Globalization, Gating, and Risk Finance

An in-depth guide to global and risk finance based on financial models and data-based issues that confront global financial managers.

Globalization, Gating, and Risk Finance offers perspectives on global risk finance in a world with economies in transition. Developed from lectures and research projects investigating the consequences of globalization and strategic approaches to fundamental economics and finance, it provides an approach based on financial models and data; it includes many case-study problems. The book departs from the traditional macroeconomic and financial approaches to global and strategic risk finance, where economic power and geopolitical issues are intermingled to create complex and forward-looking financial systems.

Chapter coverage includes: Globalization: Economies in Collision; Data, Measurements, and Global Finance; Global Finance: Utility, Financial Consumption, and Asset Pricing; Macroeconomics, Foreign Exchange, and Global Finance; Foreign Exchange Models and Prices; Asia: Financial Environment and Risks; Financial Currency Pricing, Swaps, Derivatives, and Complete Markets; Credit Risk and International Debt; Globalization and Trade: A Changing World; and Compliance and Financial Regulation.

• Provides a framework for global financial and inclusive models, some of which are not commonly covered in other books.
• Considers risk management, utility, and utility-based multi-agent financial theories.
• Presents a theoretical framework to assist with a variety of problems ranging from derivatives and FX pricing to bond default to trade and strategic regulation.
• Provides detailed explanations and mathematical proofs to aid the readers’ understanding.

Globalization, Gating, and Risk Finance is appropriate as a text for graduate students of global finance, general finance, financial engineering, and international economics, and for practitioners.

UNURJARGAL NYAMBUU is a Professor of Economics in the Department of Social Science, New York City College of Technology (NYCCT), The City University of New York (CUNY), Brooklyn, NY.

CHARLES S. TAPIERO is the Topfer Chair Distinguished Professor of Financial Engineering and Technology Management, Department of Finance and Risk Engineering, Tandon School of Engineering, New York University (NYU), Brooklyn, NY.

