Commercial and Central Banking

I. Introduction:

Probably the most important industry to any economy is the commercial banking industry. Commercial banks act as financial intermediaries, taking in deposits from one group in society and making loans to another group in society. Most commercial banks are corporations and are therefore in business to make profits. However, because banks are so important to the economy, and because the element of public trust is so crucial to their well being, the banking industry is usually highly regulated by the government. Whenever the public loses confidence in the solvency of a bank, they will rush to the bank and attempt to withdraw their deposited money. We call this a "bank run". If there are widespread bank runs in the economy, there will be a severe recession, with many bankruptcies and rising unemployment. This is precisely what bank regulators want to avoid.

Like all businesses, commercial banks have both assets and liabilities. The major liabilities of commercial banks are the various deposits which they offer to their customers. In Taiwan, these include checking deposits, savings deposits, passbook savings accounts, time deposits, and time saving deposits. Banks can also issue bonds (sometimes called financial bonds) and borrow funds, both of which act as liabilities to the banks. On the asset side of the ledger there are three principal items. These include the reserves of the banks, the securities which they hold, and the various loans which they make to borrowers. The difference between the assets and liabilities of a bank represents its net worth or owners equity.

Commercial banks are important to the economy because they reduce the cost of transactions between savers and investors, and between consumers and producers. They also affect the amount of credit extended to borrowers. Finally, they provide a relatively safe and convenient means for savers to hold their wealth.

II. Asset Management of Banks

In order to earn a profit, banks must carefully manage the asset side of their balance sheet. Naturally, this involves two factors: (1) the amount of resources which the bank has available, and (2) the attitude which the bank has towards risk and return. The amount of resources which the bank has is determined by its capital invested, its retained earnings, and its deposits. The bank must decide how to allocate its resources among its reserves, securities, and loans -- that is, its assets.

A bank's reserves are defined as its vault cash plus its money deposited with the central bank. The central bank acts as a bank for commercial banks. Just as you have a deposit account with a commercial bank, your bank has a deposit account with the central bank. These deposits are called reserves. A bank must keep a minimum amount of

reserves on deposit with the central bank. We call these the required reserves. Banks usually keep their total reserves above the required reserve amount. Excess reserves are defined as total reserves minus required reserves. Both excess and required reserves are deposited at the central bank.

Commercial banks do not earn interest on their reserves. Therefore, they will not want to hold a large amount of excess reserves. Required reserves are relatively easy to determine because they are a percentage of the bank's deposits. Each type of deposit will have a required percentage called the required reserve ratio. For example, if saving deposits are $100 and the required reserve ratio for saving deposits is 15%, then the required reserves on such saving deposits is $15. The required reserve ratios are determined by the central bank.

While it is easy to determine required reserves, it is not easy to determine excess reserves. If the outlook for the economy is good, then banks may decide to hold less excess reserves. However, if the economy goes into recession, banks may become more conservative and decide to hold greater excess reserves. Excess reserves can also be affected by changes in interest rates.

Commercial banks can also use their resources to purchase securities. Usually, these securities include government debt, but some countries such as Taiwan allow banks to buy corporate bonds and stock. Private securities often involve greater risk, but they also have greater returns to compensate for this higher risk. In Taiwan, banks often buy T-Bills and CD's issued by the Central Bank of China. They also buy government bonds issued by the Ministry of Finance, the provincial government, and the city governments. These carry little risk of default, but there is still the problem of price risk associated with changes in interest rates.

Commercial banks also earn interest by making loans. These include business loans, mortgage loans, and consumer loans. Consumer loans include credit extended by the bank for credit card purchases. Mortgages are long term loans taken out for the purchase of a house or land. The house or land acts to collateralize the loan. Firms often borrow funds to finance their inventories, and these inventories act to collateralize the loan. Loans which have collateral are called secured loans. Loans which do not have collateral are called unsecured loans. Unsecured loans will have higher interest rates associated with them due to higher risk premiums.

III. The Role of the Central Bank

The central bank of an economy is often called the banker's bank. It accepts deposits from commercial banks (which we call reserves), it buys securities from and sells securities to commercial banks, and it makes loans to banks which are short of funds. Moreover, it facilitates the transfer of funds between banks. The central bank also oversee the operation of banks, and it often helps to stabilize the foreign exchange markets.

