Dilip K. Ghosh

Profit Possibilities in Currency Markets: Arbitrage, Hedging, and Speculation

This paper reviews and extends the existing literature on covered arbitrage, delineates the conditions for profitable arbitrage with the hedging instruments of forward and options contracts in the foreign exchange markets, and defines the maximum possible profits out of a given market environment. Next, the simple rules on speculation are articulated with and without transaction costs, and then we show how speculation can be covered with options and forwards. Finally, speculation is integrated with arbitrage and hedging, and further compounding of profit possibilities is illustrated.

Pecking order as a dynamic leverage theory

Static tradeoff theories, which do not explicitly treat the impact of transaction costs, do not explain the policy of asymmetry between frequent small debt transactions and infrequent large equity transactions. Nor do these theories explain why the debt ratio is allowed to wander a considerable distance from its alleged static optimum, or how much of a distance should be tolerated. We offer a class of diffusion models that mimic this behaviour in a stochastic-dynamic framework and are designed to optimize a financing strategy using any static tradeoff theory as input. The models developed reveal the determinants of the size and frequency of equity transactions and the range of values over which leverage variations are tolerated in four generic scenarios. They also yield a new formulation of the cost of capital that recognizes stochastic transaction costs and a penalty for deviation from any static-optimal leverage. Our class of models augments the pecking order theory, provides a flexible quantitative framework for its implementation as a decision tool, and facilitates the formulation of additional hypotheses for its empirical validation. Symmetrically, our results show the importance of dynamic factors in designing and interpreting empirical tests of static tradeoff theories. The results presented have important implications for the role played by static tradeoff theories in a stochastic-dynamic framework. One such implication is that the static-optimal leverage has no direct effect on the firms leverage policy in this setting. The target leverage for refinancing transactions is different from the static-optimal leverage, and the mean leverage is generally different from both. As a consequence, the latter cannot be used to estimate the former. Another implication is that even when the mean leverage equals the static optimum, mean reversion is not an optimal behaviour and therefore not a legitimate test for the existence of a static tradeoff in a dynamic context. Still another implication is that wide variations in leverage ratios cannot be interpreted as evidence of leverage indifference. It follows that the pecking order theory is consistent with static tradeoff theories and does not require the assumption of leverage indifference.

Arbitrage with hedging by forward contracts: exploited and exploitable profits

The theoretical conditions for covered interest arbitrage and exploitable profit opportunities out of simple and triangular arbitrage in the absence and presence of market imperfection are enunciated. A distinction is made between pure arbitrage profits and arbitrage-induced total profits attainable under the risk-free environment. Operational feasibility of iterative arbitrage is also examined.

Trade Model with Nontraded Sector: Economic Expansion and Immiserization

it has been demonstrated that growth can be immiserizing if terms of trade deteriorate sufficiently as a result of growth, or if domestic distortion(s) exists, given the world terms of trade. Professor Bhagwatil [1] deals with the first case of immiserization-the case of welfare loss due to growth-induced deterioration in the terms of trade offsetting the gain due to growth per se. Professor Johnson [6] discusses the second case of immiserization caused by tariff distortion affecting the relatively faster growing sector. In Johnsons treatment, if the domestic economy is tariff-ridden in the pre-growth situation and the same tariff prevails in the post-growth condition resulting in a more rapid expansion of the importable sector, non-inferiority of both goods (in consumption) would reduce welfare in the post-growth situation. Bhagwati and others2 have provided additional examples of distortions which can make growth immiserizing, and finally Professor Bhagwati [4] enunciates the (common) sufficient condition for immiserizing growth in different possible situations. He points out that if suboptimal conditions such as monopoly power in trade or nonoptimal price distortions, e.g., import tariff or wage differential between different domestic sectors exist and if they are not optimally corrected in the post-growth situation, then growth can be damnifying. As previously noted, all these results have been derived within the 2 x 2 framework. But usually countries produce a large number of so-called nontraded goods, and hence their exclusion seems to reduce the generality of

Exchange rate uncertainty and recent U.S. export demand instability

The purpose of this article is to examine the stability property of the estimated export demand equation and also the empirical importance of exchange rate uncertainty on the demand for exports. The paper studies the export demand function for the United States using data provided by Moreno (1991). It concludes that his export demand equation is inherently unstable. The article then suggests an alternative export demand specification.

Risk-free profits with forward contracts in exchange rates and interest rates

The scope and extent of risk-free profits attainable by a rational investor within the framework of arbitrage in the foreign exchange market with the hedging instruments of forward contracts in both currency and interest rates are presented in terms of theory and evidence. Further, an attempt is made to generalize the basic results of the two-country two-subperiod structure to its n-country n-subperiod analogue via circular covered arbitrage.

