Economics

What is the Currency Quotation Convention?

P/B

• P = Price Currency

• B = Base Currency

The base currency is always the currency that you get one of

*Think Personal Best

Formula for % Spread

(Offer - Bid) / Offer

What’s a Pip(s)

% Spread

What does interbank liquidity currency pair mean?

Major currency pairs have high liquidity and tight bid-offer spreads

What does interbank liquidity time of day means

Liquidity will depend on whether exchanges are open, and in turn mean larger spreads

What does interbank liquidity market volatility mean

High market volatility = larger spreads

How does transaction size affect the bid-offer spread

Larger the size, the larger the spread

How does the dealer-client relationship impact bid-offer spread

Better relationship, tigher spread

Do spreads widen or tighten with high volume of trading thinly traded currency

Widen the bid-offer spread

Does Selling Base mean Use Bid or Use Ask

Use Bid

Does Buying the Base mean Use Bid or Use Ask

Use Ask

How does currency conversion change with the addition of bid and ask, rather than just one for both?

You need to keep in mind you swap the base currency for the price currency now, so if you had:
AUD/USD
EUR/USD
And you wanted to get AUD/EUR, you would swap the AUD/USD bid for the EUR/USD ask

If the Forward Rate > Spot Rate, What is this called?

Forward Premium

If the Forward Rate < Spot Rate, What is this called?

Forward Discount

Formula for approximate covered interest parity form

F_f/d - S_f/d = S_f/d ((i_f - i_d)/(1 + i_d))

What is the formula for Mark-to-Market Value at time T

V_f(t) = (F(0,T) - F(t,T) / (1 + i_f (t / 360))

In what situation can we say that the Forward Rate Parity holds?

If the Expected Future Spot Rate is equal to the Forward Rate, E(S_f/d) = F_f/d

What does it mean if E(S_f/d) = F_f/d

Forward Rate Parity Holds True

In what circumstances does Uncovered Interest Rate Parity tend to hold?

Typically over very long periods of time, not over the short term

Why does uncovered interest parity fail in practice?

High-interest currencies do not reliably depreciate enough to offset higher yields. They sometimes depreciate less than expected or even appreciate, allowing carry trade returns.

Most likely, the reason uncovered interest rate parity doesn’t hold well in the short run is:

Lack of arbitrage enforcement

What is the Forward Rate Parity?

Forward Exchange Rate = Unbiased Predictor of future spot rates

In what situation is the forward rate an unbiased predictor of expected future spot rate?

If both covered and uncovered interest rate parity hold

What is another name for Purchasing Power Parity (PPP)

Law of one price

What is another name for the Law of One Price

Purchasing Power Parity (PPP)

What is Purchasing Power Parity/ Law of One Price

Identical goods should sell for the same price across different countries, when expressed in a common currency

What are the the two types of PPP

Absolute PPP vs Relative PPP

What is Absolute PPP?

Exchange rate between 2 countries equal the ratio of the countries price levels

• This rarely holds

• Assumes no transaction costs/ trade barriers/ frictions

What is Relative PPP?

Changes in exchange rate are proportional to the inflation rate differential between two countries over time (~holds over long term)

• Improvement on the Absolute PPP

What is the equilibrium exchange rate (formula) for Absolute PPP?

S_A/B = P_A/P_B

Where S_A/_B = Nominal Exchange Rate

What assumption is required for Absolute PPP?

Prices of goods, when adjusted for FX rates, are the same across countries

What is the formula for Relative PPP?

%ChangeS_A/B ~ inflation_A - inflation_B

Where %ChangeS_A/B is the % change in the exchange rate between currency A & B

What does the empirical evidence suggest about the relationship between changes of inflation and changes in exchange rates?

• Over short-term, no relationship

• Over long-term, appears to be a relationship

What is the problem with Absolute PPP?

