coggan 5

Risk Management


COPING WITH FINANCIAL RISK


It is tough running a business. You have to make a product that customers like. You have to find offices or factory space, reliable suppliers, employees that will be productive at a reasonable wage, cope with value added and corporation tax, have a bank that will lend you money and so on.
Even if you overcome all those hurdles, you face issues that may be beyond your control. Your cost of borrowing may rise because the Bank of England raises interest rates. The pound may rise sharply, making your exports uncompetitive in Europe or the US, or fall sharply, raising the cost of the spare parts you import. Oil prices may rise, increasing the cost of running your lorries or aeroplanes.
A whole host of financial products have been created to try to help companies manage these risks. They are known as derivatives, because their price is derived from those of other assets. Inevitably, derivatives also create opportunities for speculators, which make them controversial. But without speculators, the markets would not function and companies would find it much harder to protect themselves. One could argue that regular insurance companies are speculating that the premiums they charge for fire and theft will bring in more money than the claims they pay out.
INTEREST RATES


A problem that faces all borrowers and investors is the possibility that future interest-rate movements will leave them at a disadvantage. A company can choose either to fix its borrowing rate or to let the rate follow the trends in the market. Each decision has its potential disadvantages. A company which borrows at a fixed rate when market rates are 10 per cent will find itself regretting the decision if rates fall to 5 per cent. Similarly, borrowing at a floating rate may ensure that the company’s borrowing costs are in line with those in the market, but if rates rise during the lifetime of the loan, the borrower may regret not having fixed the rate.
In each of the above cases investors are exposed to the opposite outcome. If they have lent at a fixed rate, they hope that interest rates will fall rather than rise. If they have lent at a floating rate, their returns will always stay in line with the market. However, if market rates fall, they will regret not having fixed the rate on the loan at the prevailing levels.
Institutions which have borrowed large amounts will try to ensure that they are not overexposed to interest-rate movements. They will accordingly aim to strike a balance between the proportion of their debt which has a fixed interest rate and the proportion which is floating. Fixed-rate funding is normally available only long-term, and UK companies have been notoriously unwilling to borrow on a long-term basis. As a result they are extremely vulnerable to interest-rate increases – a fact proved by the sharp falls in profits and the job losses throughout much of the British manufacturing industry during the early 1990s.
It is important to strike a balance between short- and long-term debt. Too much short-term debt means that the company is very vulnerable to sudden interest-rate rises; too much long-term debt means that the company may find itself with higher than average borrowing costs because, as we saw in Chapter 2, long-term rates are often above short-term. It is also essential for companies to structure the maturity dates of their debt very carefully. If too much debt matures (and is therefore due for repayment) in any one year, the company may find itself short of funds with which to repay the debt. Companies aim, therefore, to structure their debts so that the amounts due to be repaid do not fluctuate violently from one year to the next.
The ideal debt portfolio would have a mixture of fixed- and floating-rate debt and would have as wide a range of maturities as possible. However, such ideals are hard to attain, and most companies find themselves with portfolios that are extremely vulnerable to a rise in interest rates. When that happens the financial markets offer a range of instruments as protection, including the forward-rate agreement, the financial future, the interest-rate option and the swap. These instruments (futures, options and swaps) can also be used to hedge other risks, such as exchange-rate movements (see next chapter).
FORWARD AGREEMENTS


A forward/forward, or forward agreement, is simply an arrangement between two institutions to lend or borrow a set amount at a set rate for a set period which will not begin for some months. Suppose, for example, a company knows that it wants to borrow £1 million for a six-month period commencing in six months’ time. Rather than wait six months and accept whatever interest rate is then applicable, the company decides to fix the rate in advance and arranges with a bank a forward agreement.
If six-month interest rates are 10 per cent and twelve-month interest rates are 10 per cent, what rate should a bank charge for a six-month loan, beginning six months from now? Surprisingly, the answer is not 10 per cent.
Suppose the amount to be borrowed is £100. If the bank agrees to lend under a forward agreement, it will set aside that £100 for six months until the agreement begins by investing it in a six-month deposit. At the end of six months it will have accumulated £105 (£100 +£5 interest). The bank can now compare its return with the return it would have received had it invested the original deposit for a year, which would have been £110 in total. Under the forward agreement it has £105 after six months and need only charge 9.52 per cent for the second six months to achieve a total return of £110. The rate which the bank will charge for the forward agreement will therefore be slightly over 9.52 per cent (assuming that the bank has no strong view about the direction of future interest-rate movements).
Why does the bank not just avoid all the complex calculations and charge 10 per cent? Competition means that other banks can make all the same calculations and offer borrowers a better rate.
The problem with forward agreements is that they involve the actual borrowing of a sum. If a borrower is seeking to cover existing debt, the effect is to double his credit lines. As a consequence, less cumbersome instruments have been developed which do not involve the principal sums.
Forward-rate agreements (FRAs) establish interest rates for borrowers, for lenders or for a set period in advance. When that period is due to begin the parties settle the difference between the prevailing level of interest rates and the rate agreed under the FRA.
Suppose a company has a long-term bank loan on which it pays interest at a floating rate that is reset every six months. At the start of the year the company may decide that it does not want to pay more than 10 per cent interest on the loan during the second half of the year. So the company takes out an FRA with a bank (this can, but need not, be the same bank as the one with which the company has the loan). When 1 July arrives the six-month market interest rate is 11 per cent, 1 per cent more than the company has agreed to pay under the FRA. So the bank pays the company 1 per cent to bring its borrowing costs down to 10 per cent. Had interest rates been 9 per cent on 1 July, the company would have paid the bank 1 per cent.
Unlike in the forward/forward market, no principal sum is transferred. Notional principal is agreed which matches the size of the loan so that the FRA covers the company’s risk. The important part of an FRA, though, is the rate at which it is arranged.
FINANCIAL FUTURES


