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Concepts
Exchange rate

Description
Currency Exchange Rates : Understanding Equilibrium Value
Exchange rate : price of one currency in terms of another
Spot exchange rate : currency exchange rate for immediate deliery
Forward exchange rate : currency exchange rate for an exchange to be done in the future
Foreign exchange spread = offer (ask price) - bib price
- Dealer spread depends on :
+ spread in interbank market for the same currency pair
+ Size of the transacton : larger, liquidity-demanding transaction → larger spread
+ Relationship between the dealer and client
- Interbank spread depends on :
+ Currencies involved : higher volum currency pairs → lower spreads
+ Time of day : overlap time when both NY and London currency markets are open → most liquid me → narrower spread
+ Market volatility : Higher volatility → higher spread to compensate for increase risk of holding those currencies
Forward rate premium : Forward price > Spot price
Forward rate discount : Forward price < Spot price

𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑟𝑎𝑡𝑒 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 = 𝐹 − 𝑆
Cross rate

Cross rate : FX rate between 2 currencies calculated using their FX rate with a common third currency

Mark-to-market value of a forward Mark-to-market value : value of a forward currency contract prior to expiration (using 360 days per year)
contract
𝐹 − 𝐹 × 𝐶𝑜𝑛𝑡𝑟𝑎𝑐𝑡 𝑠𝑖𝑧𝑒
𝑉 =
𝑑𝑎𝑦𝑠
1 + 𝑟 × 360
Covered interest rate parity

Covered interest rate parity : forward rate premium / discount exactly offsets differences in interest rates → investor would earn same return in either currency

𝐹
𝑆

Uncovered interest rate parity

/

=

/

𝑑𝑎𝑦𝑠
1 + 𝑟 × 360
𝑑𝑎𝑦𝑠
1 + 𝑟 × 360

Uncovered interest parity : if forward contracts are not available / or CFs are restricted → expected change in FX rate = difference in interest rate

𝐸 %∆𝑆
Domestic / International Fisher
Relation

/

=𝑅 −𝑅

Domestic Fisher Relation

𝑅

=𝑅

+ 𝐸 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛

International Fisher Relation

𝑅
Purchasing power parity

−𝑅

= 𝐸 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛

− 𝐸 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛

Law of one price : identical goods should have same price in all locations
Absolute purchasing power parity : compare average price of a representative basket of consumption goods between countries

𝑆

/

=

𝐶𝑃𝐼
𝐶𝑃𝐼

Relative purchasing power parity : changes in FX rates should offset price effects of any inflation differential between 2 countries

%∆𝑆

/

= 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 − 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛

Ex-ante version of purchasing power parity : same as relative purchasing power, but uses expected inflation instead of actual inflation
Relationship between international
parity conditions

Exchange rate
Expectation /
Movement

Uncovered interest rate parity

Relative purchasing power parity
Forward rate
parity

Inflation rate
differential

Forward discount /
premium

International Fisher Relation

Covered interest rate parity

Forecast future spot FX rate

Forecast future spot rates using : ex-ante Purchasing Power Parity, uncovered interest rate parity , or forward rate
- PPP holds for long time horizons, but does not hold for short-term → FX rate fluctutate around its mean equilibrium value
International Fisher assumes all countries are equally risky → untrue

FX carry trade

FX carry trade : use funds borrowed in a lower yielding currency to invest in a higher yielding currency
- Funding currency : lower yielding currency
Risk of carry trade :
- Funding currency may appreciate significantly against the investment currency → reduce profit / loss
- Return distribution of carry trade is negative skewness and excess kurtosis → probability of large loss > normal distribu on

Interest rate
differential

Balance-of-payments

Balance-of-payment account : reflect all payments and liabilities to foreigners + paymens and liabilities received from foreigners
Current account = exchange of goods + exchange of services + exchange of investment income + unilateral transfers (gifts)
- Selling to foreigners > Buying from foreigners → current account surplus
- Selling to foreigners < Buying from foreigners → current account deficit
Financial acount (Capital account) = Debt + Equity investment
(*) Current account deficit → Financial account suplus
Current account surplus → Financial account deficit

Influence of Balance-of-payments
on exchange rates

Current account influences
1
...
The decrease in value of that
currency may restore the current account deficit, depending on :
- Initial deficit : larger initial deficit → larger deprecia on needed
- Influence of FX rates on domestic import and export prices : depreciated currency → increase cost of imported goods ; but some may not be passed on to consumers
- Price elasticity of demand of traded goods : price inelastic → no change in demand
2
...
Debt sustainability mechanism : current account deficit → capital account surplus through foreign debt → ques on the sustainabiity of debt repayment → deprecia on of borrower's
currency
Capital account influences
1
...
Higher relative real rate of return attract foreign capital
3
...

