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Introduction

Introduction. Personal Background Dan Beck E-mail: dan.leo.beck@gmail.com Thoughts on Level 2 test preparation Lesson priority for class Please interrupt with… Questions If I say something incorrect If you have a better way of remembering something Prizes Schedule/Breaks/Slides.

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Introduction

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  1. Introduction • Personal Background • Dan Beck • E-mail: dan.leo.beck@gmail.com • Thoughts on Level 2 test preparation • Lesson priority for class • Please interrupt with… • Questions • If I say something incorrect • If you have a better way of remembering something • Prizes • Schedule/Breaks/Slides

  2. 14a: calculate and interpret the bid-ask spread on a spot or forward foreign currency quotation and describe the factors that affect the bid-offer spread Has 1,000 EUR, but wants SEK USD/EUR 1.4559/1.4561 SEK/USD 6.8739/6.8741 Sell! Does Greta want to buy or sell EUR? Therefore, the dealer wants to buy, so it’s the “bid” for the dealer! 1. Greta takes her 1,000 EUR to the dealer – how much USD does she get?(Hint – Greta always gets the worst deal.) Greta 1000 EUR * 1.4559 USD/EUR = 1,455.9 USD 2. How much SEK does Greta get for 1,455.9 USD (Hint – Greta always gets the worst deal). 1,455.9 USD* 6.8739 SEK/USD = 10,007.7 SEK “Bid” = 10,007.7 SEK/1,000 EUR = 10.0077 SEK/EUR Anna

  3. 14a: calculate and interpret the bid-ask spread on a spot or forward foreign currency quotation and describe the factors that affect the bid-offer spread Anna Has 10,000 SEK, but wants EUR USD/EUR 1.4559/1.4561 SEK/USD 6.8739/6.8741 Buy! Does Anna want to buy or sell EUR? Therefore, the dealer wants to sell, so it’s the “ask” for the dealer! Anna takes her 10,000 SEK to the dealer – how much USD does she get? (Hint – Anna always gets the worst deal.) 10,000 SEK / (6.8741 SEK/USD) = 1,454.74USD 2. How much EUR does Anna get for 1,454.7 USD (Hint – Anna always gets the worst deal). 1,454.7 USD / (1.4561 USD/EUR)= 999.0632 EUR Anna Practice at www.oanda.com “Sell” = 10,000 SEK/999.0632 EUR = 10.0096 SEK/EUR

  4. 14a: calculate and interpret the bid-ask spread on a sport or forward foreign currency quotation and describe the factors that affect the bid-offer spread Currency Pair – More liquid: lower spread The time of day – When more markets are open, lower bid-ask spreads Market volatility – more volatility, higher spreads

  5. 14b: identify a triangular arbitrage opportunity, and calculate its profit, given the bid-offer quotations for three currencies USD/EUR 1.4559/1.4561 A. USD/EUR 1.4556/1.4560 Ask is lower than Bid = Arbitrage Opportunity! SEK/USD 6.8739/6.8741 B. SEK/USD 6.8740/6.8742 INR/USD 61.3289/61.3293 C. INR/USD 61.3294/61.3295 Where is the arbitrage opportunity? (No calculations needed.)

  6. 14b: identify a triangular arbitrage opportunity, and calculate its profit, given the bid-offer quotations for three currencies BRL/USD 2.398/2.405 GBP/BRL 0.2515/.2517 GBP/USD 0.6029/.60300 Is there an arbitrage opportunity here? Does George want to buy or sell BRL? Buy! Therefore, the dealer wants to sell BRL so it’s the “ask” for the dealer! 1. George takes his 1,000 GBP to the dealer – how much USD does he get?(Hint – George always gets the worst deal.) 1000 GBP/ (.60300 GBP / USD) = 1,658 USD Luis 2. How much BRL does George get for 1,658 USD (Hint – George always gets the worst deal). 1,658 USD* 2.398 BRL/USD = 3,977 BRL “Ask” = 1,000 GBP / 3,977 BRL = .2514 GBP/BRL Ask is lower than Bid = Arbitrage Opportunity! George

  7. 14c: distinguish between spot and forward rates and calculate the forward premium/discount for a given currency • Definition - Spot vs. Forward • 1. First calculate forward rate, 2. then subtractspot • Forward Premium/Discount = F - S • Formula method for forward rates: • Better: Intuition method for calculating forward or spot rates 1 + interest rate domestic 1+ interest rate foreign (Spot Rate) Forward Rate d/f= If rates are expressed as domestic / foreign then domestic is in numerator. If rates are expressed as foreign / domestic then foreign in numerator.

