International Financial Management 3

Cost of Dec calls = 1,000,000 * USD .05 = USD 50,000. (Cost of Dec call is a sunk cost.) Number of contracts = GBP 1,000,000/ GBP 10,000 = 100 contracts. There are 3 situations at exercise (third Wednesday of December): 1) St=Dec < X (call is out-of-the-money, OTM) Suppose that on Dec, SDec =1.30 USD/GBP, option is not exercised.  If the U.S. investor decides to buy the UK bonds, she will pay USD 1.30M. 2) St=Dec = X (call is at-the-money, ATM) Suppose that on Dec, SDec =1.60 USD/GBP, option is not exercised (technically, indifferent).  If the U.S. investor decides to buy the UK bonds, she will pay USD 1.60M. 3) St=Dec > X (call is in-the-money, ITM) Suppose that on Dec SDec =1.80 USD/GBP, option is exercised.  If the U.S. investor decides to buy the UK bonds, she will pay USD 1.60M. Figure 5.4: CFs under an FX Call Net CFs Payed in Dec Call USD 1.65M X=1.60 St=Dec (USD/GBP) As shown in Figure 5.4, the maximum Net Amount to Pay is (USD 1.60M+USD .5M) = USD 1.65M. Note: The U.S. investor has established a cap: Maximum net amount she may pay is USD 1.65M. ¶ Example: Situation 2 - IBM will receive a EUR 5M payment in 90 days from a French customer. Date: September 15, 2016 (90 days from today). Underlying Position = Short EUR 5,000,000. Hedging Position = EUR Sep put options: X =1.34 USD/EUR (Premium= USD 0.0217 per EUR) St = 1.3554 USD/EUR. Number of contracts = EUR 5M/EUR 10,000 = 500 contracts. Cost of Sep puts = 5M * USD .0217 = USD 108,500. Minimum amount received = EUR 5M * 1.34 USD/EUR = USD 6.70M (Net = USD 6.6915M) If St=Sep < 1.34 USD/EUR, put is ITM:  IBM will exercise the put option. IBM will receive USD 6.70M If St=Sep > 1.34 USD/EUR, put is OTM:  IBM will not exercise the put option. IBM will receive more than USD 6.70M. IFM-LN.32 Figure 5.5 shows the net cash flows for IBM in 90 days. Figure 5.5: CFs under an FX Put Net CFs Received in Sep Put USD 6.6915M X=1.34 St+90 (USD/EUR) Minimum Net Amount to Receive: USD 6.70M - USD .1085M = USD 6.5915M. Note: IBM has established a floor: Minimum amount IBM will receive is USD 6.70M. ¶  Hedging Strategies Hedging strategies with options can be more sophisticated:  Investors can play with several exercise prices with options only. Example: Hedgers can choose different options for the same maturity: - Out-of-the-money (OTM, least expensive) - At-the-money (ATM, expensive) - In-the-money options (ITM, most expensive). ¶  Same trade-off of car insurance: High deductible/high floor (cheap) Low deductible/low floor (expensive) Example: It is June 15, 2014. UP = Long bond position EUR 1,000,000. HP = EUR Dec put options: X =134 and X=136. St = 1.3554 USD/EUR. (A) OTM Sep 134 put. Total cost = USD .0170 * 1,000,000 = USD 17,000 Floor = 1.34 USD/EUR * EUR 1,000,000 = USD 1,340,000. (B) OTM Sep 136 put. Total cost = USD .0283 * 1,000,000 = USD 28,300 Floor = 1.36 USD/EUR * EUR 1,000,000 = USD 1,360,000 IFM-LN.33 Typical trade-off: A higher minimum (floor) amount for the UP (USD 1,360,000) is achieved by paying a higher premium (USD 28,300). ¶ IFM-LN.34 CHAPTER 5 – BRIEF ASSESMENT 1. Walmart has to pay in 180 days GBP 5M to a U.K. supplier. Walmart is offered a forward contract at 1.40 USD/GBP. Draw a graph showing the GBP cash flow (in USD) in 180 days relative to St+180. Does Walmart face uncertainty regarding the amount to pay (in USD) in 180 days? 2. Fifi Bank sold a call option on GBP for USD .03 per unit. The strike price was 1.45 USD/GBP, and the spot rate at the time the option was exercised was 1.40 USD/GBP. Using the following table, fill in the net profit (or loss) per unit to Fifi Bank, based on the listed possible spot rates of the GBP on the expiration date. Possible St (USD/GBP) on Expiration Date 1.31 1.36 1.39 1.42 1.45 1.49 Net Profit (Loss) per Unit if St Occurs What is the maximum net profit and the maximum net loss per unit? 3. It is September 2017. Pez Inc., a Houston-based fishing company, has a GBP 20 million payable due in November 2017. Pez decides to use options to reduce FX risk. Available options with November maturity are: X Calls Puts 1.38 USD/CAD 3.77 0.65 1.42 USD/CAD 1.08 2.88 1.45 USD/CAD 0.16 5.40, where X represents the strike price and premiums are expressed in USD cents –i.e., 1.08 equals to USD 0.0108. The exchange rate is 1.40 USD/GBP. Calculate the premium cost and use a graph to describe the net cash flows, including premium paid, (in USD) in December 2017 for Pez Oil under the following choices: i) in-the-money option ii) out-of-the money option 4. Using an example, explain how a U.K. company with BRL receivables can establish a floor (in GBP). 