International-Financial-Management---Bekaert-2e---Solutions---Ch05.doc

International-Financial-Management---Bekaert-2e---Solutions---Ch05.doc

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9

Chapter5:

ExchangeRateSystems

Chapter 5

ExchangeRateSystems

QUESTIONS

1.Howcanyouquantifycurrencyriskinafloatingexchangeratesystem?

Answer:

Tocharacterizetheriskofacurrencyposition,youmusttrytocharacterizetheconditionaldistributionofthefutureexchangeratechanges.Withfloatingexchangerates,historicalinformationprovidesusefulinformationaboutthisdistribution.Forexample,youcanusedatatomeasuretheaveragehistoricaldispersion（standarddeviationorvolatility）ofthedistribution.Thehigherthisvolatility,theriskierarepositionsinthiscurrency.Itisalsopossibletorelyonmoreforward-lookinginformationusingtheoptionsmarkets（seeChapter20）.Finally,weshouldpointoutthatvolatilityisanadequateindicatorofriskwhenexchangeratechangesareapproximatelynormallydistributed.Inreality,thedistributionofexchangeratechangesdisplaysfattails,eveninfloatingexchangeratesystems,andthisincreasestheriskofcurrencypositions.

2.Whymightitbehardtoquantifycurrencyriskinatargetzonesystemorapeggedexchangeratesystem?

Answer:

Ifthepegortargetzoneholdsforalongtime,historicalvolatilityappearstobezeroorverylimited,butthismaynotaccuratelyreflectunderlyingtensionsthatmayultimatelyresultinadevaluationorrevaluationofthecurrency.Hence,thetruecurrencyriskdoesnotshowupinday-to-dayfluctuationsoftheexchangerate.Itishardtoquantifythis“latentvolatility.”

3.Whatislikelytobethemostcredibleexchangeratesystem?

Answer:

Amongfixedexchangeratesystems,amonetaryunionwithacommoncurrencyislikelythemostcredibleexchangeratesystem.Butevenhere,weseetensionswithintheEconomicandMonetaryUnioninEuropethatcouldleadtoabreakupoftheeuro.TheinabilityofGreeceandtheotherperipheralcountriestodevaluetheircurrenciesisleadingtoaprotractedperiodofhighunemploymentwithassociatedfiscaldeficitsandaninabilitytoregenerategrowth.Ultimately,oneoftheproblemcountriesmightwithdrawfromtheEMUorthestrongcountries,likeGermanyandFinland,mightwithdrawratherthansubsidizetheirinefficientneighbors.

4.Howcanacentralbankcreatemoney?

Answer:

First,becausethecentralbankoperatestheonlyauthorizedprintingpressinthecountry,itcanactuallyprintmoneytopayitsbillsortoacquireassets,therebyincreasingthemoneysupply.Second,thecentralbankcancreatemoneybyincreasingthereserveaccountsfinancialinstitutionsholdwithit.Forexample,ifthecentralbankbuysanasset（agovernmentbondsay）fromafinancialinstitution,itcreditsthefinancialinstitution’sreserveaccountatthecentralbankforthepurchasepriceofthebond.Becausethisfinancialinstitutioncannowusethiscredittoitsaccounttolendmoneytoindividualsandbusinesses,thecentralbankhas,essentially,createdmoney.

5.Whatareofficialinternationalreservesofthecentralbank?

Answer:

Officialreservesconsistofthreemajorcomponents:

foreignexchangereserves,goldreserves,andIMF-relatedreserveassets,withthefirstbeingbyfarthemostimportantcomponent.Foreignexchangereservesarealltheforeigncurrencydenominatedassetsthecentralbankholds,andmostlyconsistofforeigngovernmentbonds.

6.Whatislikelytohappenifacentralbanksuddenlyprintsalargeamountofnewmoney?

Answer:

Whereastherearetheoriesthatpredictthatchangesinthesupplyofmoneyhaverealeffectsontheeconomyintheshortrun,itislikelythatifthecentralbankshowerstheeconomysuddenlywithmoney,theonlyresultwillbehigherinflation.Thisisbecausethedemandformoneyultimatelydependsontheamountofrealtransactionsintheeconomyandhowmuchmoneyisneededtofacilitatethesetransactions.Additionalsupplyofmoneyisunlikelytomakepeopleconsumemoreorworkharder.

7.Whatistheeffectofaforeignexchangeinterventiononthemoneysupply?

Howcanacentralbankoffsetthiseffectandstillhopetoinfluencetheexchangerate?

Answer:

Whenacentralbankbuys（sells）foreigncurrency,itsinternationalreservesincrease（decrease）,andthemoneysupplyincreases（decreases）simultaneously.Tooffsettheeffectonthemoneysupply,theforeignexchangeinterventioncanbesterilized;thatis,thecentralbankcanperformanopenmarketoperationthatcounteractstheeffectonthemoneysupplyoftheoriginalforeignexchangeintervention.Thedirecteffectsofasterilizedinterventionaretwo-fold.First,itforcesaportfolioshiftonprivateinvestors,byreplacingforeignbondswithdomesticbonds（orviceversa）.Thismayaffectexpectationsandprices.Second,theactionsofthecentralbankintheforeignexchangemarkets,whileverysmallrelativetothenominaltradingvolumes,maystillmanagetosqueezeforeignexchangeinventoriesatdealerbanksandgeneratepricingeffects.Indirectly,thecentralbankcansignalitsopiniononthefundamentalvalueoftheexchangeratethroughaninterventionthatconsequentlyaffectsmarketexpectations.Thereisnoconsensusonhoweffectivesterilizedinterventionsareinaffectingthelevelandvolatilityofexchangerates.

