Economics

Question 1

Foreign Exchange Spread

Answer 1

The difference between the offer and bid price is called the spread. It’s often stated as “pips”

Question 2

The spread quoted by a dealer depends on:

Answer 2

• The spread in an interbank market for the same currency pair. Interbank spread on a currency pair depends on:
  
  • Currencies involved
  • Time of day
  • Market volatility
• The size of the transaction. Larger, liquidity-demanding transactions generally get quoted a larger spread
• The relationship between the dealer and client

Question 3

Bid price and Ask price

Answer 3

• Investors always take a loss due to the spread (Ask price is always higher than bid price)
• Up-the-bid-and-multiply, down-the-ask-and-divide

Question 4

Mark-to-market value

Answer 4

• The value of a forward currency contract prior to expiration is also known as the mark-to-market value.
• The value of a forward contract at initiation is zero to both parties.

Question 5

Covered Interest Rate Parity (CIRP)

Answer 5

Covered interest rate parity holds when any forward premium or discount exactly offsets differences in interest rates, so that an investor would earn the same return investing in either currency.

Question 6

Uncovered interest rate parity

Answer 6

If forward currency contracts are not available, or if capital flows are restricted so as to prevent arbitrage, the relationship need not hold. Uncovered interest rate parity refers to such a situation; uncovered in this context means not bound by arbitrage.

Given a quote structure of A/B, the base currency (i.e., currency B) is expected to appreciate by approximately RA – RB. (When RA – RB is negative, currency B is expected to depreciate). Mathematically:

E(%ΔS)_(A/B) = R_A – R_B

Uncovered interest rate parity assumes that the investor is risk-neutral.

Question 7

Forward Rate Parity

Answer 7

If the forward rate is equal to the expected future spot rate, we say that the forward rate is an unbiased predictor of the future spot rate. In such an instance, F = E(S₁); this is called forward rate parity.

Question 8

Domestic Fisher Relation

Answer 8

R_nominal = R_real + E(inflation)

Question 9

International Fisher Relation

Answer 9

Under real interest rate parity, real interest rates are assumed to converge across different markets. Taking the Fisher relation and real interest rate parity together gives us the international Fisher effect:

R_{nominal A} – R_{nominal B} = E(inflation_A) – E(inflation_B)

Question 10

Absolute Purchasing Power Parity

Answer 10

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

Absolute PPP requires only that the law of one price be correct on average, that is, for like baskets of goods in each country.

Question 11

Relative purchasing power parity (relative PPP)

Answer 11

Relative purchasing power parity (relative PPP) states that changes in exchange rates should exactly offset the price effects of any inflation differential between two countries.

%ΔS(A/B) = Inflation(A) – Inflation(B)

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

Relative PPP is based on the idea that even if absolute PPP does not hold, there may still be a relationship between changes in the exchange rate and differences between the inflation rates of the two countries.

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 12

FX carry trade

Answer 12

• In a FX carry trade, an investor invests in a higher yielding currency using funds borrowed in a lower yielding currency. The lower yielding currency is called the funding currency.
• Carry trades typically perform well during low-volatility periods. Sometimes, higher yields attract larger capital flows, which in turn lead to an economic boom and appreciation (instead of depreciation) of the higher yielding currency. This could make the carry trade even more profitable, because the investor earns a return from currency appreciation in addition to the return from the interest rate spread.

Question 13

Crash risk of the carry trade

Answer 13

The return distribution of the carry trade is not normal; it is characterized by negative skewness and excess kurtosis (i.e., fat tails), meaning that the probability of a large loss is higher than the probability implied under a normal distribution. We call this high probability of a large loss the crash risk of the carry trade.

Question 14

Balance of payments

Answer 14

Balance-of-payments (BOP) accounting is a method used to keep track of transactions between a country and its international trading partners.

Question 15

Current account and financial account

Answer 15

• The current account measures the exchange of goods, the exchange of services, the exchange of investment income, and unilateral transfers (gifts to and from other nations).
• The financial account (capital account) measures the flow of funds for debt and equity investment into and out of the country.
• When a country experiences a current account deficit, it must generate a surplus in its capital account (or see its currency depreciate). 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 16

Current Account Influences

Answer 16

Leads to a depreciation of domestic currency via 3 mechanisms:

• Flow supply/demand mechanism Current account deficits in a country increase the supply of that currency in the markets. This puts downward pressure on the exchange value of that currency.​
  
  • The initial deficit - The larger the initial deficit, the larger the depreciation of domestic currency needed to restore current account balance.
  • The influence of exchange rates on domestic import and export -
  • Price elasticity of demand of the traded goods - If the most important imports are relatively price-inelastic, the quantity imported will not change.
• Portfolio balance mechanism When investor countries decide to rebalance their investment portfolios, it can have a significant negative impact on the value of those investee country currencies.
• Debt sustainability mechanism When the level of debt gets too high relative to GDP, investors may question the sustainability of this level of debt, leading to a rapid depreciation of the borrower’s currency.

