Re: General Theory Seminar--Moore (reply to Mosler)

["ÁÎ×Ó¹â HenryC.K.Liu ¹ù¤l¥ú" <hliu@xxxxxxxxxxxxxx>]

mike sproul wrote:

> Warren:
>
> By 'green money' I meant what is commonly called base money: coins, cash,
> and reserves. I would definitely not include Treasury securities.
> To use your bean analogy, there are base beans (actual beans) and
> derivative beans (claims to beans, or 'open interest'). If a trader
> issues a 'derivative bean', then that is his liability. In no sense do
> Treasury securities substitute for derivative beans. The trader might
> own some T-bills as his asset, and some of those T-bills might even back
> his issue of derivative beans, but they are not part of open interest in
> beans. Neither are Treasury securities part of open interest in base
> money.
>
> "Just like buying of bean futures can raise both the spot and forward
> price of beans borrowing to make purchases can drive up prices."--Mosler
>
> ANSWER: you forget that every purchase of beans is also a sale. Open
> interest in beans can be large or small without affecting the price of
> beans.

To have derivative beans, one must first have notional beans.

In a global economy, money in any one country and its cost (interest rates)
cannot be intelligently discussed without taking into account global
exchange rates.

The growth and evolution of financial instruments occur to address the needs
of many different end-users in a wide range of different market environments
aroung the globe. The pace of this growth has been explosive, being driven
by an underlying demand for risk management products and financial
engineering skills that reflects the fact that the overall economic
environment within which business is conducted has grown more volatile and
more unstable.

The international system of fixed exchange rates (Bretton Woods agreement)
was abandoned in 1973. It was a system which had forced countries to adjust
their inflation rates, interest rates and other tools of economic policy in
order to maintain a fixed relationship between their currency and the
gold/dollar price. With its disappearance, governments are now free to
pursue divergent monetary policies.

The result has a structural change in the financial environment. Developed
economies experienced periods of both rapid price increases (inflation) and
price decreases (deflation). Uncertainty and volatility in relation to
prices was followed by similar uncertainty and volatility in foreign
exchange rates, interest rates and commodity prices.

Risk associated with a financial environment of instability that is
characterized by change and flux has created a demand for financial
instruments to protect against that risk. These instruments are derivative
or hybrid instruments. A derivative financial instrument can be defined as
an aggregate or "bundle" of contractually created rights and obligations,
the effect of which is to create a transfer or exchange of specified
cashflows at defined future points in time. The quantum of these cashflows
are determined by reference to, or derived from (hence the word
"derivative"), underlying cash or physical markets (e.g. foreign exchange,
currency, securities, commodities such as beans) or from particular
financial indices (such as one of the benchmark interest rates, the London
inter bank offered rate or Libor. the DOW etc.).

The variety and number of derivative instruments is enormous and the
terminology used to describe them often bewildering. However, derivative
instruments, even in their most exotic forms can, and should be, approached
not as an endless series of discrete products but as examples of how basic
financial building blocks can be assembled to produce an almost infinite
series of products, namely, a forward contract, a futures contract, a swap
contract and an option contract

One of those building blocks -- and perhaps the most fundamental -- is the
forward contract.
Much confusion -- notwithstanding its longevity -- still attaches to
precisely what the forward price in a forward contract is indicating. The
principles used to price a forward contract are basic principles of
widespread application that tell us much about the workings of the
international capital markets in general.

The essential difference between a forward contract and a futures contract
is that the latter is traded on exchanges which act as a counterparty to all
transactions and which requires market users to post collateral or "margin"
against their outstanding positions. The forward contract, in distinction,
is an "over-the counter" or OTC instrument: it is traded not on organized
exchanges but by dealers (typically banks) trading directly with one another
or with their counterparties using the telephone, screens or faxes.

An interest rate swap, for example, is a series of forward contracts on
interest rates. At each settlement date (i.e. periodic date for the exchange
of cashflows) the fixed rate payer is obligated to sell a fixed-rate
cashflow for a price -- a floating rate cashflow -- specified in advance
when the interest rate swap was entered into.

