CFA L2 Econ Flashcards
Exchange rate
The price of units of one currency in terms of another.
- Base currency is the first currency
- Price currency is what the base currency is in terms of
- Ex: 1.25 USD/EURO— $ = price currency and Euros = base currency
- 1 euro costs 1.25 USD.
Spot exchange rate
The currency exchange rate for immediate delivery (in most currencies this is two days after the trade)
Forward exchange rate
A currency exchange, agreed upon now, to be done in the future.
Pips
This is how we quote the spread. When we calculate the bid-ask spread, sometimes the spread is very small, so the pips is the spread times ten thousand.
Ex: .0025 = 25 pips
Interbank market
A wholesale market for currencies where large bank dealers are trading their currencies. This is where dealers manage their foreign currency inventories.
The spread (difference between ask price and bid price) quoted by a dealer in a spot market depends on:
- The spread in an interbank market for the same currency pair (a.k.a liquidity): the spread is more narrow in more liquid markets.
- The size of the transaction: larger transactions generally get quoted a larger spread.
- The relationship between the dealer and the client.
The interbank spread on a currency in a spot market depends on:
- Currencies involved: Currency pairs that are frequently traded command lower spreads than those seldom traded.
- Time of day: liquidity. There are three primary currency exchanges: London, NYC, and Tokyo. Because of time zone differences, these 3 markets are not all open at the same times but there are overlaps. When overlaps occur, there is high liquidity which causes the spread to narrow.
- Market volatility: the risk the dealer takes by keeping the currency in inventory. The higher the volatility, the higher the spread the dealer will demand.
Up-the-bid & down-the-ask rule:
If we have a bid price and offer (ask) price, then to turn the base currency into price currency we use the bid price * amount of the price currency we are trading it for. Oppositely, it we want to turn the price currency into the base currency, we divide the amount of price currency we have by the ask price.
Ex 1: USD: Euro → bid price = 1.1401 ; ask price = 1.1403. If we have $100 and want to convert it to euros, since USD is the price currency we take 100 ÷ 1.1403 = €87.70.
Ex 2: USD: Euro → bid price = 1.1401 ; ask price = 1.1403. If we have €100 and want to convert it to USD, since € is the base currency we take €100 * 1.1401 = $114.01
True or false: Investors buy the base currency from the dealer at the ask price and sell the base currency to the dealer at the bid price?
TRUE
True or false: Investors buy the price currency from the dealer at the ask price and sell the price currency to the dealer at the bid price?
False, investors buy the price currency from the dealer at the bid price and sell the price currency to the dealer at the ask price.
Cross rate
The exchange rate between two currencies that are both valued against a third currency. We must use cross rates when there is no active foreign exchange (FX) market in the currency pair we are considering. Usually the USD or € is the third currency.
Ex: USD/AUD = 0.60 and MXN/USD = 10.70. What is MXN/AUD?→ USD/AUD = MXN/USD → The USDs cancel each other out, so MXN/AUD = 0.60 * 10.70 = 6.42.
Ex: 2 USD/GBP= 1.56 and CHF/USD=1.4860. What is GBP/CHF?→ USD/GBP = CHF/USD. The USDs cancel out, so CHF/GBP = 1.56 * 1.486 = 2.31816. To transform this into GBP/CHF, take the reciprocal = 1 ÷ 2.31816 = 0.4314
Cross rates with bid-ask quotes:
USD/AUD= 0.6000 - 0.6015 ; USD/MXN= 0.0933 - 0.0935
Compute: MXN/AUD
MXN/AUD → first, we must convert either of the two cross rates above so that USD cancels out, it doesn’t matter which bid-offer quote we choose → (1 ÷ 0.0935) = 10.70 = (MXN/USD)bid OR (1 ÷ 0.0933)= 10.72 = (MXN/USD)offer →(USD/AUD) = (MXN/USD)bid → USDs cancel out → 10.70 * 0.6000 = 6.4200 = MXN/AUD(bid) OR 0.6015 * 10.72 = 6.4481 = MXN/AUD(offer)
True or false: Real-world currency dealers will maintain bid-ask spreads that ensure the dealer makes a profit?
True. If not, the customers could earn profits through triangular arbitrage.
Exam questions surrounding arbitrage revolve around three things:
- Verify the arbitrage (does an opportunity exist meaning quoted rate ≠ calculated rate.
