Unique Source of Forex

Conclusions and Concerns (4)Main Concerns

Delay in bankruptcy proceedings and credit dispute resolution
Time taken for winding up proceedings is highest in the world
Improvement in effective enforcement of creditor rights required
Faster resolution of stressed assets of financial intermediaries
Regulation of financial conglomerates and holding companies
Role of SROs
Regulatory co-operation – particularly cross border
Management of capital account
Deficiency in retail payment systems

by Stock Specialist ~ Monday, September 28, 2009 0 comments

Conclusions and Concerns (3)Main Concerns

Financial Markets –
Risk of contagion
Development of an appropriate risk free yield curve
Corporate bond markets
Issues relating to derivatives – knowledge concentration and capacity building
Transparency –
Some issues in fiscal transparency; Need to strengthen data collection agencies

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Conclusions and Concerns (2)Main Concerns

Macro economy –
Fiscal Deficit
Agricultural Growth
Susceptibility to international commodity price movements
Institutions –
Emerging liquidity concerns
Corporate governance in co-operative sector
Health of rural co-operatives
Funding constraints for NBFCs
Lack of timely data to gauge household indebtedness
Stress Testing
Lack of database, techniques and capacity to conduct appropriate systemic stress tests taking into account sectoral interlinkages as also contagion risk

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Conclusions and Concerns (1)Summary of Assessment

Financial Sector – Has expanded; acquired greater depth and vibrancy
Macro economy – Short-term - Uncertainty; Medium-term - high growth sustainable
Banks – Healthy and Robust
Financial Markets – Resilient and fairly liquid
Financial Infrastructure – Robust
Transparency – Significant improvements

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CFSA and Advisory Panels – Some Differences

Regulatory Independence
Panel view : Issues regarding independence of SEBI and IRDA
CFSA view: Regulatory independence adequate
Review of Legislation
Panel view : Review of RBI Act needed
CFSA view : Requires to be viewed in a more comprehensive manner
Role of HLCCFM
Panel view : Further formalisation and institutionalisation
CFSA view: Not consistent with regulators’ autonomy
Prompt Corrective Action
Panel view : Appropriate time-frame required
CFSA view: Any rigidity in timeline unduly restrictive

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Accounting and Auditing

Ian Mackintosh
Exercise caution while developing country specific and sector specific accounting standards
Important to give functional independence to AASB
N.P. Sarda
Determining the role of the Quality Review Board to review and improve the quality of audit service is required

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Peer Reviewers’ Comments (3)

Bankruptcy Laws
Thomas Baxter
Indian insolvency regime remains an enigma
Special Insolvency regime for banks complement access to credit facilities of central bank and deposit insurance
Fiscal Transparency
Vito Tanzi
Better classification of expenditure central to fiscal policy
Relevant fiscal target should be GFD and not revenue deficit
Relatively few countries have made a transition to accrual based accounting

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Peer Reviewers’ Comments (2)

Assessment of BCP
Eric Rosengren
Urgent need to improve co-ordination between regulatory agencies
LoLR should have the ability to assess solvency and liquidity risks facing institutions
Report should elaborate on aspects relating to Central Government’s role in operation of PSBs – whether it interferes with the regulatory role of RBI
Corporate Governance and
Transparency in Monetary Policy
Sir Andrew Large
Higher corporate governance standards for the unlisted sector
Mechanism to enable central bank to be adequately informed to handle liquidity related events
Improvements in transparency would enhance central bank independence

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Financial Stability Assessment and Stress Testing

V. Sundararajan
Plausible shocks and vulnerabilities arising out of domestic macroeconomic and external sectors should be systemically linked to stress scenarios
Growing use of purchased funds need analysis of second round contagion effects
Andrew Sheng
Creation of secondary mortgage market
Setting up of Government sponsored secondary mortgage vehicles
On-site examination process should be supplemented by a forensic “follow the evolution of the product” approach.

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Transparency and Development Issues (4) Making Financial Inclusion Work

Rangarajan Committee on financial inclusion
Exploit synergies between local and national level financial institutions
Finance consumption and household expenditure
Scale-up IT initiatives
Biometric smart cards in rural areas
Development of mobile banking
Incentivise BCs
Urban poor
Dilute KYC norms

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Transparency and Development Issues (3) Assessment of Data Dissemination Standards

Major Gaps:
Need for proper legal and institutional support for CSO
IIP data - need to adjust basket of commodities and weights assigned
Multiple agencies in collection of labour data
WPI – outdated weights

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Transparency and Development Issues (2) Assessment of Fiscal Transparency

