§ The law of one price (LOP) refers
to the international arbitrage condition for the standard consumption Basket. LOP requires that the consumption
basket should be selling for the same price in a given Currency across
countries.
§ Absolute PPP holds that the price
level in a country is equal to the price level in another country
Times
the exchange rate between the two countries.
·
Relative
PPP holds that the rate of exchange rate change between a pair of countries is
about equal
To
the difference in inflation rates of the two countries
·
PPP
is not useful for predicting exchange rates on the short-term basis mainly
because International commodity arbitrage is a time-consuming process.
·
PPP
is more useful for predicting exchange rates on the long-term basis.
} Purchasing power parity is the
law of one price applied to a fixed basket of commodities
} The law of one price implies that
e=P/Pf, where P is the price of a basket of
commodities in the home country and Pf
is the price of that same basket of commodities abroad
} PPP
states that the exchange
rate between two currencies is in equilibrium when their purchasing power is
the same in each country, i.e. The exchange rate between two countries should
equal the ratio of the two countries' price levels
} Thus when one country’s price
level is increasing (decreasing) its exchange rate must also be depreciating
(appreciating). PPP implies that the real exchange rate should be equal to one
•
Arbitraging is the process of buying and selling the same
security (currency) in different markets to benefit or gain from the price
differential. In the international parlance, arbitraging means taking advantage
of the price differentials in the quoted prices of the currencies in different
markets. The process of arbitrage will normalise the prices.
For example, if a stock is quoted on two different equity markets, there is the
possibility of arbitrage if the quoted price (adjusted for institutional idiosyncrasies)
in one market differs from the quoted price in the other.
1.
Locational arbitrage
2.
Triangular arbitrage
3.
Covered interest arbitrage
Locational arbitrage: implies capitalizing on the differences in exchange rates
between locations. E.g. Bank X is quoting British Pound at $1.60 and Bank Y is
quoting the same at $1.62. This implies an arbitraging opportunity provided
there are no additional transaction costs. If an investor buys at bank A and
sells at Bank B he makes a gain of .02 $.
Triangular arbitrage: usually forex transactions are expressed in US dollars. But
sometimes, US dollar may not be part of the exchange transaction. In such a
case, a cross exchange rate is used to determine the relationship between two
non-dollar currencies.
E.g. If British Pound is worth $1.50, while the German Mark is
worth .50$, the value of the British Pound with respect to mark is $1.50/. 50 =
3. The value of the Mark with respect to the Pound can also be determined by
the cross exchange rate formula. The value of Mark with respect to Pound is $
.50/1.50 = .33. Say the quoted rate of Pound against Mark is $3.2. If a quoted
cross exchange rate differs from the appropriate cross exchange rate (in this
case it does), triangular arbitrage is feasible. (Assuming no transaction
costs)
Covered Interest Arbitrage: it tends to create a relationship
between the interest rates of two countries and their forward exchange rate
premium or discount. It involves investing in a foreign country and covering
against the exchange rate risk.
High interest rates (4%) are prevailing in Britain and an
investor has funds ($ 1 Million) available for three months. The interest rate
is fixed; only the future exchange rate at which the investor will exchange
pounds back to dollars is uncertain. A forward sale of pounds can be used to
guarantee the rate at which he could exchange pounds for dollars at future
point in time.
o
Gold Standard is the oldest system
which was in operation till the beginning of the First World War and a for few
years thereafter ie it was basically from 1870 - 1914. The essential feature of
this system was that the government gave an unconditional guarantee to convert
their paper money to gold at a prefixed rate at any point of time or demand.
The advantages of the gold standard include: (I) since the supply of gold is
restricted, countries cannot have high inflation; (2) any BOP disequilibrium
can be corrected automatically through crossborder flows of gold. On the other
hand, the main disadvantages of the gold standard are: (I) the world economy
can be subject to deflationary pressure due to restricted supply of gold; (ii)
the gold standard itself has no mechanism to enforce the rules of the game,
and, as a result, countries may pursue economic policies (like de-monetization
of gold) that are incompatible with the gold standard.o
The gold standard began sometime in
the 1880s
o
It was premised on three basic
ideas:
§
A system of fixed rates of exchange
existed between participating countries
§
Money issued by member countries had
to be backed by gold reserves
§
Gold acted as an automatic
adjustment
o
Under this standard, each country’s
currency would be set in value per ounce of gold
1)
BWS: The Bretton Woods system of
monetary management established the rules for commercial and financial
relations among the world's major industrial states in the mid-20th century.
