Eco 2.1

Question 1

What is the Base currency and Price currency? What is the Bid-ask or Bid-offer spread?

Answer 1

• The base currency (usually the denominator) is the currency of which we have one unit with us and the price of which is quoted in the price currency (usually the numerator).
• The bid-ask spread is the spread in the price of the base currency by the currency dealer. The bid representing the price at which the dealer will buy the base and give the price currency & the offer/ask is vice versa.

Question 2

What is a pip? Usually upto how many decimal places are the pip quoted? give examples.

Answer 2

• Most currency spreads are given by 0.0001 (upto 4 decimal places) and the bid may be 1.4126 and the offer will be 1.4131, thus having a difference of 5 pips.
• Some currencies like yen have pips represented only upto 2 decimal places -> 0.01

Question 3

What is higher? The offer price or the bid price? Where is the base currency in the currency fraction quote?

Answer 3

• The offer price is always going to be higher than the bid price as the dealer always buys at a lower cost and sells at a higher price to make his money. The base currency in the curriculum will always be given in the denominator.

Question 4

Primary factors that affect the Bid-offer spread? Secondary factors?

Answer 4

Primary:
- Currency Pair
- Time of the day
- Market Volatility

Secondary:
- Transaction size.
- Relationship between dealer & client
- Client’s credit profile.

Question 5

Arbitrage Constraints on Spot Exchange rate quotes:

Answer 5

• Dealer bid can’t be higher than interbank offer
• Dealer offer can’t be lower than interbank bid

Question 6

What is Triangular Arbitrage?

Answer 6

• Triangular arbitrage is the same as the arbitrage constraints we looked at earlier, except they are cross rates instead of normal currency pair rates.
  The logic remains the same as it does in the spot rate market. (like the earlier constraints in the spot rate quotes)

Question 7

What are the 2 shortcuts to remember the arbitrage constraints?

Answer 7

• DB iG IO
• DO L IB

Question 8

What is a forward contract?

Answer 8

• Just like derivatives, it is a contract to exchange a currency against another on a future date but at an exchange rate which was agreed upon today. Any transaction which has a settlement date longer than T + 2 is a forward contract.

Question 9

How do we calculate the forward price?

Answer 9

• by the forward price formula :
  F p/b = S p/b x [ 1 + iP (no.of days/360) / 1 + iB (no.of days/360)] -> “Base in the base” phrase to remember formula.

After the forward price, we can get the forward premium as forward price - spot price.

Question 10

When is the forward premium positive and when is it negative?

Answer 10

• Positive when the interest rate of base currency is less than interest rate of price currency
• Negative when vice versa i.e. iB > iP

Question 11

What are forward points & how do we come to a forward price from the spot price and forward points?

Answer 11

• The spot price is usually given and are the forward points, so we just need to divide the forward points number by 10,000 and add it back to the spot price. This gives up the forward price.

Question 12

How are forward contracts marked to market?

Answer 12

• Forward contracts are marked to market which a 4 step approach.
  We first need to create an offset position of our current position.
  Then, we need to determine the appropriate all-in forward position rate for this new offsetting position.
  After getting the rate, we can calculate the cash flow on the settlement date.
  Then we can discount this back using the interest rate (which will be given) & the number of days we’d like to discount it. (In simple words, we need to get the PV of our cash flow which we calculated we’d have on the settlement date)

Question 13

What helps us determine/estimate a long term currency exchange rates?

Answer 13

• International Parity conditions - Just to get a sense of long-term equilibrium value should be.
  However, no model gives us a precise exchange rate that will prevail in the future.

Question 14

What is covered interest rate parity?

Answer 14

• Is if an investor who has invested in a foreign currency and hedged the currency exchange risk completely will only earn a return on that investment based on some other similar money market instrument in the domestic currency.
  If not, then there’s an arbitrage opportunity that exists which will the investor earn a return without taking a risk.
  Thus, Arbitrage ensures that covered interest rate parity holds.

Question 15

What is uncovered interest rate parity?

Answer 15

• It is based on an assumption that the spot rate will change as per the difference between the interest rate in the country of the price currency and the interest rate in the country of the base currency.
  There is no arbitrage relationship which forces uncovered interest rate parity to hold.