- Excessive consumption in domestic market fueled by credit

Potential effects of monetary and
fiscal policy on FX rates

Mundell-Fleming model : evaluate the impact of monetary / fiscal policies on interest rates and FX rates
- Assumptions : sufficient slack in the economy to handle changes in aggregate demand + ignore inflation
Flexible FX rate regimes : FX rates are determined by demand and supply of FX markets
1
...
Low capital mobility : due to restrict of capital flows
→ Impact of trade imbalance on FX rate > impact of interest rate on FX rate → Expansion monetary / fiscal policy → ↑ net imports → depreciate domes c currency
Fixed FX rate regimes : gov' fixes the FX rate to one major currency
Expansion monetary policy → deprecia on of domes c currency → Gov' purchases its own currency in FX market → apprecia on of domes c currency

Monetary approach to FX rate
determination

1
...
Dornbusch overshooting model :
- Assume price ares are sticky in short-term, and do not immediately reflect changes in monetary policy
- Expansion monetary policy → ↓ interest rates → domes c currency deprecia on > Purchasing power parity due to capital ou low
...
floating rate)
- Dramatically decline of official FX reserves
- Currency value rise above its historical mean
- Inflation increases
- Liberalised capital markets, that allow for free flow of capital
- Increase money supply relative to bank reserves
- Banking crises

Concepts

Description

Economic Growth and the Investment Decision
Factors that influence GDP growth 1
...
Financial markets and intermediaries : drive ecomonic growth by efficiently allocating resources
- Determine potential users of capital that have the best returns on risk-adjusted basis
- Financial instruments created by intermediaries → provide investors with liquidity and risk reduc on opportuni es
- Pool small savings to finance larger scales projects
- Financial sector intermediation may lead to reduce credit standards, increase leverage, increase risk but not economic growth
3
...
) → unacceptable risk to investors → reduce poten al economic growth
4
...
Tax and regulatory systems : lower tax and regulatory burdens → boost entrepreurial ac vity → increase overall level of produc vity → higher rate of economic growth
6
...
Economic growth
- Factors that affect economic growth : capital (K) ; Labor (L) ; Technology level (T)

𝑌 =𝑇×𝐾 ×𝐿
𝛼 𝑎𝑛𝑑 1 − 𝛼 = 𝑠ℎ𝑎𝑟𝑒 𝑜𝑓 𝑜𝑢𝑡𝑝𝑢𝑡 𝑎𝑙𝑙𝑜𝑐𝑎𝑡𝑒𝑑 𝑡𝑜 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐾 𝑎𝑛𝑑 𝐿𝑎𝑏𝑜𝑟 𝐿 − 𝛼 < 0
→ Constant returns to scale : Given a level of technology, increase all input by x% → increase output by x%
2
...
Technology
progress

→ 𝑂𝑢𝑡𝑝𝑢𝑡 𝑝𝑒𝑟 𝑤𝑜𝑟𝑘𝑒𝑟 = 𝑌⁄𝐿 = 𝑇 × 𝐾 × 𝐿

= 𝑇 × 𝐾 ⁄𝐿

- Assuming α constant → Increase produc vity due to : (1) increase capital per worker (K/L - Capital deepening) or technology (T - Technology progress)
- α < 1 → addi onal capital per worker has diminishing effect on produc vity
+ More developing market → Higher K/L ra o + Lower α → less increasing produc vity from capital deepening
In economic equilibrium : Marginal product of capital (MPK = α × Y/K) = Marginal cost of capital (r)
α × Y/K = r → α = r × K/Y
Capital deepening : movemen along productivity curve
- MPK < r → increase investment
= MPK = r → stop capital deepeing → no increase in produc vity
Technology progress : shifts the productivity curve upward → Increase produc vity @ all level of K/L
Labor productivity growth rate = Growth due to technological change + Growth due to capital deepening

Growth accounting relations

Growth accounting relations

∆𝑌⁄𝑌 = ∆𝑇⁄𝑇 + 𝛼 × ∆𝐾⁄𝐾 + 1 − 𝛼 × ∆𝐿⁄𝐿
Change in technology is not observable

𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 ∆𝐴⁄𝐴 = 𝐸𝑥 𝑎𝑛𝑡𝑒 ∆𝑌⁄𝑌 − [𝛼 × 𝐸𝑥 𝑎𝑛𝑡𝑒 ∆𝐾⁄𝐾 + 1 − 𝛼 × 𝐸𝑥 𝑎𝑛𝑡𝑒 ∆𝐿⁄𝐿]
Impact of natural resources on
economic growth

Natural resources : include renewable resources (timber) and non-renewable resources (oil & gas)
Limited natural resources do not constrain economic growth, since countries could access of resources via trade
Ownership of natural resources may inhibit growth, since :
- Economic focus on extract resources, rather than developing other industries
- Demand of resources increase → Currency appreciate → Reduce export

Labor supply factors and impact on Quantity of labor = Labor force × Avg
...
Demographics :
- Younger population → higher poten al growth
- Low / Declining fertility rates → Decline labor force → reduce growth
2
...
Immigration : potential sources of continued economic growth for developed countries as a solution for declining labor force
4
...
Human capital is knowldge and skills of individals
- Investment via education / work experience → increase produc vity and economic growth
- External spillover effect : Worker innovate → used by society to create greater efficiencies for the economy
2
...
Techological development : includes investment in both physical and human capital
- Developed countries rely on technological progress for growth → spend more on R&D
- Less developed countries ofte copy from developed countries → spend less on R&D
4
...
Countries can join the club by making
appropriate institutional changes
...
Information frictions : information is not equally available
2
...
Regulatory capture theory : regulatory will be influenced / controlled by the industry that is being regulated, since regulators often have experience in the industry → affect reglators'
ability to render impartial decision
2
...
Regulatory arbitrage : businesses shop for country tht allows specific behaviour than changing the behaviour
- To avoid regulaltory arbitrage → co-opera on at global level to achieve a cohensive regulatory framework

Tools of regulatory intervention

1
...
g
...
Restricting / Requiring certain activities : ban / require to perform certain activities
3
...
Regulaton of security markets : Ensure fairness and integrity of capital markets → protect investors, by :
- Disclosure requirements → provide transparency in financial markets → promote investor confidence
- Mitigate agency problem
- Focus on protecting small investors
2
...
Regulatory burden : cost of compliance for regulated entity
2
...
g

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