Economics for CFA PDF

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Economics SS4: Currency Exchange Rates Exchange Rate  Price of one currency in term of another 1.4126 USD/EUR = 1euro = 1.4126$. EUR is the “Base Currency” & $ is the “Quote Currency” Spot Exchange Rate  Currency exchange rate for immediate delivery (2 days after trade) Forward Exchange Rate  Currency exchange rate for an exchange to be done in the future Forward Contract  Agreement to exchange a specific amount of one currency for a specific amount of another currency on a future date specified. Value is 0 at initiation. Dealer often include both “Bid” & “Offer” rates. For example, the euro could be quoted as $1.4124 – 1.4128. The Bid Price (1.4124) is the price at which the dealer will buy euros & the Offer (or Ask) Price (1.4128) is the price at which the dealer will sell it. Spread  Difference between the Bid price & the Offer (or Ask) price. It is the dealer profit. The Spread quoted by the dealer depends on:  The spread in the interbank market for the same currency pair  The size of the transaction (large size -> higher spread)  The relationship between the dealer & the client  Spread in Forward contract increase with maturity (because they are less liquid) The Interbank Spread on a currency pair depends on:  Currencies involved  Time of day (When both the NYC & London currency market are open -> Most liquid)  Market Volatility (Higher Volatility leads to higher spread) Ex: USD / AUD bid & ask quote of 1.0508 – 1.0510  Investors can buy AUD from the dealer at USD 1.0510 & Investors can sell AUD to the dealer at USD 1.0508 Investors always take a loss due to Spread. The rule is buy the currency at ask & sell the base currency at bid. In the Price Currency we do the opposite. The rule is “Buy the price currency at bid & sell the price currency at ask” TIPS: AUD / GBP => Pour convertir de AUD à GBP on va du numérateur au dénominateur, on descend donc on divise A l’inverse, pour convertir en GBP on va du dénominateur au numérateur, on monte donc on multiplie. Cross Rate  Exchange rate between 2 currencies implied their exchange rates with a common 3rd currency. You have to use it when there is no active foreign exchange market. Ex: USD / AUD = 0.60 & MXN / USD = 10.70. What is the cross rate MXN / AUD?

Cross Rates with Bid-Ask Spreads: To compute the cross rate for A/C given A/B & B/C:

To obtain C/B bid & offer rate given A/B & C/B:

In order to know if an investor should borrow or lend a domestic or Foreign currency: 1) Forward / Spot 2) (1 + Rlocal) / (1 + Rforeign) 3) On compare les deux  Si F/S > Etape 2 -> Borrow Domestic -> Funds will flow out the domestic country  Si F/S < Etape 2 -> Borrow Foreign

Triangular Arbitrage: Il y a quasiment toujours un “Arbitrage” quand on demande s’il y en a Ex: USD/AUD = 0.6000 – 0.6015 & USD/MXN = 0.0933 – 0.935 1) Compute the Implied MXN/AUD cross rate 2) If your dealer also quotes MXN/AUD = 6.3000 – 6.3025, is an arbitrage profit possible? If so compute the arbitrage profit in USD if you start with USD 1 million. Arbitrage Triangulaire: “Up to the Bid” multiplication “Down to the Ask”  Diviser A partir du tableau devises!

Forward Premium  When the forward price is > than the spot price Forward Discount  When the forward price is < than the spot price Forward Premium (Discount) of the base currency = Forward Price – Spot Price

Ex Spot & Forward: Given the following quoted for AUD/CAD, compute the bid & offer rate for a 30-day forward contract. Maturity Rate Spot 1.0511 – 1.0519 30-day +3.9 / + 4.1 90-day +15.6 / +52.3 Answer: 30-Day Bid = 1.0511 + (3.9 / 10 000) = 1.05149 30-Day Offer = 1.0519 + (4.1 / 10 000) + 1.05231 The 30-day all-in forward quote for AUD/CAD is 1.05149 / 1.05231 Mark-to-Market Value: **** Mark-to-Market Value  Forward currency contract prior to expiration. MMV =

FP = Tx Enoncé FPt = Tx. T-t (tps restant)

Where: Vt = Value of the Forward contract at time t FPt = Forward price at time t in the market for a new contract maturing at time T FP = Forward price specified in the contract at inception Days = Number of days remaining until maturity of the FP R = Interest rate of price currency