Significant improvement following FRBM Act and Fiscal Responsibility Legislations
Major Gaps/Issues:
Functional overlap by Central Government on issues relating to State Government like health and agriculture
Mode of calculating FD does not capture off-budget items separately –augmented FD required
Need for accrual-based accounting – guarded approach

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Transparency and Development Issues (1)Assessment of Transparency in Monetary and Financial Policies

Major Gaps/Issues:
Need for review of legislations- overhaul of legislations not required
Operational independence of RBI
Strengthening TACMP – requires ongoing review
Separation of debt management from monetary management – Chairman’s
dissent
Price index for measuring inflation – WPI/CPI debate

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Financial Infrastructure (7)Depositor Protection

Independence of Deposit Insurance and Credit Guarantee Corporation (DICGC) (recommended by Advisory Panel)
Increase flat-rate premium
Involvement of DICGC in resolution process- delink settlement of DICGC claims from liquidation process

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Financial Infrastructure (6)Assessment of Bankruptcy Law Principles

Major Gaps:
Implementation of bankruptcy laws – poor- average 10 years to complete liquidation proceedings – ‘Doing Business Report’- World Bank
Amendment to the Companies Act still pending – Setting up of NCLT
Issues relating to Competition Amendment Act, 2007
Lack of a Central Registry for recording security interests

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Financial Infrastructure (5)Business Continuity Management

Ease of operations during crises
Areas for strengthening
Human Resources management
Business continuity processes of vendors
Outsourcing risk
Succession planning

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Financial Infrastructure (4)Payment and Settlement

Payment & Settlement Act of 2007 fills a major gap

Sub-optimal utilisation of electronic payment infrastructure

Delays in collection of outstation cheques

Financial resources with CCIL need strengthening

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Financial Infrastructure (3)Accounting and Auditing

More autonomy for Accounting Standards Board

Need to develop sector-specific guidance

Issues in auditing about convergence with ISAs

Need to give functional independence to AASB

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Financial Infrastructure (2)Markets and Liquidity

Large capital movements
Volatility in overnight rates
Strengthen government cash management
Asset liability management of banks
Issues related to market integrity—participatory notes
Term liquidity facility not required at this stage

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Financial Infrastructure (1)Regulatory Infrastructure

Multiple roles of regulators
Consistent with financial development
Needs effective coordination
Principles vs. Rules-based: complementary
Develop supervision of financial conglomerates
Legislation, a new Act?
Develop Self -Regulatory Organisations?
Regulatory independence
Panels have raised some issues
But CFSA considered adequate

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Financial Markets (8) Compliance With IOSCO

Despite high compliance, some gaps remain
Equities Market: Responsibilities and operational independence of regulator; inspection and surveillance powers; capital and prudential requirements for market intermediaries
Foreign Exchange Market: Operational independence and accountability of regulator; co-operation and detection of manipulation and unfair trading practices
G-Sec markets: Operational independence and accountability of regulator; home-host co-operation; disclosure of financial results
Money markets: Operational independence; regulatory co-operation with foreign regulator

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Financial Markets (6)Other Market Segments

Need to develop corporate bond market

Develop credit risk transfer mechanism

But with appropriate checks and balances

Capacity building in financial institutions with

regard to securitisation and credit derivatives

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Financial Markets (5)Money Market

Liquid market
Increased share of repo and CBLO
Need for active interest rate futures market
Being re-introduced
Development of term money market
Development of short-end yield curve necessary
Under examination in TAC Group
Development of the repo market

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Financial Markets (4)Equity Market

Significant improvement in market and settlement infrastructure
Functions in robust regulatory environment
Very high compliance with IOSCO Principles
Risk management by market participants
Strengthening of inter-exchange surveillance
Need to improve IPO processes
Setting up of Central Integrated Platform

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Financial Markets (3)Sovereign Debt Market

Significant growth in volume and liquidity
Further diversification of investor base needed
Foreign investor participation: proceed with care
Increase in tradable assets desirable
Large proportion parked in HTM category

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Financial Markets (2)Foreign Exchange Market

Fastest growing market globally
Total annual turnover increased from USD 1.3 trillion
during 1997-98 to USD 12.3 trillion during 2007-08
Derivatives:
High growth in forward market
Forex futures introduced in 2008
Need for monitoring and regulation
Customer appropriateness and product suitability

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E. Financial Markets

Financial Markets (1)Regulation and Supervision

Systemic stability
Importance of markets other than equity market
IOSCO Principles extended to:
G-Sec markets; Forex Markets; Money Markets
Results: Generally satisfactory

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Financial Institutions (10)An Assessment of Insurance

