insurance advisory

Should medium-term economic forecasts be taken into account given their high level of uncertainty? Should default probabilities be taken as some form of average over a full economic cycle? The case for taking these forecasts into account is that this gives a common base case. In the event of the economic environment showing signs of being weaker than expected this provides a reason for reassessing default probabilities across the board.
It is not uncommon to overhear discussions between line managers and house economists where the former has been demanding GDP forecasts for the next five years. A typical economist response is that it’s hard enough to make forecasts for the next six months with any real confidence given current uncertainties. Five years? Dream on. The line manager patiently explains that she understands this but needs the numbers for her business plan.

Trading in equities may be in the actual instruments concerned or be achieved using options and futures contracts. Options provide a much greater level of gearing when they are trading close to being at-the-money than buying or shorting the underlying stock:
Fundamentals.Long-term investors look for opportunities to buy stocks that on the basis of fundamentals (earnings growth expectations, discount rate, risk) appear to be undervalued and sell or short stocks that are overvalued.
Rumors. Stock prices do move as a result of rumors, particularly if those rumors have some reasonable rationale. If the rumors are positive then stocks are likely to move up until a firm announcement that the rumor has no substance is made. It is easier for speculators to make money if prices are relatively volatile, whatever the cause, than if they remain largely static.
News event driven. There are a number of possible events where the timing of an announcement is known well in advance but the outcome is uncertain. Examples include the conclusions and recommendations of a competition inquiry, a change in tax policy, the announcement of awards for licenses or results of a bidding process. The market will price in an expectation of the outcome but if the result is opposite to that expectation the stock is likely to either rise sharply or correct.
Earnings releases are subject to brief but intense scrutiny. People who do not understand how stock markets work are perplexed when the stock of a company falls after it reports a good set of results with strong earnings growth. The market reaction to earnings releases depends largely on any differences between what the market was expecting and what the company actually delivered. Strong earnings growth can be disappointing if the market was expecting even stronger growth. Losses may be viewed positively if they are less than the market had feared. Analysts are frequently asked in the run-up to earnings releases if they are expecting any surprises. Remarkably, this is not quite as asinine as it appears.
Takeovers. Takeover bids can provide rich pickings for speculators. Friendly agreed offers may precipitate a hostile offer from a counterparty. Hostile bids will almost always be rejected and a higher bid demanded. Other stocks in the same sector will also be affected depending on whether the market believes a specific company is likely be the next target or bidder, or stands to lose or gain from the announced bid succeeding. Speculators may be able to sell their holdings in the target company to either the target company or bidder at a premium to market prices. The bid may be referred to regulatory scrutiny.
Indexation. From time to time the constituents of stock indices are adjusted. Some stocks are dropped from an index while other stocks are added. In the case of some indices the criteria for inclusion are very clearly defined, such as by market capitalization, and the changes are automatic. In other cases the index provider may have more leeway to act to try to ensure that the index is genuinely representative.
Traders will buy stocks they expect to be added to an index and sell or short those most likely to be dropped. They do so in the expectation that tracker funds will have to buy or sell these stocks after the index changes are put into effect.
Gray market. The gray market is an OTC market where new issues can be traded before opening on an exchange. Successful subscribers may prefer to take a guaranteed price in the gray market rather than sell in the market after the stock starts to trade. Traders will buy in anticipation of a higher opening price than that in the gray market. The time between the stock being traded on the gray market and on the market leaves the trader exposed to the risk of an overall market correction.

Two broad strategies exist for interest rate futures arbitrage. Interest rate futures contracts on US Treasury bonds or bills allow for the delivery of the actual bond or a close equivalent (Eurodollar futures involve cash settlement).
Take a 20-year bond, with a 8% coupon rate trading at par ($10 000). Assume that this is the deliverable for a three-month futures contract currently trading at $10 200. The annualized risk-free rate is 6%.
Initiation. Sell the futures contract at $10200. Purchase the bond in the spot market at $10000 by borrowing $10000 for three months. The bond can be used for the margin requirement and hence there is no net cashflow.
Settlement. Deliver the bond and receive $10 200 plus accrued interest of $200. Pay back the principal and accrued interest of $10 150 on the borrowings. Net profit is $350.
Take the same scenario but assume a futures contract price of $9700. The first strategy would result in a loss and the trades required to generate a profit are:
Initiation. Buy the futures contract at $9700. Sell or short the bond at $10 000 and invest the proceeds at 6%.
Settlement. Take delivery of the bond and pay $9700 plus $200 in accrued interest. Receive $10 150 from repayments on loan. Net profit is $250.
As usual the action of arbitrageurs will eliminate the arbitrage opportunity and with all other factors unchanged the futures contract should trade at $9950.

