Following Economies Currency and the Interest Rates - Assignment Example

Question five (40 marks). In light of recent financial/economic/political events, describe the impact, using theoretical analysis where possible, on the following economies’ currency and the interest rates. Russia The Russian rubble took the biggest smashes in the year 2014. The most influencing factor was Russia’s annexation of Crimea in Ukraine. As reported by the Matlack (2014), by October last year, the rubble was down by 20% in comparison to the US dollar. It has been described as one of the worst performers this year. The Russian Central Bank has tried to resuscitate the rubble by increasing the key interest rate to 7.5% from 7%. The reason for the increase was great inflation risks and a weak rubble (Adomanis, With Downgraded Debt, A Plunging Currency, And A Weak Stock Market Russia Is In Real Trouble, 2014a). Financial analysts state that the collapse of a currency as that of the rubble is hardly followed by good economic prospects. The Russian government allowed banks to evade the usual accounting rules in order to maintain hard currency, and it sold billions of dollars of foreign exchange holdings to no avail (Adomanis, Russias Currency Crisis Continues: The Ruble Is Crashing Again, 2014b). The Russian economy is said to have slowed and headed to recession. The capital flight raised dramatically with the investments from within Russia decreasing. With the gross domestic product growing by only 1.5%, a high decrease, the anticipation surrounding activity in the economy reduced. Hence, the population and businesses alike favored the utilization of their resources to build up their foreign exchange savings. Japan According to Jack Phang Investment (2014), amongst all the Asian currencies, the Japanese Yen dropped the greatest against the US dollar. The drop was estimated to be by around 10.59%. The reason was due to the Abenomic push by the Japanese prime minister. In the past two years, the Japanese Yen has lost one third of its value. The government of Japan has been trying to drive the Yen down and increase its competitiveness by pumping around 80 trillion per annum into the economy. What is the effect of this? The effect is suggested to be the initiation of a capital flight from Japan. It could also cause conflict involving the currency whereby, Japanese central banks purchase assets this year (Dakers, 2014). The downfall of the Japanese account surplus leading to current account deficits also led to the weakening of the Yen. It is said that the current account deficits lead to currency deflation, as the country, in this case Japan, is obliged to fund the deficit associated with the foreign currency. It results to a decrease in the domestic currency’s value (Cain, 2014). China The US Dollar was ranked as one of the start performers of 2014. By the end of 2014, the US Dollar was estimated to be 12.8% up against key currencies (Campos, 2014). As of December 2012, the Chinese Yuan was at 6.20 Chinese Yuan to one US Dollar (Trading Economics, 2015). Evans-Pritchard reports that China is on the verge of a financial crisis due to stutters in growth and pressure arising from deflation. China was faced and is still faced by a US dollar 26 trillion amount of debt that caused a fragile economy. The current president pushed to eradicate moral threats and reduce the excess credit China had led to a harmful and fragile financial system. With the growth in credit allowed in China, analysts indicate that China has been on the verge of a financial calamity and an upset in its currency. The rise in the US dollar pulled the Chinese Yuan with it. However, it was alluded that the Chinese Yuan was overvalued by between 10-20%. The result, a loss in the competitiveness of the Yuan (Evans-Pritchard, 2015). Greece The official Geek currency is the Euro. As of December 2014, it had reduced to 1.21 US dollars. Because of the sudden elections called on January 25, it was feared that Greece could trigger another Euro crisis. The reason being that the leftist party Syriza wanted to renegotiate the bailout deal Greece has with the IMF and the European Union. Greece’s, debt stands at a staggering 175% of its GDP. The country has a debt of around 300 billion Euros. The European Financial Stability Facility, the IMF, the European Central Bank, and the European Union’s crisis-resolution fund are the holders of the country’s debt (The Data Team, 2014a). By July 2014, Greece was allowed to borrow money at 6% interest rate. The deflation of the Euro in Greece made its debt a greater burden. With the Euro inflation rate standing at 0.4% by October 2014, the public-debt-to-GDP ratio was forecast to be over 100% in 2015. As a result, the European Central Bank stepped in to enhance growth in Greece and other European member countries. It did so by decreasing the interest rates to 0.05%. It also bought bonds from investors (The Data Team, 2014). Question three Current understanding of the workings of the foreign exchange market suggests that in the absence of government intervention in the market, both the spot rate and the forward rate are influenced heavily by current expectations of future events. The two rates move in tandem, with the link between them based on interest differentials. New information such as a change in the interest rate differentials is reflected almost immediately in both the spot and forward rates. (i) Explain the understanding using, a graph illustrating the Parity line and the relationship between the forward rate and the future spot rate. According to Theobald (1991), there has been empirical