Economics

Study Session 4

Weighting 5–10%
Overview of Level II Economics
SS4: Economics for Valuation
13. Currency Exchange Rates: Determination
and Forecasting
14. Economic Growth and the Investment
Overview
Decisionof Level II Corp Fin
15. Economics of Regulation

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Currency Exchange Rates
Factors affecting Forex Spread Cross Rates
 Spread in the interbank market The exchange rate between two currencies
 Volatility, time of day, implied by their exchange rates with a common
popularity of pair third currency.
 Transaction size  CHF   USD   CHF 
 Dealer/client relationship   =   ×  
GBP  bid  GBP  bid  USD  bid
Forward spread = F – S
 CHF   USD   CHF 
Forward spread > spot spread   =  × 
GBP ask  GBP  ask  USD  ask

Triangular Arbitrage
If dealer quotes differ from computed cross rates, an arbitrage may be possible.
Check by going around the triangle clockwise and counter-clock wise.
Follow the: “Up the bid and multiply / down the ask and divide” rule.

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Currency Exchange Rates
Foreign Exchange Quotations

USD/GBP USD price GBP base Cross Rates

with Bid and Ask

“BID” $ “ASK”
USD/GBP = 1.60 means 1.60 USD = 1 GBP means means
turning
€ into $
€ turning
$ into €

USD
CHF/USD 1.500 – 1.501
1.
S D 35 USD/GBP 1.350 – 1.351
/U 0
1.
D

F US
3
US

CH
51

D/
G
/

00
HF

US

5 BP
1.
1C

D/
GB
50

P
1.

Bid Rate = 2.025 CHF/GBP

CHF Ask Rate = 2.028 CHF/GBP GBP

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Currency Exchange Rates

Mark-to-market value of a forward contract:

(FPt – FP)(contract size)

Vt =
  Days  
1 + R   
 360 

Vt = value in price currency of the forward contract (long base currency) at

time t (t < T)
FPt = forward price (to sell base currency) at time t in the market for a contract
maturing at time T
Days = number of days remaining to maturity of the forward contract (T – t)
R = the interest rate of the price currency

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Currency Exchange Rates
Forward Contracts
 Premium (fwd > spot) – strong currency;
base currency buys more future price
currency
 Discount (fwd < spot) – weak currency;
Covered Interest Parity (CIP) base currency buys less future price
currency

Covered Interest Arbitrage

  n 
1+ r
 pricecurrency  360  
 
Forward – Spot ×  0
  n 
1+ rbasecurrency  360  
  
  n 
1+ r
 pricecurrency  360   Quoted
 
Spot ×  = Forward
  n   CIP “adjusted” spot
1+ rbasecurrency  360  
  

If the quoted forward rate ≠ CIP “adjusted” spot,

covered interest arbitrage will be possible
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Foreign Exchange Parity Relations
Parity Relationships

Purchasing Power Parity Uncovered Interest Rate Parity

E(%DS)(A/B) = pA – pB E(%DS)(A/B) = RA – RB

Fisher effect International Fisher

Effect
r = real r + E(i) rprice – rbase = E(iprice) – E(ibase)
Forward rate is unbiased
where: predictor of future spot
r = nominal interest rate E(ST) = F
real r = real interest rate
E(i) = expected inflation

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Foreign Exchange Parity Relations

The forward rate is unbiased predictor of the future spot rate

Forward E(Future Spott)

t
rit res
Pa nte
Covered Purchasing

y
Interest te d I Power
Ra ere
Parity Parity
ov
c
Un

E(ΔP/B) = RP – RB E(ΔP/B) =P –B

International Fisher Effect

P: price currency; B: base currency

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FX – Carry Trade
Carry Trade
If uncovered interest rate parity does not work in the short-term, one can profit by investing
in higher yielding currency and borrowing in lower yielding currency.

Return on Carry Trade:

return = interest earned on investment – funding cost – investment currency depreciation

Risks of Carry Trade:

 Crash risk due to nonnormal distribution of carry trade returns
 Negative skewness and excess kurtosis

Risk Management in Carry Trade:

 Volatility filter
 Valuation filter
 Trend following trading rule

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Forex – Value Determinants
Balance of Payments Analysis
 Current account influences:
Deficits eventually
 Flow mechanism
cause currency to
 Portfolio composition mechanism
 Debt sustainability mechanism
depreciate
 Capital (financial) account:
 In the short term, real currency values fluctuate around its long-term PPP-implied
equilibrium value.
 The real value is positively related to real interest rate differential and negatively
related to risk premium differential.