Financial futures are among the biggest growth areas in the world of finance. Their origin lies in the world’s commodity markets. In the twentieth century Chicago traders, aware of their vulnerability to sharp swings in agricultural prices, began to quote prices for the delivery of produce many months in advance. Soon trading in wheat, pork belly and coffee ‘futures’ (as they became known) became as vigorous as trading in the commodity itself. Precious and industrial metals, like gold, silver and copper, soon developed their own futures markets.
Trading on the futures exchanges was traditionally conducted by open outcry (the less polite term for it is ‘shouting’) in floor areas called pits. The London International Financial Futures Exchange used to be a riot of colour with each firm’s traders wearing different, brightly coloured jackets. If prices are moving fast, a futures exchange can seem like Bedlam as traders desperately seek others who are ready to buy or sell contracts. (A good example of futures trading appears in the film Trading Places.) Outside clients can deal with floor traders only through brokers and therefore have to pay their commissions.
In the late 1990s, however, LIFFE abandoned trading in the face of competition from the German futures market. Trading moved to a screen-based system, which was designed to be cheaper for investors. However, Chicago, the world’s biggest futures market, retains the pits and coloured jackets.
With the advent of floating exchange rates (see Chapter 14), it occurred to Chicago traders that there may well be a market for trading in currency futures, since exchange rates seemed to be exhibiting the same volatility as commodity prices. Currency futures quickly became a success; some experts now estimate that 10 per cent of all US foreign-exchange transactions take place on the Chicago futures floor. After the late 1970s and early 1980s had seen equally sharp moves in interest rates the Chicago traders developed interest-rate futures.
How are interest-rate futures used? Essentially, if an institution is worried about the effect of a rise or fall in the level of interest rates, it should buy or sell interest-rate futures to the extent that any movement in interest rates will be cancelled out by a change in the value of the future. The price of an interest-rate future is determined by subtracting the implied interest rate from 100. Thus a futures price of 88 would imply an interest rate of 12 per cent. When interest rates fall, the price of interest-rate futures rises. A cut in rates of 2 per cent will normally push up the price of the future by 2 points; conversely, a rise in interest rates will cause the futures price to fall.
Futures are especially useful as a mechanism for protecting against interest-rate risk because only a small proportion of the nominal value of the future (the margin) is required to be deposited. That margin is adjusted as the price of the future rises or falls. Since both sellers and buyers must deposit margin, it is possible to use futures to cover both the risk of an interest-rate rise and (if you are an investor) of an interest-rate fall.
To see precisely how a future works, suppose that a UK company knows in September that it will need to borrow £1 million for three months in the following December. The company might worry that interest rates could rise in the interim from the September level of 10 per cent. As the company fears an interest-rate rise, it sells futures (remember, a rise in rates leads to a fall in the price of futures).
On LIFFE the nominal size of the sterling interest-rate contract is £500,000. To cover its £1 million risk the company therefore sells two sterling contracts. Each contract carries a margin (set by LIFFE) of £1,500, so both buyer and seller deposit £3,000 with LIFFE’s clearing house.
By November interest rates have risen to 12 per cent, the very event that the UK company feared. The futures price has duly fallen from 90 to 88. This means that the position of the futures buyer has deteriorated, since he or she has bought for 90 something which has now fallen to 88. The position of the seller (the company) has improved. The clearing house accordingly credits the account of the seller and debits the account of the buyer. Each full point that a futures price moves is worth £1,250. So the company’s position has improved by £2,500 per contract, or £5,000 on its whole position. The futures buyer, however, is £5,000 worse off, and the clearing house accordingly asks the buyer to pay additional margin to bring his or her net position back up to £3,000.
Shortly before the contract is due to expire the buyer and seller agree to close out the futures position without actually exchanging the £1 million. (Most financial futures contracts end without the nominal contract being exchanged.) The clearing house then gives the seller the original £3,000 margin plus the £5,000 payment to reflect the improvement in the company’s position. The buyer also receives back the £3,000 margin, but since he or she has paid £8,000, in all the net position is a loss of £5,000.
How has the futures transaction helped the company that was worried about the interest-rate rise? Remember that it was due to borrow £1 million for three months. Had interest rates been 10 per cent, the cost of borrowing £1 million for three months would have been £25,000. However, interest rates rose to 12 per cent in November, and the company’s borrowing cost became £30,000, an increase of £5,000. The profit from the futures transaction therefore met the extra cost of the borrowing exactly. The company was able to protect itself against the rise in interest rates. Had interest rates dropped, the company would have lost on its futures position but had lower borrowing costs.
The most frequent users of interest-rate futures are not companies but banks and institutional fund managers. Many company treasurers have been unwilling to accept the work needed to keep up with the margin payments involved. Banks use futures to cover their open positions when they have failed to match their investments with their liabilities. The fund managers use futures to ensure that a fall in interest rates does not reduce the return on their investments. To do so they buy rather than sell futures. A fall in interest rates will lead to a rise in the futures price which will offset the losses on investors’ portfolios.
In all futures markets, speculators are needed to maintain liquidity. In Chicago, these speculators are affectionately known as locals. Although futures are useful for those who are concerned about existing loans or assets, they also offer a means of reaping substantial profits from a small initial position, the process known as leverage. As we saw in the example above, an initial deposit of £3,000 gave both buyer and seller an interest in £1 million. The company achieved a profit of £5,000 on an initial deposit of £3,000, a promising return for a three months’ investment. It is this sort of opportunity for profit that the Chicago locals hope to exploit. Leverage, however, works both ways – the futures buyer in the example lost £5,000 – so locals can as easily be ruined as they can be made millionaires. However, by seeking to take advantage of these speculative opportunities, locals provide the liquidity that helps the banks, fund managers and companies to use the markets effectively.
LIFFE never had the local interest that made Chicago such a success but it was very successful after a slow start in 1982. It suffered from one weakness in that the UK markets, where it had a natural advantage, were not that interesting to international investors.
While LIFFE compensated very well for a while by dominating the business in German government bond futures, it gradually lost that market to its natural home in Frankfurt. In late 2001, LIFFE agreed to be taken over by the European exchange, Euronext.
INTEREST-RATE OPTIONS


Under the interest-rate option, which is in some ways a refinement of the forward-rate agreement, an option buyer purchases the right (but not the obligation) to lend or borrow at a guaranteed interest rate. In return the option seller receives a payment known as a premium, generally paid at the time the option is sold. On the day the option expires it is up to the option buyer to exercise the option and to lend or borrow at the guaranteed rate if it is possible to do so. However, if the option buyer can achieve a better rate of borrowing or lending in the money markets, he or she will let the option lapse. The maximum loss to the option buyer is therefore the cost of the premium. The size of that premium depends on three factors: the relationship between the interest rate guaranteed under the option and the interest rate in the money markets; the time left before the option is due to expire; and the option seller’s assessment of whether interest rates are likely to move quickly.
If, for example, a company wanted to buy an option to borrow at 8 per cent at a time when interest rates were 10 per cent, there would be automatic potential for profiting from the option. As a result, the premium for the option would be at least 2 per cent and would be much larger than the premium for an option to borrow at 12 per cent in the same circumstances. An option to lend at, say, 12 per cent when interest rates were 10 per cent would carry a large premium, however, since it would have built-in profit potential.
Options which run for longer periods will also carry larger premiums. This is because the probability is greater that, over a long period, rates will move in such a way that the option will become more profitable to exercise. The option seller will charge a larger premium to reflect this extra risk.
How quickly interest rates will move is the hardest of the three elements for the option seller to assess. If the rate has shown a tendency to fluctuate violently in the past, it will obviously carry a higher premium than a rate which has shown a tendency to be stable.
An example will help to clarify the point. A company buys a three-month option to borrow at 10 per cent for three months, based on a nominal principal sum of £1 million. At the time the option is sold, interest rates are 10 per cent and the option seller charges a premium of 1 per cent (£2,500).
Outcome 1 At the end of the three-month period interest rates are 12 per cent. The company exercises the option, thus borrowing at a rate 2 per cent cheaper than if it had not bought the option (this is equivalent to a saving of £5,000). However, the premium cost 1 per cent (£2,500), and the savings that the company makes (compared with its borrowing costs if it had not bought the option) are £2,500.
Outcome 2 At the end of the three-month period interest rates are 8 per cent. The company lets the option lapse but is free to borrow at the cheaper rate available. Its extra costs are £2,500, the cost of the premium, but its borrowing costs are £5,000 less than it might have expected at the time when it bought the option.
SWAPS