The Bretton Woods system was the first example of a fully negotiated monetary
order intended to govern monetary relations among independent nation-states. • The governments of 44 of the Allied Powers gathered together in
Bretton Woods, New Hampshire in 1944 to plan for the postwar international
monetary system Setting up a system of rules, institutions, and procedures to
regulate the international monetary system, the planners at Bretton Woods
established the International Monetary Fund (IMF) and the International Bank
for Reconstruction and Development (IBRD), which today is part of the World
Bank Group. These organizations became operational in 1945 after a sufficient
number of countries had ratified the agreement. The chief features of the
Bretton Woods system were an obligation for each country to adopt a monetary
policy that maintained the exchange rate by tying its currency to the U.S.
dollar and the ability of the IMF to bridge temporary imbalances of payments.
On 15 August 1971, the United States unilaterally terminated convertibility of
the US$ to gold. This brought the Bretton Woods system to an end and saw the
dollar become fiat currency.This action, referred to as the Nixon shock,
created the situation in which the United States dollar became a reserve
currency used by many states. At the same time, many fixed currencies (such as
GBP, for example), also became free floating. • This
agreement called for the following: o Fixed
exchange rates between member countries o The
stablishment of a fund of gold and currencies for stabilization of their currencies,
the International Monetary Fund o The
establishment of a bank, the World Bank, that would provide funding for
long-term development projects. • The main objectives of the Bretton Woods
system are to achieve exchange rate stability and promote international trade
and development.
•
The
main objectives of the Bretton Woods system are to achieve exchange rate
stability and promote international trade and development.
v
The
International Monetary Fund classifies all exchange rate regimes into eight
specific categories:
◦ Exchange arrangements with no
separate legal tender
◦ Currency board arrangements
◦ Other conventional fixed peg
arrangements
◦ Pegged exchange rates within
horizontal bands
◦ Crawling pegs
◦ Exchange rates within crawling
pegs
◦ Managed floating with no pre-announced
path
◦ Independent floating
List
the advantages of the flexible exchange rate regime.
A. The
advantages of the flexible exchange rate system include: (I) automatic
achievement of
Balance
of payments equilibrium and (ii) maintenance of national policy autonomy.
B.
Criticize the flexible exchange rate regime from the viewpoint of the
proponents of the fixed exchange rate regime.
B. If
exchange rates are fluctuating randomly, that may discourage international
trade and encourage
Market
segmentation. This, in turn, may lead to suboptimal allocation of resources.
C.
Rebut the above criticism from the viewpoint of the proponents of the flexible
exchange rate regime.
C.
Economic agents can hedge exchange risk by means of forward contracts and other
techniques. They Don’t have to bear it if they choose not to. In addition,
under a fixed exchange rate regime, governments Often restrict international
trade in order to maintain the exchange rate. This is a self-defeating measure.
What’s
good about the fixed exchange rate if international trade need to be
restricted?
v
Countries
would prefer a fixed rate regime for the following reasons:
◦ Stability in international
prices.
◦ Inherent anti-inflationary nature
of fixed prices.
v
However,
a fixed rate regime has the following problems:
◦ Need for central banks to
maintain large quantities of hard currencies and gold to defend the fixed rate.
◦ Fixed rates can be maintained at
rates that are inconsistent with economic fundamentals.
v
When
the relative price of currencies are determined purely by force of demand and
supply and when the authorities make no attempt to hold the exchange rate at
any particular level within a specific band or move it in a certain
direction by intervening in the exchange
markets, it is referred to as Floating Exchange Rate.
