International Parity Conditions and Market Instruments - Assignment Example

International Parity Conditions of the of the No International Parity Conditions Forward Looking Market Instruments The chapter deals with specific instrumental policies by virtue of which the risks associated with high volatility in foreign currency value can be lowered in the market. Such policies help an importing nation (with liability to pay back foreign currency) avoid risks associated with high value of foreign currency. On the other hand, these allow an exporting nation to lower the risk associated with falling foreign currency value of nations where exports are made. Figure 1: Cross-Country Currency Trading Exchange Rates (Source: Melvin and Norrbin 1-335) The above table shows currency trading rates of some of the countries. From the above table, it can be stated that countries like, Canada, Switzerland, U.K. and other European nations, have higher currency values than that of nations like, Indonesia and Japan. The trading of currencies at a future date takes place in the forward exchange rate market. If Forward exchange rate price > Currency spot price (for a currency) = currency is sold at a forward premium. If Forward exchange rate price > Currency spot price (for a currency) = currency is sold at a forward discount (Tucker 167). Interbank trading activities of the commercial banks are conducted on the basis of swap agreements. Through a currency swap, exchange rates of two economies are simultaneously interchanged on the basis of a mutually agreed rate at a particular point of time. For example, if a commercial bank in U.S. desires to acquire pounds, then it would undertake a swap agreement with a commercial bank in U.K., hereby exchanging dollar with pounds. The swap rates are premium or discount rates. Such rates are determined in the forward exchange market. Hedging is another process whereby assets of a firm in the domestic nation are matched with that of its liabilities in foreign nations. A credit default swap (CDS) is a type of insurance instrument with the help of which buyer in a CDS transaction pays a fee to the seller for the latter to be responsible for any act of default legally. CDS has become popular after emergence of the global financial crisis. Figure 2: Foreign Exchange Turnover (Source: Melvin and Norrbin 1-335) The above table states that the swap transactions, in terms of U.S. dollars, generate the maximum amount of average daily turnovers. Nonetheless, it should be noted that in a foreign exchange market, banks often do not undertake the transaction directly; such dealings are undertaken by brokers on behalf of the banks. Recently, such transactions are often made via electronic brokers in most of the countries. Approximately 56% of swap trading in U.S. and 66% of the same in U.K. are undertaken through such computerized systems. The future market is a special type of foreign exchange market, where currencies are traded for being delivered on a future date. The largest future market in the world is International Monetary Market (IMM), belonging to Chicago mercantile exchange. At times, the buying party demands for an extra security in a foreign exchange future market dealing; this process is then known as a marginal call. The credit risks of banks are lowered to a greater extent in a future market than that in a forward exchange market (OECD 46). Foreign exchange trading is also undertaken in the options market. Such transactions are undertaken through call and put options. The trading price of the currency is known as the strike price. Break forwarding process is a method whereby a future trading contract can be transmitted as a forward trading one. Nevertheless, certain problems while hedging foreign exchange risks are experienced during the bidding process. The Eurocurrency Market This chapter deals with the offshore banking market, which is also popularly known as Eurocurrency market. In this market, commercial banks accept deposits or take loans on offshore currencies (only foreign, besides their domestic currencies). The banks that operate in this market are known as Eurobanks. Such banking practices have become popular in modern times because this allows trading of foreign currencies with minimum regulations. With growing degree of commercialization between nations, the need of offshore trading has enhanced. The U.S. and Euro Dollar prioritized loans and deposits (outside U.S.) comprise the highest value of activities among all currencies that are traded in the offshore banking market. Unlike other banks, Eurobanks are less regulated and experience lower operating costs (Marsh 145). Figure 3: Eurodollar and U.S. Spread Comparison (Source: Melvin and Norrbin 1-335) Hence, as shown in the above graph, Eurobanks offer narrower spreads (deposit-lending) than commercial banks, similar to those in U.S. It should also be noted that fewer regulations have stimulated growth of the Euro banking system, which consequently gained popularity in the international market. The investors are more interested to trade through such linear chain of banking systems. Efficiency of international finances has substantially improved with the help of Eurocurrency market. This is because cost of borrowing funds from such markets is low and excessive state regulation or intervention is absent. Additionally, there is a high degree of competition among Euro banks. Each bank, hence, provides maximum