22/USD.
2) With an existing interest-rate relationship in which if > id, it could be expected based on the IRP that a future FXd
3) The investor would compare which bond pays a higher return taking into account a future change in FXd rate. Assume
4) The FXd that would equate the return from either bond is 10,300/1,672.03 = CNY6.16/USD.
5) Therefore, the FXd one year from today must appreciate from CNY6.22/USD to CNY6.16/USD if if > id today.
2)
%FXnominal = (f d) + %FXreal
WHAT DETERMINE FX RATES IN A SHORT RUN?
There are factors that could impact FX rates in a short run including relative interest rates and relative returns from
investing in assets whose prices are identical across different countries in terms of uncertainty levels.
2) The factor that is most impactful on short-term returns is volatility of asset prices in financial markets. If domestic
asset volatility is lower (higher), demands for domestic assets would rise (fall), causing FXd to appreciate (depreciate).
3) Asset volatility affects the following variables that determine short-term FX rates:
Domestic interest rate, as a cost of fund, would inversely cause asset prices to change. If interest rate has risen, then
domestic asset prices would fall, causing demand for domestic assets to rise and FXd to appreciate relative to FXf.
Foreign interest rate that also inversely causes foreign asset prices to change. If foreign interest rate has risen, then
foreign asset prices would fall causing demand for foreign assets to rise and FXd to depreciate relative to FXf.
Expected FXd that would cause returns on domestic assets to change. If the expected FXd has risen, demand for
1)
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domestic assets would rise and FXd would appreciate relative to FXf.
Money supply that would cause liquidity level to change thereby changing asset prices. If domestic liquidity level
has risen, then domestic asset prices would also rise, causing demand for domestic assets to fall and FX d to
depreciate relative to FXf.
Short-run changes in FXd are the results of demand and supply of domestic assets.
4) Beyond the IRP relationship, other variables impacting FXd must be considered.
WHAT IS FX EQUILIBRIUM IN ASSET MARKET?
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Financial Frictions: stem from asymmetric-information problems that act as a barrier to efficient allocation of capital
after which financial markets are less capable of channeling funds efficiently from savers to households and firms.
Financial Crisis: occurs when information flows in the financial markets experience a particularly large disruption, with
the result that financial frictions increase sharply and financial markets stop functioning.
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7)
To fight inflation, the Korean central bank deployed a tighter monetary policy by raising domestic interest rate,
causing a drop in firms cash flows (due to higher interest payments) thereby forcing them to obtain external funds.
Since banks already deleveraged while chaebols and other firms struggled to get more loans to stay afloat, Korean
economy then experienced a full-fledged financial crisis that was triggered largely by a currency crisis.
Commencement of Recovery
A self-correcting mechanism by which aggregate demand in Korean economy that was shockingly shifted beyond
the countrys potential output level had been corrected by a corresponding shift in aggregate supply restoring longrun market equilibrium at a higher price level began to work after the crisis.
Domestic financial reforms to shore up investor confidence in Korean financial markets were launched so that asset
prices would pick up raising Korean firms net worth and allowing Korean banks to start lending to the public again.
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Net Transfer Payments: a difference between receipts and payments due to grants, gifts, donations, and subsidies
resulting from international policy programs
3) The KA balance is the sum of
Net Portfolio Investments: a difference between short-term capital inflows and outflows due to investments in
financial securities (e.g., stocks and bonds)
Net Direct Investments: a difference between long-term capital inflows and outflows due to investments in real
assets (i.e., productive resources)
4) If the sum of CA and KA rose (fell) from their original level, then the BoP would be surplus (deficit), causing the USD
reserve to rise (fall) accordingly.
HOW WAS FX FIXED AFTER THE BRETTON WOODS SYSTEM?
In 1969, the IMF initiated an issuance of the Special Drawing Rights (SDRs) to replace gold as an international reserve
asset due to the golds fluctuations before the USD was devalued in 1971. It then abolished the fixed FX regime and
allowed all FX rates to float freely in 1973.
