The Economics of Foreign Exchange and Global Finance

The idea of PPP can be traced back to the medieval times, though the theory is more formally contributed to Cassel (1918, 1922), developed during a period that endured noticeable inflation in the world for the first time and the inflation rate as well varied noticeably between major trading nations. Therefore, PPP has been associated with inflation and inflation differentials from the start, being thrust in to a theory by real world issues. Cassel (1918) states that “The rate of exchange between two countries is primarily determined by the quotient between the internal purchasing power against goods of the money of each country.”, and remarks that “The general inflation which has taken place during the war has lowered this purchasing power in all countries, though in a very different degree, and the rates of exchanges should accordingly be expected to deviate from their old parity in proportion to the inflation of each country.” A testimony is then reached: “At every moment the real parity between two countries is represented by this quotient between the purchasing power of the money in the one country and the other. I propose to call this parity ‘the purchasing power parity’.”

Since the sixth edition of the Balance of Payments and International Investment Position Manual (BPM6), the IMF has replaced the phrase “an economy or a country and the rest of the world” by “residents of an economy and non-residents”, to reflect the changed realities taken place in the last few decades. Transactions represented by flows of goods, services and capital are presented in the form of double-entry bookkeeping.

The balance of payments and the international investment position are designed to measure and present an economy’s external activity engaged with the rest of the world, such as flows of goods, services and capital during certain periods and the accumulated stocks of assets or liabilities at certain times. Analysis of the balance of payments, which extends national accounts for a closed economy to national accounts for an open economy, demonstrates a country’s international economic linkages with the rest of the world.

Therefore, this approach is all about the current account of the balance of payments, paying no attention to the capital account and the financial account of the balance of payments. Although the model is on the interaction between the exchange rate and the current account balances, it is largely applied to evaluate the effect of currency depreciation or currency appreciation on the balance of payments current account. In particular, it is applied to examine if a kind of currency depreciation helps improve current account balances. The current account balance examined here is, more exactly, trade balance defined as exports minus imports, leaving out income receipts/payments and current transfers:

Under perfect capital mobility, the domestic interest rate, after enduring a shock such as a monetary/fiscal expansion/contraction, returns to its original level eventually. In the SOE case, the original level of the interest rate is the world rate of interest. We know from the standard closed economy IS-LM analysis that a change in monetary policy shifts the LM curve while a change in fiscal policy shifts the IS curve. In an open economy, one policy change may shift both LM and IS curves. For example and under a flexible exchange rate regime, a monetary expansion has direct effect on the LM curve and shifts the LM curve towards the right initially; then the resulted increase in the exchange rate (depreciation) has the consequence of moving the IS curve to the right as well, a phenomenon similar to the effect of a fiscal expansion. Likewise and under a fixed exchange rate regime, a fiscal expansion has direct effect on the IS curve and shifts the curve towards the right initially. However, since the exchange rate is fixed, the deterioration in the current account may not be exactly offset by the amount of capital inflows, leading to an adjustment or change in official reserves and money supply. This consequently changes the LM curve position. From such preliminary reasoning, we become aware that, in an open economy, the economy may benefit from the implementation of a policy in more areas and to a larger extent than in a closed economy. The opposite is also true and the economy can be put in a state of complete mess.

As learned in Chap. 5, demand for money is a function of real income, the interest rate and the price level. More precisely, the velocity of money, defined as the ratio of demand for money and the price level, is an increasing function of the level of real income and a decreasing function of the level of the interest rate. Reserving these qualitative features, the relationship between these variables in the domestic country can be expressed as follows:where \( {M}_t^D \) is demand for money, P_t is the price level, Y_t is real income and r_t is the interest rate, all at time t, for the domestic country; α > 0 and β > 0 are coefficients representing the income elasticity of money demand, and the interest rate semi-elasticity of money demand. Taking logarithms of Eq. (8.1) yields:

where \( {m}_t^d= Ln\left({M}_t^D\right) \), p_t = Ln(P_t), and y_t = Ln(Y_t). The only differences between Eqs. (5.​8) and (8.2) are that demand for money, real income and the price level are in their original forms in the former, while they are in logarithms in the latter. Nevertheless, both Eqs. (5.​8) and (8.2) point out that the velocity of money increases with real income and decreases with the interest rate.

Monetary approaches to exchange rate determination, including the flexible price monetary model proposed by Frenkel (1976) and sticky price monetary model by Dornbusch (1976), assume that uncovered interest rate parity (UIRP) holds. This assumption implies that domestic and foreign assets are perfect substitutes, which the portfolio balance approach unequivocally deviates. The deviation arises from, among others, from different risk attitudes towards foreign financial assets in relation to domestic financial assets; or there exists a risk premium on holding foreign financial assets relative to holding domestic financial assets. Moreover and in contrast to the monetary models, foreign exchange rates are not expected to change, or exchange rate expectations are static with the portfolio balance approach. While purchasing power parity (PPP) holds continuously in the flexible price monetary model and PPP holds in the long-run in the sticky price monetary model of Dornbusch, there is no requirement for PPP to hold in the portfolio balance model. This implies that goods need not be perfect substitutes.

The model is named the dynamic IS-LM-X model of exchange rate movements, where X denotes external sector.