Swaps were once seen as exclusive products which were tailor-made to suit the few sophisticated borrowers who could understand them. Nowadays they are a huge global market, with many simple, standardized products.
The basic concept behind the interest-rate swap is that two borrowers raise money separately and then agree to service each other’s interest payments. However, many swap deals are much more complicated and can involve several currencies and half a dozen borrowers, with only the bank in the middle aware of all the details.
Why should two borrowers want to pay each other’s interest? There are two main reasons. The first concerns the different perceptions of different markets. Investors in one country may be prepared to lend to a US borrower at an advantageous rate but will ask for a higher rate from a UK borrower. In another country it may be the UK borrower who receives the better rate. In those circumstances it can benefit both borrowers to raise funds in the market where their credit is best and then swap the funds.
An example of an early swap deal may help to explain. The World Bank and IBM both wanted to raise funds, the World Bank in Swiss francs and IBM in dollars. Swiss investors had already accepted a good deal of World Bank debt and would accept more only if it were offered at a higher rate. They were keen, however, to invest in a top US corporation like IBM. In the US the World Bank’s credit was perceived as being better than IBM’s. So the World Bank borrowed in dollars and IBM in Swiss francs. They then arranged a swap, so that IBM got its dollars and the World Bank its Swiss francs. Each ended up paying less than if they had borrowed separately. Such are the opportunities for borrowing at advantageous rates through swaps that in some years 80 per cent of Eurobond issues have been swap-linked.
The second reason for arranging swaps concerns the different perceptions of borrowers as to the likely direction of future interest-rate movements. As we have seen, borrowers can choose to borrow either at a fixed or at a floating rate. If they think interest rates will rise, they should borrow fixed; if they think interest rates will fall, they should borrow floating. However, they may subsequently decide that they have made the wrong decision. A swap allows borrowers to manage their existing debt. They can choose to swap not only from fixed to floating or vice versa but also from one currency to another.
Now that there is a secondary market in swaps, borrowers can reverse their swap decisions if they wish. Say a borrower had swapped from borrowing fixed to borrowing floating when interest rates were 12 per cent and that rates subsequently dropped to 8 per cent. That swap would now have a value because the borrower is receiving 12 per cent from its counterparty but paying only 8 per cent. The first borrower could sell the swap or arrange another swap by which it would agree to pay a fixed rate of 8 per cent and receive a floating rate. Its floating-rate payment under the first swap would be cancelled out by the second swap. However, it would have cut its fixed-rate payments from 12 to 8 per cent.
How are banks involved in swap deals? Some act as swap principals, agreeing to switch into fixed or floating debt or into another currency as the borrower requires. Normally, such banks have a ‘book’ of swaps, and they may find that their positions over a number of different swap deals balance each other out. Other banks act purely as swap arrangers, bringing together two different companies with corresponding needs: they earn fees in the process. A third set of banks follows a compromise strategy, acting as principals in a deal until they can find a matching borrower.
Swaps are off-balance-sheet transactions – they are not regarded as assets, and banks are currently not obliged to take precautions against the possibility of default. However, regulatory authorities have shown their concern about the growth of the market. Many poor credits are involved, since swaps give them the opportunity to reduce the cost of borrowing. If swap parties do default, banks may be faced with the payment of above-market interest rates.
What swaps have done is to open up the world’s capital markets to a wide range of borrowers. It is now possible for a UK borrower, say, to pick a particular world market where borrowing seems cheap, borrow there and still, through a swap, end up with the sterling debt it really wants.
CREDIT DEFAULT SWAPS


For investors, interest-rate risk is not the only danger they face. There is also the possibility that the borrower will not repay the loan or bond. In the old days, there was not much that the investor could do about this. Bond investors could at least sell their holdings if they felt bad news was due; loan investors were usually stuck. The best protection was to have a diversified portfolio of bonds or loans and hope that the good payers outweighed the defaulters.
But the financial markets are remarkably ingenious at finding ways to insure against risk. The credit default swap is their latest wheeze. It is like an insurance policy against default. One party pays a premium to another; in return, the seller agrees to pay up if the borrower defaults. The higher the premium, the riskier the company.
This small idea created a market with some $62 trillion of outstanding contracts by the end of 2007. The phenomenal growth of the market was due to the great scope it created for both investors and speculators. Traditionally, there was not much they could do if they believed the outlook for corporate bonds and loans was deteriorating. But now they can buy credit default swaps; if it looks likely that more borrowers will default, premiums will rise. That will push the speculators into profit. Similarly, those who believe the corporate bond market can do well can take the other side of the deal. If premiums fall, they will profit. The scope for big gains would be much greater than could be achieved by just holding the bonds themselves.
Some people worry that the credit default swap market could lead to a crisis in the event of a lot of corporate failures. In some cases, the value of outstanding swaps is much greater than the value of bonds in issuance. One of the reasons for the collapse of the insurance group AIG was its huge exposure to credit default swaps. In 2009, attempts were made to improve the market by introducing a clearing mechanism, so that dealers would not be so exposed to the collapse of a counterparty.
The swap is such an incredibly versatile instrument that it is used in many other areas. For example, investors and banks can agree to a total return swap. The investor agrees to pay the bank an interest rate-linked return; the bank agrees to pay the investor a return based on a particular market, such as commodity prices. At the end of the agreed period, the two payments are netted out. If commodities have returned more than the investor’s borrowing costs, he is in profit. This may be a quicker and cheaper way of betting on commodities than buying them directly.
SPECIAL BOND ISSUES


Another way for investors to protect themselves against interest rate movements is to buy special types of bonds (some of which are described in Chapter 11).
One type of bond issue deserves treatment here because it closely resembles a swap. The capped floater offers investors a floating rate set at a margin above LIBOR. However, if LIBOR rates go above a certain level, the bond rates do not follow. A ‘cap’ is set, which is the maximum rate the issuer will pay. The investor is compensated for the cap because the bond pays a higher than usual margin over LIBOR.
The issuer sells the cap to another borrower which wishes to lock in a maximum cost for its borrowings. The bond issuer can invest the money received from the sale of the cap, so that it receives a stream of payments which it can offset against the higher than usual margin over LIBOR that it is paying on the bond issue. This effectively can bring the cost of the issue to below LIBOR. So the issuer ends up paying less than LIBOR; the investor receives a higher than usual margin above LIBOR; and the cap buyer receives protection against a rise in interest rates.
After an initial surge the number of capped floaters declined. Instead banks now sell a product known as a ‘cap’ separately from specific bond issues. Such caps are effectively long-term interest-rate options and give the buyer the right to borrow at a specific rate. The bond market is for ever ingenious, however, and it is safe to predict that issues will be designed with a similar clever mix of fixed and floating payments in the future.
All the above instruments deal with interest-rate risk. However, the risk that currencies will move is important to both borrowers and investors and also to businesses which export and import. It is that risk we shall examine in the next chapter.

Foreign Exchange


In foreign-exchange markets, billions of pounds change hand every minute and nations can be humiliated by the actions of a few hedge fund managers. Currency volatility affects everyone, from the biggest multinational to the humblest tourist. Every overseas trade deal involves foreign-exchange decisions. First the people involved must agree which currency should be used to settle the deal. If one party is from Japan and the other from Switzerland, should the transaction take place in yen, Swiss francs or some other currency such as the US dollar? Equally important, when should the currency be delivered? Just as the price of the goods being sold is central to the transaction, so the exchange rate (which is the price of one currency in terms of another) can determine whether the parties make a profit or a loss.
BRETTON WOODS AND AFTER: THE ROLE OF FORECASTING TODAY


The post-war system of fixed exchange rates was set up in 1944 at an international conference held in Bretton Woods, New Hampshire. Although not fully operational until 1958, the Bretton Woods system pegged the world’s major currencies at fixed rates to the dollar. In turn the dollar was given the strength to act as the linchpin of the world’s financial system because of its ‘convertibility’, at a set rate, into gold.
Gradually the system broke down as the American economy ran into trouble because of President Johnson’s attempts to finance the Vietnam War and his ‘Great Society’ reforms at the same time. By 1971 the dollar lacked the strength to support the system, and President Nixon announced the suspension of the dollar’s convertibility into gold. A series of attempts to shore up the system failed; eventually it proved impossible to fix the value of the major currencies against the dollar.
The assumption that lay behind the fixed-rate system was that if one country had an excessive current-account deficit, it would alter its domestic economic policies until balance was restored. The system was capable of surviving the occasional hiccup, such as the sterling devaluation in 1967. However, since the system hinged on the dollar, a US balance-of-payments crisis was a potentially mortal wound.
Thanks to President Johnson’s attempt to pay for both guns and butter, the US developed enormous current-account deficits which it proved unable to rectify. As a result, the foreign-exchange markets were overloaded with dollars ($1 billion a day flowed into the Bundesbank in May 1971). Speculators had a one-way bet. If they sold dollars and bought a strong currency such as the Deutschmark, they were highly unlikely to lose money, but if the dollar devalued, they would make substantial gains.
The enormous scale of international capital flows today means that no central bank has the reserves to defend its currency against market speculation indefinitely. As a consequence, a Bretton Woods-type system is unlikely ever to return.
Why have exchange rates been so unstable since the collapse of the Bretton Woods system? Many theories have been developed to explain why exchange rates change, but none has so far explained their movements in such a way that future exchange-rate moves can then be predicted with any degree of accuracy.
Economic theories attempt to explain exchange-rate moves in the long run. Foreign-exchange dealers have to predict exchange rates in the very short run indeed – a day or two at the most. Companies whose profits are hurt or boosted by currency movements often need to know about the medium term – between two months and a year or so. When they turn to currency forecasters they are often disappointed. Surveys of foreign-exchange analysts regularly come to the conclusion that the forecasters are right in less than half of their predictions – a record worse than might be expected from tossing a coin.
There are two schools of currency forecasters – the economists and the technical analysts – and their methods are radically different. The economists have academic respectability and intellectual recognition. Sometimes, however, the technical analysts have the greater influence in the market.
The Economists