- Structure the trades to exploit the opportunity (most questions deal with this
- Calculate the profit given an initial investment
Triangular arbitrage
A discrepancy between three foreign currencies that occurs when the currency’s exchange rates do not exactly match up. These opportunities are rare, and traders who take advantage of them usually have advanced computer equipment and/or programs to automate the process.
Bid too high, Ask too low, Out of business, sure to go! Recall, bid price is the price the dealer pays. This is how investors can make profit.
When is the dealer bidding too high and asking too low?
Bid too high: Bid price > cross ask price
Ask too low: Ask price < cross bid price
Triangular arbitrage example
Dealer quote: MXN/AUD = 6.3000 / 6.3025 ; (MXN/USD)bid = 6.4200 & MXN/USD(offer) = 6.4481
Question: Structure a profitable arbitrage trade
Dealer bid < CA → No violation
Dealer ask < CB → VIOLATION. Now we have to check if arbitrage profit is possible…
True or false: When calculating profit from a triangle, we can earn an arbitrage profit in both directions (clockwise and counter-clockwise)?
False, we can NEVER earn a profit in both directions.
Forward premium vs forward discount
Forward premium= When the forward price of the second currency > the spot price. We expect the base currency to appreciate against the price currency. Thus, we expect the price currency to depreciate against the base currency.
Forward discount= When the forward price of the second currency < the spot price. We expect the base currency to depreciate against the price currency and the price currency to appreciate against the base currency. Specifying forward premium/discount ALWAYS means the base currency is trading at a premium/discount
Calculation: F - S0
Ex: Forward price = 1.25$/€ and spot price= 1.20$/€. 1.25-1.20= .05 forward premium.
How to calculate the bid, offer, and all-in forward rates for a 30-day forward contract given spot rates and 30-day forward rates?
Given: Spot rate= 1.0511/1.0519 ; 30-day forward rate= +3.9/+4.1
30-day forward rate bid= 1.0511 + 3.9 ÷ 10,000= 1.05149
30-day forward rate ask= 1.0519 + 4.1 ÷ 10,000= 1.05231
30-day all-in forward quote= 1.05149/1.05231
True or false: If the forward contract price is consistent with interest rate parity, the value of the contract at initiation ≠ 0. After initiation, the value of the forward contract = 0.
False, if the forward contract price is consistent with interest rate parity, the value of the contract AT initiation = 0. After initiation, the value of the forward contract ≠ 0.
Mark-to-market value example- given:
contract size= $1MM
contract-specified forward rate= 1.05358
Spot rate= 1.0612/1.0614
30-day forward rate= +4.9/+5.2
60-day forward rate= +8.6/+9.0
90-day forward rate= +14.6/+16.8
Interest rates:
30-day= 1.12%
60-day= 1.16%
90-day= 1.20%
What is MTM value 30 days after initiation for a 90 day contract?
Forward bid price for a new contract expiring in 90 (contract length) - 30 (days passed)= 1.0612 + (8.6 ÷ 10,000)= 1.06206
Vt= [ (1.06206 - 1.05358) * 1MM ] ÷ [ 1 + .0116(60 ÷ 360) ] = 8,463.64 → This is how much the contract has gained in value since the inception of the contract. BE SURE TO USE PRICE CURRENCY INTEREST RATE
Covered interest rate parity
This theory is saying that forward discounts will offset any differences in interest rates so that the forward rate and the spot rate are in equilibrium
Big point 1: The currency w/ the higher nominal int. rate will trade at a forward discount.
Big point 2: When covered int. rate parity holds, an investor will make the same return holding either currency.
Ex: If the USD rate is 8% and the euro is 6%, the USD will trade at approximately a 2% relative discount to the euro.
- Under this condition, an investor would earn the same return investing in either currency (a.k.a arbitrage does not exist)
Covered interest rate parity requirement
F = ( [ 1 + Ra(days ÷ 360)] ÷ [1 + Rb(days ÷ 360) ] ) * S0
* F= Foward rate of A/B
* Ra= Interest rate for country A
* Rb= Interest rate for country B
* days= # of days in the forward contract
- If you are given USD/EUR, USD should be Ra and EUR should be Rb.
