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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, 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 Repression 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 Asset 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 Asset 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 Asset 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 Multi-Period Consumption-Based Capital Asset Pricing Model 142
3.6.1 Example: Pricing Exports 144
3.6.2 Example: The Multi-Agent Consumption-Based Capital Asset Pricing
Model 145
3.6.3 Example: Portfolio Investment 146
3.6.4 The Capital Asset Pricing Model as a Special Case of the ConsumptionBased Capital Asset Pricing Model 149
3.6.5 Foreign Exchange Rates, Bonds, and Equity 149
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
xiv Contents
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 Sustainability 182
4.5.3 Government Bonds and 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
Contents x
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