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Summary of week 5 of the course International Money and Finance. Chapter 8 and 10.
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Summary of week 5 of the course International Money and Finance. Including chapters 8 and 10.
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Chapter 8: The Portfolio Balance ModelAllowing for domestic and foreign bonds to have different characteristics is potentially very
important because operations that influence the exchange rate affect the composition of domestic
and foreign bonds in agents’ portfolios in different ways. In this chapter we will use the portfolio
balance model to examine three operations that are commonly used to influence the exchange rate:
1. An open market operation (OMO) which is defined as an exchange of domestic money base
for domestic bonds or vice versa.
2. A foreign exchange operation (FXO) which is an exchange of domestic money for foreign
bonds or vice versa. Such foreign exchange market intervention affects the domestic money
supply and is termed a non-sterilized intervention in the foreign exchange market.
3. A sterilized foreign exchange operation (SFXO) which is an exchange of domestic bonds for
foreign bonds or vice versa, leaving the domestic money base unchanged.
In the monetary models the only thing that matters for the exchange rate is the money supply in
relation to the money demand, the source of money creation being unimportant.
The concept of a risk premium
The distinguishing feature of the portfolio balance model is that investors no longer regard domestic
and foreign bonds as perfect substitutes. The UIP condition which was a key condition in the
monetary models generally no longer holds. The additional expected return on the relatively risky
compared to the less risky bond is known as the ‘risk premium’. For a risk premium to exist, all of the
following three conditions must be fulfilled:
1. There must be perceived differences in risks between domestic and foreign bonds – the
essence of a risky asset being that its expected real rate of return is uncertain. If the two
bonds were equally risky then with perfect capital mobility they must be perfect substitutes.
2. There has to be risk-aversion on the part of economic agents to the perceived differences in
risk – the principle of risk-aversion is that investors will be only be prepared to take on
increased risk if there is a sufficient increase in expected real returns to compensate. If
investors were not risk-averse then they would not expect a higher return on relatively risky
bonds.
3. Given the different risks on domestic and foreign bonds there is a theoretical portfolio known
as the risk-minimizing portfolio which would minimize the risks facing private agents. There
must be a difference between the risk-minimizing portfolio and the actual portfolio, forced at
market clearing prices into investors’ portfolios. However, the amount of domestic and
foreign bonds held by private agents is determined by the respective authorities that issue
them. If the risk minimizing portfolio is not held then agents will demand a risk premium
compensation.
If all three of the above conditions are fulfilled, then the UIP condition will not hold due to the
existence of a risk premium which represents the compensation required by private agents for
accepting risk exposure above the minimum possible:
r −r ¿ =E ś+ RP
Where RP is the risk premium required on domestic bonds, which may be either positive or
negative.
Different Types Of Risk
The basis of investors’ portfolio decisions is choosing an optimum combination of expected rate of
return and risk, given their risk-return preferences. The definition of a risky asset is that its expected
real rate of return is uncertain. Typically risks fall into one of two main categories: ‘currency risks’
and ‘country risks’. Currency risks arise because domestic and foreign bonds are denominated in
, different currencies, while country risks arise because they are issued by countries with different
legal jurisdictions and different political regimes.
Currency Risks
Inflation risk. This type of risk occurs because the inflation rates in the domestic and foreign
economies are uncertain. If PPP were to hold continuously, the real rate of return on the
domestic bond is given by the nominal interest rate less the expected domestic inflation ( P é
). If PPP holds continuously and the expected domestic inflation rate rises, this reduces the
expected real rate of return on domestic bonds but does not increase the expected real rate
on foreign bonds because the currency will depreciate by the same amount as the expected
inflation rate. The risk of holding a domestic bond can therefore be represented as a positive
function of the variance in the domestic inflation rate. A greater variance raises the relative
riskiness of domestic as compared to foreign bond.
Exchange Risk. In Chapter 6 we saw there is an overwhelming evidence for rejecting the use
of PPP as a valid approximation of short run exchange rate determination. Fluctuations in the
exchange rate that cause deviations from PPP constitute a risk specific to foreign investments
which is called ‘exchange risk’. Theoretically, exchange rate fluctuations are an incorrect
measure of exchange risk. It is fluctuations of the exchange rate around PPP that constitute
exchange rate risk.
Country Risks
Exchange control risk. This is a type of country risk whereby investors face uncertain real
rates of return. The real rate of return on domestic and foreign bonds may be uncertain due
to the risk of the imposition of a tax on the interest element during the holding period. The
risk may be greater or less for domestic as compared to foreign bonds.
Default risk. Default risk is a country risk whereby a government refuses to pay the interest
and sometimes the principal on bonds issued by them and denominated in a foreign
currency. Note that the bonds need to be denominated in foreign currency because a
government will not default on bonds issued in its own currency since, in that case, it could
always print the money to redeem the bonds.
Political risk. This risk covers an extremely broad range of scenarios, but basically refers to
the danger that investors face because the political environment in a country could cause
them to lose part or all of their investment, including returns due, or to find costly
restrictions imposed on how they may manipulate their investments.
(For 8.4-8.15 look at the slides, because this part of the book is not compulsory.)
Chapter 10: Fixed, Floating And Managed Exchange Rates.
The Case For Fixed Exchange Rates
Fixed exchange rates promote international trade and investment
The proponents of fixed exchange rates argue that fixed parities provide the best environment for
the conduct of international trade and investment. It is argued that, just as a single currency is the
best means of promoting economic activity at the national level, fixed exchange rates are the best
means of promoting international trade and investment at the international level. Exchange rate
fluctuations cause additional uncertainty and risk in international economic transactions and inhibit
the growth and development of such transactions.
Fixed exchange rates provide discipline for macroeconomic policies
An argument frequently put forward in favour of fixed exchange rates is that the commitment to a
fixed exchange rate regime provides a degree of discipline t domestic macroeconomic policy that is
absent if exchange rates are allowed to float. If the authorities are in a fixed rate regime, the pursuit
of reckless macroeconomic policies (such as excessive monetary growth) will lead to pressure for a
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