College aantekeningen
Notes lectures IFM
- Instelling
- Vrije Universiteit Amsterdam (VU)
Obtained a 9 for my exam with these notes. Very detailed explanation of the lectures.
[Meer zien]Voorbeeld 4 van de 33 pagina's
Voorbeeld 4 van de 33 pagina's
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Lecture 1Exchange rates fluctuate based on different and changing fundamentals as interest rates,
economic/ political conditions, productivity & demand shocks and default risks. If interest
rates are different that affects exchange rates.
= Relative price between different moneys, determined by supply & demand.
With pegged currencies, the government interferes. A currency peg is a policy in which a
national government sets a specific fixed exchange rate for its currency with a
foreign currency or a basket of currencies. Pegging a currency stabilizes the exchange
rate between countries. Doing so provides long-term predictability of exchange rates for
business planning. Thus, less uncertainty, promote trade and boosts income. Goal is to
reduce foreign exchange risk and encourage trade.
Example 1:
Suppose there are two countries A and B. Currencies are determined by market supply and
demand which means the exchange rates are free floating. Now there is a war in country B,
how does this affect the exchange rates between A and B? B has very high risk so rate will
depreciate because demand for currency B will diminish.
What if A and B are interconnected, they trade goods and some firms from A produce in B.
How does this affect the value of both A and B? In this case both values will depreciate.
Overall GDP decreases because trade collapses and currency value will decrease because
both face high risk. You will hold gold because this is a safe asset.
EUR/USD means 1 USD is how many EUR.
The cost of FX spreads
- There is always a spread between buying and selling
- Market makers profit from spread: measure of liquidity
Example 2:
Less liquid currencies have large spreads, why? Illiquid refers to the state of a stock, bond, or
other assets that cannot easily and readily be sold or exchanged for cash without a
substantial loss in value. As a result, illiquid assets tend to have lower trading volume, wider
bid-ask spreads, and greater price volatility. Market makers have more difficulties selling
because currency is less liquid therefore, they incur more costs in selling it (time costs/ effort
costs). Illiquid markets have not so many market makers, when there a few market makers,
so not so competitive each of them has power and set prices high.
Market imperfections
Imperfections create barriers to international investments by firms:
- It may not be possible to move capital freely
- Transaction costs may be large
- Legal restrictions on investments (policies)
Can affect the choice of where to locate production or raise debt.
Advantages international investments:
1
, - Lower operating costs
- New market access
- Lower costs to raise capital (not always)
- Regulatory arbitrage
What are the consequences of international investments for firms?
- Risks: firms are subject to local laws and regulations.
- Legal differences: firms are subject to local laws and regulations. Investor protections
differ across countries. Scandals have led to stricter rules on firms.
Lecture 2
Currencies are based on different ideas through time:
- Bimetallism (gold & silver)
- Gold Standard
- Bretton Woods
- Floating Exchange Rates (Jamaica agreement: gold abandoned as reserve)
- European Monetary System
- Currency Board
Bimetallism
Gold & silver used as currency. The value was set by the weight of coins and a ratio between
gold and silver. When different ratios were used, this could lead to arbitrage conditions
where people could make money by exchanging gold and silver.
Example:
Legal ratio = 16:1
Market ratio = 15.5:1
➔ The relative price of gold was lower in the market
➔ Exchange 15.5 oz silver for 1 oz of gold in the market and then get 16 oz silver back
from the government.
Gresham’s Law: bad (abundant with excess supply) money drives out good (scarce) money.
When new gold got discovered, the supply becomes bigger, and it will become bad money.
➔ Seigniorage profits is the difference between face value and commodity value which
goes to the central banks.
The commodity value is the amount of gold or silver a coin is made of and this is called the
actual/ intrinsic value. So, when you reduce this amount in a coin, you are debasing and can
make more coins with the same amount of gold or silver. This will lead to inflation.