The main insight provided by Myron Scholes and Fischer Black in 1973 in
creating the Black-Scholes model, the classic modern option pricing model,
was that the payoff profile of an option can be created synthetically by
combining a "dynamic" (i.e. continually adjusting) portfolio consisting
first of forward contracts on the underlying property which is the subject
of the option and a portfolio of
"riskless" (i.e. Treasury or other government) securities.

Consider the following. A US investor has US$1 million to invest and if he
were to buy a one year US Treasury security he would earn a rate of 5.75%.
In other words, at maturity he would receive his initial
investment of US$1 million back, together with US$57,500 in interest. The
same investor is, however, attracted by the higher return he could obtain by
buying a 1 year UK government security instead. This security is, yielding
7% and so if at today's spot foreign exchange rate of US$1.59/sterling, the
US investor were to sell US$1 million and acquire 628,931 sterling, this
amount of sterling invested for 1 year would yield the investor 44,025
sterling.
However, at the maturity of his investment the US investor will wish to
exchange his sterling principal and interest for US dollars. He is aware,
though, of the uncertainty attaching to future exchange rates and to protect
himself against this he enters into an agreement to sell his total sterling
proceeds 1 year forward for US dollars. The 1 year forward rate is
$1.571/sterling which means that the investor will receive US$1,057,500, a
sum exactly equal to the amount he would have received if he had not
ventured into the foreign arena at all -- in pursuit of higher interest
rates -- but had invested in US Treasury securities.

What the above example demonstrates is that differences in interest rates
for comparable risk-free assets denominated in different currencies are
already reflected in differences between spot and forward exchange rates.
Put another way, the ratio of the forward exchange rate to the spot exchange
rate is a reflection of interest rates in the two countries whose currencies
are being compared. This ratio, when expressed mathematically, is referred
to as interest rate parity, but -- to repeat -- the underlying principle can
be expressed quite simply: an investor should not be able to get different
risk free rates of interest in different countries once his investment
proceeds are converted into his domestic currency.

Forward exchange rates are not predictions of the level of current exchange
rates at various future dates. Forward exchange rates are mathematically
derived rates reflecting an arbitrage condition: interest rate parity.

However, this is not quite the end of the story. If a forward exchange rate
is lower than the current or spot exchange rate, then that currency is
viewed as trading at a premium. Alternatively, if the forward rate is
greater than the spot rate, the currency is trading at a discount. If the
currency is trading at a premium, then the market expects today, given
existing market forces, that the particular currency in question will be
stronger in the future. The converse is true if the currency is trading at a
discount. However, these are
market implications, not predictions, implications that flow from current
information, knowledge and conditions. The forward exchange rate reflects an
arbitrage condition: it is the rate that eliminates an arbitrage profit.

The one year forward interest rate in any currency must be such that no
arbitrage profit can be derived from investing for one year and then
re-investing for a second year as opposed to investing for two years
initially. The relationship of forward interest rates for various different
future periods is known as the forward yield curve, a concept and expression
that is of fundamental importance in terms of understanding swaps and in
valuing cashflows generally

Forward contracts are not, as contracts, generally traded. If they have to
be reversed or unwound, then the value of a forward contract prior to
maturity is taken to be the difference between the forward price
at which the contract was agreed initially and the forward price that
prevails in the market at the date on which the contract is unwound

A forward foreign exchange contract, by definition, involves a settlement at
maturity which will result in a net cash outflow to one counterparty and a
net cash inflow to the other counterparty. There is, therefore, credit risk
associated with a forward contract. Two aspects of this risk warrant further
consideration

First, the credit risk implicit in a forward contract can be expressed as
the risk that one party will perform, on the settlement date, the
obligations which the forward contract has imposed, relative to a change in
the value of the forward contract from zero. If during the life of the
forward contract spot prices continually mirror the forward price on which
the contract is based, then there is negligible credit risk associated with
the forward contract. The greater the deviation in spot prices from the
forward price -- i.e. the greater the volatility of spot prices -- the
greater the credit risk implicit in the swap because the more probable it
becomes that one counterparty will owe a large settlement amount to the
other counterparty at the maturity date of the contract.

