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86 Cards in this Set
- Front
- Back
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Exchange rate |
-price of one currency in exchange of another |
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Spread Quoted by the dealer depends on: |
1. spread in the interbank market for the same currency pair 2. Size of the transaction (more difficult to offset for larger) 3. relationship between the dealer and the client (and credit) |
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Interbank spread on currency pair depends on: |
1. Currencies involved (high vs. low volume) 2. Time of day (NY and London both open) 3. Market volatility (higher volatility means higher spreads) |
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Bid-Ask Spread |
-Buy the base currency at ask and sell the base currency at bid -Buy the price currency at bid and sell at ask -Up the bid and multiply, down the ask and divide |
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Cross rate |
-exchange rate between two currencies implied by their exchange rate with a common third |
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Triangular Arbitrage |
-two locations (interbank market and dealer) (buy at interbank and sell to dealer at higher price) -quoted rate does not equal calculated rate -construct a triangle where each node in the triangle represents one currency -check for arbitrage by going around the triangle clockwise |
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Covered Interest Rate Parity |
-any forward premium or discount exactly offsets differences in interest rates F = (1+ RA)/(1+Rb)*S0(A/B) |
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Uncovered Interest Rate Parity |
-in covered, arbitrage will force forward contract exchange rates to a level consistent with the difference between the two country's nominal interest rates -in uncovered, forward contract may not be available, relationship may not hold, not bound by arbitrage -if forward rate equal to expected future spot rate, forward rate is an unbiased predictor -use NOMINAL rates E (dS(A/B)) = RA - RB |
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International Fischer Relation |
Rnominal = Rreal + E(inflation) RAnominal - RBnominal = RAreal - RBreal + EA (inflation)- EB(inflation) -equality: with free cash flows, funds will move to countries with a higher rate until real rates are equalized -uncovered interest rate parity and purchasing power parity must hold (real yields between countries will be identical) |
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Absolute Purchasing Power Parity |
-compares the average price of a representative basket of goods between countries S(A/B) = CPI(A)/CPI(B) **but weights of various goods between the two countries may not be the same |
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Relative Purchasing Power Parity |
-changes in exchange rates should exactly offset the price effects of any inflation differential -better for long run, not short run -%change in S(A/B) = inflation A - inflation B |
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ex-ante Purchasing power parity |
-same except uses expected inflation instead of actual inflation |
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Real Exchange Rate |
=S(A/B) * (CPI(B))/(CPI(A)) |
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Equilibrium Real Exchange Rate |
-if relative PPP holds at any time the real exchange rate would be constant -(however) seldom holds over short term |
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Balance of Payments Accounting |
-used to keep track of payments between country and international -government transactions, consumer, business current account + financial account + official reserve account = 0 |
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current account |
-measures the exchange of goods, services, investment income, unilateral transfers (gifts) -whether we are selling more goods and services to the rest of the world than we are buying from them -if country runs surplus, currency appreciates, |
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financial account |
-flow of funds for debt and equity investments -fluctuates around long-term PPP |
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Official reserve |
-made from reserves of official monetary organization of country -does not usually change a lot from year to year |
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Current Account Influences |
1. Flow Mechanism 2. Portfolio Composition Mechanism 3. Debt Sustainability Mechanism |
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Flow Mechanism |
-current account deficit increase the supply of currency -puts downward pressure on the exchange value -decrease in value may restore deficit to balance depending on: 1. initial deficit 2. influence of exchange rate on domestic import and export prices 3. Price elasticity of demand of the traded goods (if important imports are price inelastic, quantity imported will not change) |
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Portfolio Composition Mechanism |
-investor countries may decide to rebalance portfolio, may have significant impact on value of investee currency |
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Debt Sustainability Mechanism |
-country running a current account deficit may be running capital account surplus by borrowing from abroad -if too high, investors may question sustainability |
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Capital Account Influences |
-major determinant of exchange rates -capital flows into a country, demand for that country's currency increases, appreciation X/Y would decrease when iXreal > iYreal |
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Excessive capital inflows into EM pose: |
1. excessive real appreciation of currency 2. FA or RE bubble 3. increases in external debt by business or government 4. excessive consumption in domestic market fueled by credit |
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Fluctuations around equilibrium exchange rate |
real exchange rate (A/B) = Equilibrium exchange rate (A/B) +(real I B - real I A) -(risk B - risk A) |
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Taylor Rule |
-links central bank's policy rate to economic conditions, can be used to forecast exchange rates + related to real interest rate, inflation gap, output gap -related risk premium real exchange rate (A/B) = Equilibrium exchange rate (A/B) +Dif in neutral real policy interest rate (B-A) +alpha * (dif in inflation gap (B-A) + Beta * (dif in output gap (B-A) -(risk B - risk A) inflation/output gap = current - target |
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Assessing long-term equilibrium rate chage |