Motivation xviii

About the Authors xxv

1 Globalization: Economies in Collision 1

Motivation 1

1.1 Introduction 1

1.2 Trend and Challenges in Global Finance 5

1.2.1 Global Finance and the 2007–2008 Financial Crisis 5

1.2.2 Geopolitics and Finance or Geo-Finance 7

1.2.3 Population Growth 9

1.2.4 Geo-Finance and Gating 9

1.2.5 Culture and Social Norms 10

1.2.6 Emerging Economies, Equalization, and Risks 11

1.2.7 Regulation and Politics 12

1.3 Global Finance and Trade in the Media and News 12

1.3.1 Taxing Foreign Returns When They Are Repatriated 12

1.3.2 Sovereign Gating and Protective Tariffs, Trade Defense 12

1.3.3 Global Insurance and Dependence 13

1.3.4 Finance and Politics 13

1.3.5 EU–US Regulation Risks in a Trans-Atlantic Market 13

1.3.6 Rare Earth and Strategic Trades 14

1.4 Global Risks 15

1.4.1 Factors Affecting Global Risks 15

1.4.2 Global Finance and Risk Theories 17

1.5 Global Finance and Swaps and Financial Products 18

1.6 Currencies and Liquidity 20

1.7 Foreign Exchange Regime and Markets, Global Payment, and Reserve Currency 23

1.7.1 Foreign Exchange Markets and Global Trade Currency 24

1.7.2 Exchange Rate Regimes 28

1.7.3 Foreign Exchange Reserve Currencies 29

1.7.4 Exchange Rate in Emerging Markets 30

1.8 Trade Incentives and Repressions 33

1.9 Historical Evolution 36

1.9.1 The Gold Standard System 36

1.9.2 The Bretton Woods Agreement 37

1.9.3 The Yuan Exchange Rate: An Example 38

1.10 Archaic and Modern Globalization: A Time Path 40

1.11 Discussions on Global Issues 44

References 46

2 Data, Measurements, and Global Finance 51

Motivation 51

2.1 Data and Models 51

2.1.1 National Accounts and Country-Specific Data 52

2.1.2 Financial Data 53

2.1.3 Corporate and Statistical Measurements 53

2.1.4 Big Data and Model-Less Finance 56

2.1.5 Technology and Financial Data 59

2.1.6 Transforming Data Management in Global Finance 60

2.2 Global Finance, Data Reduction, and Statistical Measurements 61

2.2.1 Moments 61

2.2.2 Skew and Kurtosis (Tails) 63

2.2.3 Outliers, Extreme Statistics, and Fat Tails 65

2.2.4 Extreme Risks 65

2.2.5 Time Series and Filtration 66

2.2.6 Dependence 67

2.2.7 Risk Exposure 75

2.3 Volatility and Implied Models Estimates 76

2.3.1 Simple Volatility Estimates 76

2.3.2 Implied Volatility 77

2.3.3 Moving Average and Autoregressive Moving Average Models 79

2.3.4 ARCH–GARCH Volatility Models 80

2.3.5 ARCH–GARCH Model: Empirical Evidence 82

2.4 Stochastic Models 86

2.4.1 The Constant Rate of Return Hypothesis 88

2.4.2 Autoregressive and Mean Reverting Models 90

2.5 Multivariate Probability Models 91

2.5.1 Bernoulli and Codependence: Qualitative Data 92

2.5.2 Multivariate Qualitative Data 93

2.5.3 Copulas and Multivariate Models 96

2.6 Statistical Data Reduction 100

2.7 Complexity: The Global Risk Finance Scourge 102

2.8 Discussion 103

References 104

3 Global Finance: Utility, Financial Consumption, and Asset Pricing 110

Motivation 110

3.1 Introduction: Financial Models and Pricing 110

3.1.1 The Walras–Arrow–Debreu Preference-Free Q Framework 111

3.1.2 Utility Finance 113

3.1.3 Utility Preferences and Pricing 114

3.2 Review: Elements of Utility and Risk 116

3.2.1 Utility and Risk Preferences 117

3.2.2 Selected Utility Functions 119

3.3 The Utility of Consumption and its Price 119

3.3.1 Example: The Financial Utility of Consumption 120

3.3.2 The Utility of Financial Consumption 121

3.4 The Capital Assets Pricing Model 123

3.4.1 Discussion 125

3.4.2 The Jensen Alpha Case: η = α−Rf 0 125