Secondly, the forward contract is a "pure" credit instrument in the sense
that the only payment made under a forward contract is at its maturity.
There are no payments made at the origination of the contract and none made
during the life of the contract. The risk, therefore, that one party will
not fulfill the settlement obligations required of him under the contract
exists throughout the life of the contract and that risk increases the
longer the maturity of the contract.

The fact that significant credit risk attaches to forward contracts has a
major impact in determining who uses these instruments. Only those
counterparties -- large corporations, governments, other major
institutions and agencies, both financial and nonfinancial -- who have
access to credit lines will use forward contracts. Individuals,
partnerships, small business, "start-up" operations and private companies of
limited size will not participate in the forward market because the cost of
obtaining the necessary credit lines -- if these were obtainable at all
would be disproportionate to the benefits to be derived from using forward
contracts.

Forward contracts can be used potentially in any situation where a measure
of currency risk exists. Classic examples might be a manufacturing company
which is forced to pay for its raw materials in a foreign currency, even
though its finished products are
priced in its domestic currency, or an importer who is importing goods from
a parent company and paying for those goods in the currency of its parent
while pricing those goods in the currency of the country in which a sales
agency is held or in which unrelated agencies are supplied by the importer.

Something more could usefully be said about the FRA (forward contract on
interest rates). Banks frequently "short fund": that is, their assets are
funded with interest bearing liabilities that have a shorter
maturity than the maturity of the assets being funded. In periods of falling
interest rates this strategy can produce significant funding profits for
banks (as in the 90s in Asia). Their longer term assets are earning interest
rates at a level reflecting a previous and higher interest rate environment
whereas their short term liabilities are continually being refinanced at a
reducing cost as interest rates fall.

If, however, a bank believes that interest rates will rise, rather than
fall, in the future or if a bank believes that rates have fallen as far as
they are going to in the short term, the bank can protect itself by using an
FRA to fix today the future interest rate or rates that it will pay on its
funded liabilities.

Financial futures contracts are exchange traded contracts which date from
1972 when foreign currency futures contracts were first introduced. Futures
contracts are now traded on currencies, on various kinds of interest bearing
securities (e.g. US T-notes and bonds, UK gilts, eurodollar deposits, bonds)
and on
various equity or stock indexes (e.g. S&P 500 index, NYSE composite index,
FT 100 index, Nikkei index). Major exchanges are the Chicago Board of Trade
(CBOT), the Chicago Mercantile (CME), the Tokyo Stock Exchange, the London
International Financial Futures Exchange (LIFFE) and the Paris Marche a
Terme d'Instrument Financiers (MATIF).

In terms of their basic structure, futures contracts and forward contracts
are identical: a futures contract is a binding obligation under which a
person either sells or buys a specified asset at a specified exercise price
on the contract maturity date. The specified asset, the contract, is not
literally bought and sold but the market price of that contract at maturity
compared to the contract price will determine whether the holder of the
futures contract has made a profit or a loss.

Futures contracts carry 3 special credit risk.

(i) Daily Cash Settlement or Marking to Market

Futures contracts are marked to market at the end of each trading day and
the resulting profit or loss is settled on that day. The performance period
of a futures contract is therefore reduced to one day compared with the
performance period for a forward contract which is equal to the entire life
of that contract

(ii) Margin Requirements

Not only are futures contracts settled on a daily basis but the exchange
ensures that all participants are able to meet the claims arising from this
continuous settlement process by requiring users to post what is, in effect,
a performance bond as security for their obligations. This performance bond
is known as the margin. On entering into a futures contract a user will have
to post an initial guarantee known as the initial margin and if calls on
that initial margin brought about by the daily settlement process reduce the
level of
the initial margin below a specified amount, the user must restore the
initial margin by paying in additional sums of money.

(iii) The Clearing House

Credit risk associated with futures contracts is further reduced by the fact
that although it is not trading as such, the exchange itself -- or the
clearing house -- interposes itself between the two parties to a futures
contract by functioning as the formal counterparty with which each
contracts. This means that the equity base of the clearing house itself is,
in effect, available to all exchange users as a further performance
bond.