Almost all the models and empirical studies have been set up, implemented and curried out between pairs of currencies, usually the bilateral exchange rates between the US dollar and the currencies under investigation and, to a less extent, between the Deutsche mark and the currencies under investigation, the euro and the currencies under investigation, and so on. The influence of a “third” currency has not been considered. While the global foreign exchange market is a multi-currency regime, it can be embodied by a number of triangular sub-regimes, where the cross exchange rate between the foreign currency and the other foreign currency, the “third” currency, must satisfy the non-arbitrage conditions. Therefore, multilateral exchange rate relationships can be feasibly examined through the triangular framework, taking into account the influence of the “third” currency. This is particularly relevant for assessing the effect of the de facto peg of a large currency to another large currency, such as the US dollar, on exchange rates between the US dollar and other currencies and between other currency pairs. When the exchange rate arrangements between the three currencies are not uniform, the causal relationship, if exists, can be asymmetric, giving rise to the driver currency effect. Research has been carried out to take on these emerging issues recently, including Wang (2010), McKinnon and Schnabl (2012), Wang and Zhang (2014), and Ryan (2015).

A phenomenal proliferation of derivative securities and their widespread use in trading and risk management is perhaps one of the most significant developments in the financial world in recent time.

Similar to forwards, a futures contract specifies that a certain amount of an asset, a financial asset or a commodity, will be purchased or sold at a predetermined price at a predetermined future time. Unlike forwards, futures are standardized contracts trading on organized exchanges with daily resettlement through a clearinghouse. Futures contracts are standardized in contract size and delivery time, and are marked-to-market. That is, gains or losses are credited or debited daily from a margin account that must be opened prior to trading, so losses are not possible to accumulate. Whereas a forward is a private agreement between a buyer and a seller for the future delivery of an asset at an agreed price, with the negotiated contract size, delivery time and delivery method, being settled at the end of the contract period. Table 13.1 contrasts a futures contract with a forward contract. Replacing in the above the general term “an asset” by a specific one “a currency”, currency futures emerge.

An option gives the option contract holder the right, but does not involve the obligation, to buy or sell a given quantity of an underlying asset, commodity or financial security at a pre determined price at or prior to a specified time in the future.

Swaps look much simpler than options, which is one of the reasons why swaps are more popular in terms of usage whereas options are more popular in terms of theory and pricing models. Therefore, it is perhaps the best way to begin with the study of swaps with an example.

Transaction exposure arises from the possibility of incurring exchange gains or losses on transactions already entered into which is denominated in a foreign currency. Management of transaction exposure is to control and reduce the risk of exchange rate fluctuations involved in these contractual transactions.

Changes or fluctuations in exchange rates have effect on cash flows/value of firms engaged in international activities as well as firms of domestic nature. The value of a pure domestic firm may be affected by economic exposure through foreign competition in the domestic and local market. Firms with more foreign costs than foreign revenues will be unfavourably affected by stronger foreign currencies; while firms with more foreign revenues than foreign costs will be unfavourably affected by weaker foreign currencies. Table 17.1 describes the effects on firms’ activity of currency appreciation/depreciation, which affect the present value of future cash flows and firm value. Currency depreciation or appreciation is in real terms when relevant, though depreciation or appreciation in terms of nominal exchange rates can also be, and in many cases is, real. However, nominal depreciation/appreciation matters where cash flows are bound by contractual agreements.

We classify factors that determine country risk into four groupings: the political climate, the economic environment, the financial condition, and the social institution. The political climate factor refers to the stability, maturity and functioning of the political system; the representativeness and collectiveness of government; the scale of domestic conflict—racial relations, civil war or insurgence; and the conditions of international relations—sanctions imposed due to political reasons, border dispute or military conflict with neighbouring countries. The economic environment is concerned with economic development stages—GDP per capita and growth in GDP; economic stability—inflation, unemployment and provision of social security; infrastructure—the communications system, skills of the labor force, the competitiveness of the industry, the maturity of the service sector and the efficiency of government departments and agencies; taxation—consistency in and levels of tax charges, and tax incentives for foreign investment and for certain industries; macroeconomic management—formation, implementation and effectiveness of monetary policy and fiscal policy; and international economic relations—international trade, balance of payments, foreign exchange rate arrangements and foreign reserves. The financial condition is related to the stability of the financial system, the functioning of the capital market, the operation of the foreign exchange market, and the maturity of the corporate sector. Finally, the social institution reveals the legal, regulative, cultural and institutional aspects of a country that may have effects on the financial interests and performance of an MNC in the country. It covers the legal system—independence, transparency and enforcement of the legal system, crime and security in the society; regulations and legislations—consistency, fairness and effectiveness; work organisation and corporate governance—compatibility, harmony and functioning; the influence of interest groups—professional bodies, trade unions and employers organisations; the ability of handling natural disasters and emergency rescues; and social attitude towards work, social life, wealth distribution, foreign investment, and national interests. Table 18.1 lists and summarises these factors of influence for country risk analysis.

As discussed in Chap. 4, FDI involves a significant degree of control and/or management in a corporation or other entities located in a foreign country with a long lasting interest. Estimation of FDI figures by the IMF involves three terms: direct investment enterprises, direct investors, and direct investment capital in foreign countries.

Dynamic global positioning strategy (dGPS) postulates the strategic dynamics, movement and progress in global positioning by institutions, individuals, nations and organizations of various types.