The major goals of the central bank are to provide adequate funds to promote stable economic growth and a stable price level. It does this by regulating the amount of loanable reserves in the banking system. The central bank has three major tools which it can use to accomplish its goals. First, it can change the required reserve ratios. This will not change the overall level of reserves, but it will affect the amount of excess reserves that can be loaned out by banks. Second, it can change the interest rate charged banks for loans from the central bank. This interest rate is called the central bank discount rate (sometimes called the rediscount rate). Changes in the discount rate can affect the overall level of reserves in the banking system. Finally, it can buy or sell government securities. When it buys bonds from the banks, this is called an open market purchase. When it sell bonds to banks or the public, this is called an open market sale. We call this kind of buying and selling of securities open market operations. Open market operations can likewise change the overall level of reserves in the banking system. The central bank's monetary policy consists of decisions on how best to use these three tools.

The central bank has a balance sheet, although it is not a corporation. The assets of the central bank consists of foreign exchange reserves, loans to commercial banks, gold, and government bonds. It's liabilities consist of currency, reserves, and securities which it has issued and sold to banks. Economists are particularly concerned with changes in currency and reserves. The sum of these two items is called the monetary base (or high powered money). Small changes in the monetary base can lead to large changes in the money supply, which is defined as currency plus commercial bank deposits. The central bank can use its three tools of monetary policy to affect the level of the monetary base, and thus change the money supply.

IV. Money Supply and Money Demand

Each person in the economy has an amount of wealth. The division of wealth between money and non-money assets is the basic idea underlying the demand for money. When we talk about the demand for money, we are really discussing peoples' decision to hold a certain percentage of their wealth in the form of money.

There are many factors which can affect the demand for money, but usually we consider only two: income and interest rates. If incomes rise, then people will want to spend more of this income. Their demand for money will increase because they need the additional money with which to transact. If interest rates on non-monetary assets increase, then people will reduce their demand for money and will try to hold other assets instead.

In deciding how fast the money supply should grow, the central bank will take into consideration how fast the demand for money is expected to increase. Suppose that the money supply grows faster than the demand for money. Then people will find they have too much of their wealth in the form of money. They will try to reduce their money holdings by purchasing goods and other assets instead.

In deciding how fast the money supply should grow, the central bank will take into consideration how fast the demand for money is expected to increase. Suppose that the money supply grows faster than the demand for money. Then people will find that they have too much of their wealth in the form of money. They will try to reduce their money holdings by purchasing goods and other assets. This creates an inflation in goods and asset prices. Conversely, if the supply of money grows slower than the demand for money, then the prices on goods and assets will fall. There will be deflation.

Discussion Questions:

#1. What functions do banks serve in the economy?#2. What is a bank run and what causes it?#3. What are the assets and liabilities of banks?#4. What are total, required, and excess reserves?#5. What are the three tools of monetary policy?#6. What are the assets and liabilities of the central bank?#7. What is the demand for money and why is it important to monetary policy?#8. What is the difference between secured and unsecured loans?

The Balance of Payments and Exchange Rates

I. Trade and Capital Flows

Each country in the world keeps an account of the transactions its citizens have with the rest of the world. This account is called the balance of payments and its basic function is to record the sale of goods, services, and assets between the home country and foreign countries. The balance of payments is important because it summarizes the condition of trade and foreign investment which the country has experienced. Furthermore, changes in the balance of payments can affect exchange rates, and thus employment, inflation, and economic growth. Usually, the balance of payments is published quarterly, with an annual summary given at the end of the year. The International Monetary Fund (IMF) provides guidelines on how the balance of payments should be calculated, and Taiwan follows this IMF format when it publishes it data.

The balance of payments is composed of three major accounts: (1) the current account, (2) the capital account, and (3) the official settlements (or reserve) account. Because the balance of payments uses the method of double entry business accounting, all three accounts must sum to zero. The current account is composed of all international transactions in goods, services, payment of income on assets, and unilateral transfers. The bulk of the current account is devoted to recording exports and imports. Services are largely payments for transportation and insurance involved in international trade. When interest and dividends are paid to individuals internationally, these are also recorded in the current account. By contrast, the capital account records all changes in the ownership of assets between the home country and the rest of the world. For example, the sale of corporate stock to foreigners represents a capital inflow, because money is flowing into the home country, while a financial asset (i.e., the stock is flowing out). The official settlements balance is largely composed of changes in the government's holding of foreign assets.

