ECO 2121, FINAL Flashcards

1
Q

What is the BOP ?

A

The balance of payments (BOP) is an accounting of a country’s transactions for a particular time.

POSITIVE = SURPLUS / NEGATIVE = DEFICIT

  • Each transaction between a country + ROW involves an exchange of value for value
  • Each transaction has 2 items (1 positive + 1 negative)
  • BOP = accounting principle for double-bookkeping
  • If we add up all the positive (credits) + negative (debits) = ZERO
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2
Q

How can we define a CREDIT?

A

An item that would cause funds/money to FLOW INTO a country = positive value

It’s an item for with the country MUST BE PAID (claim on a foreigner)

E.g., a country’s export-of-goods, purchases by foreign tourists traveling the country, foreign investers

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3
Q

How can we define a DEBIT?

A

An item that would cause funds/money to FLOW OUT = negative value

It’s an item for which the country MUST PAY (claim owed to a foreigner)

E.g., a country’s imports-of-goods, purchases by firms in this country, purchases by investors in this country of the equity shares, etc.

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4
Q

What is included in the CA ?

A
  1. Trade balance (exports - imports)
  2. Net foreign income (what we receive from abroad - what we pay foreigner, e.g., rents, loans, profits, dividends, loyalties, interests, etc.)
  3. Net unilateral transfers (governement, individuals, private)

INCLUDES ALL DEBIT/CREDIT

  • Exports/imports of goods = flows of raw materials/manufactured goods out/into the country
  • Exports/imports of services (e.g., tourism, transportation, insurance, education, etc.)
  • Income flows = mainly receipts and payments to holders of foreign financial assets
  • Unilateral transfers = are gifts that the country receives and that the country makes

———————————————————–.
Current account balance = the net value of flows of goods, services, income, and unilateral transfers

Goods and services = the number obtained by adding up exports + imports of goods and services

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5
Q

What is included in the financial account ?

A
  1. Net FDI (what we receive - what we invest)
  2. Net porfolio investment (what foreigners invest in Canada - what Canadiens invest abroad)
  3. Net loans

The financial account balance = net value of flows of financial assets + similar claims ==> the private net value

  • Credits = funds are flowing INTO the country (positive) [exporting financial assets, capital imports)
  • Debits = funds are flowing OUT of the country (negative) [importing financial asset, capital exports]
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6
Q

What is the official international reserves?

A

Money-like assets that are HELD and RECOGNIZED by governements as fully ACCEPTABLE for payments.

KEEPS TRACK OF CHANGES IN OFFICIAL HOLDINGS

Gold was used in the 19th and 20th centuries

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7
Q

What is a statistical discrepancy?

A

It’s the net result of errors + omissions on both the credit and debit sides.

If the flows were recorded properly, there would be ZERO discrepency.

E.g., for U.S = much of the discrepancy is undermeasurement of private capital flows

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8
Q

Explain why the CAB must equal it’s net foreign investment?

MACRO PERSPECTIVE

A

To calculate the CAB = the INCREASE in the country’s foreign financial assets - the INCREASE in the country’s foreign financial liabilities

  • CA SURPLUS (positive) = it’s foreign assets are growing FASTER than it’s foreign liabilities = NET LENDER
  • CA DEFICIT (negative) = it’s foreign liabilities are growing FASTER than it’s foreign assets = NET BORROWER

Net exports = Savings - Investments

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9
Q

T/F, the U.S has evolved from a net exporter to lender after the WW2 ?

A

FALSE, after the WW2, he’s a net importer and borrower

WHY = the U.S cut it’s rate of national savings much faster than it’s domestic investments

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10
Q

What does the overall balance imply?

A

It indicates wether a country’s balance of payments has acheived an overall pattern that is sustainable over time.
* no single indicator represent the overall balance perfectly

All items in the BOP must equal ZERO = any imbalance in the official settement balance must be finance through official reserves flows (OR)
* B + OR = ZERO

———————————————————-.
B is in surplus:
* Must equal an accumulation of official reserve assets or
* Decrease in foreign official reserve holdings of the country’s assets

B is in deficit:
* Must equal a decrease in the country’s holdings of official reserves or
* Accumulation of foreign official reserve holdings of the country’s assets

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11
Q

What is the math behind the official settement balance (B) ?

A

It measures the sum of CA + financial account balance + (plus statistical discrepency)

B = CA + FA + (stats)

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12
Q

What is the international investment position?

A

It is a statement of the stocks of a nation’s international assets + foreign liabilities at a point in time, usually the end of a year.

E.g., if the country as a CA SURPLUS = it’s net foreign investment is positive
* The country is adding to it’s holding of foreign financial assets
* The country’s position will increase

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13
Q

T/F, a credit + debit can go into 3 categories?