Taylor Rule
 Central bank policy rate is positively related to inflation and unemployment
 Changes in policy rate affects the real rate and hence the exchange rate
 Real interest rate = r* = rn + α(π – π*) + β(y – y*)
rn = Neutral real policy interest rate π = Current inflation rate
π* = Central bank’s target inflation rate y = log of current level of output
y* = log of sustainable output level.
α, β = policy response coefficients (> 0, Taylor suggested a value of 0.5 for both)
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Forex – Value Determinants
Capital Mobility
Monetary Policy/Fiscal Policy
High Low
Mundell-
Fleming Expansionary/Expansionary Uncertain Depreciation
(ST)
Expansionary/Restrictive Depreciation Uncertain
Restrictive/Expansionary Appreciation Uncertain
Restrictive/Restrictive Uncertain Appreciation
Monetary Approach
(Focuses on effects of monetary policy via inflation)
 Pure monetary approach: PPP holds at any point in time. Expansionary (restrictive)
monetary policies lead to higher (lower) inflation and depreciation (appreciation) of currency.
 Dornbusch overshooting model: Output prices are sticky in the short run but fully flexible
in the long run. Expansionary monetary policy increases the real money supply (and
decreases real interest rates) as prices are slow to react in the short run. This causes the
nominal and real exchange rates to depreciate (overreact). Exchange rates gradually
increase towards their PPP implied values.
Portfolio Balance Approach
(LT counterpart of Mundell-Fleming for fiscal policy)
 Portfolio balance approach looks at long-term implications of fiscal policy. In the long-term,
governments may find it increasingly difficult to fund sustained deficits, leading to
depreciation of the currency.
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Central Bank, Currency Crisis
Objectives of Central Bank
Intervention
 Ensure that the domestic
currency does not appreciate
excessively
 Allow the pursuit of independent
monetary policies
 Reduce excessive inflow of
capital
Technical Analysis
 Trend following trading rules –
have not worked post 1995 for
developed market currencies.
 FX-order books – strong
contemporaneous correlation but
no predictive ability
 Currency options market – volatility
implied by call prices relative to
volatility implied by put prices.
Positive contemporaneous
correlation but no predictive ability.
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Effectiveness of Central Bank Intervention
 Central bank can intervene in FX markets or policy
makers can employ capital controls.
 Effectiveness of intervention in FX markets depends
on the size of central bank reserves relative to
trading volume of their currency. Usually not
effective for developed countries.
 Effectiveness of capital control depends on the size
and persistence of capital flows.
Warning Signs of Currency Crisis
 Terms of trade deteriorate
 Dramatic decline in official foreign exchange
reserves
 Real exchange rate substantially higher than
mean reverting level
 Inflation increases
 Equity markets experience boom-bust cycle
 Money supply relative to bank reserves increases
 Nominal private credit grows
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Economic Growth
Factors affecting Economic Growth Faster economic growth due to:
 Savings and investment  Increase in physical or human
 Financial markets and intermediaries capital growth (Capital deepening)
 Political stability, rule of law, property rights  Increase in the rate of technological
advancement (TFP growth)
 Investment in human capital
 Tax and regulatory systems
 Free trade and unrestricted capital flows

P = (GDP) × (E/GDP) × (P/E)

%Δ P = (%Δ GDP) + (%Δ E/GDP) + (%Δ P/E)
In the long-run, stock market appreciation = GDP growth rate
Higher the potential GDP growth rate, higher the real rates (interest and asset returns)
Implications for fixed income investors:
• When actual GDP growth > potential GDP growth rate, inflationary pressure is higher and
more likely that monetary/fiscal policy is restrictive.
• Higher potential GDP growth rate reduces expected credit risk of all debt issues.

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Economic Growth
Cobb-Douglas Production Function
 Y = TKαL(1 – α)
 Exhibits constant returns: Marginal product of capital (MPK) = αY/K
 In steady-state, MPK = r
 Exhibits diminishing productivity (i.e., output per worker) of capital per worker
Labor productivity
(output per worker)
More technology
LP2
Effect of change in technology
Diminishing
Economic returns to capital Less technology
Growth
LP1
Effect of capital deepening
LP0

Capital per worker

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Growth Accounting and Inputs
Growth Accounting Relations
Growth rate in potential GDP = long-term growth rate of technology
+ a (long-term growth rate of capital) + (1 – a) (long-term growth
rate of labor)
or
= long-term growth rate of labor force + long-term growth rate in
labor productivity
Natural Resources
 Ownership of natural resources is not important as long as there is access (via trade).
 Ownership of natural resources may actually hinder growth:
 Dutch disease: Ownership of natural resources pushes up the value of domestic
currency to the detriment of other industries.
 Other industries may be neglected.

