Economics

Question 1

Calculate and interpret the bid–offer spread and describe the factors that affect the bid–offer dealer and interbank spread.

Answer 1

bid-ask spread (for base currency) = ask quote − bid quote

Dealer spreads: depend on spreads in the interbank market, the transaction size, and the dealer-client relationship.

Interbank spreads: depend on the currencies involved, time of day, and volatility in the currency pair.

Forward spreads: increase with maturities.

Question 2

What are the 2 aribtrage constraints with an offer and a bid?

Answer 2

Dealer Bid < Interbank Offer

Dealer Offer > Interbank Bid

Question 3

Identify a triangular arbitrage opportunity and calculate its profit, given the bid–offer quotations for three currencies.

Answer 3

To calculate the profits from triangular arbitrage, start in the home currency and go around the triangle by exchanging the home currency for the first foreign currency, then exchanging the first foreign currency for the second foreign currency, and then exchanging the second foreign currency back into the home currency.

If we end up with more money than what we had when we started, we’ve earned an arbitrage profit. The bid-ask spread forces us to buy a currency at a higher rate going one way than we can sell it for going the other way.

Question 4

How do you close out a forward contract?

Answer 4

The mark-to-market value of a forward contract reflects the profit that would be realized by closing out the position at current market prices, which is equivalent to offsetting the contract with an equal and opposite forward position:

Question 5

What are the 3 approaches to assessing the long-run fair value of an exchange rate?

Answer 5

Relative PPP: The long-run fair value of a currency is most commonly assessed using this method.

Macroeconomic balance approach: where we evaluate the sustainability of the country’s current account balance.

External debt sustainability approach: involves assessing the equilibrium exchange rate where the country’s external debt (or assets) will stabilize at a viable level. The equilibrium level can be estimated using a reduced-form econometric model utilizing macroeconomic fundamentals.

Question 6

What is Forward Rate Parity?

Answer 6

This is when the forward rate is an unbiased predictor of future spot rate. Both covered and uncovered interest rate parity must hold for this to be true.

Question 7

How are future spot rate and forward exchange rates forecasted using purchasing power parity?

Answer 7

Future spot rates: can be forecasted using PPP or by uncovered interest rate parity. However, neither relationship is bound by arbitrage, nor do these relationships necessarily work in the short term.

Forward exchange rates: can be estimated using covered interest parity, and this relationship is bound by arbitrage.

If uncovered interest parity holds, then we say that the forward rate parity holds, i.e., the forward rate is an unbiased estimate of the future spot rate.

Question 8

Describe the carry trade and its relation to uncovered interest rate parity and calculate the profit from a carry trade.

Answer 8

The FX carry trade seeks to profit from the failure of uncovered interest rate parity to work in the short run. In an FX carry trade, the investor invests in a high-yielding currency while borrowing in a low-yielding currency.

If the higher yielding currency does not depreciate by the interest rate differential, the investor makes a profit. Carry trade has exposure to crash risk.

profit on carry trade = interest differential − change in the spot rate of the investment currency

Question 9

Explain how flows in the balance of payment (BOP) accounts affect currency exchange rates.

Answer 9

BOP influence on exchange rate can be analyzed based on current account influence and capital account influence.

Current account influences include:

• flow mechanism
• portfolio composition mechanism
• debt sustainability mechanism

Capital account inflows (outflows) are one of the major causes of increases (decreases) in exchange rates.

Question 10

Explain the potential effects of monetary and fiscal policy on exchange rates.

Answer 10

The Mundell-Fleming model of exchange rate determination evaluates the impact of monetary and fiscal policies on interest rates and consequently on exchange rates.

Under monetary models, we assume that output is fixed and, hence, monetary policies primarily affect inflation, which in turn affects exchange rates.

The portfolio balance (asset market) model evaluates the long-term implications of sustained fiscal policy (deficit or surplus) on currency values.

Question 11

What is the affect of monetary policies on currency using the Dornbusch overshooting model?

Answer 11

Under the Dornbusch overshooting model:

a restrictive monetary leads to an appreciation of domestic currency in the short term, and then slow depreciation towards the long-term PPP value.

a expansionary monetary leads to an depreciation of domestic currency in the short term, and then slow appreciation towards the long-term PPP value.

Question 12

What is the affect of fiscal policies on currency when you combine the Mundell-Fleming and portfolio balance approaches?

Answer 12

Combining the Mundell-Fleming and portfolio balance approaches, we find that in the

In the short term, an expansionary fiscal policy leads to domestic currency appreciation. In the long term, the impact on currency values is opposite.

In the short term, an restrictive fiscal policy leads to domestic currency depreciation. In the long term, the impact on currency values is opposite.

Question 13

Describe warning signs of a currency crisis.

Answer 13

Deterioration in terms of trade

A dramatic decline in official foreign exchange reserves

An exchange rate substantially higher than its mean-reverting level

Fixed or Partially-Fixed exchange rate

Increase in money supply relative to bank reserves

Bank crisis

Question 14

What is the Monetary-Fiscal Policy Mix Under Conditions of High Capital Mobility?