research on the relationship between the forward and the spot rate. He notes that the forward rate has the ability of been a biased forecaster of the forthcoming spot rate in a market that is considered efficient. The reason being due to the organized risk rising from the exposure availed to the current. Differences occur in each of the forward exchange rates on the contracts of varying lengths up to maturity and from the spot rate at the period, the forward contracts are entered into (utoronto, 2014). When traders in the foreign exchange market anticipate that the upcoming spot price of a currency based on another currency shall be higher than the charge that currency can be bought forward, the traders all seek to purchase it. Thus, the existing forward charge of the currency shall be tendered until a certain anticipated gain is no longer feasible. In addition, if the market foresees that the impending spot price of a certain currency based on another currency shall be lower than the present forward price, then nearly all dealers will try to sell. They will all try to trade that currency in the anticipation that they can buy it when there is maturity in its contract. Their expectation is that the maturity will be at a spot price that is lesser than the forward price of sale that has been settled on. Hence, the existing forward price of the currency shall have bids down to the range where an anticipated profit from the bidding is impossible. It is said that, any forex dealer who chooses to assume the risk may gain from the hearsay surrounding the foreign exchange market if the anticipated future spot rate is different from the present forward rate. If there are such forex dealers in the market, the forward rate is bid into parity with the anticipated spot rate. Thus, the forward rate would then be equivalent to the estimates in the market. The estimates will be at the point or points where the spot rate shall be at the time of contract maturity (Pradhan, 2009). Below is a graph showing the forward and spot rate points and their association. Graph 1: Graphical representation of the association between the forward and Spot Rate (Contigency analysis, 2015). Graph 2: Graphical Representation of the Interest Parity Line (Saarinen, 1994). As is evident, either the spot or the forward rate can be utilized to come up with the other. Hence, theoretically, the existing difference between them is supposed to be the equivalent of the finance prices and any earnings resulting from the security holder in accordance with the cost of the carry model (Boundless, 2015). Thus, when parity is in existence, an equilibrium exists in the currency markets. Capital funds net flow between two countries that want a higher return does not exist (Colorado, 2015). (ii) Covered interest Arbitrage”- using a clear and well labelled graph and example, explain the transactions associated with covered interest arbitrage and how prices are affected in both the money and foreign exchange markets Covered interest arbitrage comprises the short-range investment in another country’s currency (International Monetary Fund. Research Dept., 1997a). The investment is protected by a forward contract that avails the opportunity to sell that currency at the time of maturity. Usually, the covered interest arbitrage is conceivable when the forward premium fails to show the discrepancy in the interest rate that exists in the two countries. The interest rate parity formula specifies the interest rate discrepancy (Hawawini & Claude, 2010). When the transaction costs are included, then the surplus profit obtained from the covered interest rate arbitrage should counterbalance the other deliberations for the covered interest arbitrage to be possible. Transaction costs arise from the point that external prices that are not considered in the covered interest arbitrage formulae are in existence. The costs comprise of time costs, brokerage fees, information costs, and subscription costs (Pradhan, 2009). What is the reasoning? The reasoning is that if their summation is higher than the likely profit to be obtained from the interest arbitrage, then no investor shall implement arbitrage. Graph 3: Graphical representation of the covered interest arbitrage and the transactions costs (Saarinen, 1994). (ii) Explain the following Balance of Payments categories a. Current account The current account is a measure of all transactions comprising economic values. These transactions take place between non-resident and resident units. The current account also involves the present economic values obtained or availed without a transaction of a thing of economic value. Components of the current account include the balance on services, balance on goods, balance on current transfers, and the balance on investment transfers (McDermott & Sethi, 2012). b. Capital account The capital account is made up of all capital transfers. That is, it records the currency flow and various monetary assets utilized in the buying of physical and financial assets. Thus, it keeps a record of the foreign investment undertaken in the domestic segment and the domestic investment in the foreign section. It is comprised of the transactions in banking capital, private foreign flow of loans, gold movement, and official capital transaction (Siddiqui & Siddiqui, 2011). c. Financial account According to the International Monetary Fund (2010), the financial account documents transactions involving liabilities and financial assets. These transactions occur between nonresidents and residents. From the financial account, sector instruments, maturities utilised for net