Significant growth in size, penetration and diversified products
Comfortable solvency and capital adequacy
But gaps/issues remain
Increase supervisory powers of IRDA
Group-wide supervision – effective policy to be put in place
Risk Management
Further requirement of skilled professionals – actuaries, treasury managers

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Financial Institutions (9)An Assessment of Insurance

The level of compliance of the Insurance Sector to IAIS Core Principles

Assessment
Observed
Number of Principles - 5
Largely Observed
Number of Principles - 13
Partly Observed
Number of Principles - 10
Not Observed
Number of Principles - 10

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Financial Institutions (8)Non-Bank Financial Services

NBFCs are key players in financial markets
Corporate bond market development would ease funding constraints
Development of regulatory structure for financial conglomerates
Prudential regulations of NBFCs strengthened – some way to go
Housing finance: growing and important segment
National Housing Price Index, Housing Starts Index a priority
Regulation of HFCs should be entrusted to RBI – Government’s stance – status quo

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Financial Institutions (7) Risk Management and Governance

Conservative risk management matters
Counter-cyclical prudential measures by RBI
Off-balance sheet items: Better accounting, disclosure
Capital charge if reliance on purchased liquidity beyond a threshold

Consolidation
Encourage market-based consolidation

Co-operative and rural banks need better governance
Dual control: improve corporate governance
Regulation and supervision of rural financial sector: role for RBI and NABARD

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Financial Institutions (6) New Competition Act: Some Issues

Power of Competition Commission to regulate combination
Any combination required to be notified to Commission
Maximum period of wait 210 days
RBI may be able to give sanction only after getting order of Commission or wait for 210 days
Delays the process
Possibility of regulatory conflict as order of any statutory authority not binding on Commission
Could lead to regulatory overlap and conflict
Central Government could give necessary exemption under Section 54 of the Competition (Amendment) Act 2007

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Financial Institutions (5)Banking For The 21st Century

Capacity Building:
Training
Succession Planning
Lateral Recruitment
Improved remuneration – but discourage excessive risk taking
Corporate Governance:
Improve governance in PSBs
Roadmap for foreign banks –
A well-considered approach within the WTO norms

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Financial Institutions (4)Commercial Banks Oversight

Government ownership poses dilemmas
Possibility of conflicts of interest minimized through even-handed regulation
Newer instruments
Through selective dilution of government equity

Capital augmentation of PSBs is a challenge,
but could be managed through a variety of ways
Amalgamation where commercial synergies exist

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Financial Institutions (3)Basel Core Principles: A Compliance Summary

Major Gaps:
All Institutions: Risk management (for commercial banks the level of compliance is comparatively lower in respect of banking groups); home-host country regulation
Commercial Banks: Exposure to related parties; non-compliance in respect to interest rate risk in banking book for which guidelines have since been issued
Rural & Co-operative Banks: Dual Control; internal control; corporate governance
NBFCs: Major acquisitions, transfer of significant ownership, internal control
HFCs: Permissible activities; internal control

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Financial Institutions (1)Regulation and Supervision

Inherent linkages across institutions
Inter-bank
Bank and non-banks
Basel Core Principles not applicable to:
Co-operative Sector; Regional Rural Banks;
NBFCs; HFCs
But, Assessment done for health check
Results: Generally satisfactory

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Stability Assessment and Stress Testing (9)The Way Forward

In Sum:
Commercial Banking System – Broadly Sound
Can withstand significant shocks from large potential changes
Possible Next Steps:
Need to strengthen liquidity management
Stress Testing by individual banks
Periodic scenario testing by RBI
Setting up of a Financial Stability Unit

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Stability Assessment and Stress Testing (8)Liquidity Risk Management

Gradual, growing dependence on purchased liquidity

Increase in illiquid parts of banks’ balance sheets

Greater reliance on volatile liabilities for asset growth

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Stability Assessment and Stress Testing (6)Interest rate risk

Calculates the erosion in accounting capital due to unit
increase in interest rate

Higher the DoE (duration of equity), greater the sensitivity
of banks capital to interest rate shocks
The annualised yield volatility is estimated at 244 bps

Given a DoE of 8.1 years, a 244 bps shock implies
an erosion of 20 per cent of capital and reserves.