The gold standard
- Gold is the only metal used in unrestricted coinage.
- Two-way convertibility between gold and the national currency. Thus, under the gold
standard you did not need to carry your gold around with you. So, pounds
convertible in gold.
- Unrestricted movement of gold (import/export)
- The gold content of the currency determined exchange rates
2
, - Any misalignment will be corrected via gold
Example:
1 oz of gold = 12 francs
1 oz of gold = 6 pounds
➔ 1 pound = 2 francs
When 1 pound = 1.5 francs, there is an arbitrage opportunity where you buy the pound with
francs because that is cheaper. If you want to buy francs that is too expensive using the
market exchange rate, so you would convert pounds to gold and then move gold to
exchange the gold into francs at official exchange rates. This eliminates arbitrage.
Always buy the undervalued currency when there are arbitrage opportunities.
Interest rate differences: countries with low interest rates experienced large gold outflows.
This leads to price declines (in national currencies) and deflation.
Gold standard ended with WW1 because it was too expensive to maintain government
spending to support warfare.
Bretton Wood
- Stable exchange rates to prevent economic nationalism & hyperinflation
- Gold-exchange system: national currencies pegged against dollar, which could be
exchanged into gold for $35 per oz.
- Triffin Paradox: conflict in objectives between different countries monetary policy. It
is the dilemma between the role of the United States as a provider of international
reserves on the one hand and the obligation to convert the dollar into gold at a fixed
price on the other. Because US dollar became reserve currency which led to the US
exporting their currency when other countries required more reserves. This could
lead to collapse of US dollar value because there would be less gold to back-up
system over time, which made it difficult to maintain $x per oz of gold. Instead of
gold backing, SDR was created as a new reserve currency.
Special Drawing Rights (XDR) as new reserve currency
Bretton Wood: 1 XDR=1 USD
➔ How much is 4150 XDR in EUR?
➔ 1 XDR = 1.2668 EUR -> * 4150 XDR = 5299 EUR
European Monetary System/ Union
The European Monetary System (EMS) was an adjustable exchange rate arrangement set up
in 1979 to foster closer monetary policy co-operation between members of the European
Community. The European Monetary System (EMS) was an arrangement between European
countries to link their currencies. The goal was to stabilize inflation and stop large
3
, exchange rate fluctuations between these neighboring nations, making it easy for them
to trade goods with each other. Broke down because countries were not committed to it.
- Establish a zone of monetary stability
- Coordinate exchange rate policies
- Lead the way to a monetary union
- Keep price stability with low inflation
European Monetary Union: implementing an effective monetary policy for the euro area
with the objective of price stability (low inflation).
EMU
➔ Lower transaction costs
➔ Less uncertainty
➔ Improve political integration
➔ EU wide capital markets
➔ Give up national monetary policy
➔ Different countries have different needs at different points in time
Trilemma:
1. Fixed exchange rate
2. Free capital flows (no capital controls)
3. Independent monetary policy
➔ Country can only attain two of the three.
Shorting in pound:
➔ Borrow GBP, convert to other currency, earn interest and wait for the GBP to crash
and repay loan when it has crashed to make profits.
When a currency devaluates, people will sell this currency which leads to further
denomination of assets in that currency. This leads to a huge supply shock of that currency.
Happened in Mexican Peso Crisis where investors started selling pesos after devaluation and
peso denominated assets very quickly which led to huge supply shock and the government
could not maintain its peg.
Asian Currency Crisis happened because of the devaluation of the Baht. The economy was
dependent on loans made in foreign countries and with the devaluation of the Baht, their
debt became larger. This led to a run on the Baht. This spilled over to countries with the
same characteristics.
Selling reserves = buying local currencies.
Flexible exchange rates:
- Automatic adjustment due to economic conditions
- Autonomous national policies
- Hampers trade and international investments due to more uncertainty
Lecture 3 Balance of Payments
Balance of payments
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