Outline

The course is taught by Giancarlo Corsetti and Petra Geraats. It consists of 3 parts.

Part I: INTERNATIONAL FINANCE (G. Corsetti)

We will analyse the foreign exchange (FOREX) market and arbitrage and equilibrium pricing in international financial markets. We will contrast covered and uncovered interest parity, and study currency speculation (carry trade) in detail. We will have a brief review of models of exchange rate determination, and their empirical validity. We will study how monetary policy affects the exchange rate.

Part II: RISK AND THE MACROECONOMY (G. Corsetti)

In the second part, we will analyse the potential role of international financial market in fostering (fundamental) risk sharing and an efficient allocation of resources. We will then analyse the consequences of market imperfections, causing liquidity risk, (non-fundamental) currency and financial crisis, and political and sovereign (country) risk. Topics include current account and global imbalances, asset trade and diversification, sovereign risk and moral hazard, debt crises and bailouts, debt redemption.

Part III: MARKET MICROSTRUCTURE and CLASSICAL MODELS OF CURRENCY CRISES (P. Geraats)

Readings

Unfortunately, there is no good reference book for this course. This is a reason why lecture notes are long and reasonably detailed. After each lecture, you will have a few suggested readings. Starred readings are required (**) (*). Non-starred reading are more demanding and linked to possible research projects. As general reference books, we will sometimes be using:

• Obstfeld M and K Rogoff (OR) Foundations of International Macroeconomics, MIT press, 1996

• Obstfeld M and A Taylor (OT), Global Capital Markets, Integration, Crisis and Growth, Cambridge, 2004

• Lyons R. The microstructure approach to exchange rates, MIT 2001

• Stephanie Schmitt-Grohe, Martin Uribe and Michael Woodford (SUW) International Macroeconomics.

Lecture notes and main readings

PART I

Lecture notes 1 Asset pricing and foreign exchange market: a brief review of basics

Basic asset pricing; cash flows, stochastic discount factor, beliefs about distribution. The relation between excess returns and risk. Discounting nominal and real cash flows; in domestic and foreign currency. Portfolios and return. Arbitrage portfolios. Arbitrage opportunities. An overview of the foreign exchange market. Spot and forward exchange rate, the forward premium. Forex swaps. Arbitrage and covered interest parity (CIP).

Readings

For the first lecture, there are no starred readings. You are required to familiarise yourselves with the notation and concept in the lecture notes, and read the notes by A. Chaboud to get a sense of the current state of the foreign exchange market.

Referred in class:

BIS: Triennial Central Bank Survey offoreign exchange and OTC derivatives markets in 2016

Foreign Exchange Working Group and the FX global code

Cables, sharks, and the geography of the foreign exchange market, by Barry Eichengreen, Arnaud Mehl, Romain Lafarguette, voxeu.org

Lecture notes 2 Market integration and financial globalization

Market integration and cross-border arbitrage. Deviations from Covered Interest Parity as a measure of market integration (On-shore off-shore (euro-) deposits). The removal of outward and inward capital controls, and their consequences for the covered interest parity. Evidence. Political risk (introduction of controls in the future).

Financial globalisation and the emergence of global intermediaries.

Readings:

* Manuscript SUW Chapter 8, especially section 8.2

OT Section 3.1

Global banking

Niepmann, Friederike (2015). "Banking Across Borders," Journal of International Economics, vol. 96, no. 2, pp. 244-265.

Rajan R. (2005). "Has Financial Development Made the World Riskier?" Proceedings - Economic Policy Symposium Jackson Hole, Federal Reserve Bank of Kansas City, issue Aug, 313-369.

Shin HS and T Adrian (2010). "Liquidity and Leverage," Journal of Financial Intermediation 19(3) 418-437.

A complete list of the countries and their data availability and summary statistics for the Chinn-Ito index are presented in the "Note on the Chinn-Ito Financial Openness Index."