Because the system of fixed exchange rates survived for so long, economic theories about exchange rates have been developed from earlier studies about the way in which the balance of payments changes.
The most important initial distinction to make is that between the current and capital accounts of the balance of payments. The current account broadly covers trade payments, although it also includes tourist expenditure and, most important, interest payments and dividends. The capital account is concerned largely with purchases of assets – foreign securities such as German bonds, Japanese shares or physical assets like a factory in the Philippines. Note that purchase of a foreign bond counts as a debit on the capital account, but interest on the bond will be shown as a credit on the current account. The notion of a balance of payments is that a surplus or deficit of a current account will be balanced by a deficit or surplus on the capital account.
If, under the fixed-rate exchange system, a country was in current-account deficit, then to pay for the excess goods and services that it received from abroad it would have to act to correct the deficit. Trade barriers were ruled out under the General Agreement on Tariffs and Trade (GATT), so the country would be obliged to run down its foreign physical and financial assets or to borrow abroad in order to pay for its imports. In either case the inflow would be recorded as a capital-account surplus that matched the current-account deficit.
In the long term a deficit government was expected to curb demand in the economy, so that domestic consumers cut back their expenditure on both domestic and foreign goods. The price of domestic goods would fall in response to this drop in demand, making them more attractive to foreign consumers and pushing up the country’s exports. Since imports would fall (because domestic consumers could not afford to buy them), the net effect would be to restore the balance-of-payments equilibrium. According to this model, devaluation would occur only when a country had run down its reserves so far that it was unable to restore current-account balance at the prevailing exchange rate.
The above example assumes that the capital account is not an independent variable but responds only to changes in the current account. In fact, the international flows of capital mean that the capital account is very much at the mercy of investor demand for foreign and domestic securities. As we saw, this was one of the reasons why the fixed exchange-rate system did not survive.
In the era of floating rates, economists have attempted to study how the exchange rate affects, and is affected by, both the current and the capital account. Their study has centred on two factors, the level of prices and the level of interest rates.
The study of the effect of prices on exchange rates has focused on the purchasing power parity (PPP) theory. At its simplest the theory argues that exchange rates will tend towards the point at which international purchasing power is equal. In other words, a hamburger would cost the same in any country, something The Economist highlights in its Big Mac index. In turn that means differential inflation rates are the most important driving factor behind exchange-rate movements.
Inflation matters because high prices make a country’s goods uncompetitive. If the UK’s inflation is 10 per cent per annum while the US’s is zero, British goods will be 10 per cent more expensive than American goods after a year has elapsed. Unless British productivity outpaces that of the US by 10 per cent, UK sales abroad will fall as customers find it cheaper to buy American or other alternatives, and UK imports will increase as domestic consumers prefer US goods to their own. Hence the current account will deteriorate.
This sorry picture, PPP theorists claim, is redeemed by the exchange rate. If the pound falls by 10 per cent against the dollar in the above example, the cost to the US customer of UK goods (in dollars) stays the same. Similarly, the dollar has risen by 10 per cent, and therefore the cost to the US customer of American goods (in pounds) is the same. So the exchange rate has acted to restore the balance.
Monetarists adopted and modified this theory. They believe that price increases are caused by an excess money supply. Thus, since the markets know that nations with slack monetary regimes will suffer inflation, they will sell the currency of that country and buy the currency of countries with stricter monetary control. The resulting exchange-rate depreciation will in the long run match the differential in money-supply growth between the two countries. Unless money-supply growth is checked, the process of inflation-provoked devaluation will continue.
The concept of an equilibrium level for exchange rates has given PPP theorists a lot of trouble. There is no point of zero inflation and equilibrium currency rates from which subsequent exchange-rate movements can be measured. A base year must therefore be chosen, and the choice of base year often determines whether an exchange rate appears under- or overvalued. The years of rampant Western inflation, 1974–8, are a particular source of problems.
Another major difficulty with the PPP theory is deciding what is defined by inflation. If the price of hairdressing is included in the consumer price index (CPI), will that make the index a reasonable measure of UK competitiveness? How many Americans will cross the Atlantic to get a cheaper perm? More seriously, an important component of any CPI is housing costs, which are irrelevant to consideration of export competitiveness. Even wholesale prices cover items that are not internationally traded. The most popular measure of competitiveness has therefore been unit wage costs – that is, the amount paid to workers per unit of output.
The PPP theory holds out very well for many Third World countries, in particular Latin American where exchange-rate depreciation against the dollar tends to follow the inflation rate quite closely. When it comes to predicting and explaining the exchange-rate movements of the currencies of the major industrialized countries, however, it has been far less successful.
If PPP theory is correct, real exchange rates (nominal exchange rates adjusted for inflation) should stay fairly stable. In fact, research has demonstrated that real rates show considerable volatility and exhibit little sign of returning to any equilibrium level. Some explain this by the concept of ‘overshooting’, in which because of market inefficiencies, exchange rates over-adjust in response to inflationary differentials. If they do, that makes it all the more difficult to use PPP theory as an exchange-rate predictor.
The level of interest rates is clearly a major factor in the strength or weakness of a currency. This is even more the case after the wave of financial deregulation which we noted in Chapter 1. The world is now virtually a single capital market, in which vast quantities of money shift from one country to another in search of short-term gains.
The influence of interest rates is not as easy to assess as might first be thought. To begin with, are investors attracted by the nominal rate or the real rate (the nominal rate adjusted for inflation)? Second, are high interest rates a sign of a healthy or of an ailing economy?
For a long time foreign-exchange speculators perceived currencies in high-interest economies as weak and currencies in low-interest economies as strong. If a currency were weak, the argument went, few people would want to hold it or lend it, since currency depreciation would soon reduce its value. Debtors would want their borrowings denominated in a weak currency, however, since currency depreciation would reduce their debt burden. As a result there would be few lenders and many borrowers in that currency. In other words, demand for borrowings would exceed the supply and thus force the interest rate up.
The converse would apply to strong currencies. Many people would want to hold or lend them, since, added to the interest received would be the extra value gained from the currency’s appreciation. On the other hand, few would want their debts denominated in a strong currency, since currency appreciation would keep increasing the effective total of their debt. In a strong currency, therefore, there would be many lenders and few borrowers. The supply of borrowings would exceed demand, forcing the interest rate down.
The position is complicated further by the willingness of governments to push their interest rates up in order to defend their currencies. Take the desperate attempts of the UK to prop up the pound in September 1992. The then Chancellor Norman Lamont was forced to increase interest rates twice in one day from 10 to 12 per cent, and then to 15 per cent, in an attempt to keep sterling within its Exchange Rate Mechanism band. But high interest rates impose a heavy burden on the economy, in terms of lost jobs and output, and few traders believed the UK government would sustain rates at that level. The pound fell anyway, and the UK was forced out of the ERM.
Oddly enough, ever since the UK was forced out of the ERM, currency markets have shifted again in their view of the influence of interest rates. High rates have generally boosted a currency’s value. This seems to be due to the ‘carry trade’ which sees speculators borrow money in a low-yielding currency and then invest the proceeds in a higher-yielding one. One popular trade, for example, was to borrow the yen and to buy Australian or New Zealand dollars. Such a tactic would earn a positive ‘carry’, the difference between rates in the two countries, of several percentage points.
In theory, these speculators should worry that the risk of devaluation should at least equal the higher interest rates on offer. In practice, the carry trade has been profitable most of the time.
The carry trade is thus an example of how investment decisions, as much as trade in goods, affect exchange rates. Accordingly, another theory of exchange-rate movements is the portfolio balance model. Proponents of this theory argue that exchange rates are effectively the relative prices of international financial assets (e.g. bonds and shares). Expectations of the likely risk and return of financial assets determine exchange-rate movements as investors shift their portfolios from one country to another.
The portfolio balance theory is persuasive partly because capital flows are far larger than trade flows. Another reason is that major economic or political events have an effect on the financial markets much more quickly than they do on the prices of goods. Bond prices move almost constantly, thanks to the electronic communications systems: the prices of goods change more slowly and depend on many factors. The combination of trade and capital flows results in the erratic paths of exchange rates as the two factors act sometimes in the same direction and sometimes in opposite directions.
Currency movements thus seem to depend to a large extent on the subjective views of those involved in the international capital markets. This concentration on expectation has given a great boost to the other strand of currency forecasters – the technical analysts.
Technical Analysis


