Economics Flashcards
Write down the formula to calculate the mark-to-market value of a forward contract
What is are the 5 components of the international parity conditions
- Covered interest rate parity
- Uncovered interest rate parity
- Purchasing power parity
- International Fisher effect
Forward rate parity
Covered interest rate parity
- Bound by arbitrage
- Forward premium or discount offsets differences in interest rates
- Spot * i/i = forward spot
Uncovered interest rate parity
- Not bound by arbitrage
- The difference in nominal interest rate, will influence the forecast spot exchange rate to depreciate by same amount
- Not hold in short run
Fish Relation
R nominal = R real + E(inflation)
International Fisher effect
- Under real interest rate parity
- R nominal a - R nominal b = E(Inflation a) - E(inflation b)
- If +5% in nominal interest rate , leads to 5% inflation expected, leads to the dollar to weaken
Purchasing power parity
- absolute purchasing power parity (absolute PPP) compares the average price of a representative basket of consumption goods between countries using an index such as The United States Consumer Price Index (CPI).
- law of one price
Relative Purchasing power parity
- changes in exchange rates should exactly offset the price effects of any inflation differential between two countries
Ex-Ante Version of PPP
- 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.
3 observations that need to be done
- Covered interest rate holds by arbitrage. If forward rate parity holds, uncovered interest rate parity holds
- Interest rate differentials should mirror inflation differentials. Holds id international fisher relation holds. If true, inflation differentials can be used to forecast future exchange rates.
- If the ex-ante version of relative PPP as well as the international Fisher relation both hold, uncovered interest rate parity will also hold.
What are the key methods used to forecast future spot exchange rates
- Current spot rate
- Forward Rate
- Purchasing Power Parity
- Uncovered Interest rate parity
Why does Purchasing Power Parity (PPP) typically hold over long time horizons but not short term?
PPP assumes that the real exchange rate is constant, but in the short term, the real exchange rate fluctuates around a mean-reverting equilibrium value due to deviations in inflation and market forces. Over long periods, inflation differences between countries are more likely to equalize, making PPP a better predictor of future spot rates.
how can the long-run fair value of an exchange rate be assessed?
- Ex-ante PPP: Assumes relative PPP holds over the long term, with inflation differentials driving the exchange rate toward equilibrium.
- Uncovered Interest Rate Parity (UIP): Assumes differences in interest rates reflect expectations about exchange rate movements, though it is less effective in practice due to risk premiums.
- International Fisher Effect: Assumes that real interest rates are equal across countries, but this does not account for sovereign risk premia, which are significant for emerging markets.
What is a bid-offer spread?
The difference between the offer and bid price of a currency quotation.
What does the exchange rate represent?
The price of one currency in terms of another.
What is a spot exchange rate?
The currency exchange rate for immediate delivery.
What is a forward exchange rate?
A contract rate for currency exchange to be done in the future.
How does a dealer quote currency prices?
$1.4124 − 1.4128: bid price is $1.4124 (dealer buys euros), and the ask price is $1.4128 (dealer sells euros).
What factors affect the dealer’s bid-offer spread?
Interbank market spread, transaction size, and dealer-client relationship.
How does the interbank spread on currency pairs vary?
It depends on the currencies involved, time of day, and market volatility.
What is triangular arbitrage?
Exploiting discrepancies between three currency exchange rates for profit.
What are spot and forward premiums/discounts?
A forward premium exists if the forward price is greater than the spot price; a discount exists if the forward price is less than the spot price.
What is the mark-to-market value of a forward contract?
The value of a forward contract prior to expiration, calculated based on forward price changes.
What is covered interest rate parity?
A condition where the forward premium or discount offsets interest rate differences between two currencies.
What is uncovered interest rate parity?
A theory where expected future spot rates reflect interest rate differentials without arbitrage opportunities.
What is the International Fisher Effect?
An economic theory stating that differences in nominal interest rates mirror expected inflation rates between countries.
What is purchasing power parity (PPP)?