5. Using an example, explain how a U.K. company with BRL payables can establish a cap (in GBP). IFM-LN.35 Chapter 6 - Government Influence on FX Rates In this chapter we cover the different FX systems that are adopted by different central banks (CT) around the world. • FX Rate Systems There are two pure FX Rate Systems: Flexible exchange rate (free float) system Fixed exchange rate system One way to characterize these two systems is to look at the role of the Central Bank (CB) –i.e., the institution in charge of the domestic currency, domestic money supply and domestic interest rates. • CB: Brief Review A CB is a "bank." It holds: ⋄ Assets: Foreign (international reserves of FC (mainly in FC bonds) + Gold + Domestic (mainly loans to domestic institutions and government securities) ⋄ Liabilities: DC outstanding (backed by assets the CB owns) + Deposits of banks. Note: Change in assets = Change in liabilities. That is, a purchase of an asset, say FC (or the unusual assets bought by CBs during the 07-08 financial crisis), results in an increase in the liabilities, through an increase in the domestic money supply (MS). Originally, central banks were created as lenders of last resort (“bank of banks”) and as supervisor of banks. This is the banking aspect of a central bank. But, today, central bank have other responsibilities: keep an eye on inflation (low) and the economy (full employment). This is the policy side of a modern central bank. Many times, both targets are conflicting targets (say, higher St promotes exports & economic growth, but increases Id). Around the world, CBs have different names: U.S. Federal Reserve System (“The Fed”), European Central Bank (ECB), Central Bank of UAE, Central Reserve Bank of Peru, Bank of Mexico, Swiss National Bank, Monetary Authority of Singapore, etc. 6.1. Flexible Exchange Rate System (free float) In a flexible FX rate system the CB allows St to adjust to equate the supply and demand for foreign currency, as shown below in Figure 6.1: IFM-LN.36 Figure 6.1: Free Float - CB allows Supply and Demand to determine St St (USD/GBP) Supply of GBP StE = USD 1.40 Demand for GBP Quantity of GBP All the variables mentioned in Chapter 4 will affect St. In particular, international capital inflows (outflows) will decrease (increase) St. Whatever St is, the CB is fine with it. • Features of a Flexible FX System ⋄ St reflects economic activity, through S & D for FC. ⋄ The exchange rate is subject to volatility. ⋄ Money supply is exogenous  The CB can have an independent monetary policy. ⋄ Under certain assumptions (IS-LM model, perfect capital mobility) fiscal policy does not work. ⋄ External shocks (say, oil shocks or sudden outflows of capital) can be quickly absorbed by changes in StE  Quick(er) adjustments to shocks/disequilibrium. With respect to the last point, Milton Friedman, Nobel Prize Winner, (1953) argued that under flexible exchange rates “changes in St occur rapidly, automatically, and continuously and so tend to produce corrective movements before tensions can accumulate and a crisis develop.” • Brief Aside: The Mundell-Fleming Model = IS-LM + Perfect Capital Mobility Open macroeconomic model combining: (1) Aggregate demand (IS and LM curves, representing equilibrium in goods and money markets) (2) Aggregate supply (production function and labor market) (3) BOP (=CA + KA) The assumptions behind the Mundell-Fleming Model: - Exchange rate regime: Flexible (Fixed, in the next section) - Perfect capital mobility. - Under utilized resources & no supply constraints –i.e., Keynesian world - The Marshall-Lerner condition is satisfied –i.e., St ↑ (↓)  CA ↑ (↓) - The price level, Pd, is fixed (in particular, no FX rate pass-through) - No