3.4.3 The Arbitrage Pricing Theory 126

3.4.4 The Capital Assets Pricing Model and Foreign Exchange 127

3.4.5 Pricing Foreign Exchange Rates and a Basket of Foreign Exchange Rates 128

3.4.6 Thought Experiment 130

3.4.7 Linear Regressions, Capital Assets Pricing Model, and Global Finance 130

3.5 Review of Elements of Arrow–Debreu and Q Pricing 131

3.5.1 Applications of the Arrow–Debreu Framework 134

3.5.2 Pricing a Foreign Bond and Foreign Exchange Rates 134

3.5.3 Global Investment Pricing: A Binomial Model 137

3.5.4 Global Investment Pricing: A Portfolio Problem 139

3.5.5 Foreign Exchange, Consumer Price Index, and Purchasing Power Parity 141

3.5.6 Relative Purchasing Power Parity 141

3.6 The Multiperiod Consumption-Based Capital Asset Pricing Model 142

3.6.1 Example: Pricing Exports 144

3.6.2 Example: The Multiagent Consumption-Based Capital Asset Pricing Model 145

3.6.3 Example: Portfolio Investment 146

3.6.4 The Capital Assets Pricing Model as a Special Case of the Consumption-Based Capital Asset Pricing Model 149

3.6.5 Foreign Exchange Rates, Bonds, and Equity 150

3.6.6 Example: Rate of Returns in Foreign Equity Markets and the Foreign Exchange Rate 153

3.7 Thought Experiments 154

References 155

4 Macroeconomics, Foreign Exchange, and Global Finance 157

Motivation 157

4.1 Introduction 157

4.2 Fundamental Macroeconomic Models 158

4.2.1 The Keynes Model: Goods and Money Markets in a Closed Economy 159

4.2.2 Macroeconomic Accounting in Open Economies 162

4.3 Balance of Payments Accounts 165

4.3.1 The Structure of Balance of Payments 165

4.3.2 Principles of Balance of Payments 167

4.3.3 Global External Imbalances 168

4.4 The Mundell and Fleming Model: IS–LM–BOP Model 171

4.4.1 Equilibrium Exchange Rate in the Foreign Exchange Market 171

4.4.2 IS–LM–BOP Model 173

4.4.3 Two-Country Model with Mundell–Fleming 175

4.4.4 Extension of the Mundell–Fleming Model: Trade 176

4.5 Macroeconomic Factors Reshaping Global Outlook 178

4.5.1 Foreign Direct Investment 178

4.5.2 External Debt and its Sustainability 182

4.5.3 Government Bonds and other Macroeconomic Factors 184

4.5.4 The Impact of a Strong US Dollar 185

4.5.5 The US Dollar and Commodity Prices 186

4.5.6 Globalization and Economic Inequalities 187

4.6 Conclusion 190

References 191

5 Foreign Exchange Models and Prices 195

Motivation 195

5.1 Introduction 195

5.2 Macroeconomic Models of Foreign Exchange Rates 196

5.2.1 Underlying Factors for Modeling Foreign Exchange Prices 196

5.2.2 Classification of Foreign Exchange Models 197

5.3 Exchange Rates and Purchasing Power Parity 198

5.3.1 Purchasing Power Parity and the Law of One Price 198

5.3.2 Application of the Law of One Price and Purchasing Power Parity 200

5.4 Foreign Exchange Rates and Interest Rates: The Assets Approach 204

5.4.1 Covered Interest Arbitrage 204

5.4.2 Uncovered Interest Parities 205

5.4.3 Real Interest Parity 206

5.4.4 Testing Uncovered Interest Parity 206

5.5 Demand and Supply of Money and Exchange Rates: Monetary Approach 207

5.5.1 The Frenkel–Mussa Model 208

5.5.2 Foreign Exchange Prices and Inflation 209

5.5.3 The Unified Asset/Monetary Approaches 211

5.5.4 Empirical Evidence on the Monetary Model of Exchange Rate 211

5.6 Extensions of the Models 212

5.6.1 The Balassa–Samuelson Model 212

5.6.2 The Dornbusch Overshooting Model 215

5.6.3 The Real Interest Differential Theory 219

5.6.4 Present-Value Models: Complete and Incomplete Markets 219

5.7 Conclusions 221

Appendix 5.A: Suggested Empirical Work for Econometric and Statistical Analysis 222