If we limit our consideration to exports and imports in the current account, we can focus on the trade balance. This is merely total exports minus total imports, and is sometimes referred to as the merchandise balance of trade. A trade surplus means that the value of exports during the period exceeded the value of imports during the period. Usually a trade surplus will result in a current account surplus, since trade in goods is the dominant part of the current account. The trade surplus is a closely watched statistic, and can influence economic and foreign policy. Naturally, Taiwan runs trade surpluses with some countries and trade deficits with others, but it has had an overall trade surplus every year since 1980.

II. Determining Exchange Rates

Trade between countries means that not only goods and assets are traded, but also different types of money must exchange as well. For example, an import from Japan may be paid for using Japanese yen or US dollars. This implies that at some point in the transaction, NT dollars must exchange for either Japanese yen or US dollars. Such transactions take place on the foreign exchange market. Here the supply of and demand for foreign money interact. The largest foreign exchange market in Taiwan, as with most

other countries, is the market for the US dollar. Those supplying US dollars are generally firms and banks which have received US dollars in payment for an internationaltransaction -- for example, a Taiwan exporter. Those demanding US dollars are individuals, firms, and banks who currently have NT dollars and wish to obtain US money for purposes of international transactions -- for example a Taiwan importer. The exchange rate is simply the price of the foreign money (US dollars) in terms of the domestic currency (NT dollars).

Now suppose that Taiwan exports many goods and imports very few. The result will be a flood of US dollars seeking to exchange for NT dollars, and such a dramatic increase in the supply of foreign exchange will drive down the price of the US dollar. Conversely, if Taiwanese suddenly felt a strong inclination to invest in the US and buy American corporate stock, the demand for the US dollar would rise, and the foreign exchange rate would increase sharply. In short, the foreign exchange rate is simply the price of the US dollar, and is determined by the demand for and supply of the US dollar.

It is now easy to see how the balance of payments and the exchange rate are related. Suppose that both the current account and capital account show a surplus. This means that exports exceed imports and there is a net capital inflow. Taiwanese are basically selling goods and assets to foreigners in excess of what they are buying from foreigners. As a result, the surplus generates a large inflow of US dollars seeking to exchange for NT dollars. If the government does not attempt to buy up these dollars, then the price of the US dollar will fall and this will reduce the balance of payments surplus. In this example, we assumed that both the current account and the capital account were in positive surplus. Actually, all we need is for the sum of these two accounts to be in surplus -- so one may be positive and the other negative.

Often the government can keep the exchange rate stable by entering the foreign exchange market to buy or sell US dollars whenever there is a market disequilibrium. This is how the government gains and loses its foreign exchange reserves. Whenever the government buys and sells foreign exchange, the transaction will appear in the third account mentioned above in Section I -- namely, the official settlements account. If the government took a passive attitude towards the foreign exchange market, then the official settlements account would be small, and the exchange rate would be determined entirely by the balance on current and capital accounts.

III. What Determines the Balance of Payments?

Since the exchange rate is largely determined by the balance of payments, it is natural to ask what factors affect the balance of payments. To answer this question, we must look again at the structure of the accounts. Exports and imports dominate the current account, and therefore anything which tends to affect trade in goods will affect the current account. For example, if domestic prices tend to rise faster than foreign prices, then exports will begin to fall and imports will begin to rise. Similarly, if income at home is rising faster than abroad, then imports will tend to increase faster than exports.

Both income and prices have important effects on the balance of payments through their influence on the current account.

The major variable which affects the capital account is the interest rate. If the interest rate at home is significantly lower than the interest rate abroad, then people will seek to purchase foreign assets and the capital account will be negative ( a negative capital inflow is a positive capital outflow). On the other hand, if the domestic interest rate rises, then foreigners will seek to buy domestic assets and there will be a surplus on the capital account (i.e., a positive net capital outflow).