currency substitution (say, dollarization). - Exchange rate expectations are static and/or there is no risk premium. - Pf, Yf, & if are given –i.e., not influenced at all by domestic changes. Mundell-Fleming Model in a Free Float Economy IFM-LN.37 Monetary Policy: Increase in the Money Supply (MS↑)  LM (curve) ↓ Fiscal Policy: More government spending (G ↑)  IS (curve) ↑ . Figure 6.2 shows the typical equilibrium IS-LM curves + BB (BOP equilibrium, id = if): Figure 6.2: Equilibrium under Mundell-Fleming model - IS-LM + BB i d LM (Money Market equilibrium) BB (BOP equilibrium) i f IS (Goods Market equilibrium) Y d • Why does monetary policy work (more government spending, MS ↑)? MS ↑  LM ↓  id ↓  Foreign Capital outflows  St ↑  CA ↑ (IS ↑)  Yd ↑ • Why doesn’t fiscal policy work (more government spending, G ↑)? G↑  IS ↑  id ↑  Foreign Capital inflows  St ↓  CA ↓  IS ↓ (back to original position) 6.2. Fixed Exchange Rate System In a fixed FX rate system the CB is ready to buy and sell unlimited amounts of foreign currency at a fixed price, say S*= 3 DC/FC. Sometimes, the CB pegs the value of the DC to a basket of currencies, say S*= 1.273 DC/FCBasket, where FCBasket is the price of a basket of exchange rates, usually trade-weighted. Example: Hong Kong has a fixed exchange rate (a peg) system since October 17, 1983. The exchange rate is 7.8052 HKD/USD. Note: The HKD is not fixed against all currencies, only against the USD. When the USD moves, the HKD moves. From 2010 to 2015, the USD moved widely against the EUR, taking the HKD for a ride, going from 11.50 HKD/EUR (April 24, 2011) to 9.15 HKD/EUR (January 8, 2015). ¶ In order to support the fixed parity S*, a CB needs enough FC reserves to make the system viable. At least, a CB needs to have enough reserves to purchase the total currency circulating in the public plus required bank’s reserves at the CB i.e., high-powered monetary base at the fixed exchange rate, S*. When a CB holds this amount, it holds 100% FC reserves. Having enough reserves may be a problem for CBs. A CB credibility plays a big role. If there is not enough FC reserves and the demand for FC cannot be met, the CB has a problem: A currency crisis. IFM-LN.38 A solution to the potential lack of FC reserves is to keep 100% reserves outside the reach of a CB/government. This arrangement is called Currency Board. Small Caribbean countries (Grenada, Saint Lucia, Dominica, etc.) have a fixed exchange rate system (pegged to the USD) with a currency board. Every time somebody buys FC from the CB, the domestic money supply decreases. Every time somebody sells FC to the CB, the domestic money supply increases. Thus, the domestic money supply is endogenous. Thus, international capital flows will affect the domestic money supply. A CB gives up the control of the MS under a fixed system. Example: International capital inflows For most of the past 30 years, China has maintained a fixed FX rate system and received vast amounts of capital inflows. Under this situation, the People’s Bank of China (PBOC, China’s CB) exchanges yuans (CNY) for FC, say USD. Exhibit 6.1 displays the currency exchange between the PBOC and foreign investors in China: Exhibit 6.1: Effect of Capital Inflows under a Fixed FX System Capital Inflows PBOC (China’s CB) CNY Foreign Investors USD That is, international capital inflows increase not only the PBOC’s international reserves of FC, but also China’s money supply. Note: The PBOC may not like this increase in the money supply (along with lower interest rates and inflationary pressures) and may take some counteraction to nullify or mitigate the increase in China’s money supply. A CB counteraction is called sterilization. For example, the PBOC can increase the bank’s reserve-requirement ratio. ¶ • Terminology: Devaluation/Revaluation A devaluation (revaluation) occurs when the price of FC under a fixed FX rate regime is increased (decreased) by the CB. (Remember: depreciation/appreciation occurs in a flexible FX rate system.) Example: During the previous decade, China's yuan (CNY) was fixed at 8.27 per USD. On July 21, 2005, it was revalued to 8.11 CNY/USD, following the removal of