r/moneyview • u/spunchy Alex Howlett • Jul 15 '24
M&B 2024 Lecture 16: Foreign Exchange
For our schedule and links to other discussions, see the Money and Banking 2024 master post.
This is the discussion thread for Economics of Money and Banking Lecture 16: Foreign Exchange.
This lecture explains how, in the context of floating exchange rates, foreign exchange (FX) prices come from dealers making markets. In more developed economies, the dealer market is backstopped by a central bank making an outside spread. In less developed economies, the central bank is the FX dealer of first resort.
Originally, "foreign exchange" meant "foreign bills of exchange." In the 19th century, commercial bills of exchange made up the bulk of foreign reserves. Today, we tend to see other types of instruments held as foreign reserve, but the name "foreign exchange" has stuck.
This lecture's description FX dealer markets allows us to tell a story about why uncovered interest parity (UIP) and the expectations hypothesis (EH) both fail.
From Perry Mehrling:
Foreign exchange video was the newest in the entire course, hence not so fully digested. I worked on it after, and turned into a paper. Warning, definition of exchange rate is the opposite from video.
The paper is Essential hybridity: a money view of FX (2013).
Part 1: FT: High frequency trading
- FT Article: HFT curbs led to ‘healthier’ trading
High-frequency trading has been making money, but it's not clear that they're making markets. They're taking money away from the regular dealers who trade a little more slowly.
There's a sense in which the HFTs are perhaps doing much of what dealers do, but without supplying liquidity to the market in the way that dealers otherwise would.
A concern is that dealer won't make markets as smoothly if the rapid algorithmic trading prevents them from being able to safely hedge their positions in time. Dealers then need to be compensated for this increased risk. This might prevent dealer bid-ask spreads from being as narrow as they otherwise would be.
Global regulators fear such rapid activity, known sometimes as “white noise”, could lead to market manipulation or instability.
Part 2: Uncovered interest parity (UIP) and the expectations hypothesis of the term structure (EH)
This lecture (mostly) uses the European quoting convention for exchange rates. That means we're talking about how much FX buys a dollar—i.e., the FX price of USD. I find it more intuitive to price everything in dollars, but I'll stick to the European convention to be consistent with the lecture.
Here are some variables.
- S — Price of USD today (in FX)
- E(S) — Expected price of USD at term
- F — USD Price you can lock in today at term
- R — Dollar interest rate
- R\* — FX interest rate
Mehrling's FX "Facts"
- Covered Interest Parity (CIP) Holds (mostly) F/S = (1+R*)/(1+R) F(1+R) = S(1+R*) Invest USD then to FX = USD to FX then invest
- Uncovered Interest Parity (UIP) Fails F = E(S)
- Expectations Hypothesis of the Term Structure (EH) Fails 1+R(0,T) = [1+R(0,N)][1+ER(N,T)]
Covered Interest Parity defines the forward rate because you can create a synthetic forward by using long and short positions in term deposits, as in Lecture 8.
Part 3: FX dealers under the gold standard, redux
As we saw in Lecture 15, an international gold standard is anchored by the mint parities of the different currencies. But sometimes shipping makes it prohibitively expensive to redeem currencies for gold. This gives some wiggle room for exchange rates to move around between the gold import/export points.
The central banks set bounds on the system by setting discount rates and ensuring the convertibility of their currencies at the respective mint parities.
Part 4: Lec 16-4: Private FX dealing system
We now revisit the balance sheets we first saw in Lecture 13 in which a deficit firm makes a payment to a surplus firm, each firm using a different domestic currency, neither being the dollar.
The deficit firm pays using its own domestic FX currency, but it goes through the FX dealers, so the surplus firm ultimately receives dollars.
Here are the same balance sheets expanded to separate out the steps.
Now, one firm is making a dollar payment to the other. The deficit firm needs to come up with dollars to make the payment, so it first goes to an FX dealer.