  8. 14c: distinguish between spot and forward rates and calculate the forward premium/discount for a given currency = 5.43% = 7.52% 1,000 INR 12.5771*(1+.0543) = 13.2600 GBP What forward rate do I need for no arbitrage? = 79.5093 INR/GBP = 1,075.2/13.2600 = = GBP 12.5771 = ? = 81.0859 1 Year Forward Rate Spot Forward Premium/Discount = F – S = 81.0859 – 79.5093 = 1.576 Could give you F, need to find S, or more/less than 1 year

  9. 14d: calculate the mark-to-market value of a forward contract GBP 10 million Enters into forward contract on Jan. 1 Decide to close out the forward contract on Apr 1 6 month forward rate = 1.6100 AUD/GBP 3 month forward rate = 1.6340 AUD/GBP 3 month LIBOR = 4.8% (annualized) GBP 10 million July 1 Jan. 1 April 1 1. On Jan. 1 entered into a contract to deliver GBP 10 million and receive AUD 16.1 million on July 1. 2. On Apr 1, they decide to close out the contract. What is the mark-to-market value of the contract? 1. Think conceptually – gain or loss for Qantas? Loss 2. Do the math – how much of a gain? 10,000,000 GBP * (1.61 -1.634) AUD/GBP = -240,000 AUD 3. When will they receive the AUD? On July 1, so -240,000 / (1+.048*90/360) = -237,154

  10. 14e: explain international parity relations (covered and uncovered interest rate parity, purchasing power parity, and the international Fisher effect) EUR 738.2* (1+.04) = 767.73 USD 1000 = 2% = 4% EUR 767.73/ USD 1,020 = = .7382 EUR/USD EUR 738.2 = ? = .7527 EUR/USD 1 Year Forward Rate Think of covered interest rate parity as “covered” by the forward rate - i.e. domestic int. rate, foreign int. rate, spot, and forward rate must match up so no arbitrage profit possible! Spot

  11. 14e: explain international parity relations (covered and uncovered interest rate parity, purchasing power parity, and the international Fisher effect) Yes, interest rate was higher, but EUR depreciation offset gain. No free lunch! = 2% = 4% = .7382 EUR/USD = .7527 EUR/USD Spot Rate in 1 Year Uncovered interest rate parity says that when 1 yr passes, the spot rate will be the same as the fwd rate under CIRP was 1 year ago. Spot

  12. 14e: explain international parity relations (covered and uncovered interest rate parity, purchasing power parity, and the international Fisher effect) “THE Big Mac index was invented by The Economist in 1986 as a lighthearted guide to whether currencies are at their “correct” level. It is based on the theory of purchasing-power parity (PPP), the notion that in the long run exchange rates should move towards the rate that would equalize the prices of an identical basket of goods and services (in this case, a burger) in any two countries.”

  13. 14e: explain international parity relations (covered and uncovered interest rate parity, purchasing power parity, and the international Fisher effect) = 4.56 USD = 90 INR According to PPP what should the INR/USD exchange rate be? 90 INR /4.56 USD = 19.73 INR/USD As of 1/24/43 actual = 61 INR/USD Exhibit 3 p. 531 shows that over 24 year intervals PPP has some explanatory power.

  14. 14e: explain international parity relations (covered and uncovered interest rate parity, purchasing power parity, and the international Fisher effect) 14f: describe relations among the international parity conditions If, and only if…… Uncovered IRP holds... if – id = %∆Sef/d ∏ԑf -∏ԑd =%∆Sef/d …and PPP holds... ….then…. if – id = ∏ԑf -∏ԑd Or, in words….. The foreign-domestic nominal yield spread… ….is solely determined by the expected inflation differential.