Within the emerging markets, there has been a gradual realization, particularly as barriers to trade and capital have come down, that fixed or pegged exchange rate regimes may no longer be appropriate in an economic world dominated by high capital mobility. Furthermore, there has been an equal realization that exchange rate pegs of one type or another inevitably increase “moral hazard”, in that they are seen as an official guarantee of exchange rate stability and therefore serve to encourage the taking on of unnecessary and dangerous exchange rate risk. Pegging to an international currency such as the US dollar can provide substantial monetary credibility on the one hand, but on the other the fact that US dollar interest rates are likely to be substantially lower than those in the domestic market can encourage domestic corporations and finance companies to borrow in the pegged currency without hedging out the currency risk embedded in those liabilities. The Asian crisis was greatly exacerbated by the fact that Thai, Korean and Indonesian corporations borrowed heavily in US dollars, swapped back to domestic currency and lent that out at much higher rates or used it for investment purposes. Yet, the US dollar liability remained unhedged from a currency perspective. Consequently, when domestic currencies such as the Thai baht, Indonesian rupiah and Korean won devalued, the cost of paying those US dollar loans was multiplied proportionally in terms of the domestic currency. In practice, many corporations were bankrupted as a direct result, while others defaulted in such debts. Gradually, emerging market countries have abandoned pegged exchange rates in favour of freely floating exchange rates, either willingly or otherwise, with this process being greatly accelerated in the wake of the emerging market crises of 1994–1999. With this process has come the realization that “soft” or “crawling” currency pegs are no longer sustainable in a world of high capital mobility. Either exchange rates should float freely or they should be constrained by the hardest of currency pegs. The middle ground of “intermediate” exchange rate regimes is no longer seen as tenable. This view of a “bi-polar” world of exchange rates was put most clearly and eloquently by the former IMF First Deputy Managing Director Stanley Fischer, reflecting a general move in favour of this view by the Washington official community. In several research pieces and speeches, Fischer noted that the currency pegs have been involved in just about every emerging market crisis during the 1990s, from Mexico in 1994 through to Turkey in 2001. Whether coincidence or not, emerging market countries that have not had pegged exchange rates have generally been able to avoid experiencing currency crises. Of the 33 leading countries classified as emerging market economies, the proportion with intermediate exchange rate regimes fell from 64% at the start of the 1990s to 42% at the end. By 1999, 16 of these countries had freely floating exchange rates, while three had hard currency pegs in the form of a currency board or dollarization. The remainder still had intermediate exchange rate regimes. Since then, the hollowing out of intermediate exchange rate regimes has continued, with Greece moving out of both emerging market status and a horizontal currency band into the Euro, while Turkey was forced off its crawling peg, floating its currency in the process. This hollowing out process of intermediate exchange rate regimes has also happened with the so-called developed economies, a process dominated by the drive towards EMU and the creation of the Euro. The ERM crises of 1992 and 1993 were initially thought to have endangered if not ended the dream of EMU. Conversely, it appears they actually served to accelerate the momentum away from such an intermediate exchange rate regime to the hardest of pegs, the single currency. By the end of 1999, all but one developed economy had either hard pegs or freely floating exchange rates, with that one exception being Denmark.
As countries move from targeting the exchange rate, through intermediate exchange rate regimes, towards freely floating exchange rates, the monetary emphasis shifts towards targeting inflation as the monetary anchor of credibility. Whether a country chooses a hard currency peg or allows its currency to float freely may depend at least in part on its inflationary history. In theory, a hard currency peg makes sense for countries with long histories of high inflation and monetary instability. The peg imposes a harsh policy discipline, but it also acts as a straight jacket on inflationary pressure. Even if a currency has a hard peg regime, it is also important to have an exit strategy in case of a major change (deterioration) in economic conditions which requires a similar change in the exchange rate regime. A hard currency peg should not be seen as permanent. If a country chooses to de-peg, this is best done when the currency is under pressure to appreciate.
While this idea of a “bi-polar” world of exchange rates appeared to provide an answer to the vexing question of how countries could cope with increasingly mobile capital flow, the example of Argentina would appear to challenge this view. Not only was it the first currency board in history to be “defeated”, but this example appears to prove that even the hardest pegs could be forced to de-peg. Certainly, the idea that a currency board cannot be defeated, once prevalent in the financial markets, has now gone. Going forward, it seems likely therefore that markets will charge a higher risk premium on currency board regimes than was previously the case as a result of this precedent. Not only is a hard currency peg no panacea, it can also be defeated. Countries are therefore left with the question of the most appropriate exchange rate regime in the face of a global market economy consisting of high capital mobility and instant information availability. For both developed and emerging market economies the choices left are:
Freely floating exchange rates
Adopt a base currency (US dollar or Euro)
Adopt a regional currency
While some such as John Williamson of the Institute for International Economics have long argued that intermediate exchange rates are unjustly neglected and “corner solutions” are not immune to crisis — as the case of Argentina indeed proves — it remains to be seen whether financial markets will tolerate anything other than freely floating exchange rates or alternatively adopting a base or regional currency.