Question 17

Capital Account Influences

Answer 17

As capital flows into a country, demand for that country’s currency increases, resulting in appreciation. Differences in real rates of return tend to be a major determinant of the flow of capital: higher relative real rates of return attract foreign capital.

Excessive capital inflows into emerging markets create problems for those countries such as:

• Excessive real appreciation of the domestic currency.
• Financial asset and/or real estate bubbles.
• Increases in external debt by businesses or government.
• Excessive consumption in the domestic market fueled by credit.

Question 18

Mundell-Fleming Model

Answer 18

Mundell-Fleming model evaluates the impact of monetary and fiscal policies on interest rates—and consequently on exchange rates. Changes in inflation rates are not explicitly modeled by the Mundell-Fleming model

Question 19

Pure monetary model and Dornbusch overshooting model

Answer 19

Under monetary models, we assume that output is fixed, so that monetary policy primarily affects inflation, which in turn affects exchange rates. There are two main approaches to monetary models:

• Pure monetary model. Under a pure monetary model, the PPP holds at any point in time and output is held constant. An expansionary (restrictive) monetary policy leads to an increase (decrease) in prices and a decrease (increase) in the value of the domestic currency.
• Dornbusch overshooting model. This model assumes that prices are sticky (inflexible) in the short term and, hence, do not immediately reflect changes in monetary policy (in other words, PPP does not hold in the short term). The model concludes that exchange rates will overshoot the long-run PPP value in the short term.

Question 20

Portfolio Balance Approach

Answer 20

The portfolio balance approach focuses only on the effects of fiscal policy (and not monetary policy). While the Mundell-Fleming model focuses on the short-term implications of fiscal policy, the portfolio balance approach takes a long-term view and evaluates the effects of a sustained fiscal deficit or surplus on currency values.

Question 21

Pull and Push Factors

Answer 21

• Pull factors are favorable developments that make a country an attractive destination for foreign capital.
• Push factors are largely driven by mobile international capital seeking high returns from a diversified portfolio

Question 22

The objectives of capital controls or central bank intervention in FX markets are to:

Answer 22

• 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.

The effectiveness of a central bank depends on its size of reserve relative to the trade volume.

Question 23

Warning sign of currency crisis

Answer 23

• Terms of trade (i.e., ratio of exports to imports) deteriorate.
• Fixed or partially-fixed exchange rates (versus floating exchange rates).
• Official foreign exchange reserves dramatically decline.
• Currency value that has risen above its historical mean.
• Inflation increases.
• Liberalized capital markets, that allow for the free flow of capital.
• Money supply relative to bank reserves increases.
• Banking crises (may also be coincident).

Question 24

Preconditions for growth

Answer 24

• Savings and investment
• Financial markets and intermediaries
  
  • Allocate capital
  • Provide liquidity and opportunities for risk reduction
  • Pooling small funds
• Political stability, rule of law, and property rights
• Investment in human capital
• Tax and regulatory systems
• Free trade and unrestricted capital flows

Question 25

Relation between the long-run rate of stock market appreciation and the sustainable growth rate of the economy

Answer 25

• ΔP = ΔGDP + Δ(E/GDP) + Δ(P/E)
• Over the long run
  
  • Δ(E/GDP) = 0
  • Δ(P/E) = 0
  • ΔP = ΔGDP

Question 26

Why potential GDP and its growth rate matter for equity and fixed income investors

Answer 26

• Higher potential GDP growth implies higher real interest rates and higher real asset returns in general.
• When actual GDP growth rate is higher (lower) than potential GDP growth rate, concerns about inflation increase (decrease) and the central bank is more likely to follow a restrictive (expansionary) monetary policy.
• It is more likely for a government to run a fiscal deficit when actual GDP growth rate is lower than its potential growth rate.
• A higher potential GDP growth rate reduces expected credit risk and generally increases the credit quality of all debt issues.

Question 27

Cobb-Douglas production function

Answer 27

• The Cobb-Douglas function essentially states that output (GDP) is a function of labor and capital inputs and their productivity.
  
  • Y = TK^αL^(1–α)
    
    • α and (1 − α) are referred to as capital(K)’s and labor(L)’s share of total factor cost, where α < 1]
    • T = Technology, often referred to as total factor productivity (TFP)
• Constantreturns to scale increasing both inputs by a fixed percentage leads to the same percentage increase in output.
  