It is overly simplistic, i.e. it doesn’t account for things like friction and therefore doesn’t commonly hold true

Formula for Nominal Rate

i = p + E(I)

Where: i = Nominal, p = Real, E(I) = Expected Inflation

Formula for Purchasing Power Parity (PPP):

P_f^x = S_f/d x P_d^x

Where:

P_f^x = Price of good x in foreign country

S_f/d = Exchange Rate

P_d^x = Price of good x in domestic country

Formula for Absolute Purchasing Power Parity (PPP):

P_f = S_f/d x P_d

Formula for Relative Purchasing Power Parity (PPP):

% Change S_f/d = I_f - I_d

Formula for Ex Ante Purchasing Power Parity (PPP):

% Change E(S_f/d) = E(I_f) - E(I_d)

Formula for Uncovered Interest Rate Parity:

% Change E(S_f/d) = i_f - i_d

Formula for International Fisher effect

i_f - i_d = E(I_f) - E(I_d)

What parity is required for real interest rates to maintain parity across countries?

The international Fisher effect holds

If Country A has inflation of 1.5% and Country B has inflation of 1%. Assuming uncovered interest rate parity and ex ante PPP both hold, how much will Country B’s currency change relative to Country A in one year

0.5% Appreciation

This is appreciation of B’s currency between it will take o.5% more of A to buy it

i.e. E(I_f - I_d)

What is the concept of a Carry Trade profit?

Concept is Arbitrage profits based on the follow:

• Borrow low yielding currency

• Exchange into high yielding

• Unwind the investment at t = 1

• Exchange the high yielding currency at t = 1

• Repay the low yielding loan

What condition is required for Carry Trade arbitrage profit?

Uncovered interest rate parity does not hold

When does a Carry Trade Arbitrage Profit?

Depreciation of the high-yielding currency < expected, or high-yielding currency appreciates

What is the risk with Carry Trade Arbitrage?

Adverse exchange rate movements occur

Two currencies with interest rate differential of 6%, higher rate currency appreciates by 3%, profit from a carry trade in these currencies:

6% + 3%

Because higher rate currency appreciates so you add the 3%

If a country is consistently Importing more than it’s exporting, what does it say about their domestic currency

Domestic Currency to Depreciate

If a country is consistently exporting more than it imports, what is likely to happen to the domestic currency?

Domestic Currency will Appreciate

What is the relationship between share prices and the exchange rate?

Generally uncorrelated

An emerging market country is experiencing an inflow of capital from developed countries, the most likely near-term result of the investment is:

• Currency Appreciation

• Lower Currency Risk Premiums (foreign investment signals confidence)

• Higher Inflationary Expectations (developed country capital boosted)

What does a high capital mobility economy mean?

Means that capital can move freely across boarders

What is the natural effect of Expansionary Fiscal policy with High Capital Mobility

Strengthening Domestic Currency

What is the natural effect of Restricting/ Contracting Fiscal policy with High Capital Mobility

Weakening Domestic Currency

What is an example of expansionary fiscal policy

• Increase Gov. Spending

• Decrease Taxes

What is an example of restrictive/ contractionary fiscal policy

• Decrease Gov. Spending

• Increase Taxes

What is the natural effect of Expansionary Monetary policy on the economy

Weaken the domestic currency

What is the natural effect of Restrictive/ Contractionary Monetary policy on the economy

Strengthen Domestic Currency

What is an example of restrictive/ contractionary Monetary policy

Increase of interest rates

What is an example of expansionary Monetary policy

Reduction of interest rates

Economy net affect: Expansionary Fiscal, Expansionary Monetary with High Capital Mobility

Indeterminate

Economy net affect: Expansionary Fiscal, Restrictive/ Contractionary Monetary with High Capital Mobility

Appreciation

Economy net affect: Expansionary Monetary, Restrictive/ Contractionary Fiscal with High Capital Mobility

Depreciation

Economy net affect: Restrictive/ Contractionary Monetary, Restrictive/ Contractionary Fiscal with High Capital Mobility

Indeterminate

What is the natural effect of Expansionary Fiscal policy with Low Capital Mobility