Question 16

What is Forward rate parity and what are it’s assumptions?

Answer 16

• It is an unbiased forecast of the future spot exchange rate if both covered & uncovered interest rate parity hold.
  However, if uncovered interest rate parity holds, then the forward rate parity holds.
  However, uncovered interest rate parity is not enforced by arbitrage & assumes that investors are risk neutral, which is not the case.
  Consequently, uncovered interest rate parity is often violated and the forward rate parity is a poor indicator of the expected spot rate.

Question 17

What is the law of one price?

Answer 17

• Identical goods should trade at the same price across countries when valued in terms of a common currency.

Question 18

What is the absolute version of Purchase Power Parity?

Answer 18

• Equilibrium exchange rate between two countries is determined entirely by the ratio of their national price levels.

Question 19

What are the assumptions of absolute PPP?

Answer 19

• There are two assumptions:
  a. all domestic & foreign goods are tradable
  b. domestic & foreign price indexes include the same bundle of goods & services with the same exact weights in each country. (unrealistic)

Question 20

What is the relative version of PPP? What is the assumption of relative PPP?

Answer 20

• % change in the spot exchange rate will be completely determined by the difference between the foreign and domestic inflation rates.
  Assumption: Actual changes in exchange rates are driven by the actual differences in the national inflation rates.
  %Change in Sf/d = Pie-f minus Pie-d (Pie = national inflation rate)

Question 21

What is the ex ante version of PPP?

Answer 21

• Expected changes in the spot exchange rate are entirely driven by the expected differences in the national inflation rates. (Only different to the relative PPP by Expected instead of Actual*) % change in expected Spot price f/d = Pie-f^e - Pie-d^e

Question 22

Important point to remember about PPP

Answer 22

• In the short run, the nominal exchange rate movements tend to be random. (PPP doesn’t hold in the short run)
  Over the longer run, the nominal exchange rate movements tend to gravitate towards their long-run PPP equilibrium values.

Question 23

What is the Real interest rate Parity?

Answer 23

• If uncovered interest rate parity & ex ante PPP hold, then the real interest rate in the domestic country = the real interest rate in the foreign country. Rf = Rd

Question 24

What is the International Fisher effect and what is it’s assumption?

Answer 24

• If real interest parity holds, the foreign-domestic yield spread is determined solely by the foreign-domestic expected inflation differential. Interest rate in foreign country - interest rate in domestic = Pie-f^e - Pie-d^e
  Assumption: currency risk is same throughout the world.

Question 25

What is the FX Carry trade?

Answer 25

• It’s a type of trade where one borrows in low-yield currency and invests in another high-yield currency. It’s based on an assumption that the uncovered interest rate parity doesn’t hold.

Question 26

What is the Balance of Payments?

Answer 26

• It consists of: Current account, which reflects flows related to the real economy (i.e. trade in goods and services) and a Capital account, which reflects financial/investment flows.
  Basically a track of how much money is coming in and going out of a country.

Question 27

What is the current account?

Answer 27

• The current account is used to monitor the inflows and outflows of goods and services into a country. A surplus in current account means that exports are greater than imports or outflows are more than inflows. To balance the current account, the balance must be matched by an equal and opposite capital account balance. Persistent current account surplus results in currency appreciation.
  The current account always needs to be balanced against the combined capital & financial account.

Question 28

What is the Capital account?

Answer 28

• It’s the account where all international capital transfers are recorded (referring to the acquisition or disposal of non-financial assets) and then there’s also a financial account which refers to an investment in financial assets like businesses, real estate, bonds and stocks.

Question 29

Which account’s impact on the exchange rate is determined in the long-run and which accounts impact is determined in the short to intermediate term?

Answer 29

• Current account impacts the exchange rate in the long run
• Capital/Financial accounts are the dominant factor in determining exchange rate movements in the short to intermediate term.

Question 30

Why?

Answer 30

• Prices of real goods & services tend to adjust slowly whereas prices of stocks/bonds adjust quickly and affects the exchange rate quicker.
• Production of real goods and services takes time, financial flows are fast

Question 31

How does current account imbalances affect exchange rate determination?

