Question

1. What is the balance of payment identity and what does it describe

2. “President Trump’s new tariff policies on imports will result in the US trade deficit wiped out in just a couple of years” please comment.

3. What is hedging? Can it handle labor volatility? Does hedging require interest rate parity to hold? Please comment

4. Compare hedging with forwards (futures) and options. How is hedging related to the monetary model of exchange rates?

5. Are off-shore banking centers set up to deal primarily with illegal money? Describe the international debt crisis which began in 1982 with Mexico defaulting on its international debt. Trace the origin to the early 1970’s. does this crisis compare in anyway with the collapse of the 2007-2008.

Answer 1

1. Balance of payment identity:

The BOP identity equation indicates that the country can run bop deficit or surplus by increasing or decreasing its official reserves. The below equation represents the BOP identity:

BCA+BRA+BKA = 0. Where,

BCA = Balance on current account

BRA = Balance on reserves account

BKA = Balance on capital account.

In case of fixed exchange rate regime:

BCA+BKA = BRA. Where the balance on current and capital will be equal in size but opposite in sign to the change in reserves.

In case of flexible exchange rate regime:

BCA = BKA. In this case the central bank need not maintain any reserves.

1. President Trump’s decision on sweeping tariffs on imports is globally significant as UK’s 2016 decision to leave the European Union. Trump’s decision to impose 25% & 10% tariffs on all steel and aluminum imports respectively has threatened many trade partners prompting fears of global trade war. There are risks of inflationary low growth. Some investors have already decided they will delay the investment plans as a result of uncertainty.

Ultimately because of the decision on trade tariffs, it is universally not good for growth and not good for inflation in US if it is the leader in the trade war.

1. Hedging:

Hedging is defined as risk management strategy that is used for reducing the probability of loss arising from fluctuations of prices of commodities, currencies or securities. Hedging is adopting various techniques that involves taking equal and opposite positions in two different markets such as cash and futures market. It is also used for protecting one’s capital aginst effects of inflation by investing in high yielding financial instruments like bonds, notes, shares, precious metals etc.

The risk averse agents can choose between how much they work for a firm and also how to invest their wealth in capital markets. Firms rely on labor to produce consumption based goods which they sell in the market and the proceeds used in paying the wages and dividends. Wages are perfectly related with stock returns which indicate that wage volatility determines the covariance between human capital returns and financial returns.

There can be two predictions on wages volatility:

• The higher the wages volatility, the lower the exposure to market through financial assets.
• A worker who switches to higher wage volatility decreases the exposure to market through financial assets.

1. Comparing hedging with forwards and options

Hedging refers to managing the risks to the extent that is bearable. Fluctuations in the exchange rates can have huge impact on the business decisions. Hence the most used instrument for managing risks is forward rates. Forward rates are agreement between two parties to fix the exchange rate for the transaction. This type of arrangement helps in eliminating the exchange rate risk. However the drawback is that it is difficult to get a counter party who would agree to fix the rate for the amount and also the time period.

Many investors generally don’t use trade options but hedge using options against existing investment portfolios of other financial instruments such as stock. There are numbers of options used mainly for this purpose namely calls and puts. For example, if a person owns a stock in company x, then buying the puts based on that company’s stock is considered as an effective hedge.

Relation between money market model and hedging:

The monetary model explains the behavior of exchange rate. The monetary model assumes that the prices of goods are flexible and the purchasing power parity holds good. The assumption considered by PPP is that the exchange rate remains constant over period of time.

This model is related to hedging because it allows substantial over shooting for both real and nominal prices. Since the interest rates and exchange rates compensate for the sluggishness in the prices of the goods.