The discipline of floating exchange rates is quite different to that of a pegged exchange rate system. No longer is the exchange rate itself the anchor of monetary credibility. Instead, the conventional wisdom has moved towards inflation targeting through interest rate policy as the anchor of monetary credibility. As a result, the emphasis has shifted importantly away from the exchange rate regime and in favour of central banks in seeking to maintain both internal and external price stability. This move from the certainty of an exchange rate as the monetary anchor of credibility to the uncertainty of a central bank’s monetary discipline is very much a leap of faith, and it can take a considerable period of time for a central bank to gain the respect needed of the global financial markets to pursue that discipline with the minimum of market instability. This is as true for the developed economies as it is for the emerging markets. For instance, it took the German central bank, the Bundesbank, over 30 years to achieve the revered status it had during the 1990s when German bond yields finally fell below those of th US for a sustained period of time. Further, a central bank’s monetary credibility is hard won but easily lost.
In the emerging markets also, as with the broader trend, there has been a general move away from targeting the exchange rate towards targeting inflation. This is of course particularly evident within the EU accession candidates such as the Czech Republic, Poland and Hungary, which in any case have to adopt some form of inflation targeting to ensure that their inflation rates do not exceed EU/Euro entry rules. However, inflation targeting is also now present in Latin America and Asia.
The presumed premise behind this is that as the emerging markets continue to participate to an increasing degree in the global economy and in the global financial markets, so they will be increasingly judged by the most efficient economy of that global economy, the United States, and have to adopt its economic policies, such as inflation targeting. This is richly ironic since in fact the US has no formal inflation target. Indeed, it is not too much to suggest that the official community in Washington, led by the IMF, is in many cases demanding economic policies (as quid pro quos for new loans) that would simply not be acceptable in the industrial countries. Granted, this picture is not entirely negative. Inflation targeting frameworks are usually characterized also by a greater degree of policy transparency and accountability. Inflation targeting also allows some degree of discretion in the setting of the inflation target, but thereafter little latitude in missing it. Broadly put, financial markets “reward” administrations — through lower bond yields — that meet their inflation targets and punish those that do not. Any student of international economics knows the classical argument by Milton Friedman for price flexibility:
if there is a change in economic conditions, the fastest and most efficient way of expressing this necessary adjustment is through the external price — the exchange rate — rather than through a large number of domestic prices. The analogy that Friedman used in 1953 to explain this was daylight saving time; that is, it is easier to move to daylight saving time than to coordinate a large number of people and move all activities one hour.
The basic argument in favour of flexible exchange rates is that it makes it easier for an economy to adjust to external shocks, such as a dramatic change in commodity prices which in turn triggers a change in the trade balance. A flexible exchange rate also allows the central bank to devote its energies to seeking to maintain domestic monetary stability rather than focusing on the external price. Of course, this is the theory. In practice, many central banks still try to focus on the exchange rate and not just to the extent that it affects domestic inflation. In principle, however, the central bank’s focus on internal price stability frees it from the obligation of targeting the exchange rate.
Freely floating exchange rates also have a downside, most notably in that they can be volatile and also on occasion can significantly overshoot anything approximating fundamental value. This in turn can hurt the real economy. To return to Churchill’s description of democracy, freely floating exchange rates are far from perfect, but they have so far proved better and more resilient than anything else on offer. That said, although a freely floating exchange rate system is probably the best and most flexible system on offer over the long term, there are specific economic factors that can determine which type of exchange rate system may be appropriate in the short to medium term:
Size/openness of the economy — If an economy is very open to external trade, the economic costs of currency instability are likely to be a lot higher than if this is not the case. For instance, in the wake of the Asian crisis, the structural damage to the likes of India was far less than to Korea or Thailand, not least because trade is a far smaller proportion of the Indian economy. In turn, this may suggest that it may be appropriate over the short to medium term for small open economies, such as Hong Kong or Singapore, to have either fixed or managed exchange rate regimes.
Inflation — If a country has a higher inflation rate than its trading partners, its exchange rate needs to be flexible (i.e. floating) in order to maintain trade competitiveness. Indeed, the law of PPP requires that its exchange rate depreciates to offset this higher inflation rate.
Labour market flexibility — The more rigid the wage structure within the economy, the greater the need for exchange rate flexibility to act as a buffer against real economic shocks.
Capital mobility — The general rule is that the more open an economy is to capital flow, the harder it is to sustain a fixed exchange rate system. The only exception to this is if a country adopts a currency board and relinquishes monetary independence.
Monetary credibility — The stronger the credibility of a central bank, the less the need to peg or fix the exchange rate, and vice versa. The relationship between the monetary credibility of a central bank and the trust of the financial markets is very much a confidence game. As we saw earlier, it usually takes a considerable period of time for central banks to build that relationship and that trust with financial markets.
Financial development — The degree of financial development, particularly with regard to the domestic financial system, may be a consideration when choosing a type of exchange rate regime. For instance, immature financial systems may not be able to withstand the volatility inherent in freely floating exchange rates.