1. Macroeconomic Balance Approach 2. External Sustainability 3. Reduced form econometric model |
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Macroeconomic Balance Approach |
-how much current exchange rates will have to adjust to equalize a country's expected current account imbalance |
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External Sustainability Approach |
-how much current exchange rates will have to adjust to force a country's external debt relative to GDP -high external debt generally preceded by excessive capital inflows |
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Reduce-Form Econometric Model Approach |
-estimates equilibrium path of exchange rate movements based on patterns in key macro variables |
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FX Carry Trade |
-invest in a higher yielding currency using funds borrowed in a lower yielding currency -if uncovered interest rate breaks down -return = interest earned on investment - funding cost - change in exchange rate |
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Risks of the Carry trade |
1. uncovered interest rate parity must not hold 2. return distribution not normal, excessive negative skewness, excess kurtosis (high prob of large loss) |
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Risk Management in Carry Trade |
in the INVESTMENT currency 1. Volatility Filter (close over a certain threashold) 2. Valuation Filter (valuation band to over or underweight on currency) (use PPP benchmarks) |
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Mundell-Fleming Model |
-assume inflation plays no role in exchange rate determination -evaluates impact of monetary and fiscal policy on interest rates, exchange rates |
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Flexible Exchange Rate Regime |
-rates determined by supply and demand in foreign exchange markets |
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High Capital Mobility |
-expansionary monetary and expansionary fiscal policy have opposite effects on exchange rate EXPANSIONARY MONETARY -reduce interest rate, reduce inflow of capital investment, reduces demand for domestic currency, depreciation (weaken the dollar) EXPANSIONARY FISCAL -increase government borrowing, increase interest rate, increase foreign investment, increase demand for currency |
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Low Capital Mobility |
-impact of trade imbalance more important than impact of interest rates EXPANSIONARY MONETARY AND FISCAL -both expansionary speads up economy and leads to increase in net imports, trade defecit, and depreciation |
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Fixed Exchange Rate Regime |
-fixes exchange rate relative to major currency -expansionary monetary policy would lead to depreciation, govt would have to purchase its own currency in foreign market -expansionary fiscal -->appreciation of currency, gov't would sell own currency to keep exchange rates stable |
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Pure Monetary Models |
-PPP holds, output constant -expansionary monetary or fiscal -->increase in prices, decrease in value of currency |
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Dornbusch Overshooting Model |
-prices sticky in the short term so they do not immediately reflect changes in monetary policy -expansionary monetary policy --> prices increase over time --> decrease in real interest rates --> decrease of capital inflow -->depreciation of deomestic currency SHORT TERM depreciation of currency is greater than depreciation implied by PPP LONG TERM exchange rates gradually increase toward PPP implied value |
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Portfolio Balance Model (asset market) |
-focuses on long-term implications of sustained fiscal policy -investor evaluates expansionary policy on risk and return -at some point though, investors will stop buying bonds -->currency depreciation -MEANING large levels of debt lead to currency depreciation in the long run |
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Objectives of Capital Controls |
1. ensure dom. currency does not appreciate excessively 2. pursuit of independent monetary policy, w/o being hindered by impact on currency 3. Reduce excessive inflow of foreign capital |
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Effectiveness of Intervention and Capital Controls |
INTERVENTION DEVELOPED COUNTRIES -relatively ineffective due to volume EMERGING -more mixed CAPITAL CONTROLS -depends on persistance and size of capital flows |
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Warnings of Currency Crisis |
1. Terms of trade deteriorate 2. FX reserves dramatically decline 3. real exchange higher than mean 4. inflation increases 5. Equity experiences a boom-bust 6. Money supply vs. bank reserve increase 7. Nominal private credit grows |
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Preconditions for growth |
1. Savings and Investment 2. Financial Markets and Intermediaries 3. Political stability, rule of low, property rights 4. Investing in human capital 5. Tax and regulatory systems 6. Free trade and unrestricted capital flow |
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Relationship b/w Stock Market and GDP |
dPrice = dGDP + d(E/GDP) + d(P/E) d(e/GDP) over long run is 0 |
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Cobb-Douglas production function |
Y = TK^(alpha)*L(1-alpha) Y=Output K=Capital L = Labor T = level of tech alpha = share of output allocated to capital Constant returns to scale (increasing all inputs by a percentage leads to same percentage increase) Diminishing marginal productivity of capital |
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Capital Deepening |
Increases in output by increase capital per worker, alpha less than one, additional capital has a diminishing affect -Countries with higher alpha will have more benefit from capital deepening |
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Marginal Product of Capital in Steady State Equilibrium |
additional output for one additional unit of capital -equal to the marginal cost of capital r = alpha*(Y/K) |
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Marginal Productivity of Capital |
increase in output per worker for one additional unit of capital per labor |
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Growth Rate of Potential GDP (dY/Y) (Solow Growth Accounting Equation) |
dY/Y = dT/T + alpha*dK/K + (1-alpha)*dL/L =long-term growth rate of tech (dA/A) +alpha*lt growth of capital (dK/K) +(1-alpha)* lt growth of labor (dL/L) OR =lt growth rate of labor force + lt growth rate of labor productivity |
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Labor Supply Factors |
1. Demographics 2. Labor Force participation 3. Immigration 4. Average hours worked |