Covered & Uncovered Interest Rate Parity: **** Covered Interest Rate Parity  When a forward premium or discount exactly offsets differences in interest rates. An investor would earn the same return investing in either currency. Given A/B quote structure:

Uncovered Interest rate Parity  Expected spot rate should be equal to the current forward rate. It is NOT bound by arbitrage. Given a quote structure of A/B, the base currency (B) is expected to appreciate by approximately RA – RB. When RA – RB is negative, currency B is expected to depreciate Higher Nominal interest rates -> Currency depreciation Ex:

Covered Interest Parity Derives the No-Arbitrage Forward rate Holds by Arbitrage

Uncovered Interest Parity Derives the Expected future Spot rate Investor is Risk-Neutral Not in Short-run but Long-run

Domestic Fisher Relation  The Nominal rate of return is the sum of the real rate & the expected rate of inflation Nominal Rate = Rreal + Expected inflation International Fisher Relation  Under real interest rate parity, real interest rates are assumed to converge across different market. Rnominal A – Rnominal B = Expected InflationA - Expected InflationB The argument for the equality of real interest rates across countries is based on the idea that with free capital flows, funds will move to the country with a higher real rate until real rates are equalized. Purchasing Power Parity & Relative Purchasing Power Parity: **** Law of 1 price  Identical goods should have the same price in all locations. The potential for arbitrage is the basis for the law of one price (on va acheter là ou c’est le - cher pour revendre là où c’est le + cher) Absolute Purchasing Power Parity (PPP)  Compare the average price of a representative basket of consumption goods between countries. It requires only that the law of 1 price be correct on average. Foreign price in domestic currency = Domestic country’s price currency Relative Purchasing Power Parity  Changes in exchange rates should exactly offset the price effects of any inflation differential between the 2 countries. Spot x ((Infla A – Infla B) x Spot)  Implied Forward according to Relative PPP Relative PPP is based on the idea that even absolute PPP does not hold, there may still be a relationship between changes in the exchanges rate & differences between the inflation rates of the 2 countries. Higher expected inflation -> Depreciation of the currency Violation of the Relative PPP is common in the short run. But it remains useful for estimating the relationship between exchange rates & inflation rates. Ex-Ante Version of PPP  Same as Relative PPP except that it uses the “Expected Inflation” instead of Actual inflation. Observations can be made from the relationship among the various parity conditions: - Covered interest parity holds by arbitrage -> if forward rate parity holds, uncovered interest rate parity also holds - Interest rate differential should mirror inflation differentials (thanks to Fisher R.) - If ex-ante version of relative PPP & International Fisher holds -> Uncovered interest rate parity will also hold.

The International Parity Relationship Combined:

4 Practical implications from this:  The real, risk free return will be the same in all countries  Investing in countries with high nominal interest rate will not generate excess return  All investors will earn the same expected return in their own currency  Exchange risk is simply inflation

Future Spot Rates can be forecast with PPP, uncovered interest rate parity or forward rates The real exchange rate fluctuates around its mean-reverting equilibrium value. Unbiased Predictor  When the Forward rate = The expected future Spot rate Forward Rate Parity  When Forward rate = Expected Spot Rate = Unbiased Predictor FX Carry Trade & Risks: FX Carry Trade  When an investor invests in higher yielding currency using funds borrowed in a lower yielding currency. The lower yielding currency is called the “Funding Currency” ( Look at to the 1-year %) Return = Interest Earned on Investment – Funding Cost – Currency Depreciation It attempts to capture an interest rate differential & it is a bet against Uncovered interest rate parity (Expected Spot R = Current Forward R). It performs during low-volatility periods The risk is that the funding currency may appreciate significantly against the currency of the investment which would reduce the trader’s profit. The return distribution of the Carry Trade is Not Normal & characterized by a Negative Skewness & Excess Kurtosis (Fat Tails). Large loss is higher than the probability implied under a Normal Distribution which is called “Crash Risk”. How Flows in the Balance of Payment account affect Currency Exchange Rates: Balance of Payments  Accounting method used to keep track of transactions between a country & its international trading partners. Its reflects all payments & liabilities to foreigners and payments & obligations received from foreigners. Current Account  Measures the exchange of goods, the exchange of services, the exchange of investment income & unilateral transfers -> Who is buying / selling more ? Financial Account (or Capital Account)  Measures the flow of funds for debt & equity investment into & out of the country.

