0

INTERNATIONAL CAPITAL: The Role of Derivatives in Crisis-Driven Capital Outflows 2

Posted by Connie R. Aponte on August 5, 2014 in INTERNATIONAL CAPITAL |

The payments and receipt implications for the bank are displayed in the first panel. The bank will receive 2500 baht and pay $100 in one month. These are the same movements of funds that the bank would face if it were long a baht Bank of Thailand bill and short a US Treasury bill. To eliminate the currency mismatch, the bank immediately sells 2500 baht for dollar spot exchange, the payments implications of which are combined with those of the forward contract in panel 2. The currency positions are now balanced, but there remains a maturity mismatch in each currency—one-month baht are funded with rollover baht and rollover dollars are funded with one-month dollars. To eliminate the maturity mismatch, the bank immediately undertakes a one-month foreign exchange swap, exchanging $100 for 2500 baht spot and 2500 baht for $100 thirty days forward. The complete payments implications for the bank are displayed in panel 3: the bank has eliminated market exchange and interest rate risk through these transactions.

This example indicates that a baht-dollar forward contract is equivalent to a foreign exchange swap combined with a spot exchange transaction. Also, on its origination, a forward sale of baht by the customer immediately generates a spot sale of baht by the bank.

Who is the ultimate counter party in these transactions? In time of crisis, there are few spot market buyers of the weak currency, so a central bank defending an exchange rate level must appear as the counter party through its exchange market intervention.

A customer in the forward market may be a central bank, which can intervene in the foreign exchange market to defend parity by buying its currency forward rather than spot. If the central bank’s forward purchase of its currency matches a forward sale of some other customer of the banking system, all the swap and spot transactions of the banking system will balance; specifically, spot exchange sales will be matched with purchases at the parity exchange rate.

Thus, the central bank’s forward intervention will absorb the spot sales of its currency without the central bank’s having to intervene directly in the spot market. By entering a forward contract, the central bank implicitly supplies domestic currency credit directly to the short seller of its currency. The short seller in this example is obligated to deliver the weak currency to the central bank on the value date of the forward contract, effectively a loan from the central bank.

In a currency crisis, with the potential for a one-sided bet, few private parties would be willing net suppliers of weak currency credit. Nevertheless, to fuel a speculative attack, the world banking system must in aggregate provide credit in the weak currency to the short sellers. This is evident in the first panel of Figure 1, where the bank’s baht receipts from the forward contract embody a one-month baht loan to the short seller. If the central bank does not supply the credit directly through forward intervention, the credit must come either through its money market operations or its standing facilities. In any crisis, the baht provided by the banking system are a pass-through of credit from the Bank of Thailand, which must be the ultimate counter party in both legs of the position-balancing transactions of the banking system.

Tags: , ,

Copyright © 2013 - 2019 Blog About Business And Finance. All rights reserved

Home | Site Map | Contacts