EC340FINAL13-14 Flashcards
carry-trade
involves a trader borrowing in a country with low interest rates and investing the proceeds of the loan in a country with higher rates, and pocketing the difference.
parity conditions:
Riskless arbitrage
Risky arbitrage
RISKLESS - covered interest parity (CIP)
RISKY - uncovered interest parity (UIP)
Riskless arbitrage implies in equilibrium that CIP will yield
the same rate of return in dollars
Covered interest parity CIP
No arbitrage condition in the case of riskless arbitrage states that for the market to be in equilibrium the riskless returns must be equal when expressed in a common currency
It is called covered interest parity (CIP) because all exchange rate risk on the euro side has been “covered” by use of the forward contract.
if 1 + i$ > (1 + i€)F$/ € / E$/ €
then where do investors want to invest?
investors can have a higher return by investing in $ assets:
Selling € and buying $ on the spot market will increase the demand for $ and the supply of €. The spot rate E$/ € will go down.
At the same time, investors will sell $ and buy € on the forward market, which increases the supply of $ and the demand for € on the forward market. The forward rate F$/ € will go up.
The changes of E$/ € and F$/ € will increase the dollar return on euro deposits.
Interest arbitrage will stop when the dollar return on dollar deposits are
equal to the dollar return on euro deposits
The CIP equation is used to exactly price
forward contracts (if we know interest rates and E then we can solve for F):
Uncovered interest parity UIP
*does not use forwards, therefore
There is exchange rate risk because the future spot exchange rate is not known when the investments are made.
UIP no arbitage condition
No arbitrage condition in the case of the risky interest arbitrage states that the expected returns must be equal when expressed in a common currency
risk neutrality
investor doesn’t care that the right side in unknown to him
*more concerned about the expected return on his or her investment, not on the risk he or she may be taking on.
UIP: interest arbitrage in favor of U.S dollars.
Selling € and buying $ on the spot market will increase the demand for $ and the supply of €. The spot rate E$/ € will go down.
As a result, Ee$/ € / E$/ € will go up, which will raise the gross dollar return on euro deposits.
Interest arbitrage will stop when the gross dollar return on dollar deposits is equal to the gross dollar return on euro deposits.
PPP Purchasing power parity
S-R theory
*prices fail to adjust in s-r “sticky prices”
Gross national expenditure (GNE):
three components:
-Personal consumption expenditures C (“Consumption”).
-Gross private domestic investment I (“Investment”)
-Government consumption expenditures and gross investment G
:total national spending on final goods and services.
- Total household spending on final goods and services
- Total spending by firms and households on final goods and services that add to the nation’s capital stock.
- Government spending on final goods and services, including additions to the capital stock.
Total spending (GNE) is total payments for final goods and services in the market.
In a closed economy, this must equal total sales by firms of final goods and services.
Sales of intermediate goods and services to other firms are excluded to avoid double counting.
firms use revenues in 2 ways:
payments for goods and services
income payment factors: wages, salaries to labor, dividends interest capital , rent
gross domestic product (GDP)
income payment factors: wages, salaries to labor, dividends interest capital , rent
Value added avoids double-counting and is considered the measure of production in the economy.
Gross national income (GNI) is
In a closed economy,
-the sum of factor income payments received by national entities.
These income resources are the only resources available from which the closed economy can finance expenditure.
-GNE = GDP = GNI.
In the flow of payments for an open economy,
international transactions affect the flow of spending, income, and production.
GNE, GDP, and GNI need not be equal
Trade balance equation
TB = exports - imports
Trade in factor services occurs when
one country is paid income by another, in compensation for labor, capital, and land.
gross national disposable income (GNDI) represents
the total income resources available to the home country.
The current account (CA)
The current account (CA) is a tally of all international transactions in goods, services, and income (occurring through market transactions or transfers)
Trade in financial assets means
the cross-border movement in ownership of a financial claim.
Example: If foreigners buy some domestic stocks, bonds, or real estate, they pay the domestic seller of those assets.
*recorded on financial account
Transactions in goods & services, factor services, and income transfers go in the
current account CA
records traded in assets
financial assets
records transfers of assets
capital account KA
