ECON3331 Final Exam Notes PDF

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ECON3331 Final Exam Notes Chapter 7 – Prices The law of one price- competitive market tendencies, does not guarantee one price in two locations, competition reduces price dispersion Purchasing power parity – when converted into a common currency by the exchange rate, money wages are identical in both locations (international competition flattens the wages) Purchasing power of the money wages are identical, differences in money wages do not translate into differences in material well being Exchange rate is not a good conversion factor for real income comparisons, true conversion factor is one that sets money wages equal when converted into a common currency Assumes that the exchange rate is not a good conversion factor for real income comparisons Fluctuations in the exchange rate exaggerate the true fluctuations in income differences across countries by wide margin Changes in relative money supplies and incomes in Canada and the US cannot account for large fluctuations in the exchange rate The growth rate of PPP can be approximated by home & foreign inflation differentials (based on changes in CPI) – Equation 7.1 Prices of bonds – spot transaction concludes with an immediate exchange, bond transaction concludes with promise to make a future payment – uncertainty leads to question of how to price risk Interest Parity Condition – perfect foresight Under interest parity condition, we would expect the yield differentials to be roughly identical to actual percentage changes in exchange rates, IPC gives wrong signal about direction of change, when yield differential favors USD denominated bonds, USD ends up appreciating rather than depreciating. Uncovered interest parity condition – uncertainty No longer possible to motivate or derive the IPC through an arbitrage-based argument because there is a holding period (fluctuations in the value of the exchange rate lead to unpredictable capital gains or losses) Risk needs to be priced, no longer straightforward relation between the home & foreign interest rate differentials & expected change in exchange rate Under perfect capital mobility & risk neutrality (trader indifferent between holding home & foreign currency denominated bonds when equation 7.2 holds) Rational expectations Currency carry trade: predictability - Borrowing in low interest rate currency & lending in high interest rate currency

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International commercial or investment bank borrows in the interbank market in low yielding currency, then converts the funds into a currency with a high lending (interest) rate & lends in that currency – at maturity it converts the principle & interest back to initial currency borrowed Based on belief that an interest rate differential between two currencies will not be matched by capital losses or gains arising from movements in the exchange rate Carry trade is motivated by belief that there is a predictable risk premium o Trader may believe that the central bank would not allow a large depreciation of home currency, prevent capital loss by exceeding the return differential (dirty float) o Home currency bonds are riskier than foreign currency bonds, but some traders willingly undercut this risk premium (aggressive return chasing), ex. Asian currency trade – collapsed during the speculative attack against the East Asian currencies

The Forward Bias: variable predictability Under capital mobility & rational expectations, the forward rate appears to be best unbiased estimate of the future spot rate Forward bias is related to predictability of risk premium in currency carry trades - In low volatility episode, high yielding currency tends to appreciate (predictable positive risk premium) - In high volatility episode, low yielding currency tends to appreciate by more than what is implied by the IPC (large negative returns) Chapter 8 – Fixed Exchange Rate Concepts of policymaker objectives: Public or policy preferences: stabilization (autonomous MP), trade (exchange rate stability), capital mobility, economic inequality Constraints (country characteristics): commodity trade, size, politics, labour mobility Policy instruments: fixed, float, fixed & capital controls Under a Peg: - Tendency for home currency to appreciate below the target, then CB would buy foreign currency in return for home currency – as monetary base increases, home currency becomes abundant, as a result traders revise beliefs upward towards target rate - Tendency for currency to depreciate above target, then central bank would buy home currency and sell foreign currency (becoming relatively scarce), traders revise belief downward toward target rate o Must have enough foreign currency reserves to sell otherwise traders in absence of counterparty that challenges & revises their beliefs would trade at a rate that is different from the target Central bank no longer has full discretion concerning composition of its assets

Credible peg – no difference between the current and future exchange rate, home interest rate has natural anchor (interest rate of the target currency) Model with Fixed (Exogenous) Income – modified for credible peg - Foreign reserves (CB can produce infinite amount of local currency, cannot legally produce foreign currency) - Goods market clearing condition depends on interest rate and not real interest rate - Peg requires home money supply to be equal to sum of 2 terms in equation 8.1, therefore no longer under control of CB, must be consistent with peg and foreign variables Model with Endogenous Income IS relation upward sloping, IPC consistent with credible peg. When peg is credible, no long have downward sloping interest parity condition, exchange rate is equal to future exchange rate only when the home interest rate is equal to the foreign interest rate Consequences of an unanticipated change in the home money supply (endogenous under peg) – consider change in the home currency denominated bonds held by a central bank Open Market Purchase (Increase in home money supply & monetary base) consequences for the bond market - Increase in the price of home currency denominated bonds, decline in domestic interest rate due to additional demand by CB and the investors who hold additional home currency (violates credible peg) - Absence of any adjustment in exchange rate, no investor would buy existing home currency denominated bonds at high price (lower yield relative to foreign currency denominated bonds), no new bonds can be issued -- additional currency in circulation can only be converted into foreign currency denominated bonds, additional demand for foreign currency can only be met if CB sells foreign exchange reserves - Sale identical in value (in home currency units) to original value of open market purchases, during sale excess demand for home currency denominated bonds falls, home interest rate rises - Attempt to change money supply through open market purchase completely undone by arbitraging of home & foreign yield differentials - IS-LM – IS does not change, LM relation shifts (impulse) right, leads to reduction in interest rate (temporary equilibrium) – under float this would lead to depreciation of home currency – not consistent with credible peg (would lead to capital flight out of domestic economy, & reduction in MB) Impact of changes in fiscal policy variables – in open economy IS-LM model with perfect capital mobility, fiscal policy is more effective in influencing real income under a fixed regime than under a float Relative effectiveness of open market operations – monetary policy less effective in influence real income under a fixed exchange rate regime