the peg to the USD. ¶ Note: In a Fixed FX rate system, the possibility of a currency crisis creates risk: devaluation risk. The magnitude of this risk depends on the CB credibility –i.e., very credible CB, devaluation risk is near zero. • Fixed FX System: Variations Some CBs have a fixed exchange rate system, but St is not really fixed: IFM-LN.39 - “Target zone system,” where the exchange rate is kept within a band (the target zone). - “Crawling peg system,” where the fixed exchange rate is regularly adjusted, usually to keep up with domestic inflation. Example: On July 21, 2005, the People's Bank of China (China’s CB) announced that the CNY would be pegged to a basket of foreign currencies, rather than being only tied to the USD. The CNY would trade within a narrow 0.3% band against the basket of currencies. The basket is dominated by the USD, EUR, JPY and KOW. The Central Bank of Chile, in 1983 (adjusted in 1984), adopted a crawling peg with a fluctuation band of ±0.5. The CLP/USD was adjusted according to the previous month’s inflation minus an estimate of U.S. inflation (around 2% annually). ¶ • Black Market In some countries, the exchange rate is fixed by the government, say at S*. But, it is not a fixed exchange rate system. The government sells FC at the official rate only for some transactions, for example, “favored” imports. For all non-official transactions, a free market -or in some cases, a black market- is created. Obviously, S* is set below the equilibrium StE. Example: In 2013, Argentina had three loosely recognized exchange rates. The official (“white”) rate was 6.205 ARS/USD; the tourist rate (official + 35% tax) 9.377 ARS/USD and the black market rate (“blue”) was 9.62 ARS/USD. If Argentina were to have a true fixed exchange rate system, an equilibrium exchange rate can be easily found: Monetary Base (in ARS)/CB Reserves (in USD). For 2013, Sfixed=2013 (fixed equilibrium) = ARS 342,132/USD 31,100 = 11.001 ARS/USD. ¶ • Features of a Fixed FX Rate System ⋄ Money supply is endogenous (a CB does not have an independent monetary policy!). ⋄ Exchange rate has no/low volatility; actually, St inherits the volatility of the FC the CB fixes the DC against. (No or low volatility: Good for trade, investments and inflation control.) ⋄ Under certain assumptions (IS-LM model, perfect capital mobility), fiscal policy works. ⋄ If a CB does not have enough reserves, credibility is crucial. ⋄ Since St is fixed, external shocks have to be absorbed through prices (including wages). Note: The last point tends to be the Achilles heel of the fixed FX rate system. Since prices tend to be rigid (especially, wages), adjustments to shocks and/or imbalances tend to be slower, and, usually, have contractionary effects. • Mundell-Fleming Model in a Fixed FX Rate Economy Why dose fiscal policy work (more government spending, G ↑)? G↑  IS ↑  id ↑  Foreign Capital inflows  MS ↑  LM ↓ expansion of MS amplifies effect on Yd (fiscal + monetary effects!) IFM-LN.40 • Trilemma (due to Robert Mundell (1962), Nobel Prize Winner) It is impossible for a country to have at the same time: ⋄ A stable (fixed) FX regime. ⋄ Free international capital mobility -i.e., no capital controls. ⋄ An independent monetary policy. A country that attempts to have these three policies at the same time is said to have an inconsistent fixed exchange rate system. Only two of the three are possible, as illustrated in Figure 6.2. This policy trilemma is also called “the impossible trinity.” Figure 6.2: The Impossible Trinity Typical Trilemma problems Situation 1: Under a fixed exchange rate regime, the local government substantially increases the domestic money supply (MSd) to finance deficit spending or to mitigate an external shock: Higher MSd  id ↓  (id - if) ↓  Capital will leave the country (international capital outflows)  CB’s FC reserves ↓. In a free float, St ↑ (>S*). Situation 2: Under a fixed exchange rate regime, international interest rates increase (say, iUSD ↑), but, the CB, to avoid its negative effect on GDP, does not match this increase (and, thus, attempts an independent monetary policy!): International interest rates increase  if ↑  (id - if) ↓  