Answer 14

Domestic Currency?

Expansionary Monetary + Expansionary Fiscal = Unknown

Expansionary Monetary + Restrictive Fiscal = Depreciates

Restrictive Monetary + Expansionary Fiscal = Unknown

Restrictive Monetary + Restrictive Fiscal = Appreciates

Question 15

What is the Monetary-Fiscal Policy Mix Under Conditions of Low Capital Mobility?

Answer 15

Domestic Currency?

Expansionary Monetary + Expansionary Fiscal = Depreciates

Expansionary Monetary + Restrictive Fiscal = Unknown

Restrictive Monetary + Expansionary Fiscal = Unknown

Restrictive Monetary + Restrictive Fiscal = Appreciates

Question 16

Describe objectives of central bank or government intervention and capital controls and describe the effectiveness of intervention and capital controls.

Answer 16

Capital controls and central bank intervention aim to reduce excessive capital inflows, which could lead to speculative bubbles. The success of central bank intervention depends on the size of offical FX reserves at the dispposal of the central bank relative to the average trading volume in the country’s currency.

For developed markets, the central bank resources on a relative basis are too insignificant to be effective at managing exchange rates.

However, some emerging market countries with large FX reserves relative to trading volume have been somewhat effective.

Question 17

What are the 6-factors favoring and limiting economic growth in developed and developing economies?

Answer 17

Significant differences in growth rates exist between economies. The following factors are positively related to growth rate:

• Sufficient level of savings and investment.
• Development of financial markets and financial intermediaries.
• Political stability, sound laws, and property rights.
• Investment in education and health care systems.
• Lower taxes and regulatory burdens.
• Free trade and unrestricted capital flows.

Question 18

Describe the relation between the long-run rate of stock market appreciation and the sustainable growth rate of the economy.

Answer 18

In the long-run, the rate of aggregate stock market appreciation is limited to the sustainable growth rate of the economy.

Question 19

Explain why potential GDP and its growth rate matter for equity and fixed income investors.

Answer 19

Potential GDP: represents the maximum output of an economy without putting upward pressure on prices.

Higher potential GDP growth increases the potential for stock returns but also increases the credit quality of all fixed-income investments, all else equal.

In the short term, the difference between potential GDP and actual GDP may be useful for predicting fiscal and monetary policy. If actual GDP is less than potential GDP, inflation is unlikely and the government may follow an expansionary monetary/fiscal policy.

Question 20

What is capital deepening investment and explain how it affects economic growth and labor productivity?

Answer 20

Capital deepening: is an increase in the capital stock and the capital to labor ratio. Due to diminishing marginal productivity of capital, capital deepening will lead to only limited increases in output and labor productivity if the capital to labor ratio is already high.

Question 21

What is technological progress and explain how it affects economic growth and labor productivity?

Answer 21

Technological progress: enhances the productivity of both labor and capital but not the relative productivity of either. The long-term growth rate can be increased by technological progress (also called total factor productivity) since output and labor efficiency are increased at all levels of capital to labor ratios.

Question 22

What are the formulas for forecasting potential GDP based on growth accounting relations?

Answer 22

growth rate in potential GDP = long-term growth rate of technology
+ α x long-term growth rate in capital
+ (1 − α) x long-term growth rate in labor

or

growth rate in potential GDP = long-term growth rate of labor force
+ long-term growth rate in labor productivity

Question 23

Explain how natural resources affect economic growth and evaluate the argument that limited availability of natural resources constrains economic growth.

Answer 23

Natural resources are essential to economic growth. Empirical evidence has shown, however, that ownership of natural resources is not necessary for growth. As long as nations can acquire natural resources through trade, they can experience substantial growth.

The Dutch Disease: In some cases, ownership of natural resources may even inhibit growth since countries with abundant natural resources may not develop other industries.

Question 24

Explain how demographics, immigration, and labor force participation affect the rate and sustainability of economic growth.

Answer 24

Quantity of labor is a function of population growth, workforce participation, immigration, and average hours worked. All else equal, countries with higher population growth, higher workforce participation, younger working-age populations, higher average hours worked, and higher net immigration can grow faster due to higher labor input.

Question 25

Explain how investment in physical capital, human capital, and technological development affects economic growth.

Answer 25

The economic growth rate of a country is positively correlated with investments in both physical and human capital.

Furthermore, technological development (as evidenced by spending on R&D) is critical for economic growth. This is especially true for developed countries that already have large capital stock and a slower population growth rate.

Question 26

What is Classical growth theory?

Answer 26

Classical growth theory states that growth in real GDP per capita is temporary—when the GDP per capita rises above the subsistence level, a population explosion occurs, and GDP per capita is driven back to the subsistence level.

Question 27

What is Neoclassical growth theory?

Answer 27

Neoclassical growth theory states that the sustainable growth rate of GDP is a function of population growth, labor’s share of income, and the rate of technological advancement. Growth gains from other means such as increased savings are only temporary.