•
Dirty Float(April 2003): The
authorities are intervened more or less intensely in the foreign exchange
market in which there are no officially declared parties, but there is official
intervention that has come to be known as managed or dirty float. A dirty float
system is not considered as true floating rate system don’t allow for
intervention. Floating rate system may
be independent or managed. Theoretically speaking, the system of managed
floating involves intervention by the monetary authorities of the country for
the purpose of exchange rate stabilization. The process of intervention
interferes with market forces and so it is known as “dirty” floating as against
independent floating which is known as “clean” floating. However, in practice,
intervention is global phenomenon. Keeping this fact in mind, the IMF is of the
view that while the purpose of intervention in case of independent floating
system is to moderate the rate of change, and to prevent undue fluctuation, in
exchange rate; the purpose in managed floating system is to establish a level
for the exchange rate
•
Crawling
peg : A crawling peg rate is a hybrid of fixed and flexible exchange rate
systems. Under this system, while the value of a currency is fixed in terms of
a reference currency, this peg keeps on changing itself in accordance with the
underlying economic fundamentals, thus letting the market forces play a role in
the determination of the change in exchange rate. There are several bases which
could be used to determine the direction of change in the exchange rate for
example – the actual exchange rate ruling the market, t there is gradual
modifications with permissable variations around the parity restricted to a
narrow band. The change in parity per unit period is subject to a ceiling with
an additional short term constraint, e.g. Parity change in a month cannot be
more than 1/12th of the yearly ceiling. Parity changes are carried
out , based on a set of indicators. They may be discretionary, automatic or
presumptive. The indicators are : current account deficits, changes in
reserves, relative inflation rates and moving average of past spot rates.
Countries such as Portugal and Brazil have in the part adopted variants of
Crawling Peg.
•
Adjustable
Peg :L Adjustable Peg system was established which fixed the exchange rates,
with the provision of changing them if the necessity rose. Under the new
system, all the members of the newly set up IMF were to fix the par value of
their currency either in terms of gold, or in terms of US dollar. The par value
of the US dollar was fixed at $ 35 per ounce. All these values were fixed with
the approval of the IMF, and were reflected in the change economic and financial
scenario in the countries engaged in international trade. The member countries
agreed to maintain the exchange rates for their currency within a band of one
percent on either sides of the fixed par value. The extreme points were to be
referred to as upper and lower support point, due to which requirement that the
countries do not allow the exchange rate to go beyond these points. The
monetary authorities were to stand ready to buy or sell the US dollar and
thereby support the exchange rates. For this purpose, a country which would
freely buy and sell gold at the aforementioned par value for the settlement of
international transactions was deemed to be maintaining its exchange rate
within the one percent band.
A
nation’s choice as to which currency regime to follow reflects national
priorities about all factors of the economy, including inflation, unemployment,
interest rate levels, trade balances, and economic growth. The choice between
fixed and flexible rates may change over time as priorities change. At the risk
of over-generalizing, the following points partly explain why countries pursue
certain exchange rate regimes. They are based on the premise that, other things
being equal, countries would prefer fixed exchanges rates.
·
Fixed
rates provide stability in international prices for the conduct of trade.
Stable prices aid in the growth of international trade lessens risks for all
businesses.
·
Fixed
exchange rates are inherently anti-inflationary, requiring the country to
follow restrictive monetary and fiscal policies. This restrictiveness, however,
can often be a burden to a country wishing to pursue policies that alleviate
continuing internal economic problems, such as high unemployment or slow
economic growth.
·
Fixed
exchange rate regimes necessitate that central banks maintain large quantities
of international reserves (hard currencies and gold) for use in the occasional
defense of the fixed rate. An international currency markets have grown rapidly
in size and volume, increasing reserve holdings has become a significant burden
to many nations.
·
Fixed
rates, once in place, can be maintained at rates that are inconsistent with
economic fundamentals. As the structure of a nation’s economy changes and its
trade relationships and balances evolve, the exchange rate itself should
change. Flexible exchange rates allow this to happen gradually and efficiently,
but fixed rates must be changed administratively- usually too late, too highly
publicized, and too large a one-time cost to the nation’s economic health.
The
advantages of the flexible exchange rate system include: (I) automatic
achievement of balance of payments equilibrium and (ii) maintenance of national
policy autonomy.
If
exchange rates are fluctuating randomly, that may discourage international
trade and encourage market segmentation. This, in turn, may lead to suboptimal
allocation of resources.
Economic
agents can hedge exchange risk by means of forward contracts and other
techniques. They don’t have to bear it if they choose not to. In addition,
under a fixed exchange rate regime, governments often restrict international
trade in order to maintain the exchange rate. This is a self-defeating measure.
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