  • output per worker = Y/L = T(K/L)^α
  • Assuming the number of workers and α remain constant, increases in output can be gained by increasing capital per worker, K/L, (capital deepening) or by improving technology (increasing TFP).

Question 28

Capital deepening

Answer 28

• Increasing capital per worker.
• Since α is less than one, additional capital has a diminishing effect on productivity: the lower the value of α, the lower the benefit of capital deepening.
• Developed markets typically have a high capital to labor ratio and a lower α compared to developing markets, and therefore developed markets stand to gain less in increased productivity from capital deepening.

Question 29

Marginal product of capital

Answer 29

• In steady state (i.e., equilibrium), the marginal product of capital (MPK = αY/K) and marginal cost of capital (i.e., the rental price of capital, r) are equal;
• hence: αY/K = r
• or α = rK/Y

Question 30

Productivity Curves

Answer 30

• Technological progress shifts the productivity curve upward and will lead to increased productivity at all levels of capital per worker.
• labor productivity growth rate = growth due to technological change + growth due to capital deepening

Question 31

Growth accounting relation

Answer 31

• ∆Y/Y = ∆T/T + α×(∆K/K) + (1−α)×(∆L/L)
• The change in total factor productivity (technology) is not directly observable. Therefore, it must be estimated as a residual: the ex-post (realized) change in output minus the output implied by ex-post changes in labor and capital.

Question 32

Labor productivity growth accounting equation

Answer 32

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

= growth due to technological change + growth due to capital deepening

Question 33

Dutch disease

Answer 33

“Dutch disease” refers to a situation where global demand for a country’s natural resources drives up the country’s currency values, making all exports more expensive and rendering other domestic industries uncompetitive in the global markets, in particular manufacturing.

Question 34

Labor supply factors

Answer 34

• Demographics
• Labor force participation
• Immigration
• Average hours worked

Question 35

Classical Growth Theory

Answer 35

Classical growth theory contends that growth in real GDP per capita is not permanent, because when real GDP per capita rises above the subsistence level, a population explosion occurs. Population growth leads to diminishing marginal returns to labor, which reduces productivity and drives GDP per capita back to the subsistence level. This mechanism would prevent long-term growth in per capita income. Classical growth theory is not supported by empirical evidence.

Question 36

Neoclassical Growth Theory

Answer 36

• Neoclassical growth theory’s primary focus is on estimating the economy’s long-term steady state growth rate (sustainable growth rate or equilibrium growth rate). The economy is at equilibrium when the output-to-capital ratio is constant. When the output-to-capital ratio is constant, the labor-to-capital ratio and output per capita also grow at the equilibrium growth rate, g*.
• In the equations for sustainable growth (per capita or total), growth rate is not affected by capital (K). Hence, we say that capital deepening is occurring but it does not affect growth rate once steady state is achieved.
• Capital deepening affects the level of output but not the growth rate in the long run. Capital deepening may temporarily increase the growth rate, but the growth rate will revert back to the sustainable level if there is no technological progress.
• An economy’s growth rate will move towards its steady state regardless of the initial capital to labor ratio or level of technology.
• In the steady state, the growth rate in productivity (i.e., output per worker) is a function only of the growth rate of technology (θ) and labor’s share of total output (1 − α).
• An increase in savings will only temporarily raise economic growth. However, countries with higher savings rates will enjoy higher capital to labor ratio and higher productivity.
• Developing countries (with a lower level of capital per worker) will be impacted less by diminishing marginal productivity of capital, and hence have higher growth rates as compared to developed countries; there will be eventual convergence of per capita incomes.

Question 37

Endogenous growth theory

Answer 37

• Endogenous growth theory contends that technological growth emerges as a result of investment in both physical and human capital (hence the name endogenous which means coming from within). There is no steady state growth rate, so that increased investment can permanently increase the rate of growth.
• The effects of ‘social returns’ or externalities are captured in the endogenous growth theory model, which concludes that economies may not reach a steady state growth but may permanently increase growth by expenditures that provide both benefits to the company (private benefits) and benefits to society (externalities).

Question 38

Convergence Hypotheses

Answer 38

• The absolute convergence hypothesis states that less developed countries will achieve equal living standards over time.
• The conditional convergence hypothesis states that convergence in living standards will only occur for countries with the same savings rates, population growth rates, and production functions.
• Under club convergence, countries may be part of a ‘club’ (i.e., countries with similar institutional features such as savings rates, financial markets, property rights, health and educational services, etc.). Under club convergence, poorer countries that are part of the club will grow rapidly to catch up with their richer peers. Countries can ‘join’ the club by making appropriate institutional changes. Those countries that are not part of the club may never achieve the higher standard of living.

