IF3101 International Finance Notes, for City University London students, contain an overview of every topic covered within the module.
Summarised into a 18-page single document, the notes were prepared using both lecture notes, in-class discussions and core textbook (ISBN: 2895)
Lecture 1: Intr...
Summary of week 7 of the course International Money and Finance
Summary of week 6 the course International Money and Finance.
Summary of week 5 of the course International Money and Finance. Chapter 8 and 10.
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Lecture 1 – INTRODUCTION AND MOTIVATION FOR INTERNATIONAL FINANCE
FOREX market is a perfectly competitive market where many firms compete with one
another, offering the same product. In such markets, firms are unable to earn abnormally
high profits.
MAIN PARTICIPANTS OF FX MARKET:
1. Dealers – takes risks, stands ready to transact with customers and other dealers,
provide liquidity to the market – that is, they make it easier and less costly to match
buyers and seller. When there are large number of buyers and sellers, markets are
very liquid, and transaction costs are low. Dealers try to buy a foreign currency at a
low rate and sell it at a higher rate, thus making a profit.
2. Brokers – takes no risks; they do not attempt to buy low and sell high, instead, they
fulfil the role of an intermediary – that is, they match buyer and sellers but do not
put their money at risk. They then receive a brokerage fee on their transactions.
They provide info to dealers on the best available prices, while dealers use these
brokers to unwind very large positions in a particular currency. A broker may be
able to negotiate trades with several FX dealers thereby unwinding the large
position of a dealer in small portions.
3. Customers (end-users)
The prime-broker (PB), typically a large security firm such as Morgan Stanley, offers the
hedge fund (HF) a bundle of services. Importantly, the PB’s customers trade in the PB’s name
using its existing credit lines with the dealers, so that a HF does not need to establish credit
relationships with numerous banks.
A retail aggregator (RA) is a financial firm that acts as an intermediary, aggregating bid-offer
quotes from the top foreign-dealing banks and electronic platforms, which are then
streamed live to customers via the aggregator’s online platform at very competitive spreads.
Electronic communication network (ECN): trades are often totally anonymous and it ensures
price transparency because the market price for a particular currency is visible for all
participants.
Algorithmic trading (or electronic computer based trading) firms connect their computers
directly to the ECN to trade currencies, typically at a very high frequency. “Global macro”
funds use computer algorithms to attempt to profit from incremental price movements by
conducting frequent small trades, executed in milliseconds. These systems make up an
increasingly larger portion of trading and can be viewed as liquidity providers to the market.
3 CATEGORIES OF EXCHANGE RATE REGIME:
1) FIXED (PEGGED): governments attempt to keep the values of their currencies at
particular pegged values relative to another currency or a basket of another
currencies.
No separate legal tender – adopts the currency of another country, thereby
importing both that country’s money and its monetary policy. Example:
EMU, Dollarization (Zimbabwe).
Currency boards – some countries have created currency boards to defend
the currency’s value and enhance the credibility of the peg. A currency
, board is a monetary institution that issues certain supply of money (HK$)
and keeps an equivalent amount of US$ in its vault. The reason why the
currency board offers more monetary credibility than a conventional peg is
that it limits the ability of the CB to create money. Currency board also
cannot lend to the government and hence cannot monetize fiscal deficits;
and cannot rescue banks when they get into trouble so it cannot function as
a lender of last resort. If the US$ depreciates then HK$ also depreciates, so
there is almost no exchange rate fluctuation and risks associated with it.
Example: Hong Kong.
Conventional pegs – you can change your interest rate to generate
demand/supply for your currency OR you can use a direct intervention (buy
and sell foreign currency to make sure the fixed rate is in place. But it is less
safe than the Currency Board because if people start to doubt the CB’s
credibility to defend the peg then you may get a speculative attack on your
currency. Example: Venezuela, China (used to be but not anymore!)
2) LIMITED FLEXIBILITY: in between fixed and floating exchange rate systems.
Target zones – the exchange rate is kept within a fixed band. The most
famous target zone system is the European Monetary System (EMS). As long
as private market participants deem the central rate reasonable and
recognize a credible commitment by the monetary authorities to defend the
rate, market participants will not expect the currency value to go outside the
band, and no currency crisis will occur.
Managed float – the monetary authorities intervene in the FOREX market
sufficiently often that IMF doesn’t classify them as freely floating. Example:
Russia.
3) FLOATING (FLEXIBLE) – the value of the currency is determined freely in the FOREX
market without any government interventions. Example: US, UK, Japan.
, Lecture 2 – CURRENCY CRISES
A currency crisis occurs if investors lose confidence in an economy and its currency such that
they sell their investments denominated in that currency. If this is done on a large scale in a
short period of time and the speculative attack succeeds, the value of the currency can fall
rapidly. First, there is a pressure on the existing exchange rate to depreciate. Investors then
collectively start to sell their investments denominated in the currency under pressure. The
authorities initially try to resist depreciation of the currency either by raising interest rate or
by selling part of their foreign exchange reserves and buying the local currency. As the attack
continues, the authorities eventually have to give in and the currency starts to decline.
Capital mobility is crucial for a currency crisis to occur. If investors cannot switch between
currencies, then a currency crisis is virtually impossible.
A currency crisis typically brings about a reversal of capital flows particularly in the case of
emerging market economies. These countries offer a high return on investment, therefore,
there is a large capital inflow prior to the crisis to take advantage of this high return to
investment but later this is followed by a large capital outflow if the crisis hits.
First generation model (FGM)
The FGM concerns the role that international investors play in bringing about the crisis.
Here, the currency crisis is completely due to bad fundamentals, which are incompatible
with the fixed exchange rate. The basic structure of these models is outlined in equations:
P = (V/ Y) M
P = Sf P*
dM = dC + dR
To prevent a rise in the domestic price level and to maintain the fixed exchange rate, the
money supply cannot increase. That is, a government must fix the money supply in
accordance with the fixed exchange rate.
A distinctive feature of first-generation models is that the government runs a persistent
deficit. However, the government finances its budget deficit by borrowing from the CB (that
is dC increases while dR stays constant), which increases the money supply. The resulting
increase in the money supply would increase the domestic price level and thereby make it
impossible to stick to the fixed exchange rate.
The monetary authorities can, however, prevent the government budget deficit from
increasing the money supply by selling part of the foreign exchange reserves to buy
domestic currency. However, as the amount of foreign exchange reserves is limited, the
monetary authorities will completely run down on their reserves at some point in the future.
It is not possible for the government to borrow or use reserves indefinitely, so the
government can no longer stick to the fixed exchange rate and has to devalue the currency.
Rational investors will not wait for the moment to devalue, as the currency devaluation will
imply a loss of funds. They, therefore, attack the currency by selling their investments before
reserves are depleted. Investors understand how the economy works, and the speculative
attack on the currency is successful. The crisis, thus, occurs before the foreign exchange
reserves are completely run down. The investors simply bring home the bad news a bit
earlier than would have been the case. There are 3 points in favour of the FGM. First,
currency crisis are the result of bad fundamentals. For instance, in the 18 months leading
up to a currency crisis countries experience a significant fall in their foreign exchange
reserves, just like the model predicts. Second, the model explains why a currency crisis can
occur quite suddenly. Third, the timing of the currency crisis implies investors collectively
decide they are no longer willing to invest in the home currency.
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