International capital outflows  CB’s FC reserves ↓. In both situations, in a free float, St ↑ (>S*). But, the exchange rate is fixed at S*: Now, in DC terms things are undervalued relative to rest of the world. Note: If we think of the free float St as the “true equilibrium” (or “shadow”) exchange rate, the divergence between St and the fixed S* signals a potential profit opportunity for speculators. • Currency crisis When faced with an increasing gap between the shadow St and S*, speculators realize that if the CB abandons the fixed FX rate system, a sizable profit can be made from buying FC at S* (usually, by borrowing DC to buy FC). Q: Why would a CB stop supporting S*? Because it is running out of FC reserves. Then, when a CB does not have enough reserves and/or loses credibility, speculators (and everybody else!) run to exchange DC for FC at the fixed exchange rate, S*. This is called a “currency run” or “speculative attack.” Unless some measures are taken to stop the run, the CB soon runs out of FC (currency crisis). IFM-LN.41 Usual solution: In general, domestic residents and governments do not like devaluations of the DC, since it increases inflation, decreases real wages, and has contractionary effects on the real economy. Governments often try to make it difficult to buy FC, imposing a set of restrictions on FC transactions. Typical measures: import bans, new capital outflows regulations and travel restrictions. These measures are, at best, temporary solutions. They create a black market, with an increasing gap between the shadow St and S*. Definite solution to a currency crisis: Float the currency. Example of the “usual” solution: In January 2016, the Nigerian President, Muhammadu Buhari, rejected a devaluation of the naira (NGN). During the previous months, the Central Bank of Nigeria (CBN) restricted the supply of USD, banned the import of a long list of goods, from shovels and rice to toothpicks. In January 2016, the official exchange rate was 199 NGN/USD, while the black market rate was around 300 NGN/USD. Finally, in June 2016, the CBN decided to float the currency, which quickly depreciated to 285 NGN/USD. ¶ Currency crises are not uncommon. Laeven and Valencia (2012) report 218 currency crisis during the period 1970-2011. They are often related to an “inconsistent” fixed exchange rate system. In these cases, the credibility of a CB monetary policy weakens and the likelihood of a speculative attack increases. Understanding what may trigger a currency crisis can be very profitable! Predictors of a currency crisis (“early warning signals”): Low FC reserves, low real exchange rate (DC overvalued, often due to high domestic inflation), high government deficits, weak financial system, high short-term debt, asset/real estate bubbles financed by easy credit, etc. Examples of currency crises: India ’91, U.K. ’92 (Black Wednesday), Mexico ‘94 (Tequila crisis), Thailand/Malaysia ‘97 (Rice crisis), Russia ‘98 (vodka crisis), Argentina ‘01 (Tango crisis), Iceland ’08, Nigeria ‘16. Exhibit 6.2 shows the MXN/USD before and after the Tequila crisis (mid-Dec ’94). Exhibit 6.2: USD/MXN and the Tequila Crisis IFM-LN.42 Run on the FX Market: Tequila Crisis MXN/USD 8 7 6 5 4 4/4/1995 3/4/1995 2/4/1995 1/4/1995 12/4/1994 11/4/1994 10/4/1994 9/4/1994 8/4/1994 3 Mexican USD reserves went from USD 18 billion in October 1994 to USD 5 billion in December 1994, when the decision to abandon the fixed exchange rate against the USD was made. Overall, Mexico spent USD 25B in FC reserves and borrowed USD 25B (from the U.S. Fed) to defend the peso’s USD peg. ¶ On average, a currency crisis is followed by a 30% drop of the value of DC. In many cases there is a temporary higher drop (say, 50%), before reverting to a value closer to the average. When a crisis is very serious, a 75% or higher drop is possible (Indonesia ‘97, Argentina ’01). • Twin Ds In general, a currency crisis is a product of serious macro-economic problems. These macro-economic problems often lead to liquidity problems for the government and, in these situations, sovereign defaults –a government decides not to pay its debt, usually bond debt- are not