Causes for Collapse of Peg (1) lack of credibility & commitment to peg due to incompatible monetary policy objectives ex. Recession & a desire to stabilize might result in purchases by the CB of public sector debt or private sector assets at above market prices (quantitative easing), monetization of government deficits o Initial expansion of money supply through purchases of home currency denominated government bonds, as a result MB expands o Liabilities: home currency in circulation, or deposits of financial institutions/CB increase – temporarily pushes domestic yield below the foreign yield – tendency for domestic currency to depreciate o CB sells foreign reserves, reducing domestic currency in circulation o End result: reduction in foreign exchange reserves, increase in domestic currency assets of equal amounts o Persistent policy of monetization leads to devaluation (2) overvalued exchange rate leading to incompatible monetary policy & economic policy objectives o In absence of policy coordination between the home & foreign countries, monetary policy cannot stabilize employment & output o Sustained increase in the monetary base and home credit through large capital inflows generate home and foreign inflation differentials – financial investors easily move portfolios across borders, represents sizeable inflow of foreign capital relative to existing domestic wealth in that market o Lower lending rates may lead to speculative investments in housing, land, stocks o Overvalued exchange rate due to rising goods & asset prices o CB manages risk of capital inflows & outflows through sterilization (3) self-fulfilling expectations o Shifts in investor sentiments, expectations of depreciation of exchange rate creating interest rate differential that triggers massive capital flight Short-selling in Currency Markets Speculators borrow currency that they think will devalue (borrowing a security is short-selling) Chapter 9 – Floating Exchange Rate

Chapter 11 – Risk and Insurance Limitations of IS-LM model – highly aggregated framework Risk-sharing – agents have more predictable consumption stream – can be achieved through financial markets Financial intermediation over time – steady consumption – agents whose current resources are in excess of their current needs can be matched by those whose resources are short of their current needs (debt instruments), maintains confidence & liquidity in markets Demand for risk sharing & consumption smoothing – generates real resource flows recorded in national balance sheet (current account), generates exchange of financial claims where changes in one country’s current assets are matched by another country’s current liabilities (net financial assets) A) Intertemporal decision making (no uncertainty) B) Decision making under uncertainty (no intertemporal dimension) C) Intertemporal decision making under uncertainty Two functions of financial contracts: 1) Reallocate resources over time through lending & borrowing 2) Fulfill desire to trade risks across agents Driven by desire to smooth the marginal utility of consumption over time Individual actions/decisions determine state-dependent utility levels – decision making under uncertainty concerns the optimal choice of the probability distribution over state-contingent utilities. Uncertainty at individual level Volatility – standard deviation of historic returns – wealth, characteristics & attitude towards risk Risk measures the impact of a probability of a loss on well-being (utility or monetary terms) Expected returns determine total utility Proportion of assets in the optimal portfolio, depends on covariance structure of asset returns (correlation of expected returns) Mean-variance efficient portfolio – covariance is particular measure of asset-specific risk in the context of pricing individual assets, mean-variance investor concerned about individual assets only to extent that volatility of an individual asset affects the volatility of portfolio Demand side of Assets Demand for financial assets reflected in price of assets, high demand receives a high price & low return

Capital Asset Pricing Model Primary objective of financial investors is to reduce fluctuations in wealth, portfolio with distinct assets has smaller variance than individual assets included in portfolio (asset-specific variances) Covariance of individual returns – asset whose returns correlate little with the portfolio helps smooth fluctuations in wealth, asset whose return is highly correlated with broad portfolio does not help to smooth fluctuations – preference for low wealth volatility Assets highly correlated with portfolio face relatively low demand & higher returns (low prices) Asset with low beta tends to have high covariance with the portfolio & commands a high return relative to the portfolio (provides insurance against large fluctuations in wealth) CAPM – investors are assumed to hold a diversified portfolio - risk of a market portfolio is defined as it’s variance – factors that influence the variance of the stock will not directly affect asset prices - Risk is not independent of preferences - Pooling eliminates asset-specific risk (variance) – sufficient diversification can reduce asset-specific risk – portfolio is left with systemic (aggregate/market) risk that cannot be diversified away - Two-fund separation theorem – individuals with different attitude toward risk differ solely by weights assigned to risk free asset & the portfolio in their total wealth (not composition of portfolio) - Allocation of wealth between risky portfolio and risk free asset – all risk-averse investors in this model hold the same diversified portfolio – only differ in terms of allocation of wealth between risky and risk free assets International CAPM Takes exchange rate risk into account – if PPP holds (no capital gains & losses due to price movements), then PPP covers exchange rate risk (takes supply of assets as given) - If PPP does not hold continuously, ICAPM has to account for exchange rate risk which is defined with respect to the home currency as base – risk premium is the covariance of the spot exchange rate movements with the price movements in the world portfolio (holdings of other currencies & currency contracts – short positions on the currency futures and forwards as hedges - Currency hedge ratio = domestic currency vale of foreign securities/forward currency contracts - If currency hedge ratio < 1, not all foreign exchange risk is hedged into the future markets - Stock market correlations across major markets are almost identical for hedged and unhedged returns (impact of exchange rate fluctuations on domestic stock market returns is low)