Question 28

What is Endogenous growth theory?

Answer 28

Endogenous growth theory: includes the impact of technological progress within the model. Under endogenous growth theory, investment in capital can have constant returns, unlike neoclassical theory that assumes diminishing returns to capital.

This assumption allows for a permanent increase in growth rate attributable to an increase in savings rate. Research and development expenditures are often cited as examples of capital investment that increase technological progress.

Question 29

What is the Absolute convergence hypothesis?

Answer 29

Absolute convergence states that the per capita growth rates (not growth level) will converge (i.e., be the same across all countries).

Question 30

What is the Conditional convergence hypothesis?

Answer 30

The conditional convergence hypothesis assumes that convergence in living standards (i.e., level of per capia output) will only occur for countries with the same savings rate, population growth, and production functions.

Question 31

What is the Club convergence hypothesis?

Answer 31

The club convergence hypothesis contends that living standards in some less developed countries may converge to living standards of developed standards if they are in the same “club.”

A club comprises countries with similar institutional structures (such as property rights and political stability). Countries outside of the club (without the appropriate institutional structures) will not see their living standards converge.

Question 32

Describe the economic rationale for governments to provide incentives to private investment in technology and knowledge.

Answer 32

Under the endogenous growth theory, investments in R&D, though risky, often enhance the productivity of the entire economy.

Since the private investor only reaps part of the benefit of those investments, it is likely that private sector investments in R&D will be less than what would be optimal for the economy.

Government subsidies can make these investments more attractive to private businesses.

Question 33

Describe the expected impact of removing trade barriers on capital investment and profits, employment and wages, and growth in the economies involved.

Answer 33

Economies grow faster in an environment of no trade barriers and free capital flows. Higher growth rates are possible because foreign investment can provide capital to less developed countries (neoclassical theory).

The larger markets and greater opportunity to take advantage of innovation will also increase the growth rate in open economies (endogenous growth theory).

Finally, convergence of living standards is likely to be quicker in an open economy.

Question 34

Describe the 2 economic rationale for regulatory intervention.

Answer 34

Regulations are needed in the presence of informational frictions and externalities.

• Informational frictions arise in the presence of information asymmetry.
• Externalities deal with the provision of public goods.

Question 35

Explain the purposes of regulating commerce and financial markets.

Answer 35

Financial market regulations: seek to protect investors and to ensure stability of financial systems.

Securities market regulations: include:

• disclosure requirements
• regulations to mitigate agency conflicts
• regulations to protect small investors.

Prudential supervision: is the regulation and monitoring of financial institutions to reduce system-wide risks and protect investors.

Question 36

Describe anticompetitive behaviors targeted by antitrust laws globally and evaluate the antitrust risk associated with a given business strategy.

Answer 36

Regulators often block a merger that would lead to an excessive concentration of market share.

Additionally, anticompetitive behavior such as:

• discriminatory pricing
• bundling
• exclusive dealing is often prohibited

Question 37

Describe classifications of regulations and regulators.

Answer 37

Regulations can be classified as:

• statutes
• administrative regulations
• judicial law

Regulators can be government agencies or independent regulators.

Self-regulating organizations (SROs): are given government recognition and authority.

Self-regulatory bodies do not have government recognition, and they represent as well as regulate their members. Outside bodies are not regulators themselves, but their product may be referenced by regulators.

Question 38

Describe uses of self-regulation in financial markets.

Answer 38

Self-regulating organizations, when properly supervised by regulatory agencies, have been effective in carrying out the objectives of regulations. Use of SROs is more prevalent in common-law countries than in civil-law countries.

Question 39

Describe regulatory interdependencies and their effects.

Answer 39

The regulatory capture theory: is based upon the assumption that a regulatory body will be influenced or even controlled by the industry that is being regulated.

Regulatory differences between jurisdictions can lead to regulatory competition wherein regulators compete to provide the most business-friendly regulatory environment.

Firms may use regulatory arbitrage to exploit the difference between the substance and interpretation of a regulation.

Question 40

Describe tools of regulatory intervention in markets.

Answer 40

Regulatory tools include:

• price mechanisms
• restrictions on or requirement of certain activities
• provision of public goods
• financing of private projects

Question 41

Describe benefits and costs of regulation.

Answer 41

Regulatory burden: refers to the cost of compliance for the regulated entity.

Net Regulatory burden = Regulatory burden – the private benefits of regulation

Indirect costs: of regulations need to be included in the cost benefit analysis of regulations but are difficult to measure ex ante.

Sunset clauses: require a cost benefit analysis to be revisited before the regulation is renewed.

Question 42

Describe the considerations when evaluating the effects of regulation on an industry.

Answer 42

Regulations can have material impacts on industries and companies.

Certain industries have more exposure to certain types of regulations.

Analysts should review the impact of current and proposed regulations as regulations can have a large impact on valuations for a particular company or industry.