Market Liquidity and Funding Liquidity - Philippines Currency - Assignment Example

FIN9003M International Finance Assessment a) According to the graph, it is clearly evidentthat the risks linked with uncertainty about the future level of exchange rate are seen to be present in Philippines. In relation to this, Philippines is considered to be a good case for studying foreign exchange risks. The reason for this is that Philippines has never fixed its currency in the period given(2009-2014).Furthermore, such observations makes the analysis results robust to inconsistencies in the performance of UIP that is as a result from exchange rate regime as noted in Flood and Rose(1976) b) From the Graph above it is clearly evident that the 3 month forward rate of Philippines Vis-a vis GBP started appreciating as early as 2009 on regular basis.On the other hand,1 month forward premium became negative in late 2011.It later started appreciating again up to 2012 of which hence forth it was not stable in the year 2013-2014 whereby the interval between appreciation was too small and it was between negative and positive. The question here is that for how long the PHP will remain intervening in the forex market to keep PHP in check. C) Summary Statistics table for the variables d) The results in regard to the testing of 1 month and 3 month horizon risk premium shows that both of them do exist and are statistically significant e) The UIP analog normally explored in literature is known to be the covered interest parity condition (CIP).In this case; forward exchange rate does not exist in the exchange rate expectations equation. In case UIP is valid, the equation must lead to estimates of alpha and beta whereby the difference is not significant from unity and zero respectively. Practically, researchers have majorly put more focus on the slope parameter estimates through the use of various currencies as well as time periods. Several studies have implemented the equation and got results that are not favorable to the hypothesis of efficient market under risk neutrality. root and Thaler(1990) noted that the coefficient average value if about -0.88Only few estimates got are seen to be atleast 0 and non of the estimates is seen to be greater than 1. Such kind of results tends to be robust under various estimation methods employed by the researchers as well as the mix of non-overlapping and overlapping data sets 2) Purchasing power parity is a simple theory that is seen to be disalarming.I holds that the exchange rate that exists between 2 currencies is expected to be equal to the aggregate price ratio levels between the 2 nations, so that 1 currency unit of one nation could have the same purchasing power in the foreign country. The theory or PPP is seen to have a very long history in economics, that dates back many centuries, but the specific purchasing power parity terminology is seen to have been introduced after World War I in the period when international policy debate about the relevant level regarding nominal exchange rates among the major the nations that are industrialized after a drastic inflations after and during the war (Cassel, 1918). The PPP idea since then has become integrated in the way several international economists view the world. For instance, Dornbusch and Krugman (1976) indicated: “Under the skin of any international economist lies a deep-seated belief in some variant of the PPP theory of the exchange rate.” Rogoff (1996) indicated the same: “While few empirically literate economists take PPP seriously as a short-term proposition,” “most instinctively believe in some variant of purchasing power parity as an anchor for long-run real exchange rates.” The question on the way exchange rates adjust is seen to be key to the policy of exchange rate, because fixed exchange rates nations are required to be informed about what the equilibrium exchange rate is expected to be as well as nations with exchange rates that varies might wish to know what variation and level in nominal and real exchange rates expected. In general, the question on whether there is adjustment of exchange rates toward an established level through purchasing power parity can help in determining the level at which the system of international macroeconomic is self-equilibrating. To really understand whether PPP in either its absolute or its relative versions is a relatively appropriate estimation to the real world, it has been indicated in Figure 1. The plots on top panel data on the UK and U.S. consumer price indices (CPIs) against the duration between 1820–2001. Both of this has been indicated in U.S. dollar, and this implies that the CPI of UK had to be multiplied by U.S. dollars that were exchanged for 1 UK pound at that particular point in time. The panels at the bottom indicates the comparison with the use of producer price indices, data being used at least for longer period between 1791–2001.1 (arbitrarily) each of the series was normalized to zero in the year 1900. In this case, about 3 points could be posed after considering these graphs. Firstly, absolute PPP didn’t hold continuously and perfectly: in both cases, the correlation observed between the 2 lines is considered