Economics Flashcards
late expansion phase of the business cycle:
- bond yields are usually rising but more slowly than short-term interest rates are, so the yield curve flattens. Private sector borrowing puts upward pressure on rates while fiscal balances typically improve.
- Stocks typically rise but are subject to high volatility as investors become nervous about the restrictive monetary policy and signs of a looming economic slowdown. Cyclical assets may underperform while inflation hedges, such as commodities, outperform.
- short-term interest rates are typically rising as monetary policy becomes restrictive because the economy is increasingly in danger of overheating. The central bank may aim for a soft landing.
a diffusion index (e.g., a leading indicator-based approach) VS econometric model (i.e.) structural model)
Times series with leading indicator model:
Strength = simple since it requires following a limited number of economic/financial variables. Can focus on individual or composite variables that are readily available and easy to track. Focuses on identifying/forecasting turning points in the business cycle.
Weakness = Data subject to frequent revisions resulting in “look-ahead” bias.
• “Current” data not reliable as input for historical analysis.
• Overfitted in sample. Likely overstates forecast accuracy.
• Can provide false signals on the economic outlook.
• May provide little more than binary directional guidance (no/yes).
Econometric model:
Strength: • Econometric models can be quite robust and can examine impact of many potential variables.
• New data may be collected and consistently used within models to quickly generate output.
• Models are useful for simulating effects of changes in exogenous variables.
• Imposes discipline and consistency on the forecaster and challenges modeler to reassess prior view based on model results.
Weakness =• Models are complex and time consuming to formulate.
• Requires future forecasts for the exogenous variables, which increases the estimation error for the model.
• Model may be mis-specified, and relationships among variables may change over time.
• Models may give false sense of precision.
• Models perform badly at forecasting turning points.
checklist approach: strengths are flexibility and limited complexity, although one weakness is that it imposes no consistency of analysis across items or at different points in time. Checklist assessments are time consuming because they require looking at the widest possible range of data and may require subjective judgment.
domestic-currency return
domestic-currency return = (1 + RFC)(1 + RFX) − 1
An increase in the expected correlation between movements in the foreign-currency asset returns and movements in the spot exchange rates would increase the domestic-currency return risk but would not change the level of expected domestic-currency return.
FX hedging trading costs
- bid/offer spread offered by dealers. Maintaining a 100% hedge will require frequent rebalancing of minor changes in currency movements and could prove to be expensive. “Churning” the hedge portfolio would progressively add to hedging costs and reduce the hedge’s benefits.
A long position in currency options involves an upfront payment. If the options expire out-of-the-money, this is an unrecoverable cost.
Forward contracts have a maturity date and need to be “rolled” forward with an FX swap transaction to maintain the hedge. Rolling hedges typically generate cash inflows and outflows, based on movements in the spot rate as well as roll yield. Cash may have to be raised to settle the hedging transactions (increases the volatility in the organization’s cash accounts). they become more expensive for cash outflows as interest rates increase.
overhead costs: necessary administrative infrastructure for trading (personnel and technology systems).
currency overlay program
outsource currency exposure management to a sub-advisor that specializes in foreign exchange management.
is active currency management
should introduce foreign currencies as a separate asset class, so uncorrelated as possible with other asset so currency overlay is expected to generate alpha
long or short volatility
Speculative volatility traders often want to be net-short volatility, if they believe that market conditions will remains stable. The reason for this is that most options expire out-of-the money, and the option writer can then keep the option premium as a payment earned for accepting volatility risk. A volatility-based strategy would typically be net short, as opposed to net long, volatility
Taylor rule
Taylor rule = Roptimal = Rneutral + [0.5 × (GDPgforecast – GDPgtrend)] + [0.5 × (Iforecast – Itarget)]
Singer and Terhaar approach on expected return on an asset class
risk premium arising from systematic risk as a weighted average of the risk premiums arising from a fully integrated market and fully segmented market,
Step 1 Systematic risk premium in fully integrated market = standard deviation of investments x correlation with market x sharpe ratio
Step 2 Systematic risk premium in fully segmented market = standard deviation of investments x sharpe ratio
Step 3 Weight systematic risk premiums by degree of integration:
Step 4 Add the illiquidity premium and risk free rate
Singer–Terhaar model implies that when a market becomes more globally integrated (segmented), its required return should decline (rise). As prices adjust to a lower (higher) required return, the market should deliver an even higher (lower) return than was previously expected or required by the market. Therefore, the allocation to markets that are moving toward integration should be increased. This will typically entail a shift from developed markets to emerging markets.