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Human Capital |
-knowledge and skills people posses |
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Classical Growth Theory |
-in lt, population growth increases when increases in capita above subsistence due to increase in cap or tech-->increased immigration -once population booms, productivity decreases and GDP growth decreases -long-term growth is 0 |
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Neoclassical Growth Theory |
-estimating economy's long-term steady state growth -equilibrium when output to capita is constant -lack of explanation of technology -capital deepening affects level of output but not growth rate in LT -growth rate will move towards steady state -MPK constant, marginal productivity declining |
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Sustainable growth rate of output per capital |
g=theta/(1-alpha) theta = tech growth |
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Sustainable growth rate of output |
G=theta/(1-alpha) + dL |
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Endogenous Growth Theory |
-tech growth from investment in human and physical capital -enhances productivity, can permanantly increase growth rate -no steady state growth rate, increased investment can permanently increase growth rate |
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Absolute Convergence |
-less developed countries will achieve equal living standards over time -all convergence theories introduced by neoclassical |
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Conditional Convergence |
-convergence for countries with same savings rate, growth rate, and production function |
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club convergence |
-poorer countries that are apart of the "club" will grow faster to catch up to peers |
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Benefits of Free flow |
1. Increased investment from foreign savings 2. Focus on industries with comparative adv. 3. Increase markets for domestic products 4. Increase sharing of tech and productivity 5. Increase competition --> failure of inefficient firms |
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Informational Frictions |
information is not equally available or distributed |
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Externalities |
-costs or benefits that affect a part that do not choose to incur |
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Regulatory Capture Theory |
-regulatory body will be influenced or even controlled by the industry it is regulating |
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Regulatory Competition |
-regulators compete to provide business friendly environment |
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Regulatory Arbitrage |
-business shop for a country that allows a specific behavior rather than changing the behavior |
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Three Regulatory Tools |
1. Price Mechanisms (taxes/subsidies) 2. Restricting/Requiring certain activities 3. Provisions of public good/financing |
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Prudential Supervision |
-monitoring and regulating of financial institutions to reduce system wide risks and protect financial investors -failure or institution can have a far reaching impact |
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Regulatory Burden |
-cost of compliance for the regulated entity |
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Net Regulatory Burden |
-Regulatory burden - private benefits of regulation |
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Sunset Clause |
-requires regulators to visit cost benefit analysis |
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Real Interest Rate Parity |
-both uncovered and relative PPP hold |
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Monetary Approach of Exchange Rate Determination |
-aggregate demand is fixed and monetary policy affects exchange rate through inflation APPROACHES 1. Pure Monetary 2. Dornbusch Overshooting |
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Physical (ICT vs. non-ICT) |
ICT -externalities in developed countries NON-ICT -less of an impact on GDP |
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Labor Productivity Curve |
Y/L = T * (K/L)^alpha alpha = total factor cost (output allocated to capital and labor) T = Total Factor Productivity (Technology) X axis is K/L Think of the production function! Think of where you are on the curve as who will benefit most from capital deepening |
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Valuing a Currency Forward after initiation |
1. Calculate initial Forward 2. Calculate new Spot Price 3. Spot - Forward 4. Discount 3 back using denomination of nominal |
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Appreciate vs. Depreciate |
-use uncovered interest rate parity -if spot rate X/Y, determining if Y will appreciate vs. depreciate relative to X -if RX > RY, dX/Y > 0, Y appreciates relative to X |
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Trend following trading tools |
(such as moving average crossover trading rules or filters) -implemented in combination with FX carry trade to reduce downside risk by avoiding extreme contrarian positions - |
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FX Dealer Order Books |
-volume and price data not immediately available to all parties (unlike equity market) -may have predictive value for exchange rates |
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Currency Options Market |
-implied volatitility estimates from foreign exchange options can give insight into market expectations for up or down of value of currency |
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How to compute FX Carry Trade |
1. Funding currency has the lower interest rate, investment currency higher interest rate 2. Start with $ of funding currency, exchange to investment currency, and grow per the interest rate 3. Change ending investment currency back to funding currency 4. return = (Fund(End) - interest rate(Fund) - Fund (Beg)/Fund Beg |
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What drives short term appreciation and depreciation of currency? |
=real interest rate - risk premium |
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statutue |
-written and passed by legislative body |
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Covered Interest Arbitrage |
1. Find the effective rate = rate*(forward/spot) 2. Borrow in the lower of the effective rate, invest in the higher of the effective rate 3. Find the amount to be paid back on the loan for the borrowed, convert back 4. Invested - amount paid back in the profit |
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GDP Growth Accounting Equation |
dGDP = dLabor + dLaborproductivity |