Answer 31

• flow of supply/demand channel (assume current account surplus -> high demand for domestic currency -> domestic currency appreciates)
• portfolio balance channel (Constant surplus ends up taking assets in deficit nations & when they sell, the deficit nation’s currency depreciates)
• debt sustainability channel (persistent deficit -> rising external debt -> currency has to depreciate to reduce deficit)

Question 32

Explain the Mundell-Fleming model.

Answer 32

• The mundell-Fleming model uses changes in monetary & fiscal policies to determine changes in the currency exchange rates.

Question 33

What are Monetary Policies and Fiscal Policies?

Answer 33

• Monetary policy influences the quantity of Money and credit in an economy.
• Fiscal policy is the govt’s decisions about taxation and spending.

Question 34

How do you capture the impact of the Mundell-Fleming model?

Answer 34

• Table! You make an impact table of Monetary & Fiscal Policy under both High Capital Mobility and Low Capital Mobility.
  If you can make a High Capital Mobility table then it’s just the reverse of that in low capital mobility.

Question 35

What are the Monetary models of exchange rate determination?

Answer 35

• Under monetary models, we assume that output is fixed, so that monetary policy primarily affects rate of inflation and the price level, which in turn affects exchange rates.

Question 36

What is the Pure monetary model and it’s assumptions?

Answer 36

• The pure monetary model assumes PPP holds at any point in time (short run & long run) and the output is held constant.
  Therefore, Increase in Money Supply -> Increase in domestic prices -> Currency depreciates as inflation rises.
  Decrease in Money Supply -> Decrease in domestic prices -> Currency appreciates.

Question 37

What is Dornbusch theory based on Pure monetary model?

Answer 37

• It’s an extension of the pure monetary model which states prices have limited flexibility in the short-run but are fully flexible in the long-run. Thus, if there is an increase in money supply in the short run, exchange rate overshoots the long run value (everything same as pure monetary model except short-term overshooting)

Question 38

What is the Portfolio Balance approach?

Answer 38

• The portfolio balance approach focuses only on the effects of fiscal policy (and not monetary policy). While the Mundell-Fleming model focuses on the short-term implications of fiscal policy, the portfolio balance approach takes a long-term view and evaluates the effects of a sustained fiscal deficit or surplus on currency values.
  Combining the Mundell-Fleming and portfolio balance approaches, we find that in the short term, with free capital flows, an expansionary fiscal policy leads to domestic currency appreciation (via high interest rates). In the long term, the government has to reverse course (through tighter fiscal policy) leading to depreciation of the domestic currency.
  If the government does not reverse course, it will have to monetize its debt (i.e., print money —> monetary expansion), which would also lead to depreciation of the domestic currency.

Question 39

Capital flows are driven by which two factors?

Answer 39

• Push & Pull factors.
  Pull refers to favorable developments that encourage capital inflows.
  Push refers to events not determined by domestic factors (example, capital flows from Developed markets as the interest rate in the domestic country is higher).

Question 40

How does capital flow surges effect the emerging/domestic country?

Answer 40

• It can be a blessing or a curse.
  Blessing as domestic investment increases it leads to increase in economic growth and asset values.
  Curse cos Asset bubbles are formed, currency is over-valued and reversal in capital flows can lead to economic downturn.

Question 41

What are the objectives of capital controls or central bank intervention in FX markets?

Answer 41

Prevent the domestic currency from appreciating excessively.
Reducing the aggregate volume of capital inflows.
enabling monetary authorities to pursue independent monetary policies.

Question 42

On what factor does the effectiveness of the govt intervention depend on?

Answer 42

The ratio of central bank FX reserves & FX turnover.

Question 43

What should a good early warning system for a currency crisis consist of?

Answer 43

Have a strong record of predicting actual crises & avoids frequent issuance of false signals.
Be based on macroeconomic indicators whose data are available on a timely basis.
Incorporate wide range of symptoms that crisis-prone currencies might exhibit.

Question 44

Describe the warning signs of a currency crisis.

Answer 44

Terms of trade (i.e., ratio of exports to imports) deteriorate.
Fixed or partially-fixed exchange rates (versus floating exchange rates).
Official foreign exchange reserves dramatically decline.
Currency value that has risen above its historical mean.
Inflation increases.
Liberalized capital markets, that allow for the free flow of capital.
Money supply relative to bank reserves increases.
Banking crises (may also be coincident).