Economics

Question 1

Module 6.1, LOS 6.a

What are the determining factors of dealer’s exchange rate spreads?

Answer 1

1) The spread in an interbank market for the same currency pair
2) The size of the transaction (larger - higher spread)
3) The relationship between the dealer and client

Question 2

Module 6.1, LOS 6.a

What are the determining factors of exchange rate interbank market spreads?

Answer 2

1) Currencies involved (high-volume currency pairs - lower spread)
2) Time of day (most liquid time - lower spread)
3) Market volatility (higher volatility - higher spread)
4) Maturity (higher maturity - higher spread)

Question 3

Module 6.1, LOS 6.a

In a triangle arbitrage, can you earn profit in both directions?

Answer 3

No, this is never possible

Question 4

Module 6.2, LOS 6.e

What is the difference between covered and uncovered interest rate parity?

Answer 4

Covered interest rate parity derives the no-arbitrage forward rate, while uncovered interest rate parity derives the expected future spot rate (which is not market traded)
Uncovered interest rate parity assumes that the investor is risk-neutral

Question 5

Module 6.2, LOS 6.e

In which case a forward rate is an unbiased predictor of the future spot rate?

Answer 5

If the forward rate is equal to the future spot rate

Then when covered interest rate parity holds, uncovered interest rate parity would also hold (and vice versa)

Question 6

Module 6.2, LOS 6.e

Descibe International fisher relation

Answer 6

1) The difference between two countries’ nominal interest rates should be equal to the difference between their expected inflation rates.
2) Equality of real interest rates across countries is based on the idea that with free capital flows, funds will move to the country with a higher real rate until real rates are equalized

Question 7

Module 6.2, LOS 6.e

Descibe Absolute purchasing power parity

Answer 7

S(A/B) = CPI(A) / CPI(B)

measured by consumption baskets

Question 8

Module 6.2, LOS 6.e

Descibe Relative purchasing power parity

Answer 8

%ΔS(A/B) = Inflation(A) − Inflation(B)
where:
%ΔS(A/B) = change in spot price (A/B)

Question 9

Module 6.2, LOS 6.e

What is ex-ante purchasing power parity?

Answer 9

The ex-ante version of purchasing power parity is the same as relative purchasing power parity except that it uses expected inflation instead of actual inflation.

Question 10

Module 6.3, LOS 6.i

What is FX carry-trade?

Answer 10

An investor invests in a higher yielding currency using funds borrowed in a lower yielding currency (funding currency).
The FX carry trade attempts to capture an interest rate differential and is a bet against uncovered interest rate parity

Question 11

Module 6.3, LOS 6.i

What is crash risk of FX carry-trade?

Answer 11

A high probability of a large loss in carry trade.

During turbulent times, as investors exit their positions (i.e., a flight to safety), the high-yielding currency can experience a steep decline in value, generating large losses for traders pursuing FX carry trades

Question 12

Module 6.3, LOS 6.j

In BOP which factor mostly impacts FX rate?

Answer 12

Capital flows tend to be the dominant factor influencing exchange rates in the short term, as capital flows tend to be larger and more rapidly changing than goods flows

Question 13

Module 6.3, LOS 6.j

What are the main mechanisms of current account influence on exchange rate?

Answer 13

Current account deficits -> depreciation of domestic currency:

1) Flow supply/demand mechanism - Current account deficits -> increase the supply of that currency in the markets (as exporters to that country convert their revenues into their own local currency)
2) Portfolio balance mechanism - investor countries decide to rebalance their investment portfolios (not to have to much investments into country with CA deficit
3) Debt sustainability mechanism - a country running a current account deficit -> may be running a capital account surplus by borrowing from abroad -> high D/GDP -> investors reduce their investments to borrower

Question 14

Module 6.3, LOS 6.j

Under which conditions it is easier to restore current account deficit through exchange rate depreciation?

Answer 14

1) smaller initial deficit
2) increase in cost to larger extend passed on to consumers
3) most important imports are price elastic

Question 15

Module 6.3, LOS 6.j

What are the main mechanisms of capital account influence on exchange rate?

Answer 15

Differences in real rates of return tend to be a major determinant of the flow of capital

Question 16

Module 6.3, LOS 6.k

What is the key assumption of the Mundell-Fleming model?

Answer 16

It does consider inflation - uncovered parity doesn’t hold

Question 17

Module 6.3, LOS 6.k
For countries with flexible exchange rate regimes, how does expansionary monetary and fiscal policy impact (under Mundell-Fleming model) countries with:
1) high capital mobility?
2) low capital mobility?

Answer 17

1) high capital mobility
expansionary monetary -> depreciation local
expansionary fiscal -> appreciation local
2) low capital mobility
expansionary monetary -> depreciation local
expansionary fiscal -> depreciationlocal

Question 18

Module 6.3, LOS 6.k

What are the major types ofmonetary approach to exchange rate determination and their assumptions?

Answer 18

1) Pure monetary model
- PPP holds ST
- constant output
- does not take into account expectations about future monetary expansion or contraction
- expansionary monetary policy -> increase in prices, decrease in the value of the domestic currency
2)  Dornbusch overshooting model
- prices are sticky (inflexible) in the short term -> ST PPP doesn’t hold
- exchange rates will overshoot the long-run PPP value in the short term

Question 19

Module 6.3, LOS 6.k

Which exchange rate model focuses on long term fiscal policy impacts?

