The Composition Effect
The composition effect refers to the relative riskiness of the U.S. foreign asset portfolio. The U.S. holds large amounts of foreign equities and foreign direct investment (FDI) in its portfolio – high risk, high return assets which are relatively illiquid. On the other hand, a significant percentage of U.S. liabilities consist of T- Bills and corporate bonds – low risk, low return, highly liquid assets. The composition effect derives from this portfolio weighting: the U.S.’s relatively high-risk high-return foreign asset holdings earn more income than the U.S. pays out on its low-risk low-return foreign liabilities.
The Rate of Return
The rate of return effect refers to the higher rate of return the U.S. earns on its foreign assets than it pays out on its foreign liabilities within the same asset classes. E.g. U.S. T-bills pay much lower rates of return than most foreign government bonds; U.S. equities pay lower rates of return than foreign equities. This effect is partly the due to the U.S. role as a safe haven, such that foreign investors will accept lower rates of return to hold USD assets.
When the USD appreciates which direction does wealth flow?
there is a net transfer of wealth from the U.S. to the rest of the world
In 2008 was there a net transfer of wealth from the U.S. to the rest of the world, or vice versa?
In 2008 there was a large net transfer of wealth from the U.S. to the rest of the world (-2.8 trillion USD). This was precipitated by the financial crisis, as large safe haven flows came in to the U.S., the USD appreciated, emerging market currencies suffered depreciations and high risk assets fell in value while low risk/safe assets appreciated in value.
exorbitant duty and exorbitant privilege as it applies to 2008
The large net transfer of wealth from the U.S. to the rest of the world (-2.8 trillion USD) in 2008 illustrates the exorbitant duty of the United States to play the role of insurer to the rest of the world. During economic booms, the U.S. benefits from its portfolio weighting toward high risk high return foreign assets coupled with low risk low return foreign liabilities. However, in economic crises like the 2007-2009 period, valuation effects lead high risk high return assets to decline in price and low risk low return assets (i.e. safer assets) to rise in price – leading to a net transfer of wealth from the U.S. to the rest of the world. Additionally, safe haven flows into the U.S. during crises cause the USD to appreciate, which acts as an additional mechanism to transfer wealth from the U.S. to the rest of the world.
When does overshooting occur?
exchange rate overshooting occurs when exchange rate expectations change
CIP risk vs. riskless?
CIP almost always holds in the data because it is a riskless arbitrage condition.
neutrality of money
long run neutrality of money: in the long run, money cannot impact real variables – including the real money supply. The only variables that are impacted in the long run are the nominal money supply and the nominal exchange rate.
Would exchange rate overshooting occur if prices were flexible in the short run? Briefly explain your reasoning
If prices were flexible in the short fun, prices would immediately adjust to their long run equilibrium. Thus the decrease in the Mexican nominal money supply would be matched by a proportional increase in the Mexican price level, such that the real money supply is unchanged. As a result, the interest rate will not change, and the exchange rate will fall immediately to its new long run equilibrium. There is no overshooting if prices are flexible in the short run
Net International Investment Position (∆NIIP) is most accurately described as:
∆NIIP = Current account + Effect of exchange rate movements + Effect of asset price changes in local currency
Complete the following sentence: GNP equals GDP …
Plus net receipts of factor income from the rest of the world
“exorbitant privilege” can be accurately described as:
consequence of the U.S. dollar’s role as the world reserve currency.
The ability of the United States to borrow externally at lower interest rates than most other countries.
The ability of the United States to pay off its debts and pay for imports by printing its own currency.
An appreciation of a country’s currency has what effect on relative price of exports and imports?
Raises the relative price of its exports and lowers the relative price of its imports.
Uncovered interest parity (UIP) is a ____________ no arbitrage condition, while covered interest parity (CIP) is a ____________ no arbitrage condition
Risky; riskless.
70 percent of U.S. foreign assets are in foreign currencies, and 100 percent of U.S. foreign liabilities are in USD. If the USD depreciates, is there a net transfer of wealth from the U.S. to the rest of the world, or a net transfer of wealth to the U.S. from the rest of the world?