  15. 14e: explain international parity relations (covered and uncovered interest rate parity, purchasing power parity, and the international Fisher effect) Assume 12/31/13 .7382 EUR/USD spot rate = 2% = 4% 12/31/13 – 5.00 USD 12/31/13 – 3.69 EUR Expected 12/31/14 – 5.50 USD 12/31/14 - ? = 3.69*1.12 = 4.13 EUR

  16. 14g: evaluate the use of the current spot rate, the forward rate, purchasing power parity, and uncovered interest rate parity to forecast future exchange rates The expected change in the spot exchange rate should equal: 1. The forward premium or discount (Spot, Forward, Uncovered IRP) 2. Difference in expected inflation rates (Spot, PPP) 3. Nominal yield spread between countries (Uncovered IRP)

  17. 14h: explain approaches to assessing the long-run fair value of an exchange rate 1. Macroeconomic Balance Approach: looks at how much exchange rate has to move to put current account in normal/sustainable level. Current Account = Exports – Imports Assume now Current Account = +$1 BN Normal/Sustainable Current Account = +$500MM What direction does exchange rate have to move to correct according to Macroeconomic Balance Approach? Exports – Imports Currency must appreciate!

  18. 14h: explain approaches to assessing the long-run fair value of an exchange rate 2. External Sustainability Approach: looks at assets and capital flows. Calculates how much exchange rates must adjust so that net foreign assets/GDP, or other metrics, stabilizes at a benchmark level. 3. Reduced-Form Equilibrium Model: uses trends in macroeconomic variables to estimate an equilibrium path

  19. 14i: describe the carry trade and its relation to uncovered interest rate parity and calculate the profit from a carry trade Borrow At Invest At = 1% = 15% Idea: UIRP does not hold in the real world (at least not in the short run!) * It works…..until it doesn’t.

  20. 14j: explain how flows in the balance of payment accounts affect currency exchange rates Quick Level 1 Review of BOP accounts Current Account Capital Account Merchandise and Services Foreign owned assets in the country Exports Imports X - M Current Account + Capital Account = 0

  21. 14j: explain how flows in the balance of payment accounts affect currency exchange rates Current Account X – M : Exports Minus Imports A current account surplus leads to exchange rate appreciation! But why? A current account deficit leads to exchange rate depreciation.

  22. 14j: explain how flows in the balance of payment accounts affect currency exchange rates Capital Account Foreign owned assets in the country If more people want to own assets in a country, they need and will buy the country’s currency, so based on supply/demand the currency will appreciate.

  23. 14m: explain the potential effects of monetary and fiscal policy on exchange rates Definitions First! Capital Flows: (High Cap Mobility) Interest Rates Exchange Rate Capital Flows Appreciate (Restrictive) In (Expansionary) Out Depreciate Trade Flows: (Low Cap Mobility) Exchange Rate Printing money Appreciate (Restrictive) Depreciate (Expansionary)

  24. 14m: explain the potential effects of monetary and fiscal policy on exchange rates Capital Flows: (High Cap Mobility) Capital Flows Exchange Rate Interest Rates Government Deficit High(Expansionary) Appreciate In Think of heavy government borrowing as increasing the demand for money. Low(Restricted) Out Depreciate Trade Flows: (Low Cap Mobility)

  25. 14m: explain the potential effects of monetary and fiscal policy on exchange rates Trade Flows: (Low Cap Mobility) = C + S + T GDP = C + I + G + X - M S + (T-G) – I = X - M Current Account Surplus Exchange Rate Government Deficit High(Expansionary) Depreciate (Exports down Imports up) (or if (T – G) is negative) Low(Restrictive) (Exports up Imports down) Appreciate (or if (T – G) is positve)

