Forward Markets and Transaction Exchange Risk

Transaction exchange risk -- possibility of taking a loss in foreign exchange transactions. Normal distribution for major currencies, but skewed distribution for emerging markets.

Forward contracts -- forward rate (specified in a forward contract); eliminates risk/uncertainty; usually a large sum of money; with bank. Costs: ex ante (before), ex post (after).

Swap: simultaneously purchase and sale of a certain amount of foreign currency for two different dates in the future.

Volatility clustering: when standard deviations (volatility) in forex rate demonstrate a pattern. -- GARCH model.

Exchange Rate System

• Floating currencies: determined by the market forces of supply and demand; 
• managed floating: central banks intervene enough with the country's currencies; 
• fixed/pegged currencies: "pegging" (fix at particular level) a currency to another or a basket of currencies, often used a currency board (domestic currency 100% backed by assets payable in reserve currency; 
• target zone: forex rate is kept within band, the currency is allowed to fluctuate in a percentage band around a "central value".
• crawling pegs: changes are kept lower than preset limits that are adjusted regularly (w/ inflation), adjust for inflation differential between domestic inflation vs inflation of the pegged's currency so the domestic firm's don't lose competitiveness. Latent volatility: the true currency risk does not show up in day-to-day fluctuations, in a long time, historical volatility appears to be zero or very limited.
• special arrangements: where a regional central bank controls the forex rate system for several countries.

Central Banks: Liabilities -- monetary base or base money: deposits of financial institutions (bank reserves) and currency in circulations; Assets: official international reserves ( T-Bills of other countries, gold reserves, IMF-related reserve assets) and domestic credit (government bonds and loans to domestic financial institutions). Seigniorage: the value of the real resources that the central bank obtains through the creation of base money.

The imposible trinity (only two out of three are possible): perfect capital mobility (no capital control), fixed exchange rates, domestic monetary autonomy.

Central Bank interventions: money supply/interest rates, attempts to restrict capital movements, tax/subsidise international trade to influence demand for foreign currencies.

Foreign exchange interventions: Non-sterilised and sterilised (off-setting the effect of money supply by performing an open market operation that counteracts the effect: portfolio shifting on private investors--replace foreign bonds with domestic bonds; squeezing foreign inventories at dealer banks and generate pricing effects). Direct channel: small size - short term effect to sterilised interventions; Indirect channel: interventions can alter people expectations and affect their investments - push to the desire direction.

Defending the target zone: intervene through open market operations, raise interest rates, limits foreign exchange transactions through capital controls.

Lag operations: postpone capital inflow: receivable - exporter (especially when domestic currency devalued)

Lead operations: domestic importer prepay for goods in devaluations effect.

Dollarisation: foreign currency has exclusive or predominant status as full legal tender in a particular country (Ecuador: Dollar).