When the USD depreciates against foreign currencies, U.S. assets appreciate in value, while U.S. liabilities depreciate in value. This leads to a net transfer of wealth from the rest of the world to the U.S.
Carry trade
In a carry trade, investors borrow in low-interest rate currencies (a.k.a. “funding currencies”) and invest in high- interest rate currencies (a.k.a. “investment currencies”). In the scenario presented here, the carry trade involves borrowing in yen at 0% interest and investing in dollars at 2% interest.
In other words, carry trade participants hope to profit from both the favorable interest rate differential and favorable currency movements.
A profitable carry trade does not imply the breakdown of UIP in expectation or ex-ante; it does reveal a breakdown of UIP ex-post. UIP in expectation says that expected returns across Japanese yen and Australian dollar deposits should be equalized, so the carry trade doesn’t reveal any breakdown in UIP ex-ante. We need data on actual exchange rate expectations or forecasts to test this hypothesis. However, a profitable carry trade shows that UIP ex-post does break down in the data for certain time horizons, as actual returns were higher for AUD deposits than yen deposits from 2002 to 2007 for example.
Forward Premium Puzzle
UIP ex-ante, in expectation, holds in the data for most currencies and time horizons, but UIP ex-post, in actuality, does not always hold in the data.
UIP ex-ante, in expectation, holds in the data for most currencies and time horizons, but UIP ex-post, in actuality, does not always hold in the data. List and explain the three hypotheses that resolve this puzzle
- Biased forecasts, i.e. the breakdown of rational expectations.
If foreign exchange traders consistently over- or underestimate the rate of depreciation of a particular currency, their forecasts will be biased in one direction and UIP may well hold ex-ante but not hold ex-post. - Information inefficiencies in the FX market. Traders may not fully price in all of the available information in the FX market and
thus the market may be inefficient, leading to a breakdown of UIP ex-post. - Risk premia.
Certain currencies may have constant or time-varying risk premiums, such that investors demand additional compensation over and above the expected return on deposits due to political risk, sovereign default risk, etc.
four policy tools that central banks can use to expand or contract the money supply
- Open market operations. The central bank buys short-term government bonds from commercial banks to increase the money supply and sells short-term government bonds to commercial banks to decrease the money supply.
- Interest rate on reserves. This is closely related to open market operations. If the central bank increases the interest rate on reserves, the money supply will decrease as it is more costly for banks to borrow funds in the overnight interbank market. The opposite is true if the central bank decreases the interest rate on reserves.
- Reserve ratio. Increases in the reserve ratio will decrease the money supply by reducing the fraction of deposits that banks can lend; decreases in the reserve ratio will increase the money supply by increase the fraction of deposits that banks can lend.
- Foreign exchange intervention. Also closely related to open market operations – but now the operations are conducted in the FX market. The central bank will buy foreign currency (sell domestic currency) to raise the domestic money supply and sell foreign currency (buy domestic currency) to decrease the domestic money supply.
Shift in the Money Supply Line
Money supply change:
increase in the money supply will shift the curve up (down when tilted 90 degrees)
Price change:
price decrease shifts the line right (down when tilted)
Shift in the Money Demand Curve
GDP changes: increase in GDP moves the curve to the right (out when tilted).
UIP Condition Curve Shift
Change in expected exchange: increase in E^e would move the curve out.
Change in Interest rate: Increase in R would shift the curve out
Risk premium
Adding Ro will shift the UIP out
If risk based on your own risky currency you add Ro (the curve will move in)
subtracting ro means foreign currency is risky and the returns on foreign decreases
Swap Contract
Combines a spot sale of foreign currency with a forward repurchase of the same currency
Least inexpensive. Invest money now to pay off a future liability
This is a common contract for counterparties dealing in the same currency pair over and over again.
Combining 2 transactions reduces transaction costs.
- For example, suppose Toyota receives $1 million from American sales, plans to use it to pay its California suppliers in three months, but wants to invest the money in euro bonds in the meantime.
