Monetary policy

Money creation = New deposit/Reserve requirement

Money multiplier = 1/Reserve requirement
Narrow Money or M1 – Liquid money in the market
Broad Money – Narrow money + All other non-liquid deposits
 Credit card balance is not considered money

Quantity Theory

Transmission Mechanism – Effect of interest rates on the following

Inflation
- Higher interest rates = Low borrowing and low spending in the market = Low inflation
- Low Interest rates = High borrowing and spending in the market = High inflation

Effect of Interest rates on assets such as bonds

- Higher Interest rates = Low Existing bond prices as new bonds have better interest
- Low Interest Rates = Higher existing bond prices as your bond is giving more return than
market rate

Exchange Rates
- Higher Interest Rates = Foreign investors getting more return on their investment in the
country = High investment in the country = More demand for currency = appreciation of
value
- Lower Interest Rates = Investors getting low return and thus shifting to another country =
reduced demand of the currency

Exchange Rate Targeting

- Basically, exchange rate targeting is a monetary policy between 2 countries.
- Where central bank of 1 country tries to maintain a fixed exchange rate with another
country such as US and Dubai
- If exchange rate changes such as USD appreciates, Central bank will buy Dubai currency to
increase its value as well so that the exchange rate stays the same.
- It happens to keep good amount of trade happening between 2 countries and eliminate the
fluctuation costs and provides stability and predictability.
- There’s a peg system as well where under this system, exchange rate is not exactly fixed but
fluctuates between a set range.

Contractionary Monetary Policy

- It happens when government has to control inflation and increases interest rates.
- They do it to make borrowing more expensive
- They also reduce money supply in the market, and this leads to contraction of economic
growth
Expansionary Monetary Policy
- It happens when central bank wants to stimulate economic growth
- They do it by reducing interest rates in the markets and increasing money supply in the
market.
- This leads to easy borrowing and economic growth expands

Fiscal Policy – refers to the taxing and spending policy of the government.
- The objective of this policy to manage economy by influencing real GDP

Expansionary Fiscal Policy

- To boost economic and increase real GDP, Government can increase spending on
infrastructure, education, healthcare
- Government can also lower taxes for high personal income encouraging them to spend
more and invest more

Contractionary Fiscal Policy

- To slow down inflation and ecnomic growth, govt may reduce spending and increase tax
returns
- This will also reduce personal spending

Fiscal Multiplier
- It is a concept that measures total change in the economic output by change in government
spending and taxation.
- In easy terms, this multiplier is used to calculate the effect on economic output when
government increases or decreases it spending or make some changes in tax policies
- Formula is fiscal multiplier = 1/[1-c(1-t)]
- T is tax rate, c is marginal capacity of a consumer to spend. C means that how much will you
spend out of every extra dollar you get. For example, you get 1 dollar and you only spend 8
cents, then your C is 80%

Balanced budget multiplier

- We know that increase in taxes will reduce GDP or personal spending
- We also know that increase in Govt spending will increase GDP
- However if both increase
International Trade
- GDP = Sum of all the goods and service produced in an economy
- GNP = GDP – Income generated by foreigners + income generated by nationals in foreign
- Terms of trade = Price of exports/Price of imports, the higher the better for an economy
- Autarky = closed economy, that does not trade with any other country in the world
- Trade protection = trade laws and stuff
- FDI – foreign trade investment, a German company opening real estate factory in India
- FPI – Foreign portfolio investment, A us investor buying stocks in India

Benefits
- Higher price for the same product as compared to selling within the country
- Lower price for importing the product as compared to producing within the country
- Industry experience low cost due to high volume production – Economies of sale
- Household and firms have great product variety
- High competition and more efficient allocation of resources
- Greater employment

Costs
- Potential Income inequalities
- Loss of some jobs as less efficient firms would have to exit

Gains from trade – This concept basically means that international trade between 2 countries
actually lead to overall development of both the countries.
Comparative advantage
- If country A can produce goods at a lower cost with low use of resources than country b,
then it has an absolute advantage over country B.
- If country A can produce goods at a lower opportunity cost then it has comparative
advantage over B
- Hint to solve the question – The product of which cost you need to find always comes in
the denominator.

Ricardian and Heckscher-Ohlin

- Ricardian Model says
o Trade if you have absolute advantage.
o Trade even if you just have comparative advantage.
o Labour is the only variable factor of production
o Technology leads to difference in labor productivity
- Heckscher ohlin model
o Labor and capital both are variable
o Country that has better labor should invest in labour intensive industries and vice
versa
o Technology in each industry is same across countries but varies in different
industries.

