EC340FINAL13-14

Question 1

carry-trade

Answer 1

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.

Question 2

parity conditions:
Riskless arbitrage
Risky arbitrage

Answer 2

RISKLESS - covered interest parity (CIP)

RISKY - uncovered interest parity (UIP)

Question 3

Riskless arbitrage implies in equilibrium that CIP will yield

Answer 3

the same rate of return in dollars

Question 4

Covered interest parity CIP

Answer 4

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.

Question 5

if 1 + i$ > (1 + i€)F$/ € / E$/ €

then where do investors want to invest?

Answer 5

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.

Question 6

Interest arbitrage will stop when the dollar return on dollar deposits are

Answer 6

equal to the dollar return on euro deposits

Question 7

The CIP equation is used to exactly price

Answer 7

forward contracts (if we know interest rates and E then we can solve for F):

Question 8

Uncovered interest parity UIP

*does not use forwards, therefore

Answer 8

There is exchange rate risk because the future spot exchange rate is not known when the investments are made.

Question 9

UIP no arbitage condition

Answer 9

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

Question 10

risk neutrality

Answer 10

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.

Question 11

UIP: interest arbitrage in favor of U.S dollars.

Answer 11

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.

Question 12

PPP Purchasing power parity

Answer 12

S-R theory

*prices fail to adjust in s-r “sticky prices”

Question 13

Gross national expenditure (GNE):
three components:
-Personal consumption expenditures C (“Consumption”).
-Gross private domestic investment I (“Investment”)
-Government consumption expenditures and gross investment G

Answer 13

: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.

Question 14

Total spending (GNE) is total payments for final goods and services in the market.

Answer 14

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.

Question 15

firms use revenues in 2 ways:

Answer 15

payments for goods and services

income payment factors: wages, salaries to labor, dividends interest capital , rent

Question 16

gross domestic product (GDP)

Answer 16

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.

Question 17

Gross national income (GNI) is

In a closed economy,

Answer 17

-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.

Question 18

In the flow of payments for an open economy,

Answer 18

international transactions affect the flow of spending, income, and production.
GNE, GDP, and GNI need not be equal

Question 19

Trade balance equation

Answer 19

TB = exports - imports

Question 20

Trade in factor services occurs when

Answer 20

one country is paid income by another, in compensation for labor, capital, and land.

Question 21

gross national disposable income (GNDI) represents

Answer 21

the total income resources available to the home country.

Question 22

The current account (CA)

Answer 22

The current account (CA) is a tally of all international transactions in goods, services, and income (occurring through market transactions or transfers)

Question 23

Trade in financial assets means

Answer 23

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

Question 24

Transactions in goods & services, factor services, and income transfers go in the

Answer 24

current account CA

Question 25

records traded in assets

Answer 25

financial assets

Question 26

records transfers of assets

Answer 26

capital account KA