International Finance 2019

OUTLINE

Part I: INTERNATIONAL FINANCE

Review of asset pricing. The foreign exchange market. Arbitrage and equilibrium pricing in international financial markets: covered and uncovered interest parity (CIP and UIP), theory and evidence. Effects of capital controls. Anomalies after the global crisis. Carry trade and currency speculation: evidence on extra return. The peso problem. Exchange rate determination. Monetary policy and exchange rates.

Part II: RISK AND THE INTERNATIONAL ECONOMY

International risk sharing and consumption smoothing. What happens during liberalization. Current account and global imbalances. The problem of sovereign risk. Debt Default and Financial Crisis. Addressing debt crises. Currency Crises.

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 (referred to as OR) Foundations of International Macroeconomics, MIT press, 1996

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

PART I

Lecture notes 1

Cash flows, discount, asset pricing and portfolios: a brief review of basics

Overview: 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.

Practice questions

Readings: Alain Chaboud masterclass in Cambridge Foreign exchange market

To know more:

BIS: Triennial Central Bank Survey of foreign exchange and OTC derivatives markets 2016

Foreign Exchange Working Group and the FX global code

A useful glossary of terms related to payment, clearing and settlement systems by the European Central Bank

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

Lecture notes 2

Covered Interest Parity (CIP)

Capital controls and market segmentation. The removal of outward and inward capital controls, and their consequences for the CIP: evidence from the 1970s. Political risk.

What can explain deviations from CIP: credit risk, counterparty risk in forward markets; borrowing constraint; high cost of capital for financial intermediaries; convenience yield.

The puzzling failure of the CIP after the outburst of the Global Financial Crisis. Currency basis: definition and discussion. Stylised facts. Competing explanations. Banks balance sheets and the dollar 'cycle': a first look.

Readings:

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

Borio, C, R McCauley, P McGuire and V Sushko (2016), “Covered interest parity lost: understanding the cross-currency basis”, BIS Quarterly Review, September, pp 45–64.

Advanced readings:

Deviations from Covered Interest Rate Parity, Wenxin Du, Alexander Tepper and Adrien Verdelhan, September 2016.

Data

CIP dataset Wenxin Du, Joanne Im, and Jesse Schreger

To know more:

The Chinn-Ito index of Financial liberalisation.

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).

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

Takeshi Kimura, Teppei Nagano, Exorbitant privilege and the Triffin dilemma through FX swaps, Voxeu.org 30 May 2017

Lecture notes 3

Uncovered Interest Parity

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 Fama regression. The traditional and the new Fama puzzle.

The Fama 84 result.

Readings: OR book. Section 8.7 pp. 585-591

Chinn M. and S. Quayyum S. "Long horizon uncovered interest parity re-assessed," 2013 Working Paper 18482

The new Fama puzzle, Matthieu Bussière, Menzie Chinn* Laurent Ferrara, Jonas Heipertz

To know more:

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

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.

Rosen Valchev Exchange Rates and UIP Violations at Short and Long Horizons, No 1446, 2015 Meeting Papers from Society for Economic Dynamics

Lecture notes 4

The Returns to Currency Speculation

Carry trade strategies: diversified, hedge, un-hedged. Returns net of transaction costs. Relative performance: Carry Trade versus Equities. Distribution of returns: asymmetries and fat tails. Evidence from emerging markets and after the Global Crisis.

Readings:

Hanno Lustig and Adrien Verdelhan: Carry trade as a trading and investment strategy.

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.

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

Lecture notes 5

What Explains Excess Returns to Currency Speculation?

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

Readings: Mehra-Prescott Puzzle: OR page 310-315

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.

To know more:

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

Lecture notes 6

Exchange Rate Determination and Forecast

Equilibrium exchange rate: a four-way decomposition. Purchasing Power Parity. Stationarity of the real exchange rate. Adjustment: speed and modalities. Interest rates and exchange rates. The effect of monetary policy. Dynamics of excess returns: Engel 2016. Meese and Rogoff.

Readings:

Eichenbaum Martin, Ben Johansen and Sergio Rebelo (2017) “Monetary Policy and the Predictability of Nominal Exchange Rates” mimeo

To know more:

Menkhoff Sarno Schmling and Schrimpf Currency Value∗ December 2015

Lecture notes 7

Taking stock

Charles Engel, 2016. ”Exchange Rates, Interest Rates, and the Risk Premium,” American Economic Review, 106(2):436-474. but read NBER Working Paper No. 21042 March 2015

PART II

Lecture notes 8

International Risk Sharing and Consumption Smoothing

Complete markets and perfect risk sharing. Non traded risk. 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. Global Imbalances.

** 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.).

Lecture notes 9

The problem of sovereign (and country) risk

Endogenously incomplete market: strategic default.

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

To know more:

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—pp 291–317

Lecture notes 10

Debt crises

Debt Crises: Fundamental vs. Self-Fulfilling

Debt Sustainability Analysis: State of the Art Study requested by the ECON Committee of the European Parliament, Economic Governance Support Unit Directorate-General for Internal Policies of the Union - November 2018 Direct access to text

Lecture notes 11

Addressing debt crises and On Official Lending

Backstops, bailouts and forgiveness

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

Official Lending and debt sustainability in the euro area, Giancarlo Corsetti, Aitor Erce, Timothy Uy, 13 February 2019

To know more:

Official Lending Strategies During the Euro Area Crisis, Giancarlo Corsetti Aitor Erce and Timothy Uy, CEPR DP 12228, September 2017, Download the dataset

The Mystery of the Printing Press: Monetary Policy and Self-fulfilling Debt Crisis with Luca Dedola. Journal of European Economic Association. Here is the text of my Schumpeter Lecture on the Mystery of the Printing Press at the EEA, Mannheim, August 24, 2015 (slides)

Lecture notes 12

Currency Crises

To know more:

Giancarlo Corsetti and Bartosz Mackowiak, Fiscal Imbalances and the Dynamics of Currency Crises. European Economic Review 2006

Additional and occasional material

Keynes Lecture by Professor Hyun Song Shin (BIS), "Distributed Ledger Technology and the Payment System", 22 January 2019.

References:

Chapter in the 2018 Annual Report of the BIS: Cryptocurrencies: looking beyond the hype;

The economics of blockchains | VOX, CEPR Policy Portal;

Abadi, J and M Brunnermeier (2018), “Blockchain Economics”, Princeton University, mimeo.

Historically: Nakamoto, S (2008), “Bitcoin: A peer-to-peer electronic cash system”.