Current Account Influences: C.A deficits lead to a depreciation of Domestic currency via:  Flow Supply / Demand Mechanism: the decrease in the value of the currency may restore the Current Amount deficit to a balance depending on the following factors: - The initial deficit (larger the initial deficit, larger the depreciation of domestic) - The influence of exchange rates on domestic import & export prices - Price elasticity of demand of the traded goods  Portfolio Balance Mechanism: countries with Current Account surpluses usually have Capital Account deficits  Debt Sustainability Mechanism: a country running a Current Account deficit may be running a Capital Account surplus by borrowing from abroad. Capital Account Flows are one of the major determinants of exchange rates. As capital flows into a country, demand for that country’s currency increases, resulting in appreciation. Differences in Real Rates of Return tend to be a major determinant of the flow of capital: higher relative real rates of return attract foreign capital. Excessive Capital Inflow into emerging markets create problems for those countries:    

Excessive Real appreciation of the Domestic currency Financial Asset &/or Real estate bubbles Increases in external debt by businesses or government Excessive consumption in the domestic market funded by credit

Emerging markets can counteract excessive capital flows by imposing capital control or by direct intervention in the foreign exchange markets. Mundell-Fleming Model  Evaluates the impact of Monetary & Fiscal policies on interest rates & consequently on exchange rates. Focuses on the short term implication of Fiscal Policy. Expansionary Fiscal Policy -> + Currency in Short Term & - in Long run Theory: There is sufficient slack (= relais) in the economy to handle changes in aggregate demand & that inflation is not a concern. Flexible Exchange Rate Regimes  Rates are determined by supply & demand in the foreign exchange markets. Monetary Policy / Fiscal Policy

Capital Mobility High

Expansionary / Expansionary Expansionary / Restrictive Restrictive / Expansionary Restrictive / Restrictive

Uncertain Depreciation Appreciation Uncertain

Low Depreciation Uncertain Uncertain Appreciation

Under a Fixed Exchange rate regime, the government fixes the rate of exchange of its currency relative to one of the major currencies. In order to launch an expansionary policy, the government would have to purchase its own currency in the foreign market.

Monetary Approach to Exchange Rate Determination: 2 Main approaches 1) Pure Monetary Model: The PPP holds at any point in time & output is held constant. An expansionary monetary or fiscal policy leads to an increase in prices & a decrease in the value of the domestic currency. An X% increase in the money supply leads to an X% increase in price levels & X% depreciation of domestic currency. It does not take into account expectations about futures monetary expansions or contractions. However, the future growth rate in money supply affects the trajectory of FX rates but not the current exchange rate! 2) Dornbush Overshooting Model: Assumes that prices are sticky in the Short Term & do not immediately reflect changes in monetary policy. Exchange rates will overshoot the long-run PPP value in the short term. In the long-term, exchange rates gradually increase toward their PPP implied values. Portfolio Balance Approach  Focuses only on the effects of Fiscal Policy. It takes a Longterm view & evaluate the effects of a sustained fiscal deficit or surplus on currency values. Investors evaluate the debt based on expected risk & return. Combining the Mundell-Fleming & Portfolio balance approaches, in the short-term, with free capital flows, an Expansionary Policy leads to Domestic Currency Appreciation. In the long-term, the government has to reverse course leading to depreciation of the domestic currency. If the government does not reverse course, it will have to monetize its debt. Pull Factors are favourable developments that make a country an attractive destination for foreign capital. Push Factors are driven by mobile international capital seeking high returns from a diversified portfolio. Policymakers may intervene by imposing capital controls Objectives of Capital controls or Central bank intervention in FX markets are to:  Ensure that the Domestic currency does not appreciate excessively  Allow the pursuit of independent Monetary policies without being hindered by their impact on currency values  Reduce the Aggregate volume of inflow of foreign capital In Developed market countries, central banks are ineffective at intervening because the volume of trading in a country’s currency is very large relative to the foreign exchange of its central banks. Conditions identifies as warning signs to a Currency crisis:        

Terms of trade deteriorate (ratio of export to imports) Fixed exchanged rates (vs. floating exchanges rates) Official foreign exchange reserves dramatically decline Currency value that has risen above its historical mean Inflation increases (CB will sell domestic securities to - inflation) Liberalized capital markets that allow the Free flow of capital Money supply relative to bank reserves increases Banking Crises

Taylor Rule  A higher output gap would translate into higher real interest rates leading to appreciation of the local currency.