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Returns in domestic currency terms on foreign bonds tend to be highly correlated, currency hedge matters for bond market – correlations driven by: o The relation between the interest rates and exchange rates (uncovered IPC) o In short run, currency risk tends to be larger than the risk (in local currency) of corresponding bond market Risk pooling & risk sharing CAPM not informative about supply of risky assets – once pooled across individuals, risky assets cancel each other out – social mechanism component (1) Complete financial markets – market in which individuals can insure against all future contingencies (2) No aggregate uncertainty Two-state country endowment model – no aggregate uncertainty In absence of trade with another country, Country H cannot reallocate its resources from state 1 to state 2 (Figure 11.3) Each country faces uncertainty about its income, regardless of the state, aggregate endowment in the global economy is constant Both countries allocate their resources to maximize their expected utility Allocation of consumption across countries – centralized allocation (social planner allocates based on social welfare function), decentralized allocation (allowing agents to interact through competitive markets) Decentralized allocation using complete financial markets – state contingent claims are traded - Each claim gives the buyer the right to receive one unit of the consumption good in one of the two states, & seller obligation to deliver one unit of consumption good - Claims have prices that are determined endogenously by the agents’ preferences & incomes along with likelihood of states - Forces that determine supply and demand of contingent claims o H has comparative advantage in state 1, willing to sell a contract which would deliver 1 unit in state 1, F has comparative advantage in state 2, willing to sell contract which would deliver 1 unit in state 2 o Since both countries prefer to smooth their marginal utility of consumption across states there would be demand for such contracts o H would buy from F contracts that would deliver the consumption good in state 2, F would buy contracts from H that would deliver the consumption good in state 1 – financial market is complete (number of distinct claims = number of states) Determining prices of contingent claims contracts & competitive consumption allocations - Specify budget constraints and global feasibility contracts (11.4) - Consumption in each state must be equal to state-dependent endowment plus deliveries made or received through contingent contracts - Global consumption must be equal to global endowment - General equilibrium in the net supply of each state-contingent contract must be 0

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Aggregate value of state-contingent contracts is 0 and these contracts do not generate additional wealth for the aggregate economy - Optimize competitive allocations using budget constraints, substitute out consumption allocations & restate the maximization problem - When a small open economy faces actuarially fair price of contingent claims in world markets, in absence of global uncertainty it would fully insure against fluctuations in its consumption across states – international financial markets help pool & share risks Implications of aggregate uncertainty for consumption allocations and relative prices Aggregate uncertainty – consumption ratios across two distinct states would be a constant across agents but different from 1 – relative prices would deviate from pure actuarially fair prices – accounts for fact that the relative scarcity of the consumption good depends on the state as well as its likelihood Price of claim that promises a delivery in state with relatively low aggregate income would command a relatively higher price – marginal utility of consumption high – claims that deliver in low aggregate consumption states would be priced higher relative to their actuarially fair price International portfolio diversification – significant home bias in financial portfolios - International diversification in equity and bond markets yield higher returns at lower risk, one may consider holding shares in multinational corporations traded in domestic markets – does not yield same level of diversification as holding an internationally diversified portfolio because stocks are highly correlated with domestic factors - Stock market returns are more heavily influenced by domestic factors such as monetary policy changes than international factors such as exchange rate movements (weakly correlated, exchange rates do not provide a sufficient hedge against domestic market factors) Chapter 12 – Intertemporal Consumption Smoothing Consumption smoothing over time through savings and investment in productive assets or through asset trade Through financial intermediation agents can secure steady consumption without sacrificing current consumption through savings -- asset trade solves mismatch problem Two-period model Economy starts first period with initial assets, which earn interest income (liabilities result in interest payments) – for open economy these assets correspond to net foreign assets, individual also receives income in each period Changes in net foreign assets or current account reflect savings decisions Preferences – in each period individual derives utility from stream of consumption & maximizes the lifetime utility function

Lending and borrowing take place at the same world interest rate, households can borrow fully against their future earnings – perfect capital markets assumption Consumption and saving decisions are intertemporal Optimal consumption depends on lifetime resources, each period consumption can be thought of being financed by resources that resemble and annuity payment out of the present discounted value of lifetime wealth (permanent income) The desire to equate marginal utility of consumption over time determines the consumption smoothing motive for saving When desired consumption is no...