Finally, we have seen that the government can also influence the balance of payments by buying and selling foreign exchange whenever there is disequilibrium in the foreign exchange market. Some economists have argued that this is another form of protectionism. If a government wanted to promote its exports and retard the growth of imports, it could simply buy foreign exchange and support the price of the foreign money. At other times we hear of the US government and the Bank of Japan working together to prop up the value of the US dollar. The idea is the same as we have discussed before. Essentially, the governments of both countries are working together to buy dollars with Japanese yen in order to keep the US dollar at a reasonable level. The monetary authorities are always concerned that a free market in the dollar may result in a disastrous "free fall" in the value of the dollar, as one can see from the experiences of the late-1980's.Discussion Questions:

#1. What is the function of the balance of payments?#2. What are the three accounts included in the balance of payments?#3. What items are included in the current account?#4. What items are included in the capital account?#5. Give some examples of current account transactions and give some examples of capital account transactions.#6. What is a foreign exchange rate?#7. How is the exchange rate related to the balance of payments?#8. What factors influence the current account and what factors influence the capital account?

Taiwan's Foreign Exchange Reserves

I. How are Foreign Exchange Reserves Accumulated?

The last reading introduced some of the basic elements of the balance of payments and determination of foreign exchange rates. In that reading, we found that the government often enters the foreign exchange market and buys or sells foreign money (usually US dollars) to stabilize the foreign exchange rate. If there is an excess demand for foreign money, then the central bank can sell foreign exchange, thus eliminating the pressure for the exchange rate to rise. Similarly, if there is an excess supply of foreign exchange on the market, possibly caused by a large capital inflow, the central bank can purchase the foreign money and relieve pressure on the exchange rate to fall. The key here is to remember that the foreign exchange rate is the price of foreign money, and that the government often influences this price by buying and selling foreign money.

In deciding how it will act, the central bank must consider a number of different factors. First, if there are no capital controls in place, and foreign exchange can be bought and sold freely on the open market, then small changes in domestic interest rates relative to foreign interest rates can alter the supply and demand for foreign exchange. Central bankers are therefore constantly looking at the movement of relative interest rate differentials. Since changes in expected inflation can alter the level of interest rates, this variable must also be properly gauged. Relative growth rates of real income between countries are also important in determining medium to long run levels of the exchange rate. A faster growing country will tend to import more than a slower growing country, and this will put pressure on the faster growing country's foreign exchange rate to rise.

One major factor which must be considered by the central bank is the so-called flow of "hot money". Short term movements in exchange rates often give rise to expectations of future movements in exchange rates. If the domestic currency is expected to depreciate significantly, then speculators will attempt to exchange domestic money for foreign money. This increases short term capital outflow, and produces pressure on the exchange rate to rise. If the local currency is expected to appreciate, then this will induce short term capital inflows and the exchange rate will fall. The central bank must stand ready to step in, on one side of the market or the other, to balance the change in supply or demand for foreign exchange. When it does this, it either accumulates or diminishes the government's foreign exchange reserves. Thus, such reserves act as a buffer against sudden and undesirable changes in the exchange rate.

II. Foreign Exchange Reserves and the Money Supply

One of the problems with accumulating foreign exchange reserves, as Taiwan has done, is that it can lead to excessive growth in the money supply, and therefore can fuel inflationary pressure. To see this clearly, we should consider a simple example.

Suppose that an Taiwan exporter receives payment in US dollars for his shipment of goods (which would also be registered as a capital outflow in Taiwan's balance of payments). This means that the exporter owns US dollars contained in a bank account in

the US. The exporter may sell these dollars to his bank in Taiwan, in which case the dollars are transferred to an account in the US owned by the Taiwan bank. If the Taiwan bank does not want to hold these dollars, then it may be able to sell them to the Central Bank of China (CBC). The US dollars are then transferred to an account owned by the CBC, and Taiwan's balance of payments will show an increase in the capital account balance, and a decrease in the official settlements balance. The US dollars never leave America, but merely change ownership in Taiwan.

In our example, the exporter sold his US dollars for NT dollars. The Taiwan bank used its NT dollar reserves to accomplish this. When the bank sold the US dollars to the CBC, the central bank provided new NT dollar reserves to the banking system. These new reserves are the foundation on which the money supply begins to grow. Additional loaning of the reserves by the banking system will cause the money supply to grow several times more than the initial increase in reserves. The simple act of the CBC buying US dollars has led to a multiple increase in the money supply.