Answer 19

Portfolio balance approach

Question 20

Module 6.3, LOS 6.l
What are the objectives of central banks or government intervention and capital controls when dealing with exchange rates?

Answer 20

• ensure that the domestic currency does not appreciate excessively
• allow the pursuit of independent monetary policies without being hindered by their impact on currency values
• reduce the aggregate volume of inflow of foreign capital

Question 21

Module 6.3, LOS 6.l

In which countries - developed or developing - are government and central banks interventions more efficient?

Answer 21

Evidence has shown that for developed markets, central banks are relatively ineffective at intervening in the foreign exchange markets due to lack of sufficient resources

Question 22

Module 6.3, LOS 6.i

Which distribution do carry trade returns have?

Answer 22

With negative skewness and excess kurtosis

Question 23

Module 7.1, LOS 7.a

What are the main factors that boost GDP growth and GDP level?

Answer 23

1) Savings and investment
2)  Financial markets and intermediaries
3) Political stability, rule of law, and property rights
4)  Investment in human capital
5) Tax and regulatory systems
6)  Free trade and unrestricted capital flows

Question 24

Module 7.1, LOS 7.b

Which formula describes determinants of equity stock market growth? What is the limit for its growth?

Answer 24

ΔP = ΔGDP + Δ(E/GDP) + Δ(P/E)

In LT Δ(E/GDP) and Δ(P/E) is 0, potential GDP is a limit to equity market growth

Question 25

Module 7.1, LOS 7.c

What is the relation between current interest rate, fiscal and monetary policy and potential and actual GDP growth?

Answer 25

1) If actual GDP growth is higher than potential - expected inflation - restrictive monetary policy
2) If actual GDP growth is lower than potential - fiscal deficit will be run
3) If potential GDP growth is positive - consumers save less - financial intermidiaries ask for higher yield to encourage savings
4) The higher the potential GDP - the lower credit risk in financial and government sector is assumed

Question 26

Module 7.1, LOS 7.d

What is the difference between marginal product of capital and marginal productivity of capital?

Answer 26

Marginal product of capital is the additional output for one additional unit of capital (constant returns on scale). Marginal productivity of capital is the increase in output per worker for one additional unit of capital per labor (i.e., increasing capital while keeping labor constant) - decreasing

Question 27

Module 7.3, LOS 7.i

What is the key assumption of classical growth theory? Does this theory hold?

Answer 27

Key assumption - when GPD/capita increases above subsistance level -> burst in population growth -> diminishing marginal returns to labor -> GPD/capita driven back to subsistance level.

Theory is not supported by evidence

Question 28

Module 7.3, LOS 7.i

What are the key assumptions of neoclassical growth theory?

Answer 28

1) Capital deepening affects Y but not the g in LR. Capital deepening may temporarily increase g, but it will revert back w/o A growth
2) An economy’s g will move towards its steady state regardless of the initial C/L or A.
3) In the steady state, g is a function only of the growth rate of technology (θ) and labor’s share of total output (1 − α)
4) In the steady state, MPK = αY/K is constant, but marginal productivity is diminishing
5) An increase in savings will only temporarily raise G. However, countries with higher savings rates will enjoy higher C/L and higher productivity.
6) Developing countries (with a lower level of C/L) will be impacted less by diminishing MPK, and have higher g; there will be eventual convergence of g
7) every country has access to the same technology
8) benefit of open markets is temporary

Question 29

Module 7.3, LOS 7.i

What are the key assumptions of endogenous growth theory?

Answer 29

1) technological growth emerges as a result of investment in both physical and human capital
2) returns to capital are constant -> increase in savings will permanently increase g
3) R&D may have external benefits and should be subsidized by government
4) open markets lead to higher rate of growth permanently for all markets
5) knowledge is not subject to diminishing returns

Question 30

Module 7.3, LOS 7.j

Which convergance theories exist and what they assume?

Answer 30

1) absolute convergence - less-developed countries will converge to the growth rate (but not the level of per capita output) of more-developed countries
2) conditional convergence hypothesis - convergence in living standards will only occur for countries with the same savings rates, population growth rates, and production functions.
3) club convergence - poorer countries that are part of the club will grow rapidly to catch up with their richer peers

Question 31

Module 8.1, LOS 8.e

In which law system SRO are more officially recognized?

Answer 31

In common law systems (rather than civil law)

Question 32

Module 8.1, LOS 8.f

What does regulatory capture theory state?

Answer 32

Regardless of the original purpose behind its establishment, a regulatory body will, at some point in time, be influenced or even possibly controlled by the industry that is being regulated

Question 33

Module 8.1, LOS 8.f

What is regulatory competition?

Answer 33

Regulators compete to provide the most business-friendly regulatory environment

Question 34

Module 8.1, LOS 8.f

What is regulatory arbitrage?

Answer 34

Businesses shop for a country that allows a specific behavior rather than changing the behavior

Question 35

Module 8.1, LOS 8.f

What is net regulatory burden?

Answer 35

Cost of compliance for the regulated entity (regulatory burden) minus the private benefits of regulation