Technical analysts, or ‘chartists’ as they are often known, believe that all the factors which the economist studies – inflation, the balance of payments, interest rates, etc. – are already known by the market and are thus reflected in the prices of goods and commodities. This is as true of pork bellies and oil as it is of currencies. The chartists, as their name suggests, study charts which represent the price movements of a particular commodity. Over long periods certain price patterns emerge, which cause the analysts to claim that further developments in the price pattern can be predicted.
Economists have a tendency to reject the chartist theories out of hand. However, many traders in the foreign-exchange markets follow the chartists’ predictions. To some extent such predictions can become self-fulfilling if enough people believe them. The markets react when a certain point of the chart is reached.
The underlying rationale behind chart analysis is that the key to price movements is human reaction, and that human nature does not change markedly in response to similar events. Among the main patterns that chartists see are the following.
Head and shoulders. This pattern is made up of a major rise in price (the head) separating two smaller rises (the shoulders). If this pattern is established, the price should fall by the same amount as the distance between the head and a line connecting the bottom of the two shoulders.
Broadening top. This pattern has three price peaks at successively higher levels and, between them, two bottoms with the second one lower than the first. If, after the third peak, the price falls below the level of the second bottom, this indicates a major reversal in the price trend.
Double bottoms/tops. A double bottom or top indicates a major reversal in the price trend. Both consist of two troughs (or peaks) separated by a price movement in the opposite direction.
Apart from pattern recognition, technical analysts also study momentum and moving average models. Momentum analysis studies the rate of change of prices rather than merely price levels. If the rate of change is increasing, that indicates that a trend will continue; if the rate of change is decreasing, that indicates that the trend is likely to be reversed. The concept behind the study of moving averages is that trends in price movements last long enough to allow shrewd investors to profit and that rules can be discovered which identify the most important of these trends. One of the most significant rules for technical analysts is that a major shift has occurred when a long-term moving average crosses a short-term moving average.
Although technical analysis has very little intellectual respectability in economists’ circles, it has had a great impact on the foreign-exchange markets. Many believe it to be a useful forecasting tool in the short term. In the long term, despite some setbacks, economic analysis may yet prove a more successful forecasting technique.
THE EUROPEAN SINGLE CURRENCY


Since 1999, the foreign-exchange markets have witnessed one of the great economic experiments of all time – the creation of the European single currency, or euro.
European governments struggled for a long time with the breakup of the Bretton Woods system. By nature, they were less inclined to embrace floating exchange rates than the more laissez-faire economies of the UK and the US and the subsequent twenty-five years saw a series of attempts to restrict currency movements.
The first attempt in the mid-1970s – the ‘snake’– collapsed fairly quickly and the second attempt – the Exchange Rate Mechanism – was plagued by repeated crises between 1979 and 1983.
Change started to occur when the French government decided to aim for a strong currency, or franc fort. This made it easier for the franc to stabilize against the established currency of Europe, the Deutschmark, and removed some of the tensions within the system.
But in the early 1990s, the ERM broke down. The catalyst was the reunification of Germany which created inflationary pressures that the German central bank, the Bundesbank, decided to tackle by increasing interest rates. To maintain their parity against the Deutschmark, other currencies within the system had to increase their interest rates, driving some economies into recession.
Some countries, including Britain but also Italy, could not stand the strain. They eventually opted in 1992 for the less painful option of devaluation and interest-rate cuts. One year later, speculative attacks looked like forcing the French franc to devalue; in the event the ERM was changed to allow much wider trading bands, which were close enough to floating rates as to make no difference.
The breakup of the ERM created the impetus for the drive towards a single currency. The Maastricht Treaty (from which Britain had an opt-out) established the criteria which companies needed to meet; including annual budget deficits less than 3 per cent of gross domestic product and inflation rates close to the European average.
The process for preparation went rather more smoothly than sceptics might have expected. There were no speculative attacks in the last days of the old system; interest rates and bond yields in the higher-risk countries, such as Italy and Spain, smoothly came down to German levels.
At the start of 1999, European exchange rates were ‘locked in’ at set levels against the euro and it became possible to use the currency for commercial transactions. Notes and coins duly arrived at the start of 2002, at which point the old currencies of the 12 member countries – Germany, France, Belgium, Luxembourg, Netherlands, Ireland, Spain, Austria, Portugal, Finland, Italy and Greece – ceased to exist. Since then, three more countries, Cyprus, Malta and Slovenia, have joined the system.
A single currency brings a number of advantages. First it removes a level of uncertainty when European companies do business with each other; they no longer have to worry that exchange-rate movements will eat into their profits.
Second, it reduces the costs of doing business within the continent. Every time money is converted from one currency into another, there are commission and dealing costs to be paid.
Third, it should make markets more efficient. It is now easier for Europeans to compare prices in different countries and to buy from the cheapest supplier. (Although there are still some tax and regulatory barriers that make this difficult.)
Against all this is the lack of flexibility which has resulted. One currency means one interest rate for the whole continent, no matter what the economic conditions in each country. In the early years of the euro, Germany had rather higher interest rates than its economy probably deserved, which meant a long period of sluggish economic growth. From 2003 to 2007, Ireland and Spain, with fast-growing economies, had interest rates that were too low, leading to booming housing markets and rising inflation rates.
European countries that face recession, when the rest of the continent is buoyant, will not have the option of devaluation or cutting interest rates. Nor will they be able to revive their economy through a wave of public spending; a so-called stability pact puts limits on budget deficits (although the rules have not been applied too rigorously).
Of course, the US is a big country, with one currency and interest rate. But it has a fairly mobile population; if one region is depressed, workers can quickly move to another. Language makes that option a lot harder for Europeans.
Britain has yet to join the euro at the time of writing. Government policy is to call a referendum if five (rather vague) economic tests are met. Britons will have to weigh the economic pros and cons of such a move, but many seem to be opposed on principle, arguing against the loss of sovereignty involved. If Britain were to join the single currency, interest rates would be set at the European Central Bank’s headquarters in Frankfurt.
EMERGING MARKET CURRENCIES


