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  • 1 https://isni.org/isni/0000000404811396, International Monetary Fund

APPENDIX I

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1

This paper was conceived during an external assignment at the Deutsche Bank in 1999. Special thanks to Elizabeth Milne, who suggested the topic and provided helpful ideas, and Bahar Fadillioglu for her efficient research assistance. The author also thanks Winfrid Blaschke, Patricia Brenner, Peter Breuer, Fernando Delgado, Anne-Marie Gulde, Karl Habermeier, Kay Haigh, Charles Kramer, Guy Meredith, Vasily Prokopenko, Liliana Schumacher, and Mark Zelmer for their comments and suggestions. The standard disclaimer applies.

2

BIS (1995)This definition excludes fixed price contracts and delayed transactions within the normal course of business that do not result on a separate contract; insurance and contingencies such as guarantees and letters of credit that depend on the occurrence of additional events that sometimes are not even market related; and embedded derivative-like features as they are not separable from contracts on the underlying assets.

3

Parallel contracts with different maturities, actual exchanges of assets and/or liabilities, and combinations of borrowing/depositing and purchasing/selling of financial assets are substituted by forwards, swaps and options respectively. In the absence of derivatives, investors would need to rebalance these positions continuously to achieve the same results.

4

This definition corresponds to the intrinsic value of derivatives. For derivatives with an expiration date, such as options, additional time value is associated with waiting for expiration. Time value comprises basis value, related to imperfect risk offsetting, and volatility value, which is the value of a derivative instrument when it is out of the money (zero intrinsic value).

7

The paper addresses cross-border interest and exchange rate derivatives in general. Wherever the differentiation becomes relevant, it refers to over-the-counter (OTC) rather than exchange-traded derivatives, as they are even more dominant in emerging markets.

8

Appendix I includes the description of basic derivatives referred to in the paper.

9

American options can be exercised at any time before maturity, while European options are exercised only at the time of the specified exercise date.

10

See Blejer and Schumacher (1999) for other works that analyze monetary policy aspects based on the overall central bank balance sheet.

11

A long position implies that losses are limited, unlike short positions that could lead to unlimited losses.

12

As in Merton’s example, this option is exercised partially, as the demand for currency docs not decline to zero.

13

Options are in the money when its exercise is advantageous for those holding a long position, at the money when it is neutral and out of the money when it is disadvantageous.

14

In general, the early exercise of an American put option is more attractive as the value of the underlying asset decreases, the interest rate increases and volatility decreases. See Hull (1997).

15

Numerical procedures and analytic approximations could be applied, but that goes beyond the purpose of this paper.

16

The example can be followed considering the most simple case of a fixed exchange rate regime where the domestic currency holder lays a claim directly on central bank international assets. In this case, the alternative use of domestic currency is to be substituted by foreign currency.

17

For the part that is being converted.

19

Gorton and Rosen (1995). In a study of the U.S. swap market, they found that large banks tend to be long (pay fixed interest rates) at short maturities and short (pay floating interest rates) at long maturities.

21

Consistent with that view, the 1993 recommendations for the classification of derivatives in the National Accounts considered derivative-linked cash flows as an inherent component of the cost of capital. More recently, there is increasing consensus to view derivatives as financial assets in their own right mat do not affect the cost of capital directly given that a direct provision of capital is not involved, and, consequently, net cash settlement payments associated with derivatives are classified as part of the financial accounts (Heath 1998).

24

See Scott (1993) and Morales (2000)

26

Chatrah, Ramchander and Song (1993), for the British pound, Canadian dollar, Japanese yen, Swiss franc and Deutsche mark. However, they attribute these volatility swings to more efficient pricing in the futures market.

28

Kim and Wei (1999) show similar results concerning profitability of positive feedback trading in Korea.

29

See Hsie (1999), for an analysis of the behavior of hedge funds. He analyzes profitable opportunities during the stock market crash of 1987, the ERM crisis of 1992, the world bond market rally of 1993, the Mexican Peso crisis of 1994, and the Asian currency crisis of 1997.

31

For an analysis of limits on the offshore use of currencies, see forthcoming IMF Working Paper by Ishii, Ötker-Robe and Cui.

33

Offshore banks may book these transactions as domestic currency local transactions and hedge domestically through a branch in the domestic currency country.

34

Practitioners report that lack of liquidity has been a recurrent problem in NDF markets. Non-deliverable forwards may also be subject to manipulation by official agencies like in Russia prior to the crisis of August 1998. Sudden closures of some operations left markets without price references, at the time of the imposition of capital controls in Malaysia in 1998. In Thailand and Malaysia, two-tier foreign exchange forward markets resulted from caps on onshore transactions.

37

Negligible and indeterminate effects have been found in most studies.

39

Currencies different than the U.S. dollar, the Dmark, the Yen, the Pound sterling, the Franc, the Swiss franc, the Canadian Dollar, the Australian Dollar and the ECU and other EMS currencies.

40

For examples of typical cross-border derivatives, see Figure 6.

41

See Kodres, Laura ‘Hedge Fund Investment Strategies’, in Eichengreen and Mathieson (1998).

42

Even in emerging markets where these operations are more commonly used, some pressure in the spot market has resulted from investors unease about exchange rates to close to the point where options may cease to exist.

44

However, this may be affected by lack of liquidity and varying risk premia. The U.S. Federal Reserve bank only uses information from yield curves in the context of other supporting or contradicting information.

46

Its success is related to the willingness of Mexican authorities to refrain from any other form of intervention in the foreign exchange market, which may not be consistent with alternative monetary frameworks.

47

Butterfly spreads were intensively used to protect investors from the risk of eventual Y2K volatility problems.

48

Also, this alternative does not address Breuer’s main concern, which is the need to counteract short positions. But instead, it eliminates the possibility of indefinite losses.

Monetary Implications of Cross-Border Derivatives for Emerging Economies
Author: Mr. Armando Méndez Morales