to be less than perfect. In simple terms, there exist significant deviations that are short-run from PPP. Secondly, the two nations’ price levels that are expressed in a common currency seemed not to move together against this long duration. Thirdly, there was a correlation that existed between the two levels of national price and it was observed to be much greater with prices of producer as compared to the consumer prices. Figure 2 indicate graphs generated from data for a big number of economies against the duration that is between the years 1970–1998.2 When the first the 2 graphs of Figure 2 in the top row are considered. For every nation the one-year inflation rate was calculated in each of the 29 years then this was subtracted from the inflation rate of U.S for one-year to get a relative inflation measure. The percentage change in the exchange rate of the dollar was calculated for every year. Lastly, the relative annual inflation was plotted against the depreciation of exchange rate for every 29 years for each of the economies. In this case, if the PPP held perfectly, then it means that every scatter points could be on a 45o ray that is through the origin. In the 2nd, a similar exercise was undertaken, except the averages were taken into account: The 29-year annualized average relative inflation was plotted against the depreciation of the annual currency average against the dollar of U.S. for the whole period. In this case, there was only one scatter point for every nation. Figure 2 ascertains some of the Figure 1lessons. In regard to the small differences that exist in annual inflation between the concerned country and United States, the correlation between depreciation and relative inflation in each given years tends to be low. Hence, relative PPP seems not to hold continuously and perfectly in the short run, despite, it seems to hold very closely for nations that are facing relatively high inflation. Figure 1 a)U.S and UK CPIs in dollar terms U.S. and UK PPIs in dollar terms This particular figure indicates UK and U.S consumer and producer price indices expressed in U.S dollars for the past 2 centuries on a log scale of 1900=0 Figure 2.This figure indicates the cumulative inflation rate differentials of countries against U.S.A in percentages (Y-axis) and its plotted against their c. depreciation rates against the united States dollar (X axis).The left charts indicate the CPI inflation. On the right indicate PPI inflation. On the top, they indicate the annual rates. The ones at the bottom row are 29 year average rate between 1970 -1998 The review of theoretical and empirical literature pertaining to funding liquidity risk shows that increased risk associated with funding liquidity reflects an increased valuation of bids in the market, as investors and traders seek more return for higher risk assets. In order to normalize the bid price, Drehmann and Nikolaou (2008) have introduced the concept of adjusted bid, which is ultimately used in the measurement of liquidity funding risk. Having discussed funding liquidity, funding liquidity risk and its measurement, it is now relatively a simple task to describe and understand market liquidity, which in a similar manner, refers to the ability of traders to sell and/or buy assets in the market with no or little influence on its price and at lowest possible costs (Hooker & Kohn, 1994). Market liquidity relates directly to the cost of an asset in the market. It is the bid-ask spread aimed at determining the loss caused to sellers upon selling an asset in the market and purchasing it again at the same time. Another factor which relates to market liquidity is the “market depth”. Market depth is depictive of the number of units of an asset traders are willing to trade while keeping in view the existing prices, i.e. both for bid and ask, provided that no changes in the price of unit(s) take place. In this way, it is stated that when market depth is greater, prices can be moved only if orders with large quantities are placed. Lastly, market resiliency is another concept, which deals with the determination of a market’s ability to revert back in relation to the prices of units being traded. In other words, it is reflective of the time needed for the prices to revert back to original after having declined temporarily during the trade. Market liquidity is often referred to as a systematic and non-diversifiable component of the funding liquidity risk. Funding liquidity risk has played an important role in all banking crises. However, measure based on available data is indefinable. Aggressive bidding during central bank auctions shows the funding liquidity risk. Bank of International Settlement helps to promote stability in financial sector by analyzing the issues faced by authorities and thus enable it by setting an international standard. To carry out the banking supervision BIS has set up Basel Committee on Banking Supervision. Guidelines and standards issued by BCBS is known as Basel Accords. Till date we have three BCBS Accords known as Basel I, Basel II and Basel III. Basel III Accords manages the liquidity risk and it also helps to strengthen the capital adequacy ratio. Basel III measures