The CBC can slow the increase in the money supply now by issuing bonds (or time deposits) and selling them to the banking system. This process is called "sterilization". By sterilizing the increase in reserves, the CBC can avoid a free fall in the exchange rate and also control money growth and inflationary pressure. However, the CBC must now pay interest on the bonds and time deposits which it has issued. Where will the CBC get the funds to pay this interest? The answer is that the foreign exchange reserves also have interest income (in US dollars) and after this income is exchanged for NT dollars, it can be used to pay the interest owed on the debt issued by the CBC. Therefore, anything which reduces the interest income earned on the foreign exchange reserves creates financial problems for the central bank. Taiwan has experienced an explosive growth in its foreign exchange reserves. From 1980 to 1990, Taiwan's foreign exchange reserves grew an average of 34% per year. It now comprises roughly 80% of the total assets of Taiwan's central bank and is roughly equal to 90 billion US dollars, ranking Taiwan at the very top in the world in size of foreign reserves. Beginning in 1984 and continuing until the late 1980's, the CBC engaged in a massive sterilization effort. Despite this, the money supply grew extremely fast, especially during 1986-1988, when the average rate of growth of the money supply (M1B) was 40%. The CBC used three major tools to sterilize the growth in bank reserves, including the issuance of (1) Treasury Bills - B, (2) certificates of deposits, and (3) redeposit of postal savings. Currently, about 60% of the foreign exchange reserves are held in US dollar denominated assets, with the rest being held in yen, deutschmark, and other foreign currency denominated assets.

III. How Can the Foreign Exchange Reserves be Used?

One of the most difficult questions which we can ask concerns the appropriate use of foreign exchange reserves. These reserves are an asset of the government, and they yield considerable income. Theoretically, the foreign exchange reserves should act as a cushion to help stabilize the exchange rate, but Taiwan has much more reserves than are needed to do this. A rule of thumb often used by central bankers is to keep reserves close

to about three months of the value of imports. In Taiwan, this would be about 25 billion US dollars. However, if there were a sudden increase in capital outflow, the demand for the US dollar would rise and the foreign exchange rate would experience pressure to rise. The CBC would then have to sell US dollars to accommodate the increase in demand. Thus, the CBC must also consider the highly erratic movements in capital flows in determining its foreign exchange reserves policy. Nevertheless, Taiwan appears to have too much foreign exchange reserves, even after considering these factors.

There are two basic uses which the foreign reserves can serve -- one is economic and the other is political. The reserves can be used as a pool of funds from which foreign currency loans can be made. For example, if EVA Air or China Airlines needed US dollar loans to purchase new aircraft, they could apply for loans from the CBC directly. Such large loans are especially useful since they avoid upsetting the domestic foreign exchange market. Similarly, any government organization which needed foreign currency loans to purchase goods or services from abroad could use the foreign exchange reserves. In each case, the loan would have to produce interest income, since the CBC receives most of its revenue from the foreign exchange reserves, and any reduction in these reserves reduces its operating income. The foreign reserves can also be used for political purposes. In this case Taiwan uses its foreign exchange reserves to buy US government securities. This gives the ROC government a great deal of leverage with the US Treasury, and consequently with the US government as a whole. Finally, the foreign exchange reserves can be used to fund foreign aid programs and to help other countries which are having balance of payments problems. This can help to foster Taiwan's international relations.

Sometimes misconceptions arise about the nature and use of foreign exchange reserves. For example, many people believe that the high level of foreign exchange reserves indicate that Taiwan is very wealthy. It is true that the reserves are an asset of the government, but this wealth is located overseas. They are not the same as a school, highway, or bridge which the Taiwan government builds and which is directly productive to the national economy. Remember that many countries in the world have higher per capita incomes and wealth than Taiwan, but have less foreign exchange reserves than Taiwan. Second, if the reserves are not adequately sterilized, the result is often inflation. Taiwan suffered very high inflation in its real estate market for just this reason. Third, some people feel that the reserves can be used to buy advanced military equipment. This is possible, but not likely because buying such weapons does not produce interest income. The CBC needs interest income from the foreign exchange reserves to operate without subsidies. Tanks and planes may provide greater safety in Taiwan, but they do not produce interest income like the foreign exchange reserves. Finally, the reserves cannot be withdrawn. The foreign exchange reserves, like foreign land, are held outside of Taiwan. They cannot be "brought back" to Taiwan. They can only be sold to other people wanting foreign exchange. Attempting to sell large amounts of foreign exchange would only bid down the value of the assets which the Taiwan government is holding. The real issue is how best to manage the foreign exchange reserves, and not whether Taiwan should get rid of them.

