Financial Market Issues - Assignment Example

Forex Paper Table of Content Question 6. What are purchasing power parity, covered interest parity, and uncovered interest parity? Assess whether these are likely to hold in the real world. 3 Question 11) What might “efficiency” mean in the context of foreign exchange markets? 6 Question 12) Use a specific example to explain how a currency crisis can come about. 8 Reference 11 Question 6. What are purchasing power parity, covered interest parity, and uncovered interest parity? Assess whether these are likely to hold in the real world. The Purchasing Power Parity (PPP) Theory was formalized in 1920’s by Gustav Cassel. It is based on the assumption of perfect arbitrages between markets, under condition of perfect competition and no barrier to trade. Such perfect arbitrage will ensure that price of a specific good when converted through the exchange rate will be the same in each of the two countries. These propositions refer to “The Law of One Price” (Loop). PPP Theory argues that Loop hold for all goods, and the price and exchange rates will adjust in such a way that price of a given bundle of goods will be same in both the countries. (Baillie, R & McMahon, P, 1990). This theory asserts that percentage change in the direct quote of a foreign currency will be equal to the difference between the inflation rate at the home and the inflation rate at foreign currency. Percentage change in e = [I(h)-I(f)]/1+I(f)] * 100 Where I(h) = inflation rate at home I(f) = inflation rate at foreign e = exchange rate between home and foreign currency Covered Interest Parity is also known as “Interest Rate Parity”. This theory is based on the assumption that in an effective market with no transaction cost, the interest difference should be equal to the forward differential. The currency of the country with a lower interest should be at forward premium in term of the currency of the country with the higher interest rate. When this condition is met, the forward mark is said to be at interest parity and equilibrium prevail in the market. Condition for Covered Interest Parity is as follow: [1+R(d)] = F/S * [1+R(f)] Where R(d) = the domestic interest rate for a certain interval of time R(f) = the foreign interest rate for a certain interval of time F = forward exchange rate S = spot exchange rate The uncovered interest parity propagates that the interest rate differential is equal to the ex-post exchange rate change. Uncovered Interest Parity theory is more difficult to test as because expected exchange rate changes are unobservable, also assumes that there should be no transaction cost, perfect capital flow, equal default risk on foreign and on domestic market. The risk premium should be zero. It is s follow: 1+R(d) = E[S+1]/S * [1+R(f)] Where E[S+1] = expected future spot rate As all of these theories are based on certain assumption like the market condition has to be perfect, there should be no restriction on free trade, no transaction cost should exist and the investors should be risk neutral. But in the real world, market conditions are not perfect neither free trade is possible. In many countries government imposes certain restriction on import and export of goods for economical welfare of their country. Transaction cost exists in the real world and the investors are not risk neutral; rather the investors are risk averse. So these theories do not hold in the real world. Question 11) What might “efficiency” mean in the context of foreign exchange markets? Foreign exchange market has to play a very vital role in the present globalized world. Foreign currency is the life blood which gets exchanged through foreign exchange market. There are many factors which affect the foreign exchange market directly or indirectly and bring efficiency in this market which are as follow: Trading volume- the volume indicates transaction which takes place daily among different countries. As per Bank of International settlement daily turnover in forex market is around $3.98 trillion which can be further broken down into spot transaction, outright forward, foreign exchange swaps and derivatives. Only in London daily around $1.36 trillion get traded; New York & Tokyo comes in the second position. Liquidity- This provides an ease of conversion or trading between the currencies. High volume trading provides ample liquidity to Foreign Exchange market. High liquidity is also due to the large numbers of traders in developing markets of third world countries. Traders of Forex includes banks, commercial companies, central bank, Hedge funds as speculators, investment management firm, retail foreign investment brokers, non-bank foreign exchange companies and money transfer/remittance companies. The most traded currency in foreign is US dollar (86.3%) followed by Euro (37.0%), Japanese Yen (17.0%) and Pound Starling (15.0%) and the other currency forms rest of the part of 200% as a whole. Trading hours- Foreign Exchange market can be said to operate for 24 hours. This is as because of the long trading hours of different countries which are dispersed in different location. One market closes in a countries, other remain operative so this continues for through 24 hours a day except weekends. Exchange rates- The exchange rates indicated value of foreign currency in term of domestic currency. Stable exchange rates bring stability in the Foreign Exchange market and. Basically these rate are determined by demand & supply and depend on market condition but when the degree of fluctuation is high, government comes for intervention. There are many economical factors which determine exchange rate