Session 4 - Economics

Question 1

Covered Interest Rate Parity

Answer 1

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.
= [1+interest rate A(days/360)]/[1+interest rate B(days/360)]*spot rate

Question 2

Relative Purchasing Power Parity

Answer 2

Changes in exchange rates should exactly offset the price effects of any inflation differential between the two countries.
Spot @ T = Spot*[(1+inflation A)/(1+inflation B)]^T

Question 3

Balance of Payments (BOP)

Answer 3

Method used to keep track of transactions between a country and its international trading partners:

current account
+ financial account
+ official reserve
= 0

Question 4

Current Account

Answer 4

Measures the exchange of goods, services, investment income, and unilateral transfers (gifts).
It summarizes whether we are selling more goods and services to the world than we are buying from them.

Question 5

Financial Account

Answer 5

Measures the flow of funds for debt and equity investments into and out of the country.

Question 6

Official Reserve

Answer 6

Transactions made from the reserves held by the official monetary authorities of the country.

Question 7

Real Exchange Rate (A/B)

Answer 7

= equilibrium real exchange rate
+ (real interest rate B - real interest rate A)
- (risk premium B - risk premium A)

Question 8

FX Carry Trade

Answer 8

An investor invests in a higher yielding currency using funds borrowed in a lower yielding currency.
This is a bet against uncovered interest rate parity and works best during low volatility periods.

Question 9

Growth Rate in Potential GDP

Answer 9

LT growth rate of technology
+ (alpha)(LT growth rate of capital)
+ (1-alpha)(LT growth rate of labor)

or…
LT growth rate of labor force + LT growth rate in labor productivity.

Question 10

Labor Supply Factors

Answer 10

1. Demographics
2. Labor force participation = labor force/working age population
3. Immigration
4. Average hours worked

Question 11

Pips

Answer 11

Offer/bid spreads are often stated as “pips”

1 pip = 1/10,000

Question 12

Classical Growth Theory

Answer 12

In the long-term, population growth increases whenever there are increases in per capita income above subsistence levels due to an increase in capital or technology progress.

This theory is not supported by empirical evidence.

Question 13

Neoclassical Growth Theory

Answer 13

Sustainable growth of output per capita is equal to the growth rate in technology divided by the labor’s share of GDP

Question 14

Endogenous Growth Theory

Answer 14

Technology growth emerges as a result of investment in both physical and human capital. Unlike the neoclassical model, there is no steady growth rate, so that increased investment can permanently increase the rate of growth.

Question 15

Uncovered Interest Rate Parity

Answer 15

Not bound by arbitrage - this derives the expected future spot rate as opposed to the no-arbitrage forward rate (covered parity)

Expected spot at time T = [(1+interest rate A)/(1+interest rate B)]^T * spot price

Question 16

International Fisher Relation

Answer 16

Nominal rate of return is the sum of the real rate and the expected rate of inflation.
(1+Rnominal) = [(1+Rreal) + (1 + Einflation)]