Discussion Questions:

#1. What are foreign exchange reserves? #2. How do governments accumulate foreign exchange reserves?#3. How can a trade surplus lead to greater foreign exchange reserves?#4. What is the relation of the foreign exchange reserves to the money supply?#5. What is meant by the term "sterilization"?#6. What has been the history of Taiwan's foreign exchange reserves?#7. How can Taiwan use its foreign exchange reserves?#8. What are some popular misconceptions about the reserves?#9. How could Taiwan's foreign exchange reserves be reduced?#10. What is a reasonable level for the foreign exchange reserves?

The Forward Market and Hedging

I. Introduction

Usually, when we discuss the forward market, we are talking about foreign currencies, although there are many other types of forward markets. For example, when one buys Japanese yen forward, one is fixing the exchange rate at which one will buy yen

in the future, say in three months time. This rate is often called the 90 day forward rate on yen. If one wanted to buy yen today, then one would buy at the spot yen rate.

It may seem that the forward market is very much the same as the futures market. But, there are still some important differences. First, there are no standardized contracts in the forward market, which means that the amount transacted can be anything. Second, there is no organized exchange as there is in the futures market. Instead, transactions are handled over the counter between contracting parties. Third, unlike the futures market, the forward market does not have daily settlement. Profit or loss is determined at the expiration of the forward contract. Finally, the futures market has a clearinghouse, which accepts the risk of non-payment by participants. The forward market does not have such a clearinghouse, and each party must accept the risk of non-payment by the other contracting party. Beyond this, there are differences in commissions and margins which must be paid.

To understand the forward market better, it might be useful to consider an example. An important concept which we must remember at all times is that a forward contract cannot be liquidated before it expires. One must wait until expiration of the forward contract in order to collect one's profits or pay one's losses. Thus, one must be always considering the present value of these profits or losses before expiration of the agreement.

Suppose that you buy a forward contract today at $100. The agreement will expire in 90 days and the risk free interest rate is 10%. After 20 days, suppose that the same type of forward contract is selling for $104 with 70 days left before expiration. You could now sell the underlying product forward 70 days, and this would guarantee that you have $4 profit 70 days later. What is the present value of your certain $4 profit to be received 70 days later. To find this one would simply discount this amount at the risk free rate of interest of 10% over the remaining 70 days -- which gives $3.93 of present value profit. In our example, we bought forward at $100 and sold forward at $104, but we never said what the product was that we were transacting forward. This is not really necessary, since the principle is the same whether we are transacting forward in currencies or commodities, or anything else. The key here is to understand that one's profit (or loss) is not realized until expiration, although the profit (or loss) can be determined before expiration.

If the forward (or futures) price is less than the current spot rate, then a state of backwardation is said to exist. Conversely, if the forward price is above the current spot price, then a contango is said to exist. The forward rate (price) is sometimes thought to be a good measure of the expected spot rate (price), but this is not necessarily true. The forward rate may be biased upward or downward from the investor's expected spot rate. If the forward rate is not biased, we say that it is unbiased. This means that on average the forward rate correctly predicts the future spot rate.

II. Hedging Currency Risks

The forward market can be used to hedge currency exchange risks. For example, suppose that EVA, an international airline in Taiwan, decides to purchase three 747-40 jets from Boeing. The total cost will be $180 million USD, and payment will be made in 270 days. EVA is worried that the NT$ may depreciate during this time. The current spot rate is $27.5 NT/1US$, and at this rate, the cost would be $4.95 billion NT. If the NT$ depreciates 1.82%, the cost to EVA would rise to $5.04 billion NT, for an exchange loss of about $90 million NT. EVA could hedge this risk by purchasing $180 million USD 270 days forward. Suppose that the forward rate is $27.8 NT/1US$, which means that the cost of the jets to EVA would be roughly $5 billion NT. By doing this EVA eliminates the risk that the NT$ will greatly depreciate. This hedging policy merely fixes the rate which EVA must use, 270 days later, to convert its NT$ to US$. There is no guarantee that this forward rate will be the same as the spot rate 270 days later. The actual spot rate may be either higher or lower.