4 net balances
SURPLUS vs DEFICIT

A

TRUE,
1. CA
2. Private financial account
3. Changes in the official international reserve assets

These 3 categories, generate 4 net balances:
1. The goods/services balance (equals the net exports of both goods and services, often called trade balance)
2. The CA balance (equals the net credits - debits in the flows of goods, services, income, unilateral transfers)
3. The net private financial account balance (equals net credits - debits involving changes in no official foreign financial assets and liabilities)
4. The overall balance/official settlements balance (equals the sum of the current account balance and the private financial account balance + the statistical discrepancy from mismeasuring items in the current account and financial account)

———————————————————–.
If the overall is in surplus, it is counterbalanced by an increase in the country’s official reserve holdings or a decrease in its official liabilities to other countries monetary authorities

If it is in deficit, it is counterbalanced by a decrease in the country’s official reserve assets or an increase in its official liabilities

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14
Q

What are the basics of currency trading?

A

Foreign exchange = act of trading different nations’ money

Foreign exchange market = the financial market where exchange rates are determined

Exchange rate = the price of one nation’s money in terms of another nation’s money (relative price)

  1. Spot exchange rate = the price for immediate exchange + provides clearing services that permit payments to flow for people who prefer to use different money (max 2 working days)
  2. Foward exchange rate = the price set now for an exchange that will take place sometime in the future (30, 90, 180 days)
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15
Q

What is a vehicular currency ?

A

One currency is commonly exchanged for dollars and the dollars are then exchanged for other currency

U.S. dollars

  • One foreign currency is exchanged for dollars
  • The dollars are then exchanged for the other currency
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16
Q

T/F, the foreign exchange market permits customers (i.e., individuals, businesses) to acquire foreign money to make payments OR sell foreign money they received in payments ?

A

TRUE

17
Q

Why trading increases?

A
  • Driven by large increases in trading by hedge funds, pension funds, and other financial institutions
  • They expand their foreign exchange trading as they pursue international diversification of their financial investment portfolios
  • They increase their use of algorithms for computer-driven foreign exchange
18
Q

What is a foreign exchange swap ?

A

It’s a package trade that includes both a spot exchange of 2 currencies + an agreement to the reverse foward exchange of the 2 currencies

19
Q

Explain the interbank foreign exchange trading ?

A

Participation in the interbank (or interdealer) part of the market provides a bank with a continuous stream of information on conditions in the foreign exchange market through communications with traders at other banks and through observing quoted prices.

  • Interbank allows a bank to readust it’s own position quickly + low cost.
  • Permits a bank to take on a position in a foreign currency quickly if the bank and its traders want to speculate on exchange-rate movements in the near future.
20
Q

Explain the demand/supply of foreign exchange ?

An exchange rate is the price of domestic assets in terms of foreign assets.

A

A nation’s EXPORT causes foreign moneys to be SOLD to buy that nation’s money.
* Domestic exports (capital inflow) of goods/services/financial assets create a supply of foreign currency + a demand for domestic currency.

——————————————–.
A nation’s IMPORTS tends to cause the home currency to be SOLD to buy foreign currency.
* Domestic imports (capital outflow) of goods/services create a demand for foreign currency + a supply of domestic currency.

Supply curve for domestic assets: assume amount of domestic assets is fixed (supply curve = vertical)

Demand curve for domestic assets: most important determinant is the relative expected return of domestic assets + at a lower current value of the dollar (everything else equal), the quantity of demanded of dollar assets is higher.

21
Q

What is a floating exchange-rate system?

A

The spot price of a foreign currency is market-determined by the interaction of private demand + supply for that currency.

The market clears itself through the price mechanism.

22
Q

What is a fixed exchange-rate system?

A

Government monetary authorities keep the exchange-rate value fixed (within a narrow band around the central/par value).

23
Q

What do these terms mean?
* Depreciation
* Appreciation
* Devaluation
* Revaluation

A
  • Depreciation = a fall in the market price
  • Appreciation = a rise in the market price
  • Devaluation = an official reduction in the otherwise fixed par value of a currency
  • Revaluation = an official increase in the otherwise fixed par value of a currency
24
Q

What is arbitrage + triangular arbitrage in currency trading ?

A

Arbitrage = the process of buying/selling to make a riskless pure profit
* Ensures that exchange rate values in different locations are essentially the same

Triangular arbitrage = arbitrage throught three exchange rates, typically two dollar exchange-rate values + one cross-rate value
* Ensures the two dollar exchange rates + the cross-rate are consistent amoung themselve

25
Q

What is hedging ?

A

It’s taking an action to reduce your exposure to exchange-rate risk.

  • The act of reducing/eliminating a net asset OR net liability position in the foreign currency.

It means reducing both kinds of ‘open’ positions in a foreign currency
* Long positions = holding net assets
Short positions = owing more of the foreign currency than one holds

A foward exchange contract is a DIRECT way to hedge

26
Q

What is speculation?

A

It’s taking an action that increase your exposure to exchange-rate risk.
* The act of taking a net asset position ‘long’ OR a net liability position ‘short’ in some asset class of foreign currency.

D/S drives the foward exchange rate to = the value of the spot exchange

One DIRECT way to speculate on the value of the future sport exchange rate is a foward foreign exchange contract

27
Q

T/F, in a fixed-rate system, spot exchange rates can change from minute to minute ?