=> Better management of interest rate risk by
commercial banks over time

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Stability Assessment and Stress Testing (5)Credit Risk

Concerns about credit risk remain
muted at present

Need for close monitoring of such risks
in the current scenario

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Stability Assessment and Stress Testing (4) Stress Testing

What is Stress Testing
Techniques to assess vulnerability of the financial system in the face of shocks;
identifies how portfolios respond to changes in key economic variables: e.g., interest rates, credit quality
Coverage of stress tests
Credit risk
Market/interest rate risk
Liquidity risk
Open positions in foreign exchange much below regulatory limits – Exchange rate tests not undertaken

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C. Stability Assessment and Stress Testing

Stability Assessment and Stress Testing (1)
Main Findings

Financial Institutions
Commercial Banks: financially robust
NBFCs and HFCs: healthy financial indicators
Some financing concerns
UCBs and RRBs: improvements in financials
governance concerns
Rural Co-operative Sector
significant weaknesses

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Macroeconomic Outlook and Vulnerabilities (2)Pressing Challenges

Need for revival of growth in agriculture
Address restoration of the fiscal reform path
Continuation of financial sector consolidation and development
Address the infrastructure deficit
Complement bank financing with bond market development
Insurance and pension reforms
FCAC desirable, but with concomitant macroeconomic and market developments

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Macroeconomic Outlook and Vulnerabilities

Macroeconomic Outlook and Vulnerabilities (1)
The Growth Story

Growth in recent period contributed by several factors

High domestic demand

Productivity

Credit growth

High levels of savings and investment

Current global financial crisis: shift from
benign outlook to one of uncertainty
8 %+ growth sustainable in the medium-term due to
high demand; deceleration in the short-term

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Background and Timing (3)The Process

Benefits
Composition of CFSA: ownership and commitment
Regulatory cooperation: GoI, RBI, SEBI, IRDA, other agencies
Involvement of experts: advisory panels
Peer reviews: Impartiality
Learning and capacity-building: involvement of professionals
Execution
Complex issues – approach with humility
Broad directions instead of specifics in the current context
Focus on Transparent Reporting : Differing opinions of CFSA and
Panels covered in the report

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Background and Timing (2)Overview of Self-Assessment

Approach and Methodology

Pillar I Macro-prudential surveillance and financial stability analysis

Pillar II Legal and institutional frameworks review

Pillar III International financial standards and codes:
assessment and status of implementation

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The FSAP and Self-Assessment

A. Background and Timing

Background and Timing (1)
The Story So Far

IMF-WB FSAP in 2001, self-assessment of international
standards and codes in 2002, reviewed again in 2005

Set up CFSA in 2006

India among the first country to undertake
comprehensive and holistic self-assessment
of financial sector

Post-crisis, emphasis by the G-20

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FSAP

Part I: The FSAP and Self-Assessment

A. Background and Timing

B. Macroeconomic Outlook and Vulnerabilities

C. Stability Assessment & Stress Testing

Part II: Lessons and Issues from the Assessment

D-F. Financial Institutions, Markets and Infrastructure

G. Transparency and Developmental Issues

Part III: Transparent Reporting

H. Peer Reviewers’ Comments

I. CFSA and Advisory Panels – Some Differences

Part IV: Conclusions and Concerns

J. Summary of Assessment

K. Main Concerns

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Financial Sector Assessment

What is an FSAP?

The Financial Sector Assessment Program
is an IMF-World Bank initiative

A comprehensive health check of the
financial system

A review of strengths, vulnerabilities and
weaknesses

Measures compliance with international financial
standards and codes

Initiated after the1997 Asian financial crisis

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‘Structural sensitivity analysis’

Alter assumptions about market clearing

Alter assumptions about property rights

Alter assumptions about macroeconomic closure

e.g. Adjustment to equilibrium through domestic
tax system vs. adjustments through accommodating
international capital flows.

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Institutional issues

Trees may be cut (or planted) to establish
property rights over land.

In open access forests (non-commercial),
opportunity cost of forest is set by
ag. land values and clearing costs.

In commercial forestry, timber
harvesting/replanting also depends
on property rights.

Will an increase in timber prices promote
or retard tree-felling in aggregate?
Depends on property rights.

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Land degradation

Hard to measure, and problems of aggregation.

Can use information on erosion rates by crop,
together with land use data, to build ‘baseline’
data set.

Then erosion changes can be inferred from changes in land use

Production externalities: technical ‘regress’.

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Deforestation & land degradation

Commercial and non-comm’l deforestation:
does timber have market value?

Non-comm’l deforestation is driven by search
for land, and responds to changes in the marginal
valuation of land in agricultural production...

… although institutional setting also matters

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Environmental analysis in GE

Most AGE models constructed for more
general analytical purposes: environmental
structure is added later

Given uncertainty about env. variables
and valuations this may be appropriate!

Industrial emissions: ‘side calculations’

Natural resource degradation

Questions about institutions.