the funding liquidity risk. Under Basel III the standard of minimum liquidity is based upon two ratios- Liquidity Coverage Ratio and Net Stable Funding Ratio. While the minimum requirement of LCR is used to increase the bank’s ability to survive short term liquidity crunch, on the other hand NSFR is used to uphold the flexibility for absorbing the shock in long term. After discussing the definition and the basic concepts of bank funding liquidity risk and market liquidity risk that have played very important role in global financial crisis of 2008, it is now important to understand how to measure these. The following section discusses how to measure bank funding liquidity risk and market liquidity risk. Small Essay Question 1) a) According to the literature, the capital controls could enhance welfare from the single country perspective if they have been designed in correcting domestic externalities. Policy measures which impact international capital flows have resulted to a significant controversy in international policy circle of recent(Ostry et al,2012).When there is opening up of capital accounts for private agents lending or borrowing, Ricardian equivalence results for reserve accumulation is derived According to Basel III Banks should have a minimum of 100% NSFR. It comprises of equity, demand deposits and preference stock. Demand deposits can be divided into stable and less stable. Previous one can be defined as the deposit portion is expected to stay with the bank for minimum one year. Available amount of stable funding i.e. the numerator can be calculated as:- (summation of total value of each funding source held* specific factor which are prescribed for each funding source). In the equation of NFSR numerator relates to liabilities and denominator considers the assets. NSFR helps to endorse many more medium and long term funding for banks which will help the bank to survive liquidity crunch. This can be achieved by the effect of NSFR by restraining the extent to which mismatch the duration in assets and liabilities possible by a bank (Muskawa, 2013, p.11). Market illiquidity has a positive effect on the surplus stock return of Treasury bill rate. This is responsible for the positive cross sectional relation between illiquidity and stock return. If investors expect high market illiquidity then they will price the stock in such a way that they can generate high return (Ratanapakorn and Sharma, 2007).There can be three ways to measure market liquidity. Most important measure is the bid-ask spread method which is also known as width. When bid-ask spread is low or narrow then the market tends to produce more liquidity. In this context the term depth means the ability of the market to cope up with the selling of a position and the term resiliency means the ability of the market to regain its position from temporary incorrect price position. Bid-ask spread analyzes the liquidity present in price dimension which is a feature of market. Financial models those deal with bid-ask spread is also deal with exogenous liquidity models The feature of the seller or the seller’s position depends on the position size relative to the market. Models which are used for this method measure liquidity from the dimension of quantity and also known as endogenous liquidity models. When an asset cannot be sold then it reduces its market price and can be illegible. Market liquidity risk is generated by the interaction between buyer and seller in the market. This is known as endogenous liquidity risk. If the buyers are absent from the market place then the risk will be known as exogenous liquidity risk. If the bid-ask spread is extremely high or low then that generates the market liquidity risk. Another model to measure market liquidity risk is model based on volume or transaction data. Berkowitz has invented the transaction regression model where he estimates that past trades have an impact on liquidity price (Cook, 2007).There are other models like models based on limit order book data. Theoretical models like models based on optimal trading strategies. One important issue in market liquidity risk is to manage the market liquidity risk. Liquidity of an asset depends on the market condition. Thus an asset which near to mature and where profits come from dividend, interest rate coupon possess no risk. But certain assets tend to be liquidated in nature. Trading book is an example of liquid asset. From the point of view of risk related measures, bank liquidity funding risk is a major component of probable liquidation (Lo and MacKinlay, 1990).Financial organizations having extreme requirement for cash or cash outflows will have to liquidate some portion of its assets. Thus a proper forecast and planning of funds required and risk measurement is the main step towards solvency risk management (Humpe and Macmillan, 2009). The interaction between funding liquidity and market liquidity is worth understanding, as both interrelate to each other and reap favourable conditions. According to Brunnemeier and Petersen (2007), in theory there shall exist a strong relationship between funding and market liquidity risk. According to them, when banks portray as funding