  26. 14k: describe the Mundell-Fleming model, the monetary approach, and the asset market (portfolio balance) approach to exchange rate determination 2. Effects all come from interest rate induced capital movements 1. High Cap Mobility Expansionary Monetary Policy Restrictive Monetary Policy Monetary Monetary Fiscal Expansionary Fiscal Policy Ambiguous Fiscal Appreciation Monetary Monetary Ambiguous Depreciation Restrictive Fiscal Policy Fiscal Fiscal

  27. 14k: describe the Mundell-Fleming model, the monetary approach, and the asset market (portfolio balance) approach to exchange rate determination 2. Low Cap Mobility 2. Effects all come from trade flows Expansionary Monetary Policy Restrictive Monetary Policy Monetary Monetary Fiscal Expansionary Fiscal Policy Depreciation Fiscal Ambiguous X – M = S + (T-G) - I Monetary Monetary Ambiguous Appreciation Restrictive Fiscal Policy Fiscal Fiscal

  28. 14k: describe the Mundell-Fleming model, the monetary approach, and the asset market (portfolio balance) approach to exchange rate determination Exchange Rate Printing money Appreciate (Restrictive) (Expansionary) Depreciate

  29. 14k: describe the Mundell-Fleming model, the monetary approach, and the asset market (portfolio balance) approach to exchange rate determination Interest Rate Increases Currency Appreciates Short Run (Mundell Fleming) Central Bank Monetizes Debt Expansive Fiscal Policy Means “Printing Money” = Inflation Currency Depreciates Long Run Government Debt Buildup Fiscal Stance Turns Restrictive Means Lower Deficit = Lower Interest Rates

  30. 14n: describe objectives of central bank intervention and capital controls and describe the effectiveness of intervention and capital controls Objectives of intervention and capital controls: 1. Prevent “too strong” currency appreciation 2. Reduce volume of capital inflows 3. Pursue independent monetary policy (without worrying about how changes in policy rates will attract too much external capital)

  31. 14n: describe objectives of central bank intervention and capital controls and describe the effectiveness of intervention and capital controls Central Bank Intervention: Developed Economies: Doesn’t Work Currencies too large/liquid for central bank to have impact Developing Economies: Can work to lower volatility, mixed evidence on affecting overall level

  32. 14n: describe objectives of central bank intervention and capital controls and describe the effectiveness of intervention and capital controls Capital Controls: Do work to Make monetary policy more independent Alter the composition of capital flows Reduce real exchange pressures Magnitude and Persistence of flows matters. Higher magnitude and the higher the persistence the less effective they will be.

  33. 15b: describe the relation between the long run rate of stock market appreciation and the sustainable growth rate of the economy “The drivers of potential GDP are ultimately the drivers of stock market price performance.”

  34. 15c: explain why potential GDP and its growth rate matter for equity and fixed income investors For equity investors: “The drivers of potential GDP are ultimately the drivers of stock market price performance.” For fixed income investors: 1. Inflation: Actual GDP growth above potential GDP growth = inflation 2. Credit Quality: Higher potential GDP growth leads to higher credit quality 3. Central bank policies 4. Sovereign debt ratings 5. Government deficits/surplus

  35. 15e: forecast potential GDP based on growth accounting relations How does an Economy Grow? More output from machinery More People Efficiency, or Productivity of Capital Amount of Capital Labor = L Capital = K Total Factor Productivity = A Y = A Kα Lβ Worth memorizing! ∆ Y/Y = ∆A/A + α∆K/K + (1-α) ∆L/L

  36. 15e: forecast potential GDP based on growth accounting relations Assume the following economic growth metrics for country Q in Year 1: How much did potential GDP increase over the year? 2. Change in Capital Stock = 3% * (0.3) = 0.9% Change in TFP = 1.5% 3. Change in Labor Output = 2% * (1-0.3) = 1.4% = 1.5% + 1.4% + 0.9% = 3.8%

  37. 15d: distinguish between capital deepening investment and technological progress and explain how each affects economic growth and labor productivity “Capital Deepening” : More Capital Per Worker “Technological Progress” : Increase in TFP Output per Worker Y/L “Technological Progress” Increase in TFP (∆A/A) CapitalDeepening ∆K/K Understanding this graph is key to understanding many LOSs! Capital per Worker K/L