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Open access to natural capital

Addressing env. damages and natural resource depletion

Pigovian taxes (Bovenberg & Goulder, AER 1996)

Private purchase of abatement services

Public provision of abatement or clean-up services

Quotas or limits on resource use or
emissions (command & control)

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Schematic social accounts - Social accounting matrix

Schematic social accounts

Social accounting matrix

‘Standard’ national accounts ignore environment

Assumptions:

Property rights on resources

No externalities

No non-marketed amenity values

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Data

Social accounting matrix: base year data

Input-output accounts of industries

Factor markets, household incomes & expenditures

Trade and final demand

Taxes and G. expenditures

Micro and macro balance

Elasticities

Estimated (see www.aae.wisc.edu/coxhead/apex ),
or more commonly ‘guesstimated’.

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Features of Johansen models

Parameter values are shares and elasticities
Quick checks:
Homogeneity & ‘balance’ of underlying data base.
Solution is by matrix inversion
Entire model is a system of linear equations
Examples of Johansen-style models:
ORANI (Australian economy)
GTAP (international agricultural trade)
Models in OEE, Ch.6–8

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Solving the model: the ‘Johansen’ AGE structure

First-order approximations to changes in variable values

Models solved in proportional (percentage) changes of variables, or ‘hat calculus’.

Advantages:

Models are linear in variables

Parameter values are intuitive and accessible (shares from SAM,
elasticities from other sources)

Simulation results are additive in separate shocks

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Other features

Can add in:

Intermediate inputs

Products distinguished by source (domestic, imported)

Different kinds of labor

Many sources of final demand

Trade and transport ‘margins’

Tariffs, taxes, and other policies … etc.

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Closure rules and decisions

Other closures are possible

‘Neoclassical’ closure has all domestic prices flexible

Alternatives: e.g. fix wages, allow unemployment in labor market.

These choices reflect our beliefs or observations about the real world.

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Closure

No. of equations must match endog. vars.
In (5.1)-(5.8): 4N + F + FN + M + 1 eqns.
But we have 5N + 2F + FN + 2 variables.
Must choose N - M + F + 1 exog. vars
Declare V exog; (N - M) elements of P, and f.
Now (5.1)-(5.8) solves for Y, W, R, X, D, S and U as endogenous variables.
Endogenous: income, factor prices, quantities produced and demanded, trade, and utility.
Exogenous: factor endowments, traded goods’ prices and a numeraire price.

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An N-good, F-factor economy

General structure

Equilibrium conditions

Closure rules and decisions

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Overview of AGE models

Describe Walrasian equilibria in fairly
detailed manner--sufficient to support
policy claims

Too large to be solved analytically;
must use numerical solutions instead

But structure and results depend on
same theoretical foundations

Advantages and disadvantages of size.

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Pros and cons of AGE modeling

Importance of economy-wide mechanisms
and implications

Intractability of higher-dimension
analytical models

Opportunities for ‘structural sensitivity
analysis’

X Limitations

Time is usually not explicitly taken into
account

Micro details such as risk/uncertainty or
credit market imperfections usually
ignored

aggregations can mask important differences
(e.g. intra-industry variations)

AGE approach is highly time and energy-intensive:
benefits over PE approach obtained at high cost.

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8 Applied GE modeling of economy & environment

Rationales

Basics of applied GE models

Incorporating environmental issues

Main source: OEE Ch. 5.
Additional: Shoven & Whalley, JEL 1984;
Ginsburgh & Keyzer, Structure of applied
general eq. models (MIT Press, 1997);
Coxhead, World Development 28(1), 2000.

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Research & Development

Establish Labs to

perform ground

breaking research.

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Services

Forex

Options

Commodities

Overseas Markets

Capital Management

Macroeconomic Outlook

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Advantages of premium membership

Access to all robots

Email alerts on currency trends and major
economic news

Support and comprehensive training

Automatic updates for the subscribed robots

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Neural Traders Robots

BreakEA – to capture break outs for
GBPUSD on M15.

MacPro – Based on macd and a few other
indicators to trade EURUSD, GBPUSD and
NZDUSD hourly.

AIRobot – Artifical intelligence enabled
EURUSD short term trader.

XPIPS – Maritangle Strategy on EURUSD
H4.

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Technical Indicators

Moving Averages

Stochastic

William's Percentage Range

ADX

ATR

Macd

RSI

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Risk Management

Golden rule: Risk no more than 3% per trade.

Keep greed and fear in control

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Mathematical Foundation

Probability

Expectation

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Trading Strategies

Scalping

Momentum

Breakout

Swing

Carry Trading

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Technical and Fundamental Analysis

Technical analysis: based on indicators such as moving averages, volume
oversold and undersold conditions etc

Fundamental analysis: based on news and economic events, speeches by
Key personalities such as fed chairman, ECB chairman etc.