Labor (Supply) Capital and Technology

 Demographics  Human capital: knowledge and skills (qualitative)
 Participation  Physical capital: ICT and non-ICT
 Immigration  Technological development
 Average hours worked  Public infrastructure

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Theories of Economic Growth
Classical Growth Theory
 No permanent improvement in standard of living from new technologies
 “Reversing mechanism” is population growth
 Economic growth leads to population growth which leads to declining capital per
labor hour and labor productivity falling back to subsistence level

Sustainable growth rate

Neoclassical Growth Theory in output per capita (g*)
 Economic growth stops due to diminishing returns to capital
θ
 Technological advances lead to: g* =
(1 – α)
 Short-term economic growth
 Diminishing marginal productivity Sustainable growth rate
 Steady state achieved when MPK = r in output
 Sustainable growth rate of output θ
G* = + ΔL
(1– α)
 In steady state, growth rate in productivity depends only on technology and (1 – a).
 Capital deepening occurs, affecting output but not the growth rate
 Economy will move towards its steady state equilibrium regardless of initial capital to labor
ratio or level of technology
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Theories of Economic Growth
Endogenous Growth Theory
 Economic growth go on indefinitely due to incentive to innovate
 Technological progress is endogenous
 Capital investment → social returns → technological advances
 Real R stays above target R and economic growth never stops

Endogenous Growth Theory

Innovation

Higher Social Returns

Profits

More
Investment

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Growth Convergence
Convergence Hypothesis
 Absolute Convergence: Standard of living will converge globally as productivity
differences between developed and developing countries diminish over time.
 Conditional Convergence: Convergence only for countries with similar savings rates,
population growth rates and production functions.
 Club Convergence: Countries belonging to a club will converge. Clubs are countries
with similar institutional features.

Incentives for Innovation Trade Barriers

When private benefits and
social returns together
exceed the project’s required
rate of return, government
subsidies may provide
incentives for investment in
R&D.
 Removal of trade barriers benefits growth via:
 Access to foreign savings
 Comparative advantage in production
 Economies of scale
 Neoclassical growth theory focuses on
convergence.
 Endogenous growth theory focuses on social
benefits.

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Economics of Regulation
Regulators: May reference work of
Government Agencies, ‘outside bodies’
Independent (SRO
Regulatory tools:
and non-SRO)
 Price mechanisms
Regulation
 Restricting/requiring certain
Need:
activities
 Informational  Provision of public goods
Frictions
Regulatory Interdependencies
 Externality
 Regulatory capture theory
Types:  Regulatory competition
 Statutes  Regulatory arbitrage
 Judicial law
 Administrative Regulations Regulating Financial Markets

Security Markets Financial Institutions

Regulating Commerce:  Disclosure requirements  Prudential Supervision
Company law,
bankruptcy law,  Agency Problem  Prevent crisis
competition laws, etc.  Focus on small investors

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Problem: Triangular Arbitrage
 Given the following bid/ask quotes:

CHF / USD  1.2500 / 1.2510

USD / GBP  1.8000 / 1.8010

CHF / GBP  2.3000 / 2.3010

 Calculate: USD profit from an initial position

of USD1 million

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Solution: Triangular Arbitrage

USD

US
50
1.2

D/
0

US
51

GB
D

D/G
1.2
US

P
1.8
F/

BP
SD
CH

00
F/ U

1.8

0
01
CH

0
CHF/GBP 2.3000
CHF GBP

CHF/GBP 2.3010
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Solution: Triangular Arbitrage
 Convert USD to GBP at USD/GBP 1.8010
USD1,000,000
= GBP555,247
1.8010 USD
GBP
 Convert GBP to CHF at CHF/GBP 2.3000

GBP555,247  2.30 CHF  CHF1,277,068

GBP
 Convert CHF to USD at CHF/USD 1.2510
CHF1,277,068
= USD1,020,838
1.2510 CHF
USD
 Arbitrage profit =
USD20,838
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Example
1. Labor productivity is NOT influenced by:
A. increases in labor hours.
B. increases in human capital.
C. increases in physical capital.

Labor productivity depends on amount of physical capital,

human capital growth, and technological advances.

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 Problem: Mark-to-Market Valuation
 Trader is long 1M NZD 3-month forward against
USD at USD/NZD 0.8436-38
 One month later, FX quotes and interest rates are
as follows:
Spot 0.8198-99 Int. Rates NZD USD
1-month 0.8244-45 30-day 0.33% 0.08%
2-month 0.8433-35 60-day 0.36% 0.10%
 Compute: mark-to-market value of the contract in
USD
 Calculate: USD profit from an initial position of
USD1 million
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 Solution: Mark-to-Market Valuation
 Long NZD forward contract means the trader
wants to convert USD to NZD (i.e., down the
quote) – use ask price of USD 0.8438/NZD.
 Offsetting contract would be to convert NZD
for USD using a 2-month forward contract.
Use bid price of USD 0.8433/NZD.
(0.8433 – 0.8438)(1,000,000)
Vt = = –499.92
  60  
1+(0.0010)  
  360 
 Value = –499.92 USD
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