  38. 15f: explain how natural resources affect economic growth and evaluate the argument that limited availability of natural resources constrains economic growth Natural resources not in equation!!! ∆ Y/Y = ∆A/A + α∆K/K + (1-α)∆L/L Ownership and production of natural resources is not necessary for a country to achieve a high level of income. (Though access is important.) Low Income Countries (Many Natural Resources) High Income Countries (Few Natural Resources) Saudi Arabia Venezuela Japan South Korea, Singapore Can Be “Bad”: Resource Curse or “Dutch Disease” 1. Fail to develop economic institutions necessary for growth 2. Currency appreciation leaves manufacturing sector uncompetitive

  39. 15g: explain how demographics, immigrations, and labor force participation affect the rate and sustainability of economic growth What is our growth accounting equation? ∆ Y/Y = ∆A/A + α∆K/K + (1-α) ∆L/L

  40. 15g: explain how investment in physical capital, human capital, and technological development affects economic growth What is our growth accounting equation? ∆ Y/Y = ∆A/A + α∆K/K + (1-α) ∆L/L Output per Worker Y/L 2. Investment in human capital and technology move the curve up! “Technological Progress” Increase in TFP (∆A/A) CapitalDeepening ∆K/K 1. Investment in physical capital increases output, but with diminishing returns Capital per Worker K/L

  41. 15i: compare classical growth theory, neoclassical growth theory, and endogenous growth theory 1. Tech. advance increases output Output per Worker Y/L 2. Leads to population explosion which decreases output per worker below subsistence level 3. Enough workers die, population decreases, and output per worker returns to subsistence level. 1. Subsistence Level 2. 3. Big Idea: Over time, no per capita growth in the economy Time / Capital per Worker Problems: 1. Pop growth declines with increasing living standards, and 2. tech progress outweighs pop. increase.

  42. 15i: compare classical growth theory, neoclassical growth theory, and endogenous growth theory Output per Worker Y/L “Technological Progress” Increase in TFP (Exogenous) CapitalDeepening Capital per Worker K/L Takeaways: 1. At a certain point, need TFP for growth! 2. No one knows where TFP comes from (exogenous)

  43. 15i: compare classical growth theory, neoclassical growth theory, and endogenous growth theory Output per Worker Y/L Key points: 1. TFP growth is “endogenous,” or a natural product of the system 2. No diminishing returns on capital…. 3. …no limits to growth. Capital per Worker K/L

  44. 15j: explain and evaluate convergence hypotheses Output per Worker Y/L 1. Absolute Convergence: Every country will reach the same level! 2. Conditional Convergence: Every country will reach the same level if, and only if, savings rate, pop. growth rate, and production function are the same. Capital per Worker K/L 3. Assumes Neoclassical Growth Theory is correct 4. No Convergence under Endogenous Growth Theory

  45. 15j: explain and evaluate convergence hypotheses 1. Results - mixed 2. Poorer countries may converge if they develop the appropriate legal, political, and economic institutions. Trade policy also important.

  46. 15k: describe the economic rationale for governments to provide incentives to private investment in technology and knowledge R&D spending generates ideas. Ideas can be copied. Therefore little incentive for R&D. Ideas benefit everyone, so government should spend on R&D because it generates positive externalities.

  47. 15l: describe the expected impact of removing trade barriers on capital investment and profits, employment and wages, and growth in the economies involved Capital investment: A country can borrow or lend funds in global market – investment not constrained by domestic savings. Profits increase: Shift to industries where they have a comparative advantage Access to larger global market allows them to exploit economies of scale Import technology to increase tech. progress Increases domestic competition – improve products, productivity, lower costs

  48. 15l: describe the expected impact of removing trade barriers on capital investment and profits, employment and wages, and growth in the economies involved Output per Worker Y/L Capital per Worker K/L Neoclassical Growth: Reach “steady state” Endogenous: No limit

  49. Concluding Thoughts • Please stay after if you have any questions • E-mail: dan.leo.beck@gmail.com • Please provide feedback

  50. 14o: describe warning signs of a currency crisis

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