Forward premium/discount calculation
F - S0
OR
[ (1 + Ra(days ÷ 360)) ÷ (1 + Rb(days ÷ 360)) ] * S0
OR
S0 * [ (days ÷ 360) ÷ (1 + Rb(days ÷ 360)) ] * (Ra - Rb)
Covered interest rate parity requirement example, given:
1-year USD interest rate= 8%
1-year EURO interest rate= 6%
Current spot rate for USD/Euro = $1.30
Quoted 1-year forward USD/Euro price= $1.35
Calculate the correct 1 year forward rate. Describe the correct arbitrage trade. Calculate arbitrage profits.
- [ (1+.08(360 ÷ 360)) ÷ (1+ .06(360 ÷ 360)) ] = $1.3245 → $1.3245 < $1.35, so Euro (BASE) is overvalued in the forward market. The 1-year forward rate should be $1.3245.
- Sell the Euro in the forward market and buy Euro in the spot market. If the Euro was undervalued (#1 < $1.35), we would buy it in the forward market and sell it in the spot market.
- Borrow $1,000 at 8% interest (repay $1,080 in one year). Convert the $1,000 into Euros for €769.23. Then, invest in euros (€815.38 or $1,100.76 in one year). Profit of $1,100.76 - $1,080= $20.76
Uncovered interest rate parity
In a case where forward currency contracts are not available arbitrage is available, we refer to the unconvered interest rate parity theory. W/ this theory, if one currency trades higher to another currency, the higher currency will be expected to depreciate over time so that the spot rate and the expected future spot rates (NOT the forward rate) are in equilibrium.
Calculation= Ra - Rb
OR
relative PPP + international fisher effect
Ex: Country A interest rates = 9%, country B interest rates = 4%. The uncovered interest rate parity says that an investor should be indifferent between investing in the currencies because county A is expected to decrease at 5% annually relative to country B.
- Assumes the investor is risk neutral.
- Often DOES NOT hold in the short-run but DOES hold in the long-run.
- Uncovered interest rate parities DOES NOT assume arbitrage-free.
Forward rate parity
When the forward rate = expected future spot rate. When this happens we say the forward rate is an unbiased predictor of the future spot rate. With forward rate parity, uncovered and covered interest rate parity are both true. Form: F = E(S1)
Real interest rate parity
Real interest rates are assumed to converge across different markets. The idea is based on the idea that with countries with free capital flows, funds will move to the country with a higher real rate until real rates are equal.
International Fisher relation (IFR)
Says that the difference between two countries’ nominal interest rates should be equal to the difference between their expected inflation rates.
Form: RnomA - RnomB = E(inflationA) - E(inflationB)
- Assumes real interest rate parity.
- Assumes all countries are perceived to be equally risky by investors. This is untrue since investors demand a higher real rate of return on emerging market currencies.
Law of one price
States that identical goods should be the same price in all locations after adjusting for the exchange rate. Does not hold due to the effects of tariffs, transportation costs, etc.
Absolute purchasing power parity (absolute PPP)
Since the law of one price often does not hold due to tariffs, transaction costs, etc., absolute PPP compares the avg. price of a basket of consumption goods between countries using an index such as CPI. Absolute PPP requires only that the law of one price be correct on average.
- Absolute PPP does not hold because the weights of the various goods might not be the same in two economies.
- Absolute purchasing power parity is not used to predict exchange rates.
Relative purchasing power parity (relative PPP)
An economic theory that states that exchange rates will change to reflect differences in inflation between countries.
Ex: If country A has a 6% inflation rate and country B has a 4% inflation rate, then country A’s currency should depreciate by 2% relative to country B’s currency.
Equation: % change in S = Inflation(A) - Inflation(B)S = spot price.
- This is similar to unconvered int. rate parity, however instead of int. rates, this deals w/ exchange rates.
- Since there is no true arbitrage available to force relative PPP to hold, relative PPP is commonly violated in the short-run and medium-run.
- Evidence suggests that relative PPP is useful for estimating the relationship between exchange rates and inflation in the long-run.
Ex-Ante version of PPP
Same as relative PPP but uses expected inflation instead of actual inflation.
Equation: E % change in S = Inflation(A) - Inflation(B)
* E= expected
True or false: Countries with higher relative inflation expect to see their currencies depreciate?
TRUE
Which economic theories can we use to forecast future spot rates?
- Ex-ante PPP: seldom works over short and medium terms. Holds well over long-term.
- Uncovered interest rate parity: seldom works over short and medium terms.
- Forward rates.