rare. Sovereign defaults may also trigger a large devaluations. These are the “Twin Ds”: Default and Devaluation. Reinhart (2002) reports that over the period 1970-1999 the probability of a devaluation, once a country had a default event, is 84%; while without a default even the probability of a devaluation is only 17%. A default is usually followed by a large devaluation: in a 6-year window around a default event, the change in value of the domestic currency is 45% compared to no default events. Using more data, Na, Schmitt-Grohe, Uribe and Yue (2017) estimate the probability of devaluation conditioned on a default event is lower: 48%. Na et al. (2017) suggest that large devaluations around default events are needed to realign real wages to avoid widespread unemployment. In their simulations, if a country does not devalue its currency unemployment increases by 20%. • Fixed FX Rate Regime in Emerging Markets: Importing good behavior A fixed FX rate is considered transparent and a simple anchor for monetary policy. Countries with weak institutions, usually less developed/emerging markets, can “import” monetary credibility by anchoring to a currency with a credible central bank, say the Fed or the ECB. IFM-LN.43 Another advantage for emerging markets: A fixed FX regime tends to reduce transaction costs and FX risk. In countries with less developed financial sectors, economic agents may not have the financial tools to hedge long-term currency risks. A fixed FX regime will help in this regard. • Fixed or Floating? Both regimes have pros and cons. There is no clear winner. Regime choices should reflect the individual characteristics of an economy. However, we do observe that large economies with sound monetary and fiscal policies and good institutions (say, an independent CB) prefer a flexible FX rate regime. This is fine: a flexible FX rate regime tends to insulate better a country from external shocks and/or imbalances. On the other hand, we also observe that small or less developed countries with a history of poor institutions and/or credibility problems have relied on fixed FX rate regimes to fix problems. Some of these countries have had consistent monetary policies since the adoption of the fixed FX rate, and the fixed FX rate regime has served them well. For this reason, they have been reluctant to change the FX rate regime. As Timothy Adams, Treasury Under Secretary for International Affairs, said in 2006, regarding the choice of FX rate regime: “In particular, there is no substitute for sound fiscal and monetary policies and resilient institutions.” The International Monetary Funds classifies the different currency arrangements of its members. In 2017, the IMF classified 54% of currencies as “anchored” (fixed FX rate), another 20% as “stabilized” (with an anchor, but allowed to vary in some way), and 26% as “floating” (occasional CB Intervention, see below, is acceptable). 6.3. Mixed FX System In practice, the exchange rate system in many countries is a mixture: managed floating (also called, dirty floating): A CB allows the FX Market to determine St. But, from time to time, the CB takes some actions with the intention to influence St. These actions are called Central Bank intervention in the FX Market. For example, the central bank buys or sells foreign currency to change St. This is the usual FX rate system in developed countries. • Central Bank Intervention CBs have economic models to determine what they believe is an equilibrium St. Using these models, a CB determines a range for St (a trading band)  St should move between St,L and St,U. If St is within the range (St,L < St < St,U), CB does nothing (free float system!) If St is above St,U (St>St,U), CB determines FC is overvalued (or “too” expensive)  CB intervention If St is under St,L (St< St.L), CB determines FC is undervalued (or “too” cheap)  CB intervention Summary: CB Intervention IFM-LN.44 “Appreciating” FC (St>St,U)  CB sells FC. “Depreciating” FC (St< St,L)  CB buys FC. Example: The Fed (U.S. CB) considers the CHF overvalued or St > St,U.  