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Automated vs Manual Trading

Manual trading can be effective
for people who want to be in control
and have the right trading discipline.

Automated trading consists of translating
a trading strategy into an
Automated agent or Expert Advisor for MT4

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The Forex Market - Brokers and Tools

MT4 (fxdd / alpari)

FXCM's trading station

Avafx

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Time Zones

Asian

European

Newyork

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Understanding the trading lingo

Pips

Spread

StopLoss

TrailingStop

TakeProfit

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The Forex Market - Leverage – the power to profit even from small volatility

Daily currency fluctuations are usually very small.
Most currency pairs move less than one cent per day, representing a less than
1% change in the value of the currency.
This makes foreign exchange one of the least volatile financial markets around.
Therefore, many currency traders rely on the availability of enormous
leverage to increase the value of potential movements.

A 200:1 leverage means your 100$ will control 20,000 $.

e.g If Yen goes from 95.0 to 95.10 without leverage you will only be making 1.1%
without leverage – whereas with with 100:1 leverage you will make 100%.

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The Forex Market

The foreign exchange market (forex or FX for short) is one of the most exciting,
fast-paced markets around.
Until recently, forex trading in the currency market had been the domain of
large financial institutions, corporations, central banks, hedge funds and extremely
wealthy individuals. The emergence of the internet has changed all of this,
and now it is possible for average investors to buy and sell currencies easily with
the click of a mouse through online brokerage accounts with brokers such as

FXDD
FXCM
Alpari

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Foreign Exchange Definitions

Value Rate – is the date of settlement for the
foreign exchange transactions

Bid price – the price the dealer is willing to buy
a currency at

Offer price/ ask price – is the price the dealer
sells currency for

Spread – is the difference between the buy and
sell price from the dealer’s point of view.

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Foreign Exchange - Balance of Payments

B of P – is a record of the value of all economic
transactions between residents of a country

Consists of the following accounts:

Merchandise Trade Bal.
Services
Unilateral Transfers +
Current Accounts

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Foreign Exchange Definitions

Convertibility – the degree that one currency can
be exchanged for another one without difficulty

Hard Currency – is a currency that is convertible
and is supported by a strong economy

Spot Rate – an exchange rate quoted for
immediate delivery or within 2 business days

Forward Rate – an exchange rate quoted for
today that is intended for use in the future. It is a
verbal agreement or a binding contract

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Demand for the Dollar ($)

Investment Currency

Reserve Currency

Transaction Currency

Invoice Currency

Intervention Currency

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Foreign Exchange

What is the foreign exchange rate?

What is the foreign exchange market?

What is the foreign exchange organization?

Who are the participants?

- importers/exporters, investors, tourists,
banks, dealers, brokers, speculators

Why use the foreign exchange markets?

- to hedge currency risk, to diversify
portfolios, to make money

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The Foreign Exchange Market - Interest Rates and Exchange Rates

Interest rates reflect expectations of inflation rates;

- high interest rates reflect high inflation expectation

- Fisher Effect: i = r + I

i: “nominal” interest rate in a country

r: “real” interest rate

I: inflation over the period the funds are to be lent

- International Fisher Effect: (S1-S2)/S2 X 100 = i$ - i¥

For any two countries the spot exchange rate should change
in an equal amount but in the opposite direction to the
difference in nominal interest rates between the two
countries

S1: spot rate at time 1, S2 : spot rate at time 1; i$, i¥: nominal
interest rates in the US and Japan

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Exchange Rate Forecasting

The efficient market school

- Prices reflect all available public information

The inefficient market school

- Prices do not reflect all available public information

Approaches to forecasting

- Fundamental analysis

Econometric models draw on economic theory to
forecast future movements

- Technical analysis

Extrapolation/interpretation of past trends
assuming they predict future movements

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Convertibility

Currency convertibility and government policy

- Freely convertible: residents/non-residents allowed to
purchase unlimited amounts of a foreign currency with
the local currency

- Not freely convertible: residents/non-residents not
allowed to purchase unlimited amounts of a foreign
currency with the local currency

Countertrade

- Barter agreements by which goods and services can
be traded for other goods and services
- Used to get around the non-convertibility of currencies

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Money Supply and Currency Value

Inflation occurs when the quantity of money in
circulation rises faster than the stock of goods
and services

Money supply growth related to currency value

Relative inflation rates and trends can predict
relative exchange rate movements

When changes in relative prices in two
countries change their currencies’ exchange
rate, then the currency of the country with the
highest inflation should decline in value

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Prices and Exchange Rates

The law of one price:

- Identical products sold in different countries must sell
for one price if their price is expressed in one currency

- Assumptions:

