portfolio balance model

Question 1

State the conditions for a risk premium to exist.

definition and 3 conditions for UIP not to hold

Answer 1

• Risk premium: Domestic and foreign bonds are not perfect substitutes: expected returns on both assets are not equal: UIP does not hold

• Conditions for risk premium to exist:
• 1. perceived different risks between foreign and domestic bonds. Risk= uncertain expected return
• 2. Risk aversion on the part of economic agents to perceived differences in risk. Increased risk will only be taken if expected real returns compensate.
• 3. Theoretical “risk minimizing portfolio”: If not held, agents will demand a risk premium to compensate.
• If 3 conditions are fulfilled, UIP does not hold.

Question 2

formula including risk premium and different types of risk (2)

Answer 2

r-r= ES˚+RP
RP= risk premium demanded for domestic bonds, which can be either + or -. (Negative for foreign bonds)
Different types of risk
A) Currency risks: inflation rates in the domestic and foreign economies are uncertain
Real interest rate will also be uncertain
Risk of holding a bond: function of the inflation rate domestic- domestic, foreign- foreign
Exchange rate risk: expected deviation of the exchange rate from PPP
Expected rate of return from holding foreign bonds=
r-EP˚*+ES˚

Question 3

why MM slopes up?

Answer 3

a depreciation of S leads to increase in domestic currency value of foreign bonds, so leads to wealth effect. The increase demand for money offset by increase r (s to r)

Question 4

why bb slopes down?

Answer 4

depreciation increases value of foreign bonds so a wealth effect. Demands for domestic bonds increase so price of b goes up and r falls.

Question 5

why FF slopes down?

Answer 5

as r rises, domestic bonds more attractive so currency appreciates to keep equilibrium

Question 6

increase money supply effect on mm

Answer 6

mm shifts right, as increase money supply increases, demand for bonds increase, price of bonds increase so r drops.

Question 7

increase supply in F

Answer 7

ff shifts left and r falls so foreign bonds willingly held.

Question 8

increase in supply of B

Answer 8

BB shifts right, r rises.

Question 9

bond financed expenditure -effect on s if wealth effect dominates? effect if interest rate effect dominates?

Answer 9

wealth effect- high r, depreciation

interest effect - high r, appreciation (due to smaller ff shift as rise in r reduces demand for foreign bonds)