Export Subsidies
- Payments by the govt for each unit exported.
- To stimulate exports
- Small country imposes this = higher exports to countries willing to pay higher price =
domestic prices of the product rise
- Large country imposes this = higher quantities available in the world = world prices decline
- Net benefit in both the countries is down
Summary ^^

Trading blocks
- Free trade area: No trade restrictions between members and they can have their own
policies with non members
- Customs Union: All member countries adopt a common set of trade restrictions with non
members
- Common Market: All barriers to the movement of labor and capital goods among member
countries are removed.
- Economic Union – Member countries establish common institutions and economic policy
- Monetary Union – Member countries adopt a single country

Capital Restrictions
- Some govt restrict the trade of capital
- Maybe due to strategic or defense related reasons
- To stop capital from moving out of country during an economic crisis

Balance of Payments
- A double bookkeeping system that summarises a country’s economic transaction with the
rest of the world
Components of Balance of trade
1. Current Account – Deals with flow of goods and services
a. Merchandise trade
b. Services – Tourism, Transportation, engineering, business services, legal services,
management services, Consulting and accounting, fees from payments and
copyrights
c. Income receipts – receipts that we get on our investments abroad
d. Unilateral Transfer of assets – One way transfer of asset where nothing is
expected in return eg remittances
2. Financial Account – Deals with Investment Flows
a. Financial Assets abroad – further divided into official reserve, government and
private assets. This includes gold, foreign currencies, securities, reserve positions
in the IMF, direct foreign investment, claims reported by resident banks
b. Foreign owned assets in domestic country – Securities issued and private, direct
investments and foreign liabilities
3. Capital Account – Capital transfer
a. Capital Transfer – debt forgiveness, transfer of funds related to sales and
acquisition of fixed assets, gifts, legacies.
b. Sales and purchases of non-produced, non-financial assets – proceeds from
patents

Current Account = Private Savings + Government Savings – Investments

Trade Organizations

International Monetary Fund

Imf stands ready to lend foreign currencies to member countries to assist them during external
deficits.
- Forum for cooperation on international monetary problems
- Encourages international growth and promotes employment
- Supports exchange rates stability and open system of international payments
- Help member countries to address BOP problems

World Bank
- The main purpose of world bank is to help developing countries fight poverty
- Provides no or low interest rates to those countries
- Provides anlaysis, advice and information to its member countries

World Trade Organization

- Only organization that regulates trade relationships among nations on a global scale
- Implement and administer agreements
- Act as a platform for negotiations
- Settle disputes
- WTO agreements have been signed by large majority of trading nations
Currency Exchange Rates
- Each currency has a different 3-digit code such as USD, INR, GBP
- Exchange Rate
o Price currency - numerator
o Base currency – denominator
- Currency Appreciation – Currency is becoming stronger, i.e exchange rate is high.
- Direct quote takes domestic currency as price currency.
- Indirect quote takes domestic currency as the base currency.

Nominal and Real exchange rates

Nominal – Just normal exchange rates eg 1CAD = 60INR. Also known as spot rate
Real exchange rates – It measures the relative purchase power of one currency compared with
another.
o Real rate = Spot rate * price level of base currency/Price level of price currency

Reasons for FX Transaction

- International Trade
- Capital Market transactions

Quotations
- Bid is the price at which dealer will buy the base currency
- Ask is the price at which dealer will sell the base currency
- For ex – Bid is 1.4 USD/EUR and ask is 1.5 USD/EUR
- This means for 1 EUR dealer paid 1.4 USD and is asking for 1.5 USD in the market
- When 1 currency appreciates, other depreciates

Cross Rate Calculations

- Given two exchange rates, and three currencies, it is possible to determine the third
exchange rate

Forward Calculations
- Forward exchange rates is quoted in terms of points or pips
- Count the number of decimal places in spot rate.
- Divide that many 0s from the forward rate given for a particular period to convert it to
points.
- Such as 12-month forward rate is -25.5 and spot rate today is 1.5555. To get the forward
rate, we will subtract ‘25.5/10000’.

Link between spot rate, Forward Rate, and Interest Rates

Fp/b = Sp/b * (1+ip)/(1+ib)
- The currency with higher interest rate will always trade at a discount and lower interest rate
at a premium.
- This discount premium thing is to prevent arbitrage.
- If iinr is 10% and iusd is 1% and there is no discount premium thing, an investor will convert
usd to inr, get 10% interest and convert back to usd. Therefore, this benefit without risk is
known as arbitrage.
- If forward contract is for x days, multiple interest rates by x/360 for exam purpose.