Question 39

Benefit of removing trade barriers and allowing or free flow of capital

Answer 39

• Increased investment from foreign savings.
• Allows focus on industries where the country has a comparative advantage.
• Increased markets for domestic products, resulting in economies of scale.
• Increased sharing of technology and higher total factor productivity growth.
• Increased competition leading to failure of inefficient firms and reallocation of their assets to more efficient uses.

Question 40

Classification of regulations

Answer 40

• Statutes (laws made by legislative bodies)
• Administrative regulations (rules issued by government agencies or other bodies authorized by the government)
• Judicial law (findings of the court).

Question 41

Type of Regulators

Answer 41

• Government agencies
• Independent regulators:
  
  • Independent regulators are given recognition by government agencies and have power to make rules and enforce them.
  • Usually not funded by the government and hence are politically independent.
  • Some independent regulators are self-regulating organizations (SROs) that regulate as well as represent their members.
  • Not all SROs are independent regulators, and not all independent regulators are SROs.
  • The use of independent SRO s in civil-law countries is not common. It’s more common in common-law countries such as the UK, and the US.
• Outside bodies

Question 42

Regulation intervention are needed in the presence of:

Answer 42

• Informational frictions occur when information is not equally available or distributed. A situation where some market participants have access to information unavailable to others is called information asymmetry. Regulations are put in place in an attempt to ensure that no participant is treated unfairly or is at a disadvantage.
• Externalities are costs or benefits that affect a party that did not choose to incur that cost or benefit. One externality issue commonly addressed by regulation is the provision of public goods. A public good is a resource, like parks or national defense, which can be enjoyed by a person without making it unavailable to others. Since people share in the consumption of public goods but don’t necessarily bear a cost that is proportionate to consumption, regulations are necessary to ensure an optimal level of production of such public goods.

Question 43

Regulatory capture theory

Answer 43

The regulatory capture theory is based upon the assumption that, 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, because the regulators often have experience in the industry. It is often cited as a concern with the commercialization of financial exchanges.

Question 44

Regulatory competition and regulatory arbitrage

Answer 44

• Regulatory competition, in which regulators compete to provide the most business-friendly regulatory environment.
• Regulatory arbitrage occurs when businesses shop for a country that allows a specific behavior rather than changing the behavior.
• To avoid regulatory arbitrage, cooperation at a global level to achieve a cohesive regulatory framework is necessary.

Question 45

Three regulatory tools are available to regulators:

Answer 45

• Price mechanisms. Tax and subsidies
• Restricting/requiring certain activities. Regulators may ban certain activities or require that certain activities be performed to further their objectives.
• Provision of public goods or financing of private projects. Regulators may provide public goods or fund private projects depending on their political priorities and objectives.
• The effectiveness of regulatory tools depends on the enforcement abilities (e.g., sanctioning violators) of the regulators.

Question 46

Purposes in regulating commerce and financial markets:

Answer 46

• Commerce: Government regulations provide an essential framework to facilitate business decision making. Regulations may facilitate or hinder commerce.
• Financial market regulations include regulation of securities markets and regulation of financial institutions. The objectives of securities regulations include three interrelated goals: protecting investors, creating confidence in the markets, and enhancing capital formation.

Question 47

Regulation of security markets

Answer 47

• ​​Disclosure requirements are a key element of security markets regulations.
• Many securities regulations are directed towards mitigating agency problem.
• Regulations have historically focused on protecting small (retail) investors, hence the relatively lax regulatory coverage of hedge funds and private equity funds that are marketed only to qualified investors.

Question 48

Prudential supervision

Answer 48

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

Question 49

Categories of intercorporate investments

Answer 49

• Investments in financial assets. An ownership interest of less than 20% is usually considered a passive investment. In this case, the investor cannot significantly influence or control the investee. IFRS and GAAP classify investments in financial assets as held-to-maturity, available-for-sale, or fair value through profit or loss (which includes held-for-trading and securities designated at fair value).
• Investments in associates. An ownership interest between 20% and 50% is typically a noncontrolling investment; however, the investor can usually significantly influence the investee’s business operations. The equity method is used to account for investments in associates.
• Business Combinations. An ownership interest of more than 50% is usually a controlling investment. When the investor can control the investee, the acquisition method is used.
• Joint ventures. A joint venture is an entity whereby control is shared by two or more investors. Both IFRS and U.S. GAAP require the equity method for joint ventures. In rare cases, IFRS and U.S. GAAP allow proportionate consolidation as opposed to the equity method.

Question 50

Coase theorem

Answer 50

The Coase theorem states that if an externality can be traded and there are no transaction costs, then the allocation of property rights will be efficient and the resource allocation will not depend on the initial assignment of property rights.