The problems of dealing with floating exchange rates have not been confined to the countries of Europe. The so-called emerging markets, the developing nations of Asia, Latin America and eastern Europe, have also grappled with the issue.
Economic problems have a habit of showing up in exchange-rate movements. In Latin America, historically high inflation rates caused massive depreciations of currencies against the dollar, particularly in the 1980s. Then in 1994, the Mexican government was prompted into devaluing the peso in the face of a massive trade deficit.
Asian countries had traditionally produced much better economic performances than Latin America and their currencies had traditionally been stronger. But then in 1997, Thailand suddenly devalued its currency, the baht, triggering a wave of devaluations round the region.
Asia’s apparent strength had hidden some underlying weaknesses. Many countries had linked their currencies, formally and informally, to the dollar, encouraging many companies to take out US dollar loans because of the lower interest rates in America. Furthermore, their reputations as fast-growing economies had resulted in a massive influx of capital, much of which had been invested at economically unfeasible rates. In short, a speculative bubble had been created.
When sentiment turned, the bubble burst very quickly. The hot money that had flowed into the Asian countries flowed out again; as the currencies depreciated, the burden of meeting the corporate system’s dollar debts became oppressive. Asian banks, which had lent heavily to the corporate sector, saw their finances deteriorate in the face of bad debts.
Many south-east Asian economies plunged into recession; the IMF was called in to provide rescue financing packages. The whole issue cast doubt on the ‘Asian economic miracle’ and prompted a lot of debate about free-market regimes.
Some countries and commentators argued that the system showed the instability of global capitalism, and the need for controls; Malaysia duly imposed capital controls in 1998. Free-market enthusiasts argued that it was the attempts of governments to track the dollar and their interference in the free running of their economies which caused the problem.
The reaction of the Asian countries to this debacle set up a new phase in the currency markets. They decided that they must cease being dependent on foreign capital. That required them to build up trade surpluses, an economic policy that used to be dubbed mercantilism.
They were very successful at this, with China building up surpluses of several hundred billions a year. Russia, a basket case in 1998, is now a surplus nation thanks to its oil and has reserves. Countries with current account surpluses normally see their currencies appreciate. But most Asian nations opted to control their currency movements, for fear that too rapid a rise in their exchange rates would reduce the competitiveness of their exports.
A country with a surplus, however, accumulates a lot of foreign-exchange reserves. These tend to be held in the form of government bonds. Those government bonds, in turn, tend to be issued by countries with current-account deficits.
Thus developed a system that has been dubbed Bretton Woods II. China supplies America with cheap goods. In return, America supplies China with IOUs in dollar form. China is willing to accept the deal because the export boom provides employment for its vast population, which is steadily moving from the countryside to the cities. America accepts the deal because it keeps inflation and interest rates down, allowing its consumers to keep spending with apparent impunity.
Lots of people, however, doubt whether the deal is sustainable in the long term. Eventually, China will get fed up with owning dollar bonds, especially as the US currency is likely to depreciate. Holding its currency (the yuan) down means that Chinese inflation is likely to accelerate.
America is fed up with the loss of manufacturing jobs to China and some politicians have muttered about trade barriers. In addition, China, Russia and others are diversifying their reserves away from government bonds and have set up sovereign wealth funds that invest in shares and property. That has led to fears in the West; big companies are being bought by funds controlled by our geopolitical rivals. The contrast with how Russia treats overseas investors (often forcing them out through legal and tax moves) is striking.
THE FOREIGN-EXCHANGE MARKET


Participants in the foreign-exchange market include everyone from the Governor of the Bank of England to tourists when they buy foreign currency for a holiday. Tourist purchases are, in fact, among the few foreign-exchange transactions in which notes and coins actually change hands. The vast majority of deals take place electronically or over the telephone.
At the core of the market are the banks. Most commercial banks have their own foreign-exchange room. Although banks could not deal if they were not providing a service for their corporate clients who need foreign exchange as part of their everyday business, the majority of any bank’s deals are done with other banks. One bank has estimated that 95 per cent of its foreign-exchange business is done with other banks and only 5 per cent with outside customers.
There are three major dealing time zones, all of which have more than one centre. London was considered the most important centre, although New York has now probably taken over that role. The market begins each day at 1 a.m. Greenwich Mean Time (GMT), when Tokyo opens. The Far Eastern time zone holds sway until 9 a.m. GMT, by which time London, Frankfurt, Paris and Zurich have begun the European time-zone trading. By 2 p.m. GMT, New York has opened trading in the American time zone. The market does not close in New York until 10 p.m. GMT. Those dealers who are still awake can trade in San Francisco and Los Angeles until Tokyo opens the next day.
With so many markets to keep track of, the pace of a dealer’s life is often frenetic. Most are young, and some are burnt out by their middle thirties. How do they operate?
Suppose a dealer gets a commercial request to buy or sell a large volume of currency. He has several choices. He can satisfy the request himself or ask one of his colleagues to do so. If his colleague cannot, he can ring up a dealer in another bank and hope that he will be able to sell the currency to the rival bank. But this can be time-consuming. His alternative is to contact a foreign-exchange broker, whose job is to find a willing counterparty to the deal. In return for this service, the broker charges a commission, which can be as small as one-hundredth of 1 per cent. However, one-hundredth of 1 per cent of deals worth £10 million a time can quickly add up to a lot of money.
The broker will always attempt to cover his position; in other words, he will ensure that he is selling and buying the same amount of currency, so that he is safeguarded against fluctuation. Dealers will usually do the same, although they are allowed, within limits, to leave surplus funds in currencies which they believe will appreciate.
An exchange of currencies for immediate delivery is conducted at the spot rate. Dealers will quote two exchange rates for each currency, one at which they will buy the currency and one at which they will sell. The difference between the two is one way in which a bank makes money and is called the spread. So if you wanted to buy dollars in exchange for sterling, the bank might offer $1.4850/£1. If you had wanted to buy sterling in exchange for dollars, the rate would have been $1.4870/£1. (For brevity the sterling/dollar rate would be given by a dealer as 50/70.) The 0.2 cent difference between the two rates is the spread. These rates are displayed and continually updated throughout the day in foreign-exchange dealing rooms and on Reuters screens, and they appear every day in the Financial Times. The faster an exchange rate is moving, the wider the spread, since the dealer will not want to be committed to dealing at an unfavourable rate.
Tourists buying foreign currencies will find that the spread is very wide, often several percentage points. Banks can afford to charge each other a narrow spread because the deals are large and frequent and because the competition is intense. The tourist, by comparison, has little bargaining power, and the bank’s costs in supplying the small amounts of currencies involved are proportionately higher.
THE FORWARD RATE


Banks will quote a price for a currency which is not wanted for immediate delivery. If a UK company knows that it is going to receive goods from Switzerland in three months’ time, for which it will have to pay Swiss francs, it can fix its exchange rate in advance by locking in a forward rate with a bank. If the spot rate is Sfr 2.2568/72 per £1, the bank might offer a three-month forward rate of Sfr 2.2291/97 per £1. Once again the bank is taking a spread – notice that the spread for the three-month forward rate is larger than for the spot rate. On screen the bank will in fact show only the differential between the spot and forward rates. So in this case the screen would show:


Rates against the £

Spot
Forward
Swiss franc
2.2568/72
277/275


Currencies that are more expensive to obtain at the forward rate than at the spot rate are described as being at a premium, and those that are cheaper on the forward than on the spot market are at a discount. In this case, the Swiss franc is at a premium to the pound and the pound is at a discount to the franc. On a dealer’s screen the distinction is shown by the ordering of the forward’s spread. As the Swiss franc is at a premium to the pound, the largest figure appears first in the forward column. If the Swiss franc were at a discount, the forward column would read 275/277.
Forward rates are determined largely by interest differentials. Imagine that Swiss interest rates were 10 per cent and UK rates were 5 per cent and that the spot and the twelve-month forward rates for Swiss francs against sterling were the same. A UK investor would then be able to buy Swiss francs at the spot rate and invest the money in Switzerland to earn the higher interest rate. At the same time the investor could take out a forward contract with a bank to buy back sterling in exchange for Swiss francs in a year’s time. No money would be lost as a result of currency movements, since the investor has guaranteed the same Swiss franc/sterling rate as when the investment was made. So the investor could benefit from higher Swiss interest rates without risk. This method of profiting from inconsistencies between markets is known as arbitrage.
Attractive though it may seem, the above example could not happen in the real world. Every investor would be anxious to profit from the trade. The result would be: (a) increased demand from UK investors for Swiss francs at the spot rate, driving the Swiss franc up against sterling;(b) increased demand for Swiss and reduced demand for UK assets, driving Swiss interest rates down and UK rates up; (c) increased demand for twelve-month sterling, driving the twelve-month Swiss franc rate down and thus opening up a differential with the spot rate, which would be pushed in the opposite direction. All these factors combined would quickly eliminate the investment opportunity described.
Although arbitrage possibilities do sometimes exist and some speculators make a living out of exploiting them, the speed of the markets means that inconsistencies do not last very long. A country which has higher interest rates than those in the UK will have a currency at a discount to the pound on the forward market, so that investors would lose on the currency what they would gain on the interest-rate differential. By contrast, countries with lower interest rates than the UK’s will have currencies at a premium to sterling.
THE COMPANY’S DILEMMA


