Lecture 3:The Foreign Exchange Market An Empirical Analysis of the Impact of Foreign Exchange Regimes on Exchange Rates

Where is this International Financial Center?

Relationship of Exchange Rate Volatility to Exchange Rate Regime Question: Given the spectrum of exchange rate regimes which can confront both global firms and global investors, an important question is whether there is a difference in exchange rate volatility from one regime to another.  Additionally, what happens to volatility when regimes change.

Measured Volatility (Standard Deviations of % Changes) Against the U.S. Dollar Using monthly data from January 1990 – August 2011 Floating Currencies:  British Pound:2.31%  Japanese Yen:2.30%  Australian Dollar:3.22%  Euro:2.59% Managed Currencies:  Singapore Dollar:1.20% Pegged Currencies (“Crawling Peg):  Chinese Yuan:0.42% (since 7/05) Pegged Currencies (Fixed Rate):  Hong Kong Dollar:0.12%

Volatility of 3 Exchange Rate Regimes (Monthly Data, Jan 1990 – Aug 2011)

Measured Volatility (Standard Deviations of % Changes) Against the U.S. Dollar Using weekly data from August 2008 – August 2011 Floating Currencies:  British Pound:1.55%  Japanese Yen:1.26%  Australian Dollar:2.17%  Euro:1.55% Managed Currencies:  Singapore Dollar:0.73% Pegged Currencies (“Crawling Peg):  Chinese Yuan:0.16% Pegged Currencies (Fixed Rate):  Hong Kong Dollar:0.07%

Measured Volatility (Standard Deviations of % Changes) Against the U.S. Dollar Using daily data from August 2008 – August 2011 Floating Currencies:  British Pound:0.77%  Japanese Yen:0.80%  Australian Dollar:1.30%  Euro:0.82% Managed Currencies:  Singapore Dollar:0.41% Pegged Currencies (“Crawling Peg):  Chinese Yuan:0.11% Pegged Currencies (Fixed Rate):  Hong Kong Dollar:0.04%

Issues of Floating Currencies Presents the greatest ongoing risk for global firms.  Because as we have seen, as a group they exhibit the greatest exchange rate volatility. Over the long run as well as the short term.  Volatility results from market (demand and supply) forces, which are also difficult to predict.  In addition, these currencies are subject to abrupt trend changes (see next slide) Issue: How does a firm or investor estimate a floating rate currency’s future price or a change in trend. What are the implications of intermediate and long term trend change for global companies and investors?  They complicate the longer term FDI location decision (impact on costs and revenues in home currency). Where should you set up your production facilities?  What is the appropriate country weights for long term financial assets?

Intermediate and Long Term Trend Changes in the British Pound

Issues of Floating Currencies Data also showed that these currencies are very volatile over the short term (e.g., daily and weekly basis).  Again, these currencies are subject to large percentage changes over the short run resulting from demand and supply swings.  Complicates doing business or investing on an ongoing basis for: Exporters, importers, global asset managers, global commercial banks, overseas sales and manufacturing subsidiaries. What will be the costs and returns associated with different markets and different investments? Thus, global firms and global investors need to pay close attention to both their short term and long term floating currency exposures and utilize appropriate risk management tools.

Daily Volatility of the British Pound Over the Last 6 Months

Managed Currencies (Dirty Float) Under this regime, governments manage their currency to offset (i.e., counteract) market forces.  They do this when market demand factors or supply factors are seen as creating undesirable exchange rate moves. Exchange rate management may occur on  A regular basis or when governments feel conditions warrant. Management involves either  intervention action (buying or selling currencies) or  interest rate adjustments (to make the currency more or less attractive).

Managed Currencies Over the long term, managed currencies are somewhat risky for global firms, but not as risky as floating currencies (as measured by their volatility).  Reason: since these currency moves are being “managed” their trend moves are generally likely to be more gradual than the currencies under floating rate regimes.  Review the Singapore dollar at: Look at weekly data for USD/SGD  However, these currencies are still subject to trend moves and trend changes (similar to floating rate currencies).  So, global companies need to assess currency exposures and risk, over the intermediate term and long term.  Trend changes will affect their FDI positions and longer term export and import situations

Trend Changes in the Singapore Dollar,

Managed Currencies Over the short term, these currencies are not as volatile as floating currencies.  Reason: Government management is aimed at countering short term volatility (perhaps more so than long term trends or trend changes). Thus daily and weekly changes are not potentially as great as with floating rate currencies. Exception: At times, governments managing their currencies may engage in strong intervention to support their currencies. This has the potential for a substantial short term currency move.  Example: Swiss franc on September 6, 2011