of a country such as economy policies (fiscal and monitory policy), government budget deficit, balance of trade, inflation level and trends, economic growth and productivity of an economy. Political scenario and market psychology also plays important role in determining the exchange rate. Transparency- It is very important that there should be transparency in working of Forex Market. This has been achieved through fast transmission of information. This makes the market aware of incidents happening through out the glob. The information should not only move fast but it should be free of cost or at the most should be available at low price. Question 12) Use a specific example to explain how a currency crisis can come about. Asian Financial Crisis of 1997 is among the major currency crisis which will always remain in the memories of people through out the world. There is no single reason which was responsible for the major disaster which engulfed the whole south eastern world economy from June 1997 and January 1998, still the root cause is considered as the unprecedented economic growth of Asian countries. The financial deregulation and liberalization took through the world; the international markets got interconnected through speed transaction through computer technology. This increased the number of institutional players in form of hedge funds, investment banks, mutual funds and pension funds. All these factors created a shift in the short term capital flow, around 42 trillion of turnover of cash took place in one day out of which only on or two percent was used for foreign exchange transaction, the rest amount was invested for speculation. So th sequence of event that lead to development of this crisis is as follow; First and foremost cause was financial liberalization was uncontrolled conversion of currency. The foreign currency was converted into local currency not just for trade and direct investment in domestic market but mainly for autonomous inflow and out flow of capital. Thus there was a large inflow of fund in form of international bank loan from local banks and companies, large number of purchase of fund along with portfolio investment in local stock market. For example Bangkok International Banking Facilities (BIBF) on March 1993- March 1996 received huge foreign funds (US$31 billion) for recycling in local banks and companies. South Korea banks received US$150 billion of foreign debt for short term investment. Indonesia’s local banks also heavily borrowed heavily from abroad. Another major factor was currency depreciation and debt crisis in the south eastern countries. As the short term debt was increasing in the alarming rate in Thailand, Indonesia and South Korea; there was a sharp and sudden depreciation in the currency in of these countries along with reduction in the foreign reserves to reduce speculation. Due to depreciation of the currency, burden of debt servicing increased in terms of local currency to make the payment o foreign debt. These short term foreign loans started pulling the foreign reserve further low, which soon fall below the danger level. Thus Thailand, Indonesia and South Korea could not meet their foreign debt obligation and took help from IMF. During this phase Malaysia gave financial liberalization for foreign fund for conversion between foreign and local currency to be invested into stock market, foreign currency loan by the companies exceeded RM5 million should received grant from central bank. This policy adopted by Malaysia help to meet its external obligation for export earnings, so the level of debt remains under controlled. This control of central bank, kept Malaysia’s condition different from the three other countries which took help from IMF. High liquidity due to inflow of foreign funds as loan from banks or equity investment into the stock market contributed to boom in prices of property and I the stock market. The depreciating currency and expectation of dept crisis led to economic slowdown, loan withdrawal and fall in share prices. The higher interest rate squeezed the liquidity and monitory policy went tight which increased the financial burden of firms and individual and increased the non-performing loans and financial position went poor. Inflation rate went high making the prices move up further. Thus to reduce the current account deficit, governments reduced their expenditure and made budget cut which make the condition worst. One of the reasons which made the condition of recession mare worst was fall of GDP of Indonesia by 6.2% in the first quarter of 1998, inflation at 80% and expected unemployment at around 17% or 15 million. South Koreas GDP dropped to 3.8% in the first quarter 1998. Thailand’s GDP was dropped by 4 to 5.5 percent in 1998. Hong Kongs GDP dropped to 2% . Singapore had 5.6% growth in the first quarter but it faced a negative growth in the second half of 1998 in Malaysia GDP fell to 1.8% in first- quarter. Reference Baillie, Richard & McMahon, Patrick, 1990. Purchasing Power Parity Theory & Real Exchange Rates. The Foreign Exchange Market; Theory and Econometric Evidences. [online]. Available at:http://books.google.co.in/books?id=ihGXhphBeHkC&pg=PA16&dq=purchasin+power+parity+theory&as_brr=3&client=firefox-a [accessed 25th June, 2009] Hill, W.L. Charles, no date. The Asian Financial Crisis. University of Washington. [online]. Available at: http://www.wright.edu/~tdung/asiancrisis-hill.htm [accessed 25th June, 2009] Princeton Encyclopedia of the World Economy, 2007. World Economy - Interest Rate Parity 1. [online]. Available at: http://www.ssc.wisc.edu/~mchinn/IRP.pdf [accessed 25th June, 2009] Read More