Any company involved in overseas trade has to face the problems described in the introductory paragraphs of this chapter. Which currency should it choose to pay or be paid in, and when should it arrange for that currency to be delivered?
The volatility of the foreign-exchange market is such that currency moves can wipe out profit margins and render companies bankrupt. Suppose a US company had made a five-year investment denominated in sterling in 1981, when the dollar sterling rate was $2.40/£1. By early 1985 the rate had fallen to $1.10/£1. The investment would have had to double in value to eliminate the currency-depreciation effect.
To counter these problems many companies have a set policy for choosing the denominating currency for their transactions. Often this policy will be to trade always in the currency of the country in which the firm is based, in an attempt to eliminate currency risk altogether. This policy works very well until the company attempts to deal with another firm with the same policy but in a different country. It is also very unlikely that a UK company would accept payment in, say, Venezuelan bolivars because of the difficulty of converting the currency when delivered.
For these reasons the majority of international trade is denominated in dollars. Not only is the US unit freely convertible but it is also used by many governments as a reserve currency. Since such a large proportion of their business is done in dollars, companies can match up their payments and receipts to reduce their foreign-exchange risk, using the dollars received from sales to pay for supplies.
If a company cannot arrange to pay or be paid either in dollars or in its native currency, its best option is to ask to be paid in some other strong currency. The euro may yet develop to challenge the dollar as the currency of choice. Multinational companies, which usually have to cope with a wide variety of currencies, will attempt to match their payments and receipts in all of the units in which they have transactions in order to keep their total exchange risk to a minimum.
Once a transaction in a particular currency has been arranged, how does a company cope with the foreign-exchange risk involved? Most companies think that their business is trading and not currency speculation, so they will try to avoid risk as much as possible. Suppose a UK company is due to receive dollars three months ahead. It has a number of choices.
First, it could wait for three months, receive the dollars and exchange them for sterling on the spot market. If, in the meantime, the dollar has appreciated against the pound, the company has made money; if the dollar has fallen, the company has lost money.
Second, it could arrange a forward transaction with a bank to sell dollars three months ahead or to buy a dollar-denominated deposit which matures in three months’ time. The company’s treasurer can sleep at night; the firm is protected against a dollar collapse. But if the dollar rises, the firm will find itself getting a great deal less for its dollars than it might have done.
Third, a middle position: the company could assess which way it thinks the dollar will move. Say it feels there is a 50 per cent chance that it will get a better dollar rate three months ahead than by using the forward market. It therefore sells enough dollars forward to cover 50 per cent of its total position and waits to buy the rest on the spot market. Total disaster has been avoided, and there is the chance of profiting if the dollar rises.
In recent years more and more companies have shown a preference for taking a fourth possible course of action – buying a currency option.
CURRENCY OPTIONS


Currency options are similar to the interest-rate options described in Chapter 13. They give the buyer the right, but not the obligation, to buy foreign currency at a specified rate. Thus the buyer is protected against an adverse exchange-rate movement but retains the potential to take advantage of any favourable movement.
Suppose that a UK company is committed to paying US dollars for oil in three months’ time. It is worried that sterling will fall during that period, thus forcing up the cost of the oil. Sterling is at that moment $1.20 on the spot market. So the company buys a three-month sterling put option (the right to sell sterling in exchange for dollars) at a strike price of $1.20. If, during the life of the option, sterling falls to $1.10, the company exercises its option and sells sterling at the more favourable rate of $1.20. However, if sterling rises to $1.30, then the company allows the option to lapse and sells sterling (and buys dollars) on the spot market.
The catch is the cost. The option buyer must pay the seller a premium when the option is purchased. That premium is non-returnable and is considerably larger than the cost of using the forward market. The option seller charges more than for forward cover because of the higher risk involved. An option can be exercised at any time before its expiry date, and that means that the seller must be constantly prepared to exchange currency at an unfavourable rate. In the forward market, however, the day and the rate at which currencies will be exchanged are known in advance.
Although the option buyer pays more, it is for a better product than forward cover. If the UK company in the example above had covered its risk by buying a three-month forward contract at $1.21, it would have been unable to benefit from a move in the spot rate to $1.30 and might well have ended up paying more for its oil than its competitors. It is also important to remember that the premium represents the maximum possible cost to the option buyer.
Let us take another example. An American company wishes to buy Swiss goods. The company negotiates a price of Sfr 1,250,000, which it must pay in three months’ time. The spot rate is $0.73 per Sfr. The forward rate is 0.74 per Sfr. The premium of a $0.73 option is $0.015 per Sfr.
Scenario A



The spot rate moves to Sfr 0.76.
If the company does nothing, the cost of goods is:
Sfr 1,250,000 × 0.7600 = $950,000.
If the company buys forward, the cost of goods is:
Sfr 1,250,000 × 0.74 = $925,000.
If the company buys an option and exercises it, the cost of goods is:
Sfr 1,250,000 × 0.73 = $912,500,
plus cost of premium
Sfr 1,250,000 × 0.015 = $18,750.
Total = $931,250.


Scenario B



The spot price moves to Sfr 0.70.
If the company does nothing, the cost of goods is:
Sfr 1,250,000 × 0.70 = $875,000.
If the company buys forward, the cost of goods is:
Sfr 1,250,000 × 0.74 = $925,000.
If the company buys an option and does not exercise it, the cost of goods is:
Sfr 1,250,000 × 0.70 = $875,000,
plus cost of premium
Sfr 1,250,000 × 0.015 = $18,750.
Total = $893,750.
In both scenarios the option outperforms the worst strategy but does not perform as well as the best strategy. This makes options very attractive to many companies, which see them as a form of insurance covering foreign risk rather than fire or theft.


Most companies buy options direct from banks (over-the-counter options – OTCs). However, it is also possible to buy and sell options on futures exchanges such as the LIFFE (the London International Financial Futures Exchange). Traded options are for standardized amounts and time periods and are available only in a limited number of currencies. However, the premiums are generally cheaper than those of OTC options.
CURRENCY FUTURES


Currency futures are priced in dollars per foreign currency unit. (For example, a sterling contract on a Chicago futures exchange might be priced at $1.10 per £1.) Contract sizes are quite small to accommodate the small speculators who give futures exchanges their liquidity.
Those who use currency futures can be divided into two groups: speculators and hedgers. Speculators act on a hunch that currencies are moving in a particular direction. If they believe that the dollar is going to fall against sterling, then they buy sterling futures in the hope that the value of these will appreciate. Hedgers will already be committed to a foreign-exchange position and will buy or sell enough futures contracts to ensure that their initial position is cancelled out.
Suppose a US company is due to pay out £100,000 in three months’ time. Its worry is that sterling may rise against the dollar over that period. So it buys four sterling futures contracts, each worth £25,000. The prevailing sterling exchange rate is $1.10. If sterling rises to $1.25, the company will find itself paying out $115,000,$5,000 more than it would have paid if the exchange rate had stayed the same. But the futures contracts will have increased in value by the same amount. The company will have covered its losses.
As explained in Chapter 13, the system of margin payments allows users of futures contracts to insure against the risks of currency movements without actually exchanging the nominal amount of the contract.