Daily Volatility of the Singapore Dollar Over the Last 6 Months

Pegged Currency Regimes: Ultimate Currency Management Under a pegged currency regime, g overnments link their national currency to a key international currency (usually the U.S. dollar or the euro or some combination of currencies). Why do governments peg their currencies?  A peg is seen as a necessary condition to promote confidence in the currency and in the country and promoting economic growth. May encourage foreign direct investment or long term capital inflows. Or by pegging the currency at an undervalued currency this may support the country’s export sector.  Pegs can either be at a fixed rate (e.g., Hong Kong dollar) or in relation to a trend (i.e., a crawling peg).  As long as the peg is maintained, the exchange rate risk is negligible (recall there is some potential daily variation). See 10 minute trades USD/HKD at Peg is maintained through market intervention (buying and selling)

Hong Kong Dollar: Pegged to a Fixed Rate (7.8HKD = 1 USD)

Daily Volatility of the Hong Kong Dollar Over the Last 6 Months

Mexican Peso Crawling Peg (with a Floor of )

Pegged Currencies As long as the peg is maintained, this regime presents the smallest risk to global firms; however there is the potential for enormous risk, where:  Governments either (1) abandon the peg for another foreign currency regime or (2) adjust to a new peg.  These changes occur either by An orderly change adopted by the government (China from a fixed peg to a crawling peg on July 21, 2005 with move changes which followed). Peg coming under successful market attack (e.g., Argentina from a fixed peg to a float on February 11, 2002 and Mexico from a crawling peg to a float on December 22, 1994). These changes can have substantial impacts on global firms and global investors.  Especially if the firm or investor did not take advanced steps to protect itself. Thus, global firms and global investors must be on the alert for exchange rate regime changes

China: From a Fixed Peg to a Crawling Peg to a Fixed Peg to a Crawling Peg

Argentina: Abandoning the Fixed Peg: Moving to a Floating Regime, Jan 2002

Percent Change in ARS-USD Daily Data, Jan 1, 2000 – Dec 31, 2001

Percent Change in ARS-USD Daily Data, Jan 1, 2003– Jan 1, 2005

Abandoning a Pegged Rate and the Currency Weakens: RISKS for Global Firms and Investors As noted, changes in exchange rate regimes pose potential risks for global firms. Using the Argentina example, discuss the following:  What do you think happened to foreign multinationals located in and selling in Argentina after the peso weakened? For Example: McDonalds’ U.S. dollar profits in Argentina?  What do you think happened to foreign multinationals exporting to Argentina after the peso weakened? For example: Boeing ability to export airplanes to Argentina?  What do you think happened to the portfolios of investors holding Argentina stocks and bonds?

Abandoning a Pegged Rate and the Currency Weakens: OPPORTUNITIES for Global Firms However, changes in exchange rate regimes also offer potential opportunities for global firms. Again, using the Argentina example:  What do you think happened to foreign multinationals importing from Argentina after the peso weakened? For Example: Wal-Mart’s U.S. dollar cost associated with importing goods from Argentina?  What do you think happened to foreign multinationals considering expanding FDI into Argentina after the peso weakened? For Example: The new U.S. dollar cost to Ford Motor Company considering setting up a production facility in Argentina?

Potential Costs to Holding a Peg If market forces push a pegged currency above its peg (i.e., the currency becomes “too strong” or “overvalued”) this happens because:  The market is buying the currency, then Government management involves either selling the pegged currency on foreign exchange markets (thus, buying hard currency) or reducing domestic interest rates. Issues: If the government sells its currency this created to potential for expansion of its domestic money supply and hence inflationary pressures. On the other hand, lowering domestic interest rates can also stimulate domestic investment and economic activity which may lead to inflationary pressures.

Potential Costs to Holding a Peg If market forces push a pegged currency below its peg (i.e., the currency becomes “too weak” or “undervalued”) this happens because:  The market is selling the currency, then  Government management involves either buying the pegged currency on foreign exchange markets (thus, selling hard currency or raising domestic interest rates. Issues: Does the government want to give up its hard currency (does it have potentially better uses for this (e.g., buying oil or paying off international debts) On the other hand, raising domestic interest rates can dampen economic activity and lead to rising unemployment.  Note: The last two slides summarize one reason (i.e., the costs) why major central banks have probably gotten out of the currency management business.

Appendix 1: Monitoring FX Intervention

Most major central banks provide timely information regarding their intervention activities in foreign exchange markets. As on example see:  This site provides a quarterly report on both the U.S. dollar and intervention activities on behalf of the dollar. Go to archives, July 30, 1998 to view intervention activity.