True or false: Forward exchange rates are often good predictors of future spot rates?
False, since forward rate parity only holds if there covered and uncovered interest rate parties hold, and since uncovered interest rate parity is often violated, forward exchange rates are often poor predictors.
How to forecast future spot exchange rates if all international parity conditions hold?
Expected change in spot rates = Nominal yield spread + Difference in expected national exchange rates + forward premium/discount
- In this model, there are no excess returns
- Since there is high volatility in exchange rates in the short-term, it’s hard to predict future spot rates accurately.
True or false: Combining all parities indicates that expected returns on risk-free securities should be different in risk-seeking countries and exchange rate risk is really just inflation risk.
False, combining all parities indicates that expected returns on risk-free securities should be the same in all countries and exchange rate risk is really just inflation risk.
What are the four practical implications of combining all parities?
- The real, risk-free return will be the same in all countries.
- Investing in countries with high nominal interest rates will not generate excess returns because the high nominal interest rates will be accompanied by local currency depreciation.
- Exchange rate risk is simply inflation risk, so investors interested in real returns will not face exchange rate risk.
- All investors will earn the same expected return in their own currency on any investment denominated in a foreign currency.
Relationships among the various parity conditions:
- If forward rate parity holds, uncovered int. rate parity also holds and vice versa.
- If ex-ante relative PPP and the IFR both holds, uncovered int. rate parity will also hold.
- Forward rates are unbiased predictors of future spot rates if covered and uncovered int. rate parities hold.
FX carry trade
An investor invests in a higher yielding currency using funds borrowed in the lower yielding currency (a.k.a the funding currency). The carry trade is premised on uncovered interest rate parity not holding.
Return calculation= interest earned on investment - funding cost - currency depreciation
- This is not an arbitrage trade. This is a leveraged trade. This is betting against interest rate parity.
- Carry trades typically perform well during low volatility periods.
- Carry trades have a non-normal distribution.
- These distributions are negatively skewed with positive excess kurtosis (fatter tails).
Risks of carry trade
- If the funding currency appreciates significantly against the currency of the investment.
- Crash risk
Crash risk
Probability of a large loss on a carry trade. Stems from other investors having the same idea of a carry trade, thus the demand for the investment currency goes up and therefore the value goes up. However, this creates the risk that all these investors will try to sell at the same time leading to a steep decline in the investment currency.
Balance of Payments (BOP)
The method by which countries measure all of the international monetary transactions within a certain period. This includes government transactions, consumer transactions, and business transactions. BOP accounts include all payments/liabilities to foreigners and payments/obligations from foreigners.
(X - IM) = S + I + (T - G)
- Comprised of current account, capital account, and a financial account
Current account
Summarizes whether a country is selling more goods/services to the rest of the world (current account surplus) or whether they are buying more of them (current account deficit).
* Exchange of goods/services
* Exchange of investment income
* Unilateral transfers (one-way transfer of assets (ex: money received from those working abroad))
How do interest rates affect the current and capital accounts.
It is unclear. This is because high interest rates tend to decrease consumer spending, which leads to less imports being purchased because people will save more (increase the current account) but higher rates will also increase the exchange rate and therefore make exports more expensive (decrease the current account). The impact to the current account depends on which of these affects is more powerful. The three mechanisms decide which of the effect is most powerful.
What mechanisms cause current account deficits to lead to a depreciation of the domestic currency or current account surpluses to lead to appreciation in the domestic currency.
- Flow supply/demand mechanism: Looks at imports/exports in the current account. When imports > exports, there is a currency deficit which results in lack of demand for the currency- currency depreciation. This is dependent on the initial deficit, the influence of exchange rates on prices, and price elasticity of demand.
- Portfolio balance mechanism: When a country has a current account surplus, it usually has a capital account deficit in the form of investments into other countries with current account deficits. When these investor countries rebalance their portfolios, it can have a negative impact on the value of the currencies of the countries invested in.
- Debt sustainability mechanism: When a country runs a current account deficit it may have a capital account surplus by borrowing from abroad. Once the country takes on too much debt, it can lead to a confidence erosion from investors which can lead to rapid depreciation of the borrower’s currency.
What does flow mechanism depend on?
- The initial deficit: The larger the initial deficit, the larger the depreciation of the domestic currency is needed in order to restore the current account balance.