The concept that identical goods should cost the same in different countries after adjusting for exchange rates.
What is the difference between absolute and relative PPP?
Absolute PPP compares price levels directly, while relative PPP focuses on changes in price levels (inflation rates).
How can the current spot rate forecast future exchange rates?
By assuming no future changes, but it ignores expected changes.
How is the forward rate used to forecast exchange rates?
It is often used but is not an unbiased predictor of future exchange rates.
What is the carry trade?
An investment strategy where funds are borrowed in a low-yield currency to invest in a high-yield currency.
What are risks associated with carry trades?
Currency appreciation, negative skewness, excess kurtosis, crash risks, and herding behavior.
What is the balance of payments?
A method to track transactions between a country and its international trading partners.
What is the current account?
It measures the exchange of goods, services, investment income, and unilateral transfers between nations.
What is the financial account?
It tracks the flow of funds for debt and equity investments into and out of a country.
What is the Mundell-Fleming model?
A model explaining how monetary and fiscal policies affect exchange rates under different capital mobility scenarios.
What is the impossible trinity in exchange rate policy?
The trade-off between maintaining a fixed exchange rate, allowing free capital flows, and pursuing an independent monetary policy.
What is the pure monetary model for exchange rates?
A model where inflation drives exchange rates via purchasing power parity.
What is the Dornbusch overshooting model?
A model where short-term exchange rate changes overshoot long-term equilibrium due to sticky prices.
What is the portfolio balance approach?
A model focusing on fiscal policy’s long-term effects on exchange rates through debt levels and investor confidence.
What are push factors in capital flows?
External conditions driving capital flows, such as low returns in developed markets.
What are pull factors in capital flows?
Favorable domestic conditions attracting foreign capital, such as price stability and fiscal health.
What is a warning sign of a currency crisis?
Deterioration in terms of trade, declining foreign exchange reserves, or rising inflation.
What are factors favoring economic growth?
Savings, investment, financial markets, political stability, and free trade.
What does the Grinold-Kroner model describe?
The expected equity returns based on dividend yield, earnings growth, inflation, dilution, and repricing.
What is the sustainable growth rate of an economy?
The maximum real GDP growth rate a country can sustain without imbalances.
Why is potential GDP growth important for investors?
It indicates long-term earnings growth for equities and real interest rates for bonds.
What is capital deepening?
Increasing capital per worker to boost productivity, subject to diminishing returns.
What is technological progress?
Advances improving the efficiency of labor and capital, sustaining long-term productivity growth.
What is the Cobb-Douglas production function?
A model explaining output based on labor, capital, and technology.
How is labor productivity growth calculated?
Growth due to technological change plus growth due to capital deepening.
What is absolute convergence?
The hypothesis that less-developed countries will catch up with developed countries over time.
What is conditional convergence?
The idea that countries with similar savings rates and population growth will converge in living standards.
What is the club convergence hypothesis?
The notion that only countries with similar institutional structures will converge.
What is endogenous growth theory?
A theory suggesting growth arises from investments in human and physical capital generating technological progress.
Why should governments incentivize R&D?
To address market failures and align private R&D investments with societal benefits.
What are the impacts of removing trade barriers?
Increased investment, higher wages, economic growth, and technology sharing.
What is the neoclassical growth model?
A model where technological progress drives long-term growth while capital deepening provides temporary boosts.
What is the role of demographics in economic growth?
Population growth, labor force participation, and immigration affect labor supply and sustainability of growth.
What is the resource curse?
Over-reliance on natural resources leading to slower economic growth and reduced diversification.
What is the difference between developed and developing economies regarding capital deepening?
Developed economies benefit less due to high capital-to-labor ratios, while developing economies see short-term gains.
What is the impact of technology sharing on economic growth?
It enhances total factor productivity and innovation in open economies.
What is the role of public infrastructure in economic growth?
It supports private investment and boosts productivity.
How do trade policies affect convergence?
Open trade accelerates convergence, while protectionism hinders it.