References 223

6 Asia: Financial Environment and Risks 226

Motivation 226

6.1 Introduction 226

6.2 Driving Engines of Economic Growth in Asia 228

6.2.1 International Trade 229

6.2.2 Exchange Rate 229

6.2.3 Foreign Investments Expansion 234

6.3 Financial Sector Development in Asia 235

6.3.1 Fast-Growing Banking Sector 237

6.3.2 Bond Market Development 239

6.3.3 Stock Market Development 242

6.4 Risks of Investing in Asia 245

6.4.1 Foreign Exchange Risk 245

6.4.2 Foreign Exchange Option 248

6.4.3 Portfolio with Asian Assets 249

6.5 Financial Development in China 251

6.5.1 Importance of the Banking Sector in China 252

6.5.2 State-Owned Enterprises 254

6.5.3 Challenges in Equity Markets in China 257

6.5.4 Stock Market Development in China 257

6.6 Finance in Japan 260

6.6.1 Banking Sector in Japan 260

6.6.2 Effectiveness of Corporate Governance 260

6.6.3 The Importance of Industry 261

6.6.4 Bond Market Volatility in Japan 263

6.7 Conclusion 265

References 266

7 Financial Currency Pricing, Swaps, Derivatives, and Complete Markets 269

Motivation 269

7.1 Introduction 269

7.2 Pricing Consumption Price Index and Foreign Exchange in Complete

Financial Markets 272

7.3 A Generalized Consumption Price Index Foreign Exchange Pricing

Model 276

7.4 Relative and Foreign Exchange Basket Price Tracking 278

7.4.1 Currency Basket Design 281

7.4.2 A Global Index Consumption Price Index Price Reversion and Foreign

Exchange Prices 284

7.4.3 Global Index Reversion and Foreign Exchange 288

7.4.4 Q Pricing and Multiple Risks 290

7.5 Options Pricing: Applications and Examples 292

7.5.1 Pricing Currency Options 293

7.5.2 Options and Martingale Pricing Relative to a Global Index 295

7.6 Spread and Two-Factor Options 296

7.6.1 Spread and Correlation Options 297

7.6.2 The Price and the Profit/Loss of a Foreign Investment 298

7.6.3 A Quanto Option 299

7.7 Optional Trading Strategies 300

7.7.1 The Protective Put and Foreign Trading 300

7.7.2 The Covered Call 303

7.8 The Greeks and Financial Risk Management 303

Appendix 7.A: Mathematical Review 304

7.A.1 Itô Calculus 305

7.A.2 The Feynman–Kac Formula 309

7.A.3 Stochastic Integral and Quadratic Variations (Benhamou, 2007) 310

7.A.4 Pricing, the Radon–Nykodim Derivative and Girsanov Theorem 311

7.A.5 Reducing a Dependent Vector to be Independent 312

References 314

8 Credit Risk and International Debt 315

Motivation 315

8.1 Introduction 315

8.2 Growth of Debt and Debt Dependency 317

8.3 Foreign Exchange is a Credit Bestowed to a Sovereign Entity 321

8.4 Credit and Global Risks 323

8.4.1 Country-Specific Risks 323

8.4.2 Foreign Exchange Risks 324

8.4.3 Credit Trading and Currency, Sovereign Bond Risks, Currency Stability 326

8.5 Credit Risk, Credit Derivatives, and Credit Default Swaps 330

8.6 Swaps 332

8.6.1 A Definition and Types of Swaps 332

8.6.2 The Theoretical Q-Price of Spread Options 334

8.6.3 A Swaps Pot-pourri 335

8.7 Credit Default Swaps and Securitized Volatility 338

8.8 Pricing Credit Risk 340

8.8.1 Reduced-Form Models 342

8.8.2 Credit Price and Debt Leverage: An Example 343

8.8.3 Utility and Credit, Debt Leverage and Reimbursement at the Second

Period 344

8.9 Debt, The Merton Model, and Default 347

8.9.1 The Merton Debt Model and Foreign Exchange 349

8.9.2 Market Pricing Debt and Credit Risk 350

8.9.3 Debt and Options: A Merton Continuous-Time Model 351

References 355

9 Globalization and Trade: A Changing World 358

Motivation 358

9.1 Introduction 358

9.1.1 Trade and Globalization: A Gated and Changing World 361

9.1.2 Trade and Comparative Risks 363

9.1.3 Inversion and Outsourcing 365

9.1.4 Trade and Risk Externalities 365

9.1.5 Globalization, Gating, and Strategic Trades 366

9.2 Tracking Trade and Globalization 368

9.3 Strategic Trade and Gating 375

9.3.1 Strategic Trade 375

9.3.2 Trade Models 377

9.4 A Multicountry Financial Consumption Utility 378

9.4.1 A One-Period Utility Model: The Consumption Demand Side 379

9.4.2 A One-Period Utility Model: The Supply Side 380

9.4.3 A One-Period Financialized Utility Cournot Model 384

9.4.4 The Cournot Multiperiod Financial Consumption 386

9.5 The Demand Sector and its Supply 388

9.6 Conclusions 390

References 391

10 Compliance and Financial Regulation 395

Motivation 395

10.1 Introduction 395

10.1.1 Regulation, Politics, and Geopolitics 397

10.1.2 Regulatory Risks, Finance, and Compliance 399

10.1.3 Regulation and Risks: Economic Literature 401

10.2 Regulation Risks 403

10.3 Regulation, Technology, and Compliance 405

10.3.1 Importance of Technology and Information 405

10.3.2 Regulation, Technology, and Complexity Risks 407

10.4 Statistical and Compliance Risks 407

10.4.1 Statistical Regulation and Compliance 409

10.4.2 Bernoulli Audits and Noncompliance 409

10.4.3 A Beta Probability Distribution of Noncompliance 410

10.4.4 Auditing a Bank for Compliance 410

10.4.5 The Persistent Regulator 411

10.4.6 The Beta Prime Model 412

10.4.7 The Logit and Beta Prime Compliance Models 414

10.5 A Multivariate Bernoulli Compliance and Audits 415

10.5.1 Bernoulli Compliance 415

10.5.2 Bernoulli and a Codependent Model 417

10.6 Regulation and Compliance Games 418

10.7 Satisficing Games and Regulation–Compliance 421

10.8 Conclusion 423

Appendix 10.A: Games, Risk and Uncertainty 423

Appendix 10.B: Concepts of Games and Risk 424

References 428

Index 000

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