In sum, a futures contract is much like a portfolio of forward contracts. At
the close of business of each day, in effect, the existing "forward"
contract is settled and a new one written. This daily settlement feature
combined with the margin requirement allows futures contracts to eliminate
the credit risk inherent
in forwards".

The impetus for the evolution of both currency swaps and interest rate swaps
lies in the enormous increase in the volatility of foreign exchange rates
that accompanied the breakdown of fixed exchange
rates. The first financial response to this fundamental environmental change
was the parallel loan. Under a typical parallel loan agreement, a US parent
company would make a US dollar loan to the US subsidiary of a UK
counterparty. This UK company would make an equivalent or "parallel"
sterling denominated loan to the UK subsidiary of the US corporation. Both
loans would be of identical amount having regard to current exchange rates
when they were entered into and both loans would have matching interest and
principal repayment schedules.

As far as the UK parent company was concerned, it had now hedged its
exposure to pound sterling/US dollar exchange rate movements, since if the
pound strengthened against the dollar, a fall in the sterling
value of the UK company's US dollar denominated assets would be offset by
the fact that the US subsidiary's dollar denominated loan was worth less in
sterling terms. The US corporation would be in a
similar position as regards its US dollar/pound sterling currency exposure.

Two major problems arose, however, with parallel loans, default risk and
their balance sheet impact:

(i) Since the two loans which make up the parallel loan structure are
independent obligations, a default by one party under one obligation does
not release the other party from the requirement to make the
payments contractually due under the second loan.

(ii) The consolidated balance sheet of the parent company will be inflated
in each case, since there was no basis to "net" or set-off the matching
asset and liability, even though these were offsetting as a matter of
economic substance.

These problems can be eliminated, however, if the two loans are simply
merged into a single transaction in which the two counterparties agree to
exchange or "swap" cashflows. An initial sum in US dollars is therefore
exchanged for its pound sterling equivalent and a reverse exchange takes
place at the maturity of the swap. In the intervening period there is a
regular exchange of semi-annual or quarterly payments as an alternative to
the interest payments that would otherwise have been made on the two loans
in the parallel
loan structure. Default risk is reduced by netting the flows that are
periodically exchanged and the accounting impact of a parallel loan is
avoided because a contractual agreement to exchange cashflows is
treated as an off-balance sheet transaction.

The first public interest rate swap transaction -- that between the World
Bank and IBM in 1981 -- was a currency swap as described above, but it is
clear that if every aspect of a swap transaction is denominated in a single
currency there is no need to have an initial exchange of currencies and a
subsequent re-exchange at maturity. The swap structure becomes even simpler,
therefore, being reduced to nothing more than a periodic exchange of
payments, with no principal amounts. This is the interest rate swap.

An interest rate swap is a contractual agreement entered into between two
counterparties under which each agrees to make periodic payment to the other
for an agreed period of time based upon a notional amount of principal. The
principal amount is notional because, as explained above, there is no need
to exchange actual amounts of principal in a single currency transaction:
there is no foreign exchange component to be taken account of.

Equally, however, a notional amount of principal is required in order to
compute the actual cash amounts that will be periodically exchanged.

Under the commonest form of interest rate swap, a series of payments
calculated by applying a fixed rate of interest to a notional principal
amount is exchanged for a stream of payments similarly calculated but using
a floating rate of interest. This is a fixed-for-floating interest rate
swap. Alternatively, both series of
cashflows to be exchanged could be calculated using floating rates of
interest but floating rates that are based upon different underlying
indices. Examples might be Libor and commercial paper or Treasury bills and
Libor and this form of interest rate swap is known as a basis or money
market swap. a Bank of International Settlements
 survey for une 1998.... estimated that size of the global OTC market
at an aggregate notional value of $70 trillion, a figure that doubtless
is closer to $80 trillion today.

Sorry for this long post, but it may help clear up some confusion.

Henry C.K. Liu