Exchange Rates, International trade, and Capital Flows

- Impact of exchange rates and other factors on the trade balance must be mirrored by their
impact on capital flows.
- Here trade balance refers to current account and capital flows refers to financial and capital
accounts both.
- Basically, it means that both sides should be equal as in a real balance sheet
- Imagine if there is a trade deficit in a country i.e., X-M = -ve then the company must be
borrowing from outside or other countries must be investing capital in the country to fund
this deficit

Calculations – Income must equal expenditure

- Income = Consumptions + Savings + Taxes
o C+S+T
- Expenditure = Consumption + Investments + Government Spending + trade deficit
o C+I+G+X-M

Elasticities Approach and Absorption Approach is used to find the impact of exchange rate on
trade balance

Elasticities Approach - Important

- Price elasticity: If a small change in price majorly affects the quantity demanded then we
can say that the demand is elastic and vice versa.
- When a country’s currency goes up, demand for its exports goes down and vice versa.
- If wxex + wm(em-1)>0, currency depreciation will move the balance towards trade surplus
and appreciation will increase trade deficit. If the equation is <0, then trade surplus will go
up with currency appreciation and will go down with currency depreciation.
- When a currency depreciates, exports increase by elasticity amount, and imports decrease.
- However, Imports decrease by elasticity amount but the price of imports go up. Therefore
imports increase by (price up – elasticity) amount.
- Note: All this mentioned above is long term impact
- In short term: currency going down will lead to a J curve i.e., trade surplus will immediately
go down and then go up in long term because impact on exports take time but impact on
imports are immediate.

Absorption Approach
- Exchange rate change that decreases domestic expenditure relative to income will move
trade balance towards a surplus.
- That means It should increase domestic saving relative to domestic investment.
- X-M = S - I + G + T, therefore S, G, T, should go up
- If currency depreciates, income increases by switching demand to domestic products.
Income rises relative to expenditure. This situation occurs in excess capacity available.
- If economy is full employment, households reduce expenditure and increase savings

Derivatives
Make notes for intro

Lo2: Forward commitment and contingent claim features and instruments

- Derivatives can be classified as forward commitments or contingent claims.
- Forward commitments are obligations to trade
- Contingent provides the right to trade
- Person selling the options have the obligation to trade if the person given the options
decides to trade
- Forward commitments can be exchange traded contracts such as futures or over the
counter contracts such as Forwards and swaps.
- For all the three types of forward commitments, price is specified at the initiation.

Forward Commitments
Forwards
- A forward is an agreement to make a trade at future date at a specified price. If the price of
the asset goes up in the future, the buyer will get the asset at lower price due to the
agreement and will make a profit.
- The buyer is said to have a long position and the seller is said to have a short position.
- Forward price is denoted by F0(T), 0 is time 0 and T stands for maturity time.
- ST stands for spot price of the asset at maturity.
- Long = St – F0(T) and short is reversed

Futures
- A future contract is similar to a forward contract.
- Differences between future and forward contracts are
o Future = standardized, forward = customized
o Future trade on public exchange with a clearinghouse that guarantees the
performance of all traders. Forward contract trade OTC without guarantees. Credit
risk in forward is present.
o Futures are market to market, gains and losses are realized at the end of each day.
Forwards profits and losses are not realized until expiration.
o Futures are highly liquid, but forwards are usually held to maturity.
- Future requires initial deposit to reduce the exposure to default risk.
- At the end of each trading day, clearing house credits gains to one party and loss is debited
to the counterparty’s account. This is known as daily settlement.
- A margin call is made if an account balance drops below the maintenance margin and the
party will be required to bring the balance back up to initial margin. This amount is known
as variance margin.
- Forwards realize the full amount at maturity however futures are accumulated
incrementally over the time through the daily settlement process.

Swaps
- A swap is a series of future contracts.
- Occur in private market
- Usually work as interest rate swaps.
- For example, there are three parties, A, B, and C. A issues a bond and promises to pay B a
floating coupon on that bond. The floating rate for that bond is LIBOR + 3% spread.
According to A, LIBOR is going to increase but according to a new person C, LIBOR is going
to decrease. A decides to swap his coupon rate. This means A and C get into a contract that
C will pay coupon to A and A will give him a fixed amount for that coupon. If LIBOR goes
down, C will have to pay less coupon than what he is getting from A.
- Obligations are netted that means only net amount is paid.