Economic Growth & The Investment Decision: Preconditions for growth:  Savings & Investments are positively correlated with economic development  Financial Markets & intermediaries augment economic growth by efficiently allocating resources. Financial sector intermediation may lead to increase risk but not economic growth  The political stability, rule of law & property right environment of a country influence economic growth  Investment in Human Capital Countries that invest in educations & health care systems tend to have higher growth rates.  Tax & Regulatory Systems need to be favourable for economic development  Free Trade & Unrestricted Capital Flows are related to economic growth Equity prices are positively related to earnings growth. The potential GDP of a country (the upper limit of real growth for an economy) is an important factor in predicting returns on aggregate equity markets. Positive Growth in potential GDP indicates that future income will rise relative to current income. When consumers expect their incomes to rise, they increase current consumptions & save less for futures consumptions. Higher potential GDP Growth  Higher Real Interest R In the Short Term, the relationship between actual GDP & potential GDP may provide insight to both equity & fixed income investors as to the state of the economy. When actual GDP growth rate is higher than potential GDP growth rate, concerns about inflation increase & the Central bank is more likely to follow a restrictive monetary policy. It is more likely for a government to run a fiscal deficit when actual GDP growth rate is lower than its potential growth rate. Growth in GDP may be used to gauge credit risk of both corporate & government debts. A higher potential GDP growth rate reduces expected credit risk & increases the credit quality of all debt issues. Cobb-Douglas Production Function  Examine the effect of capital investment on economic growth & labor productivity. GDP is a function of Labor & K inputs & their productivity. )

Y = TKL(1- 

 = The share output allocated to K & Labor T = A Scale factor that represent the technological progress of the economy, often referred to as total factor productivity

 It exhibits constant returns to scale, increasing all inputs by a fixed percentage leads to the same percentage increase in output.  If  < 1, additional K has a diminishing effect on productivity Developed Markets have a high Capital-to-Labor ratio & a lower  compared to developing markets. Developed markets stand to gain less in increased productivity from K deepening. In Steady (equilibrium) state, the marginal product of capital & marginal cost of capital are equal.   = RK / Y. Rental Price of Capital  R = Y / K

Capital deepening is a movement along the Productivity curve. The curvature of the relationship derives from the diminishing marginal productivity of capital (MPK). Economies will increase investment in capital as long as MPK > r. Technological progress shifts the productivity curve upward & will lead to increased productivity at all levels of capital per workers. Labor Productivity Growth Rate = Growth due to Technical change + Growth due to Capital deepening Capital deepening in developing countries can lead to at least increase in productivity Steady Growth rate = (Growth rate of TFP / Labor Cost in TFP) + Labor Force growth Solow’s Gross Accounting Relation = Y/Y = T/T +  x (K/K) + (1-) x (L/L) where: Y= Output, T= Technology, L=Labor, K= Capital, = Elasticity of output with respect to K & (1-) = elasticity of output with respect to labor. TFP = Labor Productivity Growth – Growth in K deepening Other approach to forecasting potential GDP growth is the Labor Productivity growth accounting method which focuses on changes in labor as follows: Growth rate in Potential GDP = LT growth rate of Labor force + LT growth rate in labor prod LT growth rate in labor prod reflects both capital deepening & technological progress Dutch disease  Situation where global demand for a country’s natural resources drives up the country currency values, making all exports more expensive & rendering other domestic industries uncompetitive in the global markets. Quantity of Labor = Sized of Labor x Average hours worked Labor Force  Number of working age (ages 16-64) people available to work, both employed & unemployed. Labor supply factors are:  Demographics  Labor force Participation (proportion of working age population in the labor force) = Labor Force / Working Age population  Immigration  Average hours worked Human Capital  Knowledge & skills individuals possess. It is a Qualitative measure of the labor force & may have external spillover effects as knowledge workers innovate. Physical Capital  Separated into infrastructure, computers & telecommunications capital & non capital. Strong correlation between investment in physical K & GDP growth rate. Technological Development  Investment in technology includes investment in both physical & human capital

Classical Growth Theory  In the long-term population growth increases whenever there are increases in per capita income above subsistence level due to an increase in K or Te...