international financing transactions, and functional categories are obtainable. There are three key flow types in financial acounts. They include direct investments, reserve assets, and portfolio investments. Also, financial derivatives are included (International Monetary Fund, 2010b). Question one (10 marks) What is the importance and relevance of understanding International Finance in today’s global economy? Include theoretical models/frameworks and contemporary examples you have gained from your research and study in this unit. From the research undertaken, it has been realized that international finance is comprised of an evaluation of international monetary economics. International monetary economics includes the interactions that are involved in transactions world over. The international transactions are made up of factors like prices, money, and the national income. In the system making up the international monetary economics, there exists, governments, international institutions, private units, and organizations that are partakers of the financial assets exchange-taking place globally (Lead, Herd, Jackson, Sullivan, & Terreell, 2013). Studying international finance is vital as it can aid leaders involved in the financial section to prevent harmful repercussions resulting from international occurrences. An example is when the Euro goes into recession and countries like Greece are negatively impacted. With the globalization of financial markets, it is relevant because one can comprehend the merits of a raise in the capital flow among or between nations. They include bigger prospects for all countries to expand the risks and a more effective capital allocation internationally. It has been noted that the globalization surrounding investments has brought about new risks and raised the economic and financial interdependence of various countries (Levi, 2007). What about international financial crises? International finance enables persons to understand these financial crises. The foreign exchange is the largest market it the globe. With the US now being the biggest international debtor and other countries offering finances to the U.S. It is quite ironical if taken in the literal context. However, for the US, which owns the world’s reserve currency, to counterbalance the disparity in its current account, then the US dollar has to adjust tremendously. What do the rest of the countries supplying the US with finances gain? International finance helps in determining what these countries gain. Thus, international finance is a result of many currencies, inter-temporal trade that can be the focus of the trade theory. The overall relevance and understanding of international finance teaches that the major cause of financial and currency crisis like the one involving the Russian rubble is because numerous countries borrow using foreign currencies that are different from their local ones (Ickes, 2008). References Adomanis, M. (2014b). Russias Currency Crisis Continues: The Ruble Is Crashing Again. Retrieved January 09, 2015, from http://www.forbes.com/sites/markadomanis/2015/01/06/russias-currency-crisis-continues-the-ruble-is-crashing-again/ Adomanis, M. (2014a). With Downgraded Debt, A Plunging Currency, And A Weak Stock Market Russia Is In Real Trouble. Retrieved January 09, 2015, from http://www.forbes.com/sites/markadomanis/2014/04/25/with-downgraded-debt-a-plunging-currency-and-a-weak-stock-market-russia-is-in-real-trouble/ Boundless. (2015). Spot & forward rates are settlement prices of spot & forward contracts; cross rates are the exchange rate between two unofficial currencies. Retrieved from boundless: https://www.boundless.com/finance/textbooks/boundless-finance-textbook/financial-management-outside-of-the-u-s-21/types-of-rates-and-transactions-139/spot-rates-forward-rates-and-cross-rates-560-740/ Cain, A. (2014). Japan currency under pressure. Retrieved January 09, 2015, from http://www.afr.com/p/japan_currency_under_pressure_1Q8xUZXGKnpJ6HmPrXp1EN Campos, R. (2014). Chinese stocks and dollar were stars, oil big loser in 2014. Retrieved January 09, 2015, from http://www.reuters.com/article/2014/12/31/us-markets-global-idUSKBN0K900520141231 Colorado. (2015). Comparing Expected returns on domestic and foreign assets. Retrieved from colorado: http://www.colorado.edu/economics/courses/econ2020/6550/section3/readings-summaryII.html Contigency analysis. (2015). Fixed Income Term Structure. Retrieved from riskglossary: http://www.riskglossary.com/link/fixed_income_term_structure.htm Dakers, M. (2014, December 26). 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World Economic Outlook, May 1997: Globalization: Opportunities and Challenges (EPub). Washington: International Monetary Fund. Retrieved from bauer. Lead, J. S., Herd, J., Jackson, R., Sullivan, J., & Terreell, E. (2013, November 12). International Economics & Trade, 7/8. Retrieved from Business Reference Services: http://www.loc.gov/rr/business/BERA/issue7/issue7_main.html Levi, M. D. (2007). International Finance: Contemporary Issues. New York: Routledge. McDermott, J. C., & Sethi, R. (2012, July 13). Balance of payments - Current, financial and capital accounts, Te Ara - the Encyclopedia of New Zealand. Retrieved from teara: http://www.teara.govt.nz/en/balance-of-payments/page-2 Pradhan, R. P. (2009). Forecasting Financial Markets in India. (R. P. Pradhan, Ed.) New Delhi: Allied Publishers. Saarinen, O. (1994). An Empirical study of Covered Interest Arbitrage: Margins During the European Monetary System Crisis of 1992. Honors Projects. Paper 52. 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