1 Foreign Exchange Markets and Foreign Exchange Rates..................................1
1.1 Foreign Exchange Rate Quotations and Arbitrage.....................................2
1.1.1 Foreign Exchange Quotations..........................................................2
1.1.2 Cross Rates and Arbitrage ...............................................................3
1.2 Foreign Exchange Transactions .................................................................5
1.2.1 The Bid-Ask Spread.........................................................................5
1.2.2 Transaction Costs and Arbitrage Opportunities...............................8
1.3 Spot and Forward Exchange Rates ..........................................................11
1.4 Effective Exchange Rates ........................................................................13
1.5 Other Currency Markets ..........................................................................15
2 Exchange Rate Regimes and International Monetary Systems........................17
2.1 Exchange Rate Regimes ..........................................................................17
2.2 A Brief History of International Monetary Systems ................................21
2.3 The European Single Currency ................................................................25
3 International Parity Conditions ........................................................................31
3.1 Purchasing Power Parity ..........................................................................31
3.1.1 Absolute Purchasing Power Parity.................................................32
3.1.2 Real Exchange Rates .....................................................................36
3.1.3 Relative Purchasing Power Parity..................................................37
3.1.4 Empirical Tests and Evidence on PPP...........................................39
3.2 Interest Rate Parities ................................................................................45
3.2.1 Covered Interest Rate Parity ..........................................................46
3.2.2 CIRP and Arbitrage in the Presence of Transaction Costs.............51
3.2.3 Uncovered Interest Rate Parity ......................................................52
3.3 International Fisher Effect .......................................................................55
3.4 Links Between the Parities: a Summary ..................................................57
4 Balance of Payments and International Investment Positions .........................59
4.1 Balance of Payments................................................................................60
4.1.1 Balance of Payments Accounts and Classification ........................61
4.1.2 Balance of Payments Entries and Recording .................................65
x Contents
4.1.3 The Balance of Payment Identity...................................................75
4.2 International Investment Position Statements and Analysis ....................76
5 Open Economy Macroeconomics ....................................................................85
5.1 The Balance of Payments, National Accounts
and International Economic Linkages......................................................85
5.1.1 National Accounts with an External Sector ...................................85
5.1.2 International Economic Linkages ..................................................87
5.2 IS–LM in Open Economy Macroeconomics ...........................................89
5.2.1 IS–LM Analysis.............................................................................89
5.2.2 IS–LM–BP Analysis......................................................................95
5.3 Aggregate Supply and Assumptions on Price Attributes .........................99
6 The Mundell-Fleming Model ........................................................................103
6.1 Effects and Effectiveness of Monetary Policy and Fiscal Policy
- Perfect Capital Mobility ......................................................................103
6.1.1 Monetary Expansion - Perfect Capital Mobility,
Flexible Exchange Rates..............................................................104
6.1.2 Fiscal Expansion - Perfect Capital Mobility,
Flexible Exchange Rates..............................................................107
6.1.3 Monetary Expansion - Perfect Capital Mobility,
Fixed Exchange Rates..................................................................109
6.1.4 Fiscal Expansion - Perfect Capital Mobility,
Fixed Exchange Rates..................................................................112
6.2 Effects and Effectiveness of Monetary Policy and Fiscal Policy -
Imperfect Capital Mobility.....................................................................114
6.2.1 Monetary Expansion - Imperfect Capital Mobility,
Flexible Exchange Rates..............................................................115
6.2.2 Fiscal Expansion - Imperfect Capital Mobility,
Flexible Exchange Rates..............................................................119
6.2.3 Monetary Expansion - Imperfect Capital Mobility,
Fixed Exchange Rates..................................................................121
6.2.4 Fiscal Expansion - Imperfect Capital Mobility,
Fixed Exchange Rates..................................................................124
6.3 Monetary Policy Versus Fiscal Policy ...................................................127
6.3.1 Effect on Income .........................................................................127
6.3.2 Effects on the Exchange Rate and Official Reserves...................129
6.3.3 Effect on the Balance of Payments Current Account ..................129
7 The Flexible Price Monetary Model..............................................................131
7.1 Demand for Money in Two Countries and Foreign Exchange Rate
Determination ........................................................................................131
7.2 Expectations, Fundamentals, and the Exchange Rate............................137
7.3 Rational Bubbles and Tests for
the Forward-Looking Monetary Model .................................................140
7.4 Empirical Evidence on the Validity of the Monetary Model .................144
Contents xi
8 The Dornbusch Model ...................................................................................149
8.1 The Building Blocks of the Model and the Evolution Paths of the
Exchange Rate and the Price..................................................................149
8.2 Adjustments of the Exchange Rate and the Price and Overshooting
of the Exchange Rate .............................................................................154
8.3 A Tale of Reverse Shooting and the Sensitivity of Exchange Rate
Behaviour...............................................................................................163
8.4 The Real Interest Rate Differential Model.............................................167
8.5 Empirical Evidence on the Dornbusch Model and Some Related
Developments ........................................................................................169
9 Global Derivatives Markets ...........................................................................173
9.1 Global Use of Derivatives –
Current State, Trends and Changing Patterns ........................................173
9.2 Organised Derivatives Exchanges,
Contract Specifications and Trading......................................................186
9.3 Use of Derivatives Shapes Investor Behaviour, Risk Management
Concept and Risk Management Methods...............................................200
10 Currency Futures ...........................................................................................203
10.1 Futures Contracts and Trading...............................................................203
10.2 Futures Quotes .......................................................................................207
10.3 Pricing of Futures Products....................................................................210
11 Currency Options...........................................................................................219
11.1 Option Basics.........................................................................................219
11.2 Option Terminology and Quotes............................................................229
11.3 Currency Options...................................................................................233
11.4 Option Pricing – the Binomial Tree Approach.......................................239
11.5 Option Pricing – the Black-Scholes Model ............................................253
12 Currency Swaps .............................................................................................259
12.1 Basics of Swaps .....................................................................................259
12.2 Currency Swaps .....................................................................................263
12.3 Swapnotes ..............................................................................................267
13 Transaction Exposure ....................................................................................273
13.1 Introduction to Transaction Exposure and Its Management ..................273
13.2 Forward Hedge and Futures Hedge........................................................275
13.3 Money Market Hedge ............................................................................281
13.4 Option Hedge.........................................................................................285
14 Economic Exposure and Accounting Exposure.............................................289
14.1 Measuring Economic Exposure .............................................................290
14.2 Managing Economic Exposure ..............................................................293
xii Contents
14.3 Measuring Accounting Exposure...........................................................295
14.4 Managing Accounting Exposure............................................................300
15 Country Risk and Sovereign Risk Analysis...................................................303
15.1 Factors of Influence on Country Risk ....................................................304
15.2 Country Risk Analysis and Ratings .......................................................306
15.3 Sovereign Risk Analysis and Ratings ....................................................317
16 Foreign Direct Investment and International Portfolio Investment ...............323
16.1 Recent Profiles of Foreign Direct Investment........................................323
16.2 FDI Types and Strategies.......................................................................331
16.3 International Portfolio Investment .........................................................336
References ...........................................................................................................341
Index ...............................................................................................................347