The changing environment of international financial markets : issues and analysis

Preface - Notes on the Contributors - PART 1: INTRODUCTION - Introduction D.K.Ghosh & E.Ortiz - PART 2: EXCHANGE RATES MARKETS - Foreign Exchange Market Efficiency: A Look at London J.P.Lajaunie, B.L.McManis & A.Naka - Freedom of Free Floating Exchange Rate: Empirical Analysis of Currency Fluctuation Patterns M.A.Hashmi - PART 3: INTERNATIONAL INTEREST RATES - Statistical Analytical of Eurocurrency and Treasury Interest Rates from 1975 to 1991 C.Maxwell & L.Guin - A Cross-Country Comparison of Consumer Discount Rates W.V.Weber, J.K.William & M.J.Morey - Interest Rate Parity, Covered Interest Arbitrage and Speculation under Market Imperfection D.K.Ghosh - PART 4: BALANCE OF PAYMENTS AND INTERNATIONAL RESERVES - An Empirical Test on the Demand for International Reserves A.N.Islam, M.Khan & M.M.Islam - The United States Current Account Deficit and Net Capital Inflow E.Y.Lee & M.Szenberg - Balance of Payments Implications of the USSR for its Former Republics and the East European Countries M.R.Zaman - PART 5: FOREIGN DEBT AND COUNTRY RISK ANALYSIS - Foreign Exchange Dynamics, Debt, and the Peso Problem D.K.Ghosh - International Lending and Sovereign Debt in the Presence of Agency Costs: The Case of Mexico State University C.A.Erickson & E.Willman - A New Look at Country Risk Analysis: An Analytical Approach to Judgmental Risk Scoring R.S.Koundinya - Political Risk in Latin American Stock Markets: A Rational Expectations Approach B.Charmichael, J-C.Cosset & K.P.Fischer - PART 6: CAPITAL MARKETS - A Real Return Test of International Market Efficiency S.Khaksari & N.Seitz - Risk Management and Corporate Governance in Imperfect Capital Markets K.P.Fischer, E.Ortiz & A.P.Palasvirta - Structural Changes in the Korean Financial Market J.Poznanska - An Analysis of Equity Markets of Quotation Systems G.Duteil & A.Mulugetta - PART 7: TAXES, DISTORTIONS AND INTERNATIONAL BANKING - Economic Integration and Mexican Municipal Finances A.Cabello - Optimum Distortions in Closed and Open Economies: Some Aspects of the Theory of Second Best D.K.Ghosh & S.Ghosh - Socio-History of French Banks and Banking: Role Model for Global Banking I.Finel-Honigman - Offshore Banking Centers: Prospects and Issues E.N.Roussakis, K.Dandapani & A.J.Prakash - Index

New directions in finance

Meton Miller, University of Chicago, USA Keith Howe, DePaul University, USA K. Thomas Liaw, St. Johns University, USA Pradeep Jalan, University of Regina, Canada and Givanni Barone-Adesi, University of Alberta, Canada Helen Lange, Scott Armstrong and Li-Anne Woo, University of New South Wales, Australia Sarah J. Lane and Martha A. Schary, Boston University, USA Ki Han, Suffolk University, USA and David Suk, Rider College, USA Atreya Chakraborty and Christoper Baum, Boston College, USA Jinho Jeong, University of Otago, New Zealand and Thomas Noe, Georgia State University, USA Winston Koh, Swee-Sum Lee and K.C. Tsui, National University of Singapore Dev Prasad, University of Texas, USA Jahangir Sultan, Bentley College, USA, Ked Hogan, McGill University, USA and Ken Kroner, University of Arizona, USA Obiyathulla Bacha and Anne Fremault, Boston University, USA Scott Stewart, Fidelity Management Trust Company, USA Cheng-Few Lee and Peter Zhang, Rutgers University, USA Michael Moore, Queens University, Belfast J.T.J. Smit, Erasmus Universiteit, The Netherlands Gang Shyy and Min-Teh Yu, National Central University, Taiwan Meher Manzur, National University of Singapore

Optimum Choice of an MNC: Location and Investment

The existing literature is quite voluminous on how one country engages in trade relations with another country, how international trade is mutu ally gainful to each other, what factors determine trade structures, and so on. There has been a sub stantial exploration on different aspects of multina tional corporations engaged in production and transnational trade. Yet there exists an area which seems to have remained quite unexplored, and it is the question of optimum location of production of goods and services and the optimum marketable quantity of output and investment outlay. In this paper, we try to fill in this gap in the literature by way of determining optimum factory location for a multinational corporation (MNC) and ascertaining optimum investment outlay for such a firm. Consider an MNC that produces only one good (X) by employing two mobile factors, labor (L) and capital (K), which are available at geographic loca tions of A and B, respectively. Let the market for

Optimum Tariffs in a Multi-Commodity Framework

For an economy operating under perfectly competitive conditions with no distortions and externalities, it has been proved that free trade is the best policy. That means, marginal rate of substitution in consumption (MRS), marginal rate of domestic transformation (MRT) and marginal rate of foreign transformation (FRT) be all equal to each other under such economic environment. But, if market imperfections or distortions exist, then equality of MRS, MRT, and FRT does not necessarily ensure the optimum condition [5; 6]. This is indeed the essence of the Theory of Second Best [20]. For most political economies ideal conditions of perfect competition and total absence of externalities or distortions of any kind are hardly facts of economic reality [15]. Almost always these economies operate under exogenously imposed constraints and commitments of various kinds. Because of national and sometimes international pressures an open economy has to choose optimum policy in the presence of some unalterable price distortions. The major purpose of this paper is to determine the optimum in such a constrained framework.