Weaken the domestic currency

What is the natural effect of Expansionary/ Restrictive Fiscal policy with Low Capital Mobility

Weaken the domestic currency

Economy net affect: Expansionary Fiscal, Expansionary Monetary with Low Capital Mobility

Depreciate

Economy net affect: Expansionary Fiscal, Restrictive/ Contractionary Monetary with Low Capital Mobility

Indeterminate

Economy net affect: Expansionary Monetary, Restrictive/ Contractionary Fiscal with Low Capital Mobility

Indeterminate

Economy net affect: Restrictive/ Contractionary Monetary, Restrictive/ Contractionary Fiscal with Low Capital Mobility

Appreciation

Does the Expansionary/Restrictive Monetary or Fiscal policy swap how it effects the domestic currency for low/ vs high?

The effect swaps for Fiscal, not Monetary

What is a ‘Pull’ factor?

Domestic attributes that make the economy attractive to international capital

• Internal Strengths

• Improvements in domestic currency

What are some examples of Pull Factors for Currency Inflows?

• Less Debt/inflation

• Less financial market regulation

• Lower capital mobility barriers

• Flexible exchange rates

• Privatization

What are ‘Push’ Factors

External factors originating from the global or international economics that push capital towards specific destinations

What are some examples of ‘Push’ factors?

• Low interest rates in developed countries

• Asset allocations factoring emerging market assets

Why is Less debt/inflation a pull factor?

A stable macroeconomic environment (less debt/inflation) is more appealing to investors

Why is less financial market regulation a pull factor?

Fewer restrictions makes it easier for investors to allocate funds

Why is lower capital mobility barriers a pull factor?

(Encourages foreign investment)

Why is flexible exchange rate a pull factor?

Allows markets to adjust naturally to economic shocks, reducing currency risk

Why is privatization a pull factor?

signals market orientated forms, attracting foreign capital

Why is low interest rates in developed countries a push factor?

When returns are low in developed countries, investors seek higher investment returns in emerging or developing countries

Why is asset allocations favouring emerging market assets a push factor?

Global Portfolio diversification pushes capital towards emerging economies for higher returns

To avoid hyperinflation and currency depreciation, an emerging market country with a fixed exchange rate and easy monetary policy would most likely

Buy its own currency in the open market

Why would lowering interest rates not help to avoid hyperinflation and currency depreciation in an emerging market country with a fixed exchange rate and easy monetary policy?

Because it would cause capital outflow and currency depreciation

What is a currency crisis?

Situation where a countries currency rapidly losses value

What is M2

Broad measure of a country’s money supply

What are Free reserves?

Represent the excess reserves banks hold beyond what is required

What movements of M2 to Banking Reserves would indicate an impending currency crisis?

An increasing M2 to reserves indicates heavy lending and potential inflation that could lead to a quickly depreciating currency

What does Low Investment lead to?

Low Capital Formation

What does Low capital formation lead to?

Lower GDP Growth

What does Lower GDP growth lead to?

Lower employment levels and income

What does lower income lead to?

lower savings

What does lower savings lead to?

Lower investment

What are the 5 things that limit economic growth?

• Low Investment

• Low Capital Formation

• Low GDP Growth

• Lower Income

• Lower Savings

What are the three roles financial intermediaries play in efficient capital allocation?

• Channelling Capital

• Creating Instruments

• Sharing Risks

What is the Channelling Capital role in efficient capital allocation?

Intermediaries move capital to investments with the highest risk-adjusted returns

What is the creating instruments role in efficient capital allocation?

Intermediaries create instruments to transfer risk, promote diversification, and enhance liquidity

What is the Sharing Risks role in efficient capital allocation?

Intermediaries break big projects into smaller risks that can be handled by cooperation among intermediaries

What do financial intermediaries generally achieve in their roles within an efficient capital allocation?

Ensure that the Financial system can support growth by optimising how resources are deployed across the county’s economy