Competitive markets
No transportation costs; no trade barriers

Purchasing Power Parity (PPP):

- If the law of one price holds for all goods / services, the
PPP exchange rate is found by comparing prices of
identical products in different countries

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The Foreign Exchange Market

Minimizes foreign exchange risk (unpredictable rate
swings)

To do so there are different ways to trade currencies

- Spot exchange rates: the day’s rate offered by a
dealer/bank
- Forward exchange rates:
Agreed in advance rates to buy/sell a currency on a future
date
Usually quoted 30, 90, 120 days in advance
The market is “open” 24 hours…
Arbitrage is the process of buying low and selling high
… given slightly different exchange rate quotes in one
location vs another (e.g., London vs Tokyo)

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Currency Conversion In The Foreign Exchange Market

Currency conversion in the foreign exchange
market

- Is necessary to complete private and commercial
transactions across borders
- A tourist needs to pay expenses on the road in local
currency
- A firm
Buys/sells goods and services in the other country’s local
currency
Uses the foreign exchange market to invest excess funds

Is used to speculate on currency movements

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Foreign Exchange

The foreign exchange market

- Is the market where one buys or sells
the currency of country A with
the currency of country B

A currency exchange rate

- Is simply the ratio of
a unit of currency of country A to
a unit of the currency of country B
at the time of the buy or sell transaction

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The Foreign Exchange Market

Form and function of the foreign exchange
market

Difference between spot and forward rates

Determinants of currency exchange rates

Foreign exchange risk and the exchange
market

Exchange rate forecasting

Convertibility of currencies

Countertrade as convertibility mitigation factor

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Economic Risk

- How can we capture empirically economic risk?

- Empirical literature has tried to estimate the rate of
return of a firm as a function of the market rate of
return (CAPM) and exchange rate variability

- Mixed results

- Younger firms more exposed than older firms to the
effects of exchange rate variability

- Older firms may be more capable of hedging economic
risk

by Stock Specialist ~ Saturday, September 12, 2009 0 comments

Economic Risk

- Now, change assumptions. US exports are
invoiced in $ and Italian exports in euros.

With demand partially elastic, $ export revenues rise

With euro pricing unchanged, dollar imports
(inputs) now cost more in dollars. US exporter will
be looking for cheaper alternatives. If demand is
inelastic, dollar imports rise.

- Case when exports and imports are € invoiced

- Case when exports are invoiced in euros and imports in dollars

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Economic Risk

- Assume a $1 = € 1, products priced at $ 1, 10%

depreciation of the dollar, and $ invoicing

With $ pricing unchanged, $ depreciation → € 0.91

With demand completely inelastic, $ revenues
remain unchanged

With demand partially elastic, $ revenues rise

$-based inputs do not change in value

FCF rises

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Economic Risk

- Value of the firm or value of the project. Us firm sells
partly in the US and partly exports to Italy. Cash
outflows partly in dollars and partly in euros

- Concept of cash flow. Start from net income and adding
non-cash items like depreciation and subtracting cash
items like expenditures on fixed assets

- Free cash flows are projected or forecasted forward,
into infinity. Euro-based cash flows need to be
converted into dollars

- Stream of cash flows discounted by a dollar-based rate
of return expected by US shareholders

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Kelley Instruments

- Pound is functional currency; dollar is reporting currency

- $2=£1 at year beginning; $2.2=£1 at year end; $2.1= £1 mid-point

- I shall assume that you know accounting sufficiently well to arrive
at the solution indicated on page 45 of my text

- Let’s concentrate on current method

- Income statement: all items are recorded at mid-point exchange
rate. Net income is equal to retained earnings. No translation gains

- Balance sheet: all assets and liabilities at year-end exchange rate,
except common stock at year beginning and retained earnings at
mid-point exchange rate

- Net worth: common stock at year beginning plus retained

- CTA: (common stock and retained earnings)*(2.2) – (common
stock)*(2.0) – (retained earnings)*(2.1)

- CTA goes into dollar net worth

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Translation risk

- US accounting principles allow conversion

gains or losses to be shielded from taxation in

the current period; these gains or losses are

accumulated in a separate account, which are

taxed when the investment is sold or liquidated.

The idea is that yearly gains or losses may be

temporary but long-term ones are not.

- Best way to understand how this works is to

consider the case study in Box 2.3 of the text.

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Types of Forex risk

- Translation risk: multinational co. (MNC) with branches or
subsidiaries in different currency areas of the world must report its
consolidated financial accounts in a single currency. The
conversion creates gains or losses and may have tax
consequences. The US has the most elaborate system of
accounting to handle the conversion risk. Light coverage in the
course

- Transaction risk: arising from transactions in different currencies.
Heavy coverage in the course.