A

TRUE, but the range of the rate is typically limited to a small band around the par value as long as the fixed rate is defended successfully by the government.

Floating rates sometimes change quickly by large amounts as a result of large shifts in D + S.

28
Q

What is the difference between the foward market + the foward exchange market + the foward foreign exchange contract ?

A

Foward market = deals are transacted for foreign exchange deliveries to be made at some specified future date (30, 60, 90 days). Bank provide foward foreign exchange on all curency pairs.

Foward exchange market (more for large corps) that are viewed by banks as acceptable credit risks.

Foward foreign exchange contract = it’s an agreement to exchange 1 currency for another on some date in the future at a price set now (foreign exchange rate)

29
Q

What is the difference between a currency future, currency option and currency swap?

A

Currency future = contract that are traded on organized exchanges
* Lock in the price at which you buy/sell a foreign currency at a set date in the future
1. the profit/loss is not taken till the maturity date
2. almost anyone can put a margin to ensure their commitment
3. strandard + customizable contracts by the banks

Currency option = gives the buyer of the option the right (but NOT the obligation) to buy/sell foreign currency at some time in the future at a price set today.
* Pays a premium fee to the seller for the option
* The price set is called striked price of exercise price

Currency swap = 2 parties agree to exchange flows of different currencies during a specified period of time

30
Q

T/F, decisions about international investments are based on returns and risks of the available investment alternatives?

A

TRUE

31
Q

What is the difference between the covered + unconvered international investment ?

A

COVERED = hedged exposure to exchange-rate risk
UNCOVERED = unhedged investment with a speculative element

32
Q

What is F, and what does foward premium imply?

A

F = foward premium or discount

It’s the proportionate difference between the current foward exchange-rate value of the currency + it’s current spot exchange-rate value

If F is negative = the currency is at a foward discount because it loses its value between buying it at the current spot rate and selling it at the current foward rate

33
Q

What is the covered interest differential (CD) and the covered interest arbitrage ?

A

CD = It’s the difference between the overall covered international investment return [i.e., the hedge exposure to exchange-rate risk] + the domestic return

Covered interest arbitrage = it’s making a profit when CD is NOT ZERO
* Buying a country’s currency spot + selling that country’s currency foward to make a net profit from the combination of the difference in interest rates between countries and the foward premium on that country’s currency

CD = (1 + i UK) x F/E - (1 i US)

Foward premium: proportionate difference between the current foward exchange-rate value of the currency + it’s current spot exchange-rate value

34
Q

What does covered interest parity imply ?

John Maynard Keynes + based on LAKES

A
  • The overall covered return on a foreign-currency investment = the return on a comparable domestic-currency investment
  • A currency is a foward premium/discount by as much as its interest rate is lower/higher than the interest rate in the other country.

———————————————.
Links the 4 rates:
1. The current spot exchange rate
2. The current foward exchange rate
3. + 4. The current interest rates in the two countries

CD = 0

35
Q

T/F, the investor is exposed to exchange-rate risk because the actual return depends on the actual value of the future spot exchange rate, which is certain at the time of the investment?

A

FALSE, the investor is exposed to exchange-rate risk because the actual return depends on the actual value of the future sport exchange rate, which is UNcertain at the time of the investment ?

The investor can use the expected future spot rate to calculate the expected return to the uncovered foreign financial investment.

36
Q

What is the expected uncovered interest differential (EUD) ?

A

The difference between the overall expected uncovered foreign investment return + the domestic return.

EUD = expected appreciation/depreciation + (i UK - i US)

37
Q

What is the unconvered interest parity (Fisher effect) ?

A

The expected overall uncovered return on the foreign-currency investment = the return on the domestic-currency investment

A currency is expected to appreciate/depreciate by as much as its interest rate is lower/higher than the interest rate in the other country

The 4 rates are needed to test for covered interest partity

International Fisher effect (EUD = 0)

No direct way to measure it VS covered parity:
* With capital controls that limit OR prevent arbitrage
* With financial market turmoil OR crisis

38
Q

What does Y = C + Id + G + X - M entail?

National saving: S = Id + If
Net foreign investment: If = S - Id
Current account: CA = S - Id

A
  • Y: National Income (GDP)
  • C: Consumption — the total spending by households on goods and services (e.g., food, clothing, entertainment).
  • Id: Domestic Investment — spending on capital goods that will be used for future production (e.g., machinery, buildings, infrastructure).
  • G: Government Spending — expenditures by the government on goods and services (e.g., defense, education, public services).
  • X: Exports — the total value of goods and services sold to other countries.
  • M: Imports — the total value of goods and services purchased from other countries.

A current account surplus indicates that the nation is producing more than it is consuming domestically, with the excess output being sold abroad = CA > 0
———————————————————–.
The nation is effectively using the surplus to accumulate wealth abroad, reflecting strong export competitiveness or restrained domestic consumption/investment. = Y > E

39
Q

The trading done with customers is called what?

A

The retail part of the market (usually small amounts)