Contingent claims
Options
- An option give owner the right but not the obligation to buy or sell the underlying asset.
- Call Buyer: Right to buy the share at Specified Price
o [Unlimited Gain] [Limited Loss of premium amount]
- Call Seller: Obligation to sell the share at request of call buyer.
o [Limited gain of premium amount][Unlimited Loss]
- Put Buyer: Right to sell the share at specified price.
o [Limited Gain to max if share goes 0] [Limited loss of premium]
- Put seller: Obligation to buy the share at request of Put buyer.
o [Maximum Gain of premium][Limited loss till share goes 0]
- European options can be only exercised at maturity and American options can be exercised
any time after initiation.
- Long call option payoff – Ct = MAX(0,St – X), Profit = Ct-C0
- Long Put option payoff - Pt = MAX(0,X-St), Profit = Pt-P0
- Short position holders have an unlimited risk and therefore charge a premium for that risk.
That premium is charged at initiation.
- Options have value when contract is initiated.
- Only the buyer has the right to counterparty risk

Credit Default Swaps

- CDS are like insurance policies.
- Imagine if there is a bond in the market (Either you hold it or someone else) and you know
the issuer will default, you can get CDS on that asset.
- You will pay insurance premiums on that asset and in return you get a guarantee from
insurance company if these assets fail.

Arbitrage
- An assets that offer the same benefits and have the same risk should sell for the same
price.
- Law of one price.

Replication
- Derivatives are used to replicate the cashflows that would be generated by taking long or
short positions in the cash market.
- If derivatives are properly priced, replication strategies will earn the same return as trading
the underlying asset in the cash market.

Calculation

Additional Costs or benefits

- Dividends, convenience yield, coupon payments

-
-

-
-
- At time T(generally used in calculation of futures)
Pricing and valuation of interest rates in derivatives
- Interest rates are characterized by a term structure. You can use interest rates as derivatives
too.
- Spot rate refers to an interest rate that is applicable for a specific period, T. = ZT. It is known
as Zero rate as it is a yield on zero coupon bond that matures at time T.
- Spot rate can be calculated using bootstrapping method.

Bootstrapping Method
- Start with the shortest-term bond usually 1 year.
- Discount the price of 1 year bond i.e., Par value + Coupon Payment to today. Today’s price is
given and thus you will find the discount rate which in this case is spot rate.

-
- Then for two year spot rate, Discount the first coupon payment at first year spot rate which
we calculated above and then second year total payment at z2.

- Discount rate

Spot Rate vs forward rate in interest rates as underlying assets

- Forward rate indicates interest rates on loan beginning at some time in future.
- Spot rates refers to interest rates on loan beginning now.
- 3y1y means borrow in 3 years and for 1 year.
For example, you want to know what the interest rate might be in 6 months.
- Implied forward rate, breakeven reinvestment rate
- The relationship between spot rate and implied forward rate can be found using this
formula.
- where

- Government Benchmark Rates

Forward Rate Agreement

- An agreement to apply a specific interest to a future period.
- The underlying asset under this condition is a hypothetical deposit of a notional amount in
the future.
- It is basically an interest rate swap where long party pays a fixed interest rate and the other
party pays a MRR (floating rate).
- We can also say FRA is a fixed period swap.

Calculation of Futures
- All calculations same as forwards except Interest rates
- Futures contract on short term interest rates

Pricing and valuation of interest rates and other swaps

- FRA is same as single period swap
- Multi period swap is a series of FRA or Single swaps
- For example contract to start at time A and end at Time B is single swap or FRA.
- Contract to start at time A and first payment at time B and second at Time C and so on….
- Each payment is considered a different single swap.
- Calculate IFR0,1 IFR1,1 IFR2,1 … for each period. Then to find a swap rate from start to end, use

this formula

Valuation of swaps
- Fixed Rate Payer = Fixed Rate X Notional Amount X Period
- Floating Rate Payer = MRR X Notional Amount X Period
- Period Settlement Value = (MRR – Fixed) X Notional Amount X Period
- Value of swap at any settlement date = above formula + PV of remaining future swap
settlements.

Calculations of Options
- Premium Amount: Intrinsic Value + time Value
- Intrinsic value refers to loss today
- Time value is 0 at expiry
- There is concept call put call parity for European options where Payoff on a protective call
(Share + Put Option) is same as payoff on a fudiciary call (Call option + Bond). This can be

expressed by the following formula -

- Value of a time value option is determined using a one period binomial model
o Calculate the price of share after downmove and upmove
o Downmove = 1/upmove
o Probability of upmove = 1+Rf – D/(U-D)
o Probability of downmove = 1-p of upmove
o Multiple payoffs of each case * probability
o Discount the value to today.