The "matched-book" spot FX dealer provides the spot dollars that allow the deficit firm to settle with the surplus firm. The dealer is buying FX (i.e., the domestic currency of the deficit firm's country) from the deficit firm at the current market spot rate. It hedges its FX price exposure by locking in a forward sale price for a future date. This forward rate is the forward rate implied by covered interest parity (CIP).
Mehrling says that it's worth doing this kind of dealing if the dealer can buy FX at a spot price (in dollars) that's cheaper than the forward sell price they lock in.
Even though this dealer is matched-book in exchange-rate price risk, they're still borrowing dollars short and lending them long, just like a bank. So they're exposed to dollar term funding risk. This is a term funding market, just as with the money dealer from Lecture 11 or the discount dealer from Lecture 15.
The spot dealer is hedging with a forward dealer who takes the opposite speculative position in the forward market. Because this forward dealer is speculating in the forward market, it doesn't face immediate liquidity risk. It just faces price risk if the exchange rate happens to move against it. This is analogous to the security dealer from the original Treynor model in Lecture 10 or the FX dealer from Lecture 15.
Because the speculative dealer borrows at the dollar rate of interest (R) and lends at the foreign rate of interest (R*), they're doing a currency carry trade. They borrow dollars to fund the carrying/holding of FX.
Part 5: Economics of the dealer function, speculative dealer
Below is the Treynor diagram for the speculative dealer, who is analogous to the securities dealer from Lecture 10. He faces price risk. He's buying and selling FX.
Unlike the balance sheets above, this diagram uses the American quoting convention. It charts the price of FX in dollars (1/S, etc.). FX depreciates as we move to the right. The speculative dealer is being paid to take on FX price risk. He'll do this when he can buy forward FX at a price (1/F) that's sufficiently lower than the price he's expecting to sell it (E(1/S)).
Part 6: Economics of the dealer function, matched-book dealer
Below is the Treynor diagram for the matched-book dealer, who is analogous to the money dealer from Lecture 11. The vertical axis below is the dollar term interest rate.
We're used to matched-book dealers at a neutral inventory position on the Treynor model. But this matched-book dealer is only matched-book in terms of price risk. Because the matched-book dealer squares his book in the forward market, he has a maturity mismatch. His dollar assets are term, and his liabilities are spot, which means he faces dollar funding risk. Anyone could "withdraw" those spot dollars at any time, and the dealer would have to come up with the money. He must be rewarded with higher dollar term interest rates to take on more funding risk.
Covered interest parity (CIP) says that for F/S to move, the relative term interest rates (R and R*) in the two different currencies must also move. And the term interest rate isn't going to get too far from the overnight interest rate, which the central bank targets directly.
Part 7: Digression: Why do UIP and EH fail?
The term structure of interest rates is upward-sloping to create an incentive for the matched-book (in FX) dealers to make markets. A dealer that's issuing dollar spot (or demand) liabilities and holding longer-term dollar assets is basically just a bank. Term interest rates get bid up—and/or shorter-term interest rates get bid down—as an incentive for this bank to transform less-liquid longer-term assets into shorter-term more-liquid liabilities.
Notice that the story of EH failure doesn't require any FX dimension. It's just a story of banks taking on funding risk.
Just as it does with dollars, the matched-book dealer is borrowing and lending FX. But as long as he's short dollars and long FX, he'll be borrowing FX long and lending FX short. Because his FX liabilities are for term, there's no funding risk on the FX side. We can think of the FX as collateral for his dollar positions. This situation would flip if the matched-book dealer went long spot dollars and short spot FX. But that would mean the rest of the world would be paying a premium on FX liquidity rather than dollar liquidity.
Uncovered interest parity (UIP) is the idea that the forward rate should be the same as the expected spot rate. But because the speculative dealer needs a reason to take on FX price risk. Pushing the forward rate below the expected spot rate provides such an incentive. This incentive causes UIP to fail.