amount of feasible opportunities to the investors and depositors. LIBOR (London Interbank Offered Rate) Euro is a type of special benchmark interest rate used by the Eurodollar market. This benchmark rate helps banks to set the lending rates optimally. The LIBOR rate is fixed for ten currencies every day. Since 2010, financial assets traded at LIBOR rates are considered to be most worthy. Banking activities in the Eurocurrency market are also undertaken by some U.S. banks, which are members of International Banking Facilities (IBF) departments. The Eurodollar market’s net size measures the amount of loans provided to non-banking institutions. The bank syndicates often opt for large Eurocurrency loans (Pope, “When the Fed raises or lowers interest rates”). Figure 4: International Banking Activities (Source: Melvin and Norrbin 1-335) The above graph shows that U.K. is experiencing maximum amount of international banking activities. Exchange Rate, Interest Rate and Interest Parity The interest parity indicates that investment interest rate differential of two countries is exactly equal to the forward discount or premium rate between those two economies. The investors often hedge themselves from risks associated with the future spot exchange rates. When such forward contracts are used by investors in the market, then it is stated that their foreign investments are covered. If interest rate of a currency of a nation A is lower than that of the currency of another nation B, then currency of the former country is termed to be at a forward premium rate. On the other hand, if the interest rate of a country A is higher to that of country B, then currency of A is stated to be at a forward discount. The current spot, current forward exchange rates and current interest rate are three rates included in the covered interest rate parity. If one of these three changes, then the other rates must also change in order to maintain the covered interest rate parity equation. Therefore, arbitrage of covered interest rate ensures the interest parity condition. Due to transaction costs, government regulations, political risks and differential taxation, the parity of inertest rate in a market might fluctuate. Real Interest Rate = Nominal Interest Rate - Expected Inflation (Mankiw and Taylor 199). So, if the real interest rate of two nations is equal, then it implies equality of the expected interest rate differentials. This also implies equality of the two nations’ forward discount of premium rates. Figure 5: The Inflation and Interest Rates of the some major Economies (Source: Melvin and Norrbin 1-335) The relationship of various bonds (with different maturity rates) and interest rates in market are provided by the term structure. Thus, the expected exchange rate alterations between two nations are reflected by interest rate term structure differentials. There are several theories that foreground rationality of the structure of interest rates. These are theories of expectations, liquidity premium and preferred habitat (Hirsch 222). Exchange Rates and Prices: Purchasing Power Parity The relationship between exchange rates and product price levels are explained by the purchasing power parity (PPP) equation. So, the condition of absolute PPP holds when average price levels of two nations are equal to the exchange rates. On the contrary, relative PPP holds if the inflation rate differential between two economies becomes equal to the change in exchange rate. The PPP between the nations experiencing high inflation rates are better maintained (Gerlach and Peng 461-481). Empirically, it is found that exchange rate deviates from PPP in the short run; but, in reality, it approaches to PPP in the long run. Additionally, if non-traded commodities, transaction costs, differentiated goods and state restriction costs are included in the average price indexes, then the PPP condition deviates. Such deviations might also arise in situations, where consumption bundles are dissimilar in price indexes of different nations and exchange rates and product prices between them are also different. Figure 6: Exchange Rates Nations (Source: Melvin and Norrbin 1-335) If currency of a nation appreciates at a greater degree than that of its interest rate differential (with another nation), then the concerned currency is regarded as overvalued. The implications are opposite for the undervalued currency situation. Figure 7: Trends of Exchange Rates (Source: Melvin and Norrbin 1-335) The above graph shows exchange rate trend in the global market, adjusted in terms of PPP. Works Cited Gerlach, Stefan and Wensheng, Peng. “Bank lending and property prices in Hong Kong.” Journal of Banking and Finance, 2004. 29, pp 461–481. PDF file. Web 31 March 2014. Hirsch, Arnold, R. Macroeconomics. Connecticut: Cengage Learning, 2008. Print. Mankiw, Gregory N. and Mark P. Taylor. Microeconomics. Connecticut: Cengage Learning EMEA, 2006. Print. Marsh, David. The Bundesbank: The Bank that Rules Europe. London: Mandarin, 1992. Print. Melvin, Michael and Stefan C. Norrbin. “International Money and Finance.” Elsevier Inc. 2013, pp 1-335. PDF file. Web 31 March 2014. OECD. OECD Regions at a Glance 2009. Paris: OECD Publishing, 2009. Print. Pope, Ethan. “When the Fed raises or lowers interest rates.” Foundations for living. Foundations for living, 2007. Web.16 October 2013. Tucker, Irvin. B. Macroeconomics for Today. Connecticut: Cengage Learning, 2010. Print. Read More