- Economic risk: typical in a foreign direct investment (FDI).
Investment is valued in terms of discounted cash flows in foreign
currencies and then converted in local currency, with the local
discount rate. Light coverage in the course

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Quotes and practices

- Forward one month for the dollar/euro (same date)

$1.2887/ €1

- Forward premium at an annual rate

(1.2887-1.2862)*1200/1.2862 = 2.3324%

- Euro is at a premium, or the dollar is at a discount

- Cross rates: these appear in the FT every day and can be computed
simply by taking the ratio of two exchange rates

E.g., C$/US$ = 1.117 and US$/€ = 1.2862 → without
transaction costs (C$/US$)*(US$/€) = C$/€ = (1.117)*1.2862)
= € 1.4367

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Quotes and practices

- Direct quote: domestic money/foreign money

€ 0.7775/$1 (17/8/2006)

- Indirect quote: foreign money/domestic money

$1.2862/ €1 (same date)

- Indirect quote prevails for the euro and the pound

- Bid rate: rate at which dealer buys

$1.2860/€1

- Ask rate: rate at which dealer sells

$1.2864/€1

- Spread: (ask rate – bid rate)/bid rate

[(1.2864-1.2860)/1.2860]*100 = 0.03%

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Organized exchanges

- Chicago Mercantile Exchange, an offshoot of
the Chicago Board of Trade: oldest exchange

- Euronext: from the merger of Amsterdam,
Brussels and Paris plus acquisition of the
London International Financial Futures and
Options Exchange

- Moscow Interbank Currency Exchange

- Tokyo Commodity Exchange

- Sydney Futures Exchange

by Stock Specialist ~ 0 comments

Organized exchanges

- Smaller segment than the OTC market

- Have a physical place, rules, and face
regulation

- Three features

Product standardization

Clearinghouse

collateral

by Stock Specialist ~ 0 comments

Types of transactions

- Foreign currency options

Gives the right but not the obligation to buy or sell a
specified quantity of one currency in exchange for
another at a specified price within a specified period
of time.

Differs from the forward in that the owner of the
option does not have to execute the transaction

by Stock Specialist ~ 0 comments

Types of transactions

- Forex swap (two legs)

In the first leg there is a swap of one currency for another

In the second leg, which occurs in the future, there is a re-
exchange, that is the opposite swap

The swap can occur with the first leg, say, in one month, and
the second in three months

- Currency swap (three legs)

First: a spot exchange of two currencies with underlying assets

Second: an exchange of flows of fixed or floating interest rate payments

Third: a re-exchange of the currencies at the initial spot rate

It thus combines an interest rate swap with a forex swap

by Stock Specialist ~ 0 comments

Types of transactions

- Spot

Outright exchange of one currency for another at the current spot price
with a two-day settlement.

Currency covers both actual currency and bank deposits.

Large transactions are in deposits. Currency for retail

- Outright forward

Outright exchange of one currency for another at the current
market price but with future delivery

Transaction used to be done typically in agriculture. An Italian
exporter of Parmigiano cheese to the US, with an invoice due in 60 days,
would sell forward the dollars against liras.

Now forwards are used for a variety of reasons.

by Stock Specialist ~ 0 comments

Two components to Forex

- Forex has two components

Over-the-counter (OTC)

Organized exchanges

- OTC is a network of dealers, brokers, and final customers. Low
regulation

Dealers are mostly commercial and investment banks that buy a
currency at a bid price and sell it at an ask price

Dealers take a position and thus face a risk of a price change between
purchase and sale

Biggest dealers are Deutsche Bank, UBS, Citigroup, HSBC, Barclays
Bank, Merril Lynch, J.P. Morgan Chase, Goldman Sachs, ABN
AMRO, and Morgan Stanley

Brokers help in carrying out a deal, connecting a dealer with a final
buyer or seller. They receive a fee and take no exchange rate risk

by Stock Specialist ~ 0 comments

Size of the Forex Market

- Largest and most liquid in the world

- BIS issues a Triennial Central Bank Survey; latest in 2004

Daily turnover of $1,800 billion

$ 621 bn spot transactions

$ 208 bn forwards

$ 944 currency swaps

Dollar 88.7/200

Euro 37.2/200

Yen 20.3/200

- Market never sleeps and has its own circadian rhythm

Starts in Sydney and ends in S. Franciscoand ends in S. Francisco

Max. intensity at 8:00 and 14:00 (GMT)

Min. intensity at 4 (Tokyo lunchtime) and 23 (end of NY)

- Important centers: London, NY, Frankfurt, Tokyo

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