- The influence of the exchange rate on prices of traded goods that are imported/exported: As a country’s currency depreciates, the cost of imports increases.
- Price elasticity of demand: For inelastic goods, imports consumed will remain stable.
True or false: Eventually, a current account deficit will cause a nation’s currency to appreciate?
False, eventually a current account deficit will lead to currency depreciation.
Capital account
Measures the flow of funds for debt and equity investment into and out of the country. Comprised of:
* capital transfers (financial assets that migrants bring when they come to a country, debt forgiveness)
* sales and purchases of non-financial assets (copyrights, franchises, etc.)
What influences capital account flows?
- Higher REAL interest rate countries attract capital flow which leads to currency appreciation.
- Excessive capital flows can lead to excessive appreciation and can be problematic.
True or false: Current accounts have a more immediate impact on exchange rates than capital accounts?
False, capital accounts have a more immediate effect on exchange rates than current accounts.
True or false: When a country experiences a current account deficit, its currency must apreciate?
False, when a country experiences a current account deficit it must generate a capital account surplus or it will have to see its currency depreciate.
Mundell-Fleming model
Evaluates the short-term impact of monetary and fiscal policy on interest rates and thus exchange rates.
- Assumes inflation is not a concern.
- Assumes changes in demand are not a concern.
Implications of Mundell-Fleming model for fixed exchange rate regimes:
Recall, under a fixed exchange rate regime, a currency is fixed relative to another major currency. Expansionary monetary policy (in an economy w/ high capital mobility) leads to depreciation of the domestic currency under a fixed rate regime. The government would have to purchase its own currency in the FX market, which would essentially reverse the expansionary attempt. The opposite is true for restrictive monetary policy. Restrictive fiscal policy will lead to a ST decrease in the value of the local currency.
True or false: In a fixed exchange rate regime, governments can manage exchange rates and pursue independent monetary policy?
False, if the government wants to manage monetary policy, it must either use floating exchange rates or restrict capital movements to keep them stable. This is due to the implications of Mundell-Fleming model for fixed exchange rate regimes.
Difference between Mundell-Fleming model and monetary models:
The Mundell-Fleming model assumes that inflation plays no role in exchange rate determination. However, monetary models assume that output is fixed so that monetary policy primarily affects inflation and thus exchange rates. Monetary models only focus on monetary policy, not fiscal policy. The two primary monetary models are:
* Pure monetary model
* Dornbusch overshooting model
Pure monetary model
Under this model, the PPP holds at any point in time and output is held constant. This model assumes monetary policy affects exchange rates over the long run through its impact on prices and inflation, not through interest rates and GDP (what the Mundell Fleming model says). Expansionary monetary policy (increase in MS) leads to an increase in prices and a decrease in the value of the domestic currency over the long-run. Growth in MS affects the trajectory of FX rates but not the current exchange rate. The opposite is true for restrictive monetary policy.
- Does not take into account expectations about future monetary policy decisions.
Dornbusch overshooting model
Under this model, PPP does not hold in the short-term. This model assumes that prices are sticky in the short-term and are not readily affected by monetary policy in the short-term. However, prices are flexible in the long-run. With expansionary monetary policy in this model, prices increase over the long-run. Expansionary policy leads to a decrease in interest rates and a larger-than-PPP-implied (excessive) decrease in domestic currency value due to capital outflows. Exchange rates decrease in the short-term, but in the long-run, exchange rates gradually increase toward their PPP implied values. In this model, currency depreciates in the short-term and long-term. The opposite is true for restrictive monetary policy in this model.
Portfolio Balance Approach
This is a model for only fiscal policy, and takes a longer-term view that the Mundell-Fleming model. If a government pursues sustained expansionary fiscal policy, investors will evaluate risk vs return, which typically the yield will increase due to a high risk premium. If investors feel comfortable with the risk, they will continue to purchase bonds, however continued increases to fiscal deficits are unsustainable and eventually investors may refuse to continue to invest in the domestic currency leading to currency depreciation.
Combining the Mundell-Fleming model and the Portfolio Balance Approach to see impacts of FISCAL policy in the short and long runs:
In the short-term, with free capital flows, expansionary FISCAL policy leads to domestic currency appreciation through higher interest rates. In the long run, the government must reverse course which will lead to currency depreciation. If the government doesn’t reverse course, it will have to print money to monetize its debt, which will also lead to currency depreciation.