EVA could hedge the same transaction using a variety of other means (if they are available), such as currency futures, currency options, or even through a money market hedge.

For a money market hedge, EVA would borrow $4.774 billion NT for 270 days and immediately sell these NT dollars on the spot market to get $173.62 million USD. Suppose the riskless US interest rate in 5%. Then EVA would invest the $173.62 million USD in US money market instruments for 270 days. At the end of this time, it would have $180 million USD which it would use to pay Boeing for the jets. Note that EVA eliminated its exchange risks since the $180 million USD is guaranteed (riskless). Furthermore, when EVA pays off its NT$ loan, it does not need to worry about exchanging NT$ for US$ -- that is, the NT$ loan carries no exchange risk. If the interest rate on the 270 day NT$ loan is 8%, then EVA pays $5.054 billion for the Boeing jets. It would appear that the forward market is a cheaper way to hedge the risks, given these interest rates.

III. Interest Rate Parity and Covered Interest Arbitrage

An important concept showing the relation between interest rate, the spot exchange rate, and the forward exchange rate is that of interest rate parity. The word parity refers to a balance which should exist between these variables. Interest parity is a type of equilibrium condition. If parity doesn't hold, then it should be possible for an investor to profit from the imbalance. The imbalance can be arbitraged away by investors. This type of arbitrage is often called covered interest arbitrage. Therefore, to really understand covered interest arbitrage, one must clearly understand interest rate parity.

Suppose that you have $100 USD and you have a choice of investing this money in the US or in Taiwan. In equilibrium, it should not matter whether you invest in Taiwan or in the US. The rate of return on your investment should be the same, as long as everyone can freely invest where they want and the tax treatment on such investment is the same in Taiwan and the US. Now suppose that RT is the risk free return in Taiwan,

RUS is the risk free return in the US, e is the spot rate on the US dollar ( NT$/US$), and f is the forward rate on the US dollar (NT$/US$). Interest rate parity refers to a balance between these variables. We can write this parity condition as (1 + RUS) = (1+RT)e/f.

Now suppose that (1+RUS) is greater than (1+RT)e/f. Interest parity does not hold, so it must be possible to make a profit. How can this be done?

If you were a Taiwanese investor, then you would borrow NT$ at interest rate RT and sell these NT$ for US$ on the spot market at rate e. The US dollars you receive would today be invested in the US at interest rate RUS. You would also sell US dollars forward today for NT$ at forward rate f. At the end of your investment period, you would be able to pay back your NT$ loan with interest and still make a profit.

Note that borrowing NT dollars puts pressure on RT to rise, and selling NT$ for US$ on the spot market causes e to rise. Finally, selling the US$ forward will cause f to fall and investing these US dollars in the US will cause RUS to fall. Therefore, there is string pressure to bring all the variables back into balance. This transaction is an example of covered interest arbitrage.

Interest rate parity shows clearly how that changes in short term interest rates can affect exchange rates. If RUS rises sharply, then there will be pressure on both e and RT to rise, and f to fall. We have seen before that short term interest rates are important to the economy because they can influence the exchange rate. We now see that international interest rate differentials can affect both the spot and the forward exchange rates. It is because of this that investors must carefully watch changes in monetary policies of different countries, especially the US. Changes in monetary policy can affect short term interest rates and thus the spot and forward exchange rates.

Discussion Questions:

#1. What is a forward contract to sell German deutschmarks?#2. Why do we consider the present value of profits and losses in the forward market?#3. Suppose that today you buy yen 90 days forward at 97. After 30 days you find that you can sell yen 60 days forward at 100. If the riskless yield to maturity is 6%, then what is the present value of your profit.#4. When is there backwardation in the forward market?#5. Explain the basic idea of a money market hedge.#6. How is the forward market used to hedge exchange risks?#7. What is interest rate parity?#8. What is covered interest arbitrage?