Forward vs. Futures
- A forward contract is less expensive. -> absence of margin requirements as in futures, reducing portfolio management expense.
- A forward contract has greater liquidity. -> a forward contract is more flexible in terms of currency pair, settlement date, and transaction amount./ more liquid than futures for trading in large sizes because the daily trade volume for OTC currency forward contracts dwarfs those for exchange-traded futures contracts.
Settling fx forward. To hedge EUR exposure, (lock in buy euro rate) -> sell USD buy Euro forward
When hedging one month ago, Delgado would have sold USD2,500,000 one month forward against the euro. To calculate the net cash flow (in euros) to maintain the desired hedge, the following steps are necessary:
Buy USD2,500,000 at the spot rate. Buying US dollars against the euro means selling euros, which is the base currency in the USD/EUR spot rate. Therefore, the bid side of the market must be used to calculate the outflow in euros.
USD2,500,000 × 0.8875 = EUR2,218,750.
Sell USD2,650,000 at the spot rate adjusted for the one-month forward points (all-in forward rate). Selling the US dollar against the euro means buying euros, which is the base currency in the USD/EUR spot rate. Therefore, the offer side of the market must be used to calculate the inflow in euros.
forward rate bias, carry trade strategy
forward rate bias = Buy (invest in) the forward discount currency and sell (borrow) the forward premium currency.
The carry trade strategy of borrowing in low-yield currencies and investing in high-yield currencies is equivalent to trading the forward rate bias
change in regime
A change in regime is a shift in the technological, political, legal, economic, or regulatory environments. Regime change alters the risk–return relationship since the asset’s risk and return characteristics vary with economic and market environments. Analysts can apply statistical techniques that account for the regime change or simply use only part of the whole data series.
NDF
Expect the won—the price currency—to depreciate relative to the USD. This would require a long forward position in a forward contract, but as a country with capital controls, a NDF would be used instead. (Note: While forward contracts offered by banks are generally an institutional product, not retail, the retail version of a non-deliverable forward contract is known as a “contract for differences” (CFD) and is available at several retail FX brokers.)
The credit risk underlying an NDF is lower than an outright forward contract since the notional size of the contract is not exchanged at settlement, but only the non-controlled currency amount by which the notional size of the controlled currency has changed over the life of the contract—that is, the change in the controlled currency times the notional size converted to the non-controlled currency at the spot rate on the settlement date.
Impact on contraction/ lower inflation on: short term rates, bonds, equities and properties
With the economy contracting and inflation falling, short-term rates will likely be in a sharp decline. Cash, or short-term interest-bearing instruments, is unattractive in such an environment. However, deflation may make cash particularly attractive
high-quality bonds will benefit from falling inflation or deflation. Persistent deflation benefits the highest-quality bonds because it increases the purchasing power of their cash flows. It will, however, impair the creditworthiness of lower-quality debt.
Within the equity market, higher inflation benefits firms with the ability to pass along rising costs. In contrast, falling inflation or deflation is especially detrimental for asset-intensive and commodity-producing firms unable to pass along the price increases.
Falling inflation or deflation will put downward pressure on expected rental income and property values. Especially negatively affected will be sub-prime properties that may have to cut rents sharply to avoid rising vacancies.
Fiscal policy on yield curve
Fiscal policy may affect the shape of the yield curve through the relative supply of bonds at various maturities that the government issues to fund deficits. Unlike the impact of monetary policy, the impact of changes in the supply of securities on the yield curve is unclear. large government budget deficits (govt spending/ borrowing > tax) forecasted are unlikely to have much of a lasting impact on the yield curve, especially given that private sector borrowing will be falling during the contraction, somewhat offsetting the increase in the supply of government securities.