constraints in the market, there is a decline in the prices of assets being traded and as a result there exists a greater risk related to funding liquidity. In such a situation, declining prices of assets will ultimately result in increased margin calls by traders, which in itself signify the increase in risk associated with funding liquidity. In order to upkeep their liquidity positions, banking institutions tend to sell more assets and such practices lead to decline in the prices of assets and even more higher margin calls in the market. This interaction between funding liquidity and market liquidity risks play a significant role in stimulating a situation of financial crisis on a larger canvas. Keeping in view the lack of empirical evidences in this regard, Drehmann and Nikolaou (2008) conducted an empirical investigation to determine the impact of interactions between funding liquidity risk and market liquidity risk. For this purpose, the researchers investigated the relationship between liquidity risk proxy and an index used by the European Central Bank in 2008 as a representative of market liquidity. The empirical investigation revealed that when market liquidity risk was higher, the funding liquidity risk was also following an increasing trend on the graph, thus implying a positive and direct relationship between the two types of liquidity risks. This relationship can be put in a different manner by stating that funding liquidity risk is negatively related to the market liquidity index, that is to say when market liquidity increases, funding liquidity risk is on a declining side and when there is a decline in the market liquidity (index), the risk associated with funding liquidity increases (Avramov et al, 2006). b) In securities markets across the globe, warrants are increasingly being used by investors as a tool for investment, hedging, market speculation or even arbitrage. A call/put equity warrant offers the holder the right, although not an obligation, to buy/sell the underlying stock within a given predefined price on, or possibly prior to, the date of expiry. In return, issuers of warrant earn a warrant premium as a result of their obligation to offer stock (or its cash equivalent) to the holders of the warrant holders in instances where the warrants are exercised. The warrant’s attractions are inclusive of the gearing effect that provides higher returns for lower investment principals, the capped downside risk, as well as the easier procedures in relation to other forms of derivatives such as options or even futures. Basically, there are two types of warrants, one being the equity warrants and the other being the derivative warrants. Equity warrants provide their holders with the right to make subscriptions for equity securities of a given issuer at predefined price and they are provided by that issuer of any of its existing subsidiaries. The warrant’s issuer has an obligation to deliver the underlying securities once full payment of the determined price by holder of the warrant has been made. On the other hand, derivative warrants also known as the covered warrants) although similar to equity warrants, tend to have shorter lifespans usually within the range of half to two years. They can be issued across a wide range of assets, such as, stocks, stock indices, trading currencies, commodities in the market, or even a basket of securities. They are basically issued by a third party, often an investment bank, which is independent of the underlying assets issuer or any or any of its subsidiaries. Given that derivative warrants may have wide scope, extensive warrant markets in the globe are often derivative warrant markets. For instance, equity warrants in the Philippines warrant market accounts for a meagre 7% of capitalization in the market. According to World Federation of Exchange (WFE) statistics, 24 stock exchanges which trade in warrants exist. The total trading volume amounts to a whopping >300 billion US dollars as per the 2010 finings. Also important to note is the fact that there are >60,000 warrants listed in 2010. A ranking by list number revealed that the leading markets are Deutsche Borse, Euronext, Swiss Exchange, Borsa Italiana, and Luxembourg while ranking in terms of annual turnover put Philippines market among the giants with the top five warrant markets being Deutsche Borse, Philippines, Swiss Exchange, Borsa Italiana and Euronext in order of merit. The option pricing theory, largely traced to Black & Scholes (1973) and believed to have been further developed by Merton (1973), has played a critical role in advancement of the thinking that options are redundant securities. In such a setting scenario, the presence or absence of the options will have no influence on the risks associated with financial markets or even the volatility linked with the underlying stocks due to the fact that they do not provide any new investment opportunity beyond what is availed by the underlying stock. These researchers claimed that an investor may replicate the option’s payoff via a dynamic trading strategy; a situation whereby the option position can be replicated via a portfolio made of stock and riskless bonds. Among the multiple