The Fed intervenes in the FX market to stop the appreciation of the CHF against the USD, as shown below in Figure 6.3: Figure 6.3: Central Bank Intervention in the FX Market FX Market St (USD/CHF) S0 S1 Fed Sells CHF St = .80 SU = .78 St = .77 D0 Quantity of CHF The Fed determined SU=.78 USD/CHF. Now, demand for CHF has increased –suppose Swiss interest rates are up. New St = .80 USD/CHF. The Fed determines the St = .80 USD/CHF is too high (CHF too expensive) since St>St,U. Fed FX intervention  Sell CHF Exhibit 6.3: CB Intervention in the FX Market – Effect on Money Supply FX Int Fed Reserve CHF Banks USD As shown in Exhibit 6.4, the Fed’s FC reserves (CHF) and the U.S. Money supply are decreased. Note: The arrows above are a simplification of three transactions. Technically speaking, the Fed sells Swiss government securities (in CHF) to a Swiss commercial bank, which pays the Fed through a deposit in a U.S. commercial bank. Then, the Fed debits the reserves of the U.S. commercial bank. ¶ In general, CB FX intervention is justified by arguing that the CB has better information (CB knows the true model for St) to determine StE –i.e., the equilibrium value for St. If this is not the case, the CB may be setting a “wrong rate,” which can have side effects. • CB FX Intervention Issues: IFM-LN.45 1. Implicit notion of "overvaluation/undervaluation" in FX market. The wrong rate problem.  Q: Do CB have "superior" information –i.e., do they know better than the FX Mkt? A: Not clear consensus in the academic literature: Sometimes CBs lose millions, sometimes CBs make millions. However, there is some evidence that shows that CB purchases of FC tend to be associated with subsequent FC appreciation. This evidence is taken to support the leaning-against-the wind behavior by CBs. 2. CB can generate FX instability:  Uncertainty over CB actions increases FX volatility and risk (what a CB dislikes!) Academic studies tend to find that CB intervention does increase FX volatility. 3. Potential conflict with other countries:  When a CB intervenes in the FX market to depreciate the DC to boost domestic exports, trading partners will be affected. This type of FX intervention is called beggar-theyneighbor devaluation. Popular in the 1930s. Despite these issues and the academic sentiment that FX intervention is not worth it, central banks do intervene in FX markets. In a 1999 BIS survey of CBs, the percentage of business days on which CB report intervening from 0.5% to 40% percent, with a 4.5% median. The largest player by far is Japan. For example, between April 1991 and December 2000, the Bank of Japan bought USD on 168 occasions for a cumulative amount of USD 304 billion and sold USD on 33 occasions for a cumulative amount of USD 38 billion. Japanese interventions dwarf all other countries' official intervention in the foreign exchange market; for example, it exceeds U.S. intervention over the same period by a factor of more than 30. • CB Intervention: Details According to a 1999 BIS survey, CB interventions transactions almost always (95%) are conducted at least partially in spot markets. Some CBs also use the forward market, perhaps in conjunction with the spot market to create a swap transaction. During FX intervention, CBs tend to deal with major domestic and, less often, foreign banks. Some countries have large FX reserves, which can be used to influence the value of exchange rates. For example, by the end of 2014, China and Japan had the largest FX reserves in the world, USD 3.9 trillion and USD 1.2 trillion, respectively. Saudi Arabia was in third place with USD 0.74 trillion (& the U.S. was in 13th place with USD 0.13 trillion.) But, large FX reserves are not necessary in many markets. In emerging markets, CBs have a huge potential “firepower,” since the ratio of official reserves to average daily turnover is very high. On average, official reserves were 15 times the size of daily turnover in emerging market currencies, compared with less than half in smaller industrial countries. When a CB has firepower, sometimes just a rumor or the verbal threat of CB FX intervention can bring the FX market in line with the CB’s desired valuation. This type of verbal intervention is referred as jawboning. It is cheap and, sometimes, effective. IFM-LN.46