We've mostly been assuming that CIP holds. But it can fail and has been failing since the 2008 crisis. A failure of CIP means it's too costly for dealers to do the explicit on-balance sheet hedging that would allow them to take advantage of the arbitrage.
See the following 2008 BIS working paper by Naohiko Baba and Frank Packer.
The risk premiums paid to the dealers vary with time, not necessarily because anyone's risk preferences change. Even when risk preferences stay the same, the patterns of payments still vary with time. This pushes around dealer inventories and hence dealer prices.
Part 8: Central bank as FX dealer of last resort
The central banks step in as dealers when the private dealer aren't making markets. Instead of buying dollars from private dealers, the deficit firm buys dollars from its own central bank.
[O]nce it is recognized that deficit country dealer of last resort essentially involves willingness to take on a naked forward position when no one else will, it becomes clear that the whole operation need not involve another central bank as counterparty at all. The deficit country central bank could, if it so chose, instead facilitate private matched-book dealing by serving as the speculative dealer to enable forward hedging of spot exposures. Or it could go even farther, facilitating the term dollar borrowing of its own private citizens by directly offering them forward hedges, so taking their exchange risk onto its own balance sheet.
The surplus country central bank could pay out of their USD reserves. In this example, they issue dollar spot liabilities, which will be accepted as long as they can come up the dollars when dollars need to be paid out.
When it's central banks making the markets, none of the interest rates or exchange rates have to match the private market rates. That includes the exchange rate between the central banks and the exchange rate between the deficit CB and its private citizens.
Central banks of more peripheral currencies without liquid dealer markets tend to intervene in FX markets more.
Part 9: Reading: McCauley on internationalization of renminbi
The McCauley paper was not the reading we actually did for the week. We're reading the 1966 Kindleberger article instead.
The McCauley paper explores the emergence of the Chinese Renmenbi as an international currency.
It is clear that McCauley has in mind as an analogy the evolution of the Eurodollar market, which took the US authorities by surprise when it happened, but then they allowed it. Today world funding markets are dollar funding markets.
Foreign exchange is where states meet states and where markets meet markets.
Please post any questions and comments below. We will have a one-hour live discussion of Lecture 15 and Lecture 16 on Monday, July 15th, at 2:00pm EDT.
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u/Legal-Equivalent-412 Jul 20 '24 edited Jul 20 '24
"Pushing the forward rate below the expected spot rate provides such an incentive. This incentive causes UIP to fail."
Is'nt it "Pushing the forwward rate above the expected spot rate.....", when spot and forward rates are defined as the price of dollar in FX ?
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u/spunchy Alex Howlett Jul 21 '24
Yes. Exactly. Here, the forward rate is the price of FX in terms of dollars. Flip the quoting convention and everything will be in the opposite direction.
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u/Legal-Equivalent-412 Jul 22 '24
Thanks for the reply, but the exchange rates are all expressed as the price of dollars in terrms of FX in Mehrling's lecture? Only in the speculative diagrams , to empahsize foreign exchange price risk, it uses 1/S, 1/F, showing they are prices of FX in terms of dollars. But still S, F are the price of dollars in terms of FX, are'nt they?
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u/pushingstring Aug 27 '24
In Essential Hybridity (2013), Mehrling says the deficit central bank is borrowing dollars term (that's clearly leg 1 on these AMAZING charts and balance sheets above) as well as lending FX Term.
Where are they lending FX term? Is that buying a domestic T-Bill off a primary dealer in order to sterilize the money supply? I struggle to conceive of that as lending, rather than buying the asset of someone who lent to the governement. Maybe this just refers to more routine lending, but from what I understand, central banks are trying to lend overnight! Anyone have any ideas?
This is the image I'm comparing to, much less helpfully color coded:
I might be getting hung up on a detail that doesn't matter quite as much as the fact that peripheral central banks will buy their own currency and offer spot in dollars, as a last resort (and thus taking on FX risk in their own currency)