M. Chinn and I. Hito (2008) "A New Measure of Financial Openness" Journal of Comparative Policy Analysis 10(3): 307-320. Data: Chinn-Ito (2006) Financial Openness measure (data extending to 2008, updated July 2010) Notes to Chinn-Ito Financial Openness measure (7/28/10).

To know more: a useful reading on market integration in general, and with an application to European market

Jappelli T and M Pagano: Financial Market Integration under EMU - Tullio Jappelli and Marco Pagano

(868 kB),European Economy. Economic Papers. 312. March 2008. Brussels

Lecture notes 3:

3.1 Why can CIP deviations arise in a globally integrated capital markets?

3.2 The failure of the CIP since the global crisis (typos corrected)

Readings

*** Deviations from Covered Interest Rate Parity, Wenxin Du, Alexander Tepper and Adrien Verdelhan, September 2016, Media Coverage: Bloomberg

*** Addendum to “The dollar, bank leverage and the deviation from ...

** The dollar, bank leverage and deviations from covered interest parity , Stefan Avdjiev, Wenxin Du, Catherine Koch and Hyun Song Shin, BIS Working Paper No. 582, November 2016, Media Coverage: Bloomberg

Bye-bye covered interest parity. Claudio Borio, Robert McCauley, Patrick McGuire, Vladyslav Sushko, Voxeu.org, 28 September 2016

Baba, N, F Packer and T Nagano (2008), “The spillover of money market turbulence to FX swap and cross-currency swap markets”, BIS Quarterly Review, March, pp 73–86

Patrick McGuire and Goetz von Peter The US dollar shortage in global banking and the international policy response, BIS Working Paper 291 October

Lecture notes 4 Uncovered interest parity and its failure in the short run (with a new numerical example)

Contrast covered and uncovered interest parity --- arbitrage vs equilibrium conditions. Deriving the UIP condition: the role of inflation variability and risk. Derivation of UIP tests based on rational expectations. The UIP puzzle. The Fama 84 result.

Readings:

** OR Section 8.7 pp. 585-591

Chinn M. and S. Quayyum S. "Long horizon uncovered interest parity re-assessed," 2012 NBER Working Paper 18482 [pdf]

M.Chinn "The (Partial) Rehabilitation of Interest Rate Parity in the Floating Rate Era: Longer Horizons, Alternative Expectations, and Emerging Markets," JIMF26 (2006): 7-21.

Chaboud A.P. and J. Wright "Uncovered interest parity: it works, but not for long" Journal of International Economics, 2005, 66(2) 349-362

Ravi Bansal R. and M. Dahlquist "The forward premium puzzle: different tales from developed and emerging economies" Journal of International Economics 2000 51(1), Pages 115–144

Advanced readings

C. Engel "The Forward Discount Anomaly and the Risk Premium: A Survey of Recent Evidence," Journal of Empirical Finance 3, June 1996, 123-192.

Lecture notes 5: The returns to Currency Speculation: evidence

Carry trade strategies: diversified, hedge, un-hedged. Returns net of transaction costs. Relative performance: Carry Trade versus Equities.

Readings:

** A simple and short paper by Hanno Lustig and Adrien Verdelhan on carry trade as a trading and investment strategy.

** Lukas Menkhoff, Lucio Sarno, Maik Schmeling, Andreas Schrimpf, The risk in carry trades, www.voxeu.org, 23 March 2011

** Burnside Craig, Martin Eichenbaum, Isaac Kleshchelski and Sergio Rebelo, "Do Peso Problems Explain the Returns to the Carry Trade?" . Review of Financial Studies 24(3), 2011, 853-91.

Lecture notes 6: What explains excess returns to currency speculation?

Risk-based explanations. The Mehra Prescott puzzle. The peso problem (disaster risk).