8.Howcanacentralbankpegthevalueofitscurrencyrelativetoanothercurrency?

Answer:

Topegthevalueofitscurrencytoanothercurrency,thegovernmentmustmakeamarketinthetwocurrencies.Ifthereisexcesssupplyoftheforeigncurrency（whichisequivalenttoexcessdemandforthedomesticcurrency）thatwoulddrivedownthedomesticcurrencypriceoftheforeigncurrency,thegovernmentmustbuytheprivateexcesssupplyofforeigncurrencyanddeliverdomesticcurrencytothosedemandingit.Onthecontrary,ifthereisexcessdemandforforeigncurrency（whichisequivalenttoexcesssupplyofdomesticcurrency）thatwoulddriveupthedomesticcurrencypriceoftheforeigncurrency,thegovernmentmustsupplytheforeigncurrencyanddemandthedomesticcurrencytopreventtheforeigncurrencyfromappreciatinginvalue.

9.Describetwochannelsthroughwhichforeignexchangeinterventionsmayaffectthevalueoftheexchangerate.

Answer:

Thereisadirectandanindirectchannel.Asindicatedinquestion7,thedirecteffectofforexpurchasesorsalesislikelysmall,becausetradingvolumesaresolargeintheforexmarket,buttheremaybesomeshort-termeffectsiftheinventoriesofdealerbanksareadverselyaffectedbytheintervention.Ifnotsterilized,interventionsaffectthemoneysupply,butthateffecttoo,islikelytobesmallrelativetothesizeofthemoneysupply.Theindirectchannelreferstothefactthataninterventioncanalterpeoples’expectationsandaffecttheirinvestments,thushelpingtopushtheexchangerateinthedirectionthecentralbankdesires.Forexample,theinterventionmaybeasignaltothepublicofthecentralbank’smonetarypolicyintentions,oritmaysignalthecentralbanksinsideinformationaboutfuturemarketfundamentals,oritmaysignaltoinvestorsthatacurrency’sexchangerateisdeviatingtoofarfromitslong-runequilibriumvalue.Thesignaliscostlyandthereforepotentiallymorecredible,becauseifthecentralbankiswrongand,forexample,buysan“undervalued”currency,whichkeepsdepreciating,theinterventionwilllosemoney.

10.WhatwastheBrettonWoodscurrencysystem?

Answer:

IntheBrettonWoodsSystem,inplacebetween1944and1971,theparticipatingcountriesagreedtoanexchangerateregimethatlinkedtheirexchangeratestothedollar.Theycouldfluctuateina1%bandaroundafixedparity.Thedollaritselfhadafixedgoldparity（$35perounce）.Whenacountryranintoatemporarybalanceofpaymentsproblem（acurrentaccountdeficit）thatthreatenedthecurrencypeg,itcoulddrawonthelendingfacilitiesoftheIMF,alsoestablishedatBrettonWoodsin1944,tohelpitdefendthecurrency.Countrieswerealsoallowedtochangetheirparitieswhentheirbalancesofpaymentswereconsideredtobein“fundamentaldisequilibrium.”ThesystembrokedownwhenPresidentNixonabandonedtheU.S.commitmenttoexchangedollarsforgoldinAugust1971.

11.Howdodevelopingcountriestypicallymanagetokeepcurrenciespeggedatvaluesthataretoohigh?

Whobenefitsfromsuchanovervaluedcurrency?

Whoishurtbyanovervaluedcurrency?

Answer:

Suchasituationisdifficulttomaintain,becauseiftheexchangerateovervaluesthelocalcurrencyontheforeignexchangemarkets,therewillbeanexcesssupplyofthelocalcurrency—everybodywillwanttoturninlocalcurrencytothecentralbank,receiveforeigncurrencies,andinvestthemabroad.Ifthissituationpersists,thecentralbank’sforeignreserveswilldwindlequitefast.Theonlywaytosustainsuchasystemistoimposeexchangecontrols.Thecentralbankofthedevelopingcountrymustrationtheuseofforeignexchange,managewhogetsaccesstoit,andrestrictcapitalflows;inshort,itmuststrictlycontrolfinancialtransactionsinvolvingforeigncurrencies.Thatcurrenciesofdevelopingcountriesareprimarilytradedbythecentralbankofthecountryorbyanumberoffinancialinstitutionswithstrictcontrolsontheiruseofforeigncurrency（i.e.thecurrenciesareinconvertible）,ishelpfultomaintainsuchasystem.

Itisclearwhobenefitsandwholosesfromthissituation.Thefixedexchangerateundervaluestheforeigncurrencyandovervaluesthedomesticcurrency,therebysubsidizingbuyersofforeigncurrency（suchasimportersandthoseinvestingabroad）andtaxingsellersofforeignexchange（suchasexportersandforeignbuyersofdomesticassets）.Notsurprisingly,onemainreasonfor