Many emerging market countries have chosen to float their currencies only as a last resort and only when they have been forced so to do. Even those who have eventually floated have still sought to manage or interfere in otherwise floating currency markets in some way. From this, we have the idea of “fear of floating”, which Calvo and Reinhart set out in a major research paper. While it is understandable that emerging economies fear — or at least are nervous about — the risks of allowing the market free rein, in my view this is like democracy — the worst option apart from all the rest. Government intervention in the economy inevitably creates economic distortions, which can have significant costs. Similarly, if intervention is anything other than occasional in order to smooth price action and correct market overshooting, it can create pricing distortions, which in any case will eventually be reversed.
This notwithstanding, the move from pegged to floating exchange rate regimes has frequently been done with considerable reluctance within the emerging markets, that is to say in many instances it has been forced by the market. Countries such as Mexico, much of Asia, the Czech Republic, Brazil and Turkey did not adopt floating exchange rates willingly. These were forced on them as a result of the breaking of currency pegs and maxi-devaluations that in many cases resulted in catastrophic economic contractions. It should be no surprise therefore that the relationship between the emerging markets and the idea of freely floating exchange rates is an uneasy one. However, barring a major reversal in terms of trade or capital market deregulation and liberalization, there is no going back on this trend towards freely floating exchange rates. The question now is no longer whether emerging markets will choose freely floating exchange rates as one type of exchange rate regime, but when and how they will move to that.

Aside from the complete adoption of another and more credible currency, such as the US dollar, the hardest form of currency peg is the currency board. Here, the central bank relinquishes theoretically all discretion over monetary policy. Capital inflows lead automatically to a proportional reduction in money supply by the “monetary authority”, which replaces the job of the central bank, and vice versa. The monetary authority pledges to exchange the domestic currency for the peg currency, usually the US dollar, at the peg rate in any size. Needless to say, this means it has to have the foreign exchange reserves in order to be able to do so. This in turn has real impact on the economy. For a start, there has to be a strong degree of domestic price flexibility in order to ensure that domestic prices are able to adjust to changes in the economy since the external price — the exchange rate — cannot adjust because of its peg/currency board constraint.
Currency boards are no panacea. They imply and impose a very harsh policy discipline.
A country has to be willing — and be seen to be willing — whatever economic pain is required in order to maintain the currency board. On the positive side, they should provide transparency and monetary credibility in addition to stability, which in turn should provide a medium-term foundation for growth, albeit at a cost. As the example of Argentina suggests, currency boards do not imply a guarantee of stability. They have tended however to be considerably more resistant to speculative attack than has been the case with the crawling peg, in large part because they have provided a greater degree of monetary credibility. Note that a currency board requires that the monetary authority’s foreign exchange reserves more than cover the monetary base. They do not and are not able to cover the broad money definition, which means that they remain vulnerable in theory, particularly if locals abandon their own currency.

These four periods have been characterized by a general — although not universal — move from fixed exchange rate systems to convertible pegs and finally to freely floating exchange rates. In the mid-1970s, almost 90% of emerging market countries had some form of fixed/pegged exchange rate. As of the end of 2001, this had fallen to 30%. It should be noted of course that this is still a high number and thus it remains important to examine the dynamics of fixed and pegged exchange rate systems, why they came about and their relevance in the modern world. Fixed or pegged exchange rate systems made sense for emerging markets during the 1970s and 1980s. For the most part, their involvement in the global economy was still relatively limited, for both political and economic reasons. Their financial systems were still for the most part in their infancy and certainly not able to cope, at least early on, with the harsh disciplines imposed by global financial markets. A credible anchor was needed for monetary policy and it was found in the form of the US dollar. The pegged exchange rate value between the US dollar and the emerging market currency became the anchor of monetary credibility. Sometimes these were hard pegs to the US dollar, sometimes they were “crawling pegs”, meaning that the peg value changed to reflect a gradual depreciation of the emerging market currency in line with its higher inflation rate. Others were pegged not to a single currency, but instead to a basket of currencies. In all cases, however, the exchange rate peg was the anchor of monetary credibility. What does this mean? A pegged exchange rate system implies a commitment by the financial authorities of a country to limit exchange rate fluctuation within the limits of the peg. At the macroeconomic level, the aim of this is to provide both stability and credibility. Atthe microeconomic level, it is to provide an implicit guarantee to the private sector of exchange rate stability.