2) The use of SDRs to stabilize international exchange rates in addition to lending to restore the BoP has led to a hybrid
regime between fixed and floating FX regimes since SDRs allowed any central bank to intervene to adjust its FXd
without being negatively affected by market mechanisms.
The SDRs themselves is simply a basket of such major currencies beside USD as DEM, JPY, and GBP. At present,
DEM had been replaced by EUR.
SDRs are not a currency for international trade and finance but the rights for any country to exchange its own
domestic currency with those four major currencies.
Any country that holds a lot of SDRs could let other countries to buy SDRs from it, allowing for voluntary
adjustments in any particular FXd.
Due to a free floating of many currencies and advances in global money and capital markets nowadays, the
importance of SDRs has gradually been lessened.
1)
2)
3)
4)
5)
In 1979, eight nations within the European Economic Community (EEC) agreed to establish the European Monetary
System (EMS) to fix their own currencies through the European Currency Unit (ECU) by intervening to actively trade
their own FXd within the EMS but allowing ECU to float against USD.
Until 1992 after the German Unification, inflation hit Germany causing the Bundesbank to raise domestic interest rate
to curb its inflation. As a result, DEM appreciated beyond what ECU could preserve its parity, leading to speculative
attacks on some weaker European currencies.
GBP was attacked and depreciated by 10% relative to DEM while others e.g. Spanish peso (-5%) and Italian lira (-15%).
Those countries with depreciating FXd would intervene to shore up their value by buying their currency with FXf. As a
result, their fixed rates with ECU had collapsed causing the deficits in their BoP.
Central banks within the EMS had lost about USD4-6 billion from intervention.
Speculators like George Soros pocketed a profit of about USD 1 billion while Citibank earned about USD200
million during that European currency crisis.
Since 1999, the ECU has been effectively replaced by the euro (EUR) based on the Treaty of Maastricht (1992).
2)
3)
If the central bank doesnt wish to cause a change in domestic money supply or inflation rate due to its FX intervention,
it could offset such an effect through an opposite trading of domestic securities while it trades foreign securities.
This method of FXd adjustment is known as a sterilized FX intervention because it would not cause any effect
on domestic MB, MS, id, and d.
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2) In this case, the offsetting effect would lead to a counter-balanced repercussion in the central banks holdings of both
2)
3)
4)
FX Rate Anchoring
Allowing FXd to vary with the value of the countrys trading partner on a one-to-one basis in order to eliminate any
deviation from both currencies relationship.
FX Rate Pegging
Allowing FXd to vary according to the changes in the countrys trading partners price levels (of either goods or
assets) so that FXd is kept relatively weaker than FXf.
Currency Boards
Targeting FXd in advance with a central bank standing-by to defend domestic currency at a pre-determined rate
irrespective of any speculative attack.
Dollarization
Accepting any given FXf as the countrys domestic currency to reduce any complication in FX intervention while
eliminating any fluctuation in FXd.
2)
2)
2)
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The money-creation and lender-of-last-resort roles of a central bank would diminish since all financial participants
would shift from domestic to international system.
Domestic economic and financial systems would be affected more by international events leading to higher level of
uncertainty. Financial participants cannot blame the authorities for any wrong decisions they made.
WHAT ARE THE PROS AND CONS OF DOLLARIZATION?
1)
2)
Advantages of Dollarization
It eliminates all non-transparency issues in FX intervention since there will not be any under dollarization.
It also eliminates all variability and fluctuation between currencies thereby entirely avoiding any speculative attack.
Disadvantages of Dollarization
A central bank loses all of its control over domestic monetary policy and ability to determine domestic interest rate
and fight inflation. In short, the country loses its financial sovereignty to a foreign country to which it dollarizes.
All negative impacts from the foreign country would be automatically passed on to domestic economy.
The country will lose its seignorage (i.e., benefits from creating money) such as interest income from the printed
money or cost-saving from not paying any interest on utilizing its own money.
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