Readings:

** Mehra Prescott Puzzle: OR page 310-315

More readings:

Burnside C, M Eichenbaum, and S Rebelo, Carry Trade and Momentum in Currency Markets. Annual Review of Financial Economics 3, 511-35.

Menkhoff L, L Sarno, M Schmeling and A Schrimpf "Carry Trades and Global Foreign Exchange Volatility" Journal of Finance, 2012 67(2) 681--718

Carry trade in a monetary union: Viral Acharya, Sascha Steffen, The banking crisis as a giant carry trade gone wrong, voxeu.org, 23 May 2013

Lecture notes 7: Exchange rate determination: prices and interest-rate models

PPP vs asset pricing approach. Empirical properties of the real and nominal exchange rate. Exchange rate as forward-looking asset price. Empirical evidence on the exchange rate response to interest rate changes and monetary policy. Meese and Rogoff.

Readings:

** C. Engel and K. West “Global Interest Rates, Currency Returns, and the Real Value of the Dollar,” American Economic Review, Papers and Proceedings 100, May 2010, 562-567.

Menkhoff Sarno Schmling and Schrimpf Currency Value∗ December 2015

Gopinath, Gita. Forthcoming. “The International Price System.” Jackson Hole Symposium Proceedings. NBER Digest, January 2016

IPS paper and appendix

L Dedola G Rivolta L Stracca If the Fed sneezes, who catches a cold? 2015

A fun piece in economic policy telling the story of the Meese and Rogoff puzzle, by Ken Rogoff on The failure of empirical exchange rate models

On exchange rate and prices: a good general reading is chapter 9 of SUW Manuscript

Advanced Readings

C. Engel “The Real Exchange Rate, Real Interest Rates, and the Risk Premium”, 2011

Exercises on Part I

PART II

International Financial System: facts

Risk Sharing and Consumption Smoothing via asset trade in international financial markets

Complete markets and perfect risk sharing: implications for the stochastic discount factor. Non traded risk with incomplete market. Gains from trade and law of comparative advantages in international finance: which country exports assets on average. Determinants of the current account. First and second order stochastic dominance.

** OR chapter 5 page 269-285 (5.1, 5.2.3)

Lars Svensson, "Trade in Risky Assets", AER 1988.

OR 1.1 (1.2 and 1.3.4.).

Advanced readings and Facts:

Niepmann Friederike, "Banking across Borders", Federal Reserve Bank of New York Staff Reports, 576, October 2012, Forthcoming Journal of International Economics

Chapter 4 of the IMF World Economic Outlook from October 2014: Are Global Imbalances at a Turning Point?

Sovereign risk

Diversification of risk via equity market. Endogenously incomplete market: strategic default.

moral hazard in international lending is not examinable

** OR 6.1 (up to page 369 and 6.1.2.4) 6.2.4-6.2.5, 6.4

** SU2 chapter 11

SUW chapter 11

Readings:

Ugo Panizza, Federico Sturzenegger and Jeromin Zettelmeyer, "The Economics and Law of Sovereign Debt and Default," Journal of Economic Literature, Vol. 47, No. 3, Sep., 2009

Juan Carlos Hatchondo and Leonardo Martinez, The Politics of Sovereign Defaults, Federal Reserve of Bank of Richmond, Economic Quarterly—Volume 96, Number 3—Third Quarter 2010—Pages 291–317

Sovereign crises

Self-fulfilling debt crises, Dealing with SF crises, Modalities of debt relief.

Self-interested solidarity is not examinable.

The Mystery of the Printing Press: Monetary Policy and Self-fulfilling Debt Crisis with Luca Dedola, Journal of European Economic Association, December 2016

• The text of the Schumpeter Lecture on the Mystery of the Printing Press at the EEA, Mannheim, August 24, 2015 (slides)

Tirole Jean, Country Solidarity in Sovereign Crises. American Economic Review, 2015

** SU chapter 11

Exercises on Part II

Lectures by Petra Geraats:

Market microstructure

Currency and Financial Crises