Controlling the City


The credit crunch caused politicians and regulators to rethink their approach to the financial sector completely. The hundreds of billions that had to be spent in rescuing the banks was understandably seen as a sign of the failure of the old system.
In a wide-ranging review of regulation, Lord Turner, the chairman of the Financial Services Authority, admitted the old regime was based on a flawed intellectual approach. It was assumed that markets were self-correcting, with market discipline a more effective tool than regulation. It was also assumed that senior managers and boards of directors were better placed to assess business risk than regulators.
This led, Lord Turner argued, to a focus on individual businesses rather than on the system as a whole. The result was that regulators failed to spot that the banking industry was taking too many risks. Specifically, Turner admitted that the FSA ‘was not in hindsight aggressive enough in demanding adjustments to business models which even at the level of the individual institution were excessively risky’. He added that, with Northern Rock, ‘the FSA also fell short of high professional standards in the execution of its supervisory approach, with significant failures in basic management disciplines and procedures’.
Britain had its own problems, with many people feeling that the tripartite system of regulation, with the system watched over by the FSA, Bank of England and the Treasury, had proved to be flawed. Government ministers had boasted of Britain’s ‘light touch’ approach, although Lord Turner claimed the FSA had never used that phrase.
But it was not just the British authorities that felt they failed. In March 2009, the US Treasury Secretary Tim Geithner announced sweeping plans for regulatory reform, including bringing hedge funds and private equity into the supervisory system. And there was much talk of the need for a global regulatory regime.
THE BANKING ISSUE


What are the big issues that need attention? The first is the banks. We have always known that banks are risky; they borrow short (from depositors) and lend long (to companies). If depositors lose confidence, banks can be caught by ‘runs’ which lead them to fold.
Over the decades, authorities have taken different approaches to this problem.
After the crash of 1929, the US authorities separated commercial and investment banking activities; they did not want the risky activities of the latter to contaminate the former. They also guaranteed bank deposits to try and prevent the loss of depositor confidence. The quid pro quo was a fairly tight regime of bank regulation. In Britain, the Bank of England used its authority to keep rogue banks in line.
But the increasing sophistication of financial markets made it hard to enforce a dinstiction between commercial and investment banking activities. The use of complex derivative products made the risk exposures of banks hard for managers, let alone regulators, to understand. Banks became more complex creatures; regulators tried mainly to control them through the use of capital ratios that, in retrospect, proved easy to get around.
There was also a view in the 1980s and 1990s that government regulations only introduce distortions into the market that prevent it from working efficiently. Those who worked for investment banks or hedge funds were wealth generators who knew what they were doing; after all, didn’t they earn a lot of money? Interfere with them and they would move to a more friendly regime abroad. One need only gaze at those ‘temples of Mammon’ in Canary Wharf to see how the aura of success must have dazzled regulators and politicians.
But the 1980s and 1990s were uniquely favourable for the banking system. Interest rates were low or falling, asset markets were generally rising, recessions were short and mild. As a result, bad debts were small. As the late economist Hyman Minsky argued, these benign conditions encouraged banks (and almost everyone else) to take risks. If you are confident that the future will look roughly as it does today, you will be willing to lend (as a bank) and borrow (as a consumer or company). But the act of lending and borrowing increases your risk level and ensures that tomorrow will be less like today than you think. In the end, it means a small change in economic conditions can prove disastrous.
The regulators failed to recognize this. They thought that banks’ risk models were sophisticated. But those models contained fatal flaws; they assumed that economic conditions would stay benign and they forgot that other banks were taking similar risks. For an example, take the Value at Risk approach. This was used by banks to control their trading risk. When markets were volatile, they committed less capital to trading; when markets were calm, they committed more. But what happens when calm markets turn volatile? Banks try to cut their positions. That means selling securities. But everyone else is doing the same. Such selling means more volatility and thus a further attempt to cut positions.
Any new system will try to deal with some of these flaws. For example, it will probably encourage banks to put aside more capital in good times to deal with the inevitable bad times. It may also require banks to be more cautious about their trading activities. The result will be less profitable, but safer, banks. Of course, in the long run, they will find some new road to ruin; they always have in the past.
INCENTIVES


For much of the last twenty years, the best and the brightest from our universities have flocked to the financial sector. They believed that working for an investment bank or hedge fund was the fastest route to riches.
Bankers earned vast sums in the form of bonuses or share options in the companies they worked for. But there was a problem with this incentive structure. All too often the bonuses were based on short-term results. But such results could be achieved by bankers following a strategy that might lead to long-term ruin; by the time that ruin occurred, the bankers have already pocketed their money.
Take for example, bonuses based on the amount of loans completed. A salesman motivated by such a scheme would have a natural incentive to lend to as many people as possible, regardless of their ability to repay the money. The inevitable default by the borrower would occur on someone else’s watch.
Traders could follow strategies described as ‘picking up nickels in front of steamrollers’ – a long series of small profits culminating in a big loss. Time it right and you look like a genius, and you get a big bonus.
All this might not have mattered, were it not for the need for governments to bail out banks when they go wrong, either implicitly by cutting interest rates (which at least helps other borrowers) or explicitly, by outright injections of public money. This leads to an entirely unhealthy system where profits are privatized and losses are socialized. The anger of voters over the need for the government to fund Sir Fred Goodwin’s pension or in America, the bonuses at failed insurance group AIG, was understandable.
Tackling incentives will be difficult. Some of the failed banks, like Bear Stearns and Lehman Brothers, gave bonuses in the form of deferred stock to try to get round the incentives issue; the employees lost a lot of their personal wealth when the banks collapsed. Clearly, the individuals concerned were blind to the risks they were taking. But an additional safeguard could be introduced; ensure that bonuses only be given for results achieved over the long, not the short-term.
SHADOW BANKS


The credit crunch has also shown that it is not just the banks that create problems. There is also a vast shadow banking system, consisting of hedge funds, private equity and structured investment vehicles or SIVs. These both invested in the mortgage debts that originated the problems and borrowed money from the banks to do so. When they collapsed, the banks were brought down with them; their disappearance also left a gap in the funding of the private sector.
Should they be regulated? The answer is clearly yes, if only because of the mess that they have left. But it will be very difficult. By their nature, hedge funds, for example, are vehicles designed to be as flexible as possible; regulate them too much and they might disappear altogether. Normal people might not weep at the prospect but the result might be less liquid markets and a higher cost of capital for businesses and homebuyers. It seems likely that the authorities will aim to increase the amount of information they hold about such funds, so they can see whether they pose a risk to the system.
In his report, Lord Turner discusses the need for ‘macroprudential regulation’, a sort of longstop to the system that worries about the risks being taken across the industry. Such a regulator would warn when mortgage debt was growing too quickly or when banks were taking too much of a risk in trading. There is also talk of a global version, based around a body called the Financial Stability Forum.
The problem lies in giving such a body teeth. At the national level, this could be done, as Lord Turner suggests, by using a committee drawn from the FSA and Bank of England. But both these bodies had the chance to curb risk-taking before the credit crunch, and failed to do so. At the international level, governments might rebel if told to change economic course by some bureaucrats in Frankfurt or Geneva. It is in the nature of booms that all appears to be going well when they are in full swing; it is only later the excesses prove obvious.
No regulatory system will be perfect. Britain has spent much of the last twenty years tinkering with its system. For a while it had a whole network of self-regulatory bodies before it settled on the FSA. In the US, supervision has been hampered by the existence of a network of overlapping bodies.
It is, in any case, inevitable that the private sector will be able to pay more than the regulators and will attract people who will find ways around the rules. People like to speculate; even Sir Isaac Newton lost money in the South Sea Bubble. Without speculation, Britain would be a far less vibrant society. Fewer new businesses would be started and new products invented. Busts are a price worth paying, the creative destruction that allows an economy to start anew. But the 2007–9 bust is a severe test of that thesis.