presumptions necessary include the lack of market imperfections such as transaction costs/margin requirements, as well as the ability to sell short with full usage of the realized proceeds. Given that the presumption of perfect capital market is non-existent, it is expected that option listing bring about various impacts towards its underlying stock market. Various researchers in the past suggested that option listings may raise the quality of underlying stock market. Ross (1976) claimed that the introducing options tends to enlarge the opportunity set of traders by allowing them to achieve fresh payoff patterns and hence making the rather not complete market much more complete. As a result, the necessary rate of return may be substantially reduced and resulting into an increase in the price associated with the underlying stock. Detemple & Selden (1991) on the other hand demonstrated that introduction of options enables development of a more efficient risks allocation approach across securities and as a result there is an increased demand for the underlying securities followed by a consequent reduction in the spot price volatility. The net effect is believed to be an increase in the aggregate demands as well as price of the stock, and at the same instance the volatility associated with stock return rate suffers a decline. As a result, most studies conclude that introduction of options has a stabilizing effect on the underlying stock market. Additionally, the presence of derivatives is believed to have an enabling effect on market makers with respect to underlying stocks in order to hedge the risk associated with their portfolio inventory in a way likely to result into lower bid-ask spread accompanied by greater liquidity for the underlying stocks (Detemple & Selden, 1991) C) However, some market observers hold the claim that derivative markets could have a destabilization effect on the underlying stock market. The rationale behind their argument is that the presence of derivative instruments provides an avenue for institutional investors to grab a large position with regard to both the derivative as well as the underlying stock markets and hence take advantage of the discrepancies in pricing. This large trading volume, as a result produces price pressures in the underlying stock market. Additionally, derivative instruments provide and enabling environment for investors to get increased leverage gain than if the invested had purely invested in underlying stocks. It therefore follows that various researchers have argued that existence of options could as a matter of fact result into trading volume being diverted away from the underlying stock to the accompanying option, and hence decreasing liquidity (Skinner, 1989). This argument is also seen in Skinner (1989) who claims that if the introduction of options lures substantial trading volume further from the underlying stock, the liquidity has the potential of increasing the stocks return variance. Funding liquidity risk has played an important role in all banking crises. However, measure based on available data is indefinable. Aggressive bidding during central bank auctions shows the funding liquidity risk (Acharya and Pedersen, 2005). Bank of International Settlement helps to promote stability in financial sector by analyzing the issues faced by authorities and thus enable it by setting an international standard. To carry out the banking supervision BIS has set up Basel Committee on Banking Supervision. Guidelines and standards issued by BCBS are known as Basel Accords. Till date we have three BCBS Accords known as Basel I, Basel II and Basel III. Basel III Accords manages the liquidity risk and it also helps to strengthen the capital adequacy ratio (Acharya and Pedersen, 2005). Basel III measures the funding liquidity risk. Under Basel III the standard of minimum liquidity is based upon two ratios- Liquidity Coverage Ratio and Net Stable Funding Ratio (Acharya and Pedersen, 2005). While the minimum requirement of LCR is used to increase the bank’s ability to survive short term liquidity crunch, on the other hand NSFR is used to uphold the flexibility for absorbing the shock in long term. After discussing the definition and the basic concepts of bank funding liquidity risk and market liquidity risk that have played very important role in global financial crisis of 2008, it is now important to understand how to measure these Bibliography Drehmanna, M., & Nikolaou, K. (2008). Funding Liquidity Risk: Definition and Measurement. Munich: Deutsche Bundesbank. Hooker, M. A., & Kohn, M. (1994). An empirical measure of asset liquidity. Hanover: Dartmouth College. Ostry, J. D., Ghosh, A. R., and Korinek, A. (2012). Multilateral aspects of managing the capital account. IMF Sta¤ Discussion Note 12/10. Muskawa, T., 2013. Measuring Bank Funding Liquidity Risk. [online]. Available at: http://www.actuaries.org/lyon2013/papers/AFIR_Musakwa.pdf. [Accessed on November 28,2013]. Ratanapakorn, O. and Sharma, S. C. (2007), Dynamic analysis between the US stock returns and the macroeconomic variables, Applied Financial Economics, 17:5,369-377. Cook, S. 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