02 Economics

2013CFA
Economics

20121216

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katherine
2-94 100% Contribution Breeds Professionalism

CFA
Study Session 1-2 Ethics & Professional Standards 10
Study Session 3 Quantitative Analysis 5-10
Study Session 4 Economics 5-10
Study Session 5-7 Financial Reporting and Analysis 15-25
Study Session 8-9 Corporate Finance 5-15
Study Session 18 Portfolio Management and Wealth Planning 5-15
Study Session 10-12 Equity Investment 20-30
Study Session 14-15 Fixed Income 5-15
Study Session 16-17 Derivatives 5-15
Study Session 13 Alternative Investments 5-15
Total: 100

Summary of Readings and Framework
SS 4
R14 Currency exchange rate: determination and forecasting
R15 Economic Growth and investment decision
R16 Economics of Regulation
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91 100% Contribution Breeds Professionalism
Economics for Valuation
Reading 14: Currency exchange rate:

determination and forecasting
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R14. Currency Exchange Rates
Warm-up
Exchange rate is simply the price or cost of units of one currency in terms of another.
Nominal exchange rate: the price that we observe in the marketplace for foreign
exchange.
Real exchange rate: the focus shifts from the quotations in the foreign exchange market
to what the currencies actually purchase in terms of real goods and services.
z FX real(d/f) = FX nominal (d/f) *CPIf/CPId
z Changes in real exchange rates can be used when analyzing economic changes over
time.
9 When the real exchange rate (d/f) increases, exports of goods and services have
gotten relatively less expensive to foreigners, and imports of goods and services
from the foreign country have gotten relatively more expensive over time
Example: At a base period, the CPIs of the U.S. and U.K. are both 100, and the exchange
rate is $1.70 per euro. Three years later, the exchange rate is $1.60 per euro, and the CPI
has risen to 110 in the U.S. and 112 in the U.K.. What is the real exchange rate?
Solution: The real exchange rate is $1.60 per euro * 112/110 = $1.629 per euro.
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Warm-up: Foreign exchange quotations

Direct quotes: Domestic currency (DC) per foreign currency: DC/FC
(three equivalent quotation for currency)
AUD: USD=0.6
0.6USD/AUD
AUD=0.6 USD
Indirect quotes: Foreign currency per domestic currency: FC/DC.
To convert an indirect quote to a direct quote, you simply take the
reciprocal of the one that you are given (use the 1/x calculator key).
If AUD: USD=0.6 equal to 0.6USD/AUD,
Then USD: AUD=1/0.6=1.67 equal to 1.67AUD/USD
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Warm-up: FX Appreciation and Depreciation

Example: the dollar-Swiss franc rate increase from USD: CHF = 1.7799
to 1.8100. The Swiss franc has depreciated relative to the dollar it now
takes more Swiss francs to buy a dollar.
An increase in the numerical value of the exchange rate means that the
base currency has appreciated and that the price currency depreciated.
1.7799CHF/USD to 1.8100CHF/USD USD appreciated therefore
CHF depreciated
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Spot Rate And Forward Rate
Spot rates are exchange rates for immediate delivery of the currency.
Spot markets refer to transactions that call for immediate delivery of
the currency. In practice, the settlement period is two business days
after the trade date.
Forward rates are exchange rates for currency transactions that will
occur in the future.
Forward markets are for an exchange of currencies that will occur in
the futures. Both parties to the transaction agree to exchange one
currency for another at a specific future date.
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Bid-Ask Spread
The spread on a foreign currency quotation
The bid price is smaller and listed first. It is the price the bank/dealer will
pay per FC unit.
The ask price is higher and always listed second. It is the price at which
the bank will sell a unit of FC.
The difference between the offer and bid price is called the spread.
Spreads are often stated as pips.
Example: the euro could be quoted as $1.4124-1.4128. The spread is
$0.0004 (4 pips).
The spread on a forward foreign currency quotation
Consider a 6-month (180 days) forward exchange rate quote from a U.S.
currency dealer of GBP:USD = 1.6384 / 1.6407.
spread = (1.6407 1.6384) = 0.0023 (23 pips)
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Bid-Ask Spread
The spread quoted by the dealer depends on

The spread in the interbank market for the same currency pair. Dealer
spreads vary directly with spreads quoted in the interbank market.
The size of the transaction. Larger, liquidity-demanding transactions
generally get quoted a larger spread.
The relationship between the dealer and client. Sometimes dealers
will give favorable rates to preferred clients based on other ongoing
business relationships.
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Bid-Ask Spread
The interbank spread on a currency pair depends on

z Currencies involved. Similar to stocks, high-volume currency pairs (e.g.,
USD/EUR, USD/JPY, and USD/GBP) command lower spreads than do
lower-volume currency pairs (e.g., AUD/CAD).
z Time of day. The time overlap during the trading day when both the New
York and London currency markets are open is considered the most liquid
time window; spreads are narrower during this period than at other times of
the day.
z Market volatility. Higher volatility leads to higher spreads to compensate
market traders for the increased risk of holding those currencies.
z Spreads in forward exchange rate quotes increase with maturity.
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Cross Rate
Calculate cross rate 2

USD:IDR=2400 (USD:NZD)/(USD:IDR)=IDR:NZD
=1.6/2400
USD:NZD=1.6 IDR:NZD=0.00067
IDR:NZD
1 3
1USD=2400 IDR1USD=1.6 NZD 2400IDR /USD1.6 NZD/USD
2400 IDR=1.6 NZD NZD/IDR?
1 IDR=1.6/2400 NZD 1.6/2400NZD/IDR
IDR:NZD=0.00067 0.00067NZD/IDR
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Cross Rate
Calculate cross rate with bid-ask spreads

Example1: AUD: USD= 0.6000 - 0.6015
USD: MXN=10.7000 - 10.7200

AUD: MXN=6.4200 6.4481
Example2: USD: SFR=1.5960 70
USD: ASD=1.8225 35SFR:ASD

SFRASD=1.1412 1.1425
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Triangular Arbitrage
Triangular arbitrage means converting from currency A to currency B, then
from currency B to currency C, then from currency C back to A. If we end up
with more of currency A at the end than we started with, we've earned an
arbitrage profit.
Example: AUD: USD=0.6000 - 0.6015
USD: MXN=10.7000 - 10.7200
AUD: MXN=6.3000 - 6.3025
How to arbitrage from these markets?
0.6000-0.6015USD/AUD (1)
10.700-10.720MXN/USD (2)
6.3000-6.3025MXN/AUD (3)
Step One: 1$(1) 1/0.6015AUD(3) (1/0.6015)*6.3000MXN(2)
((1/0.6015)*6.3000)/10.720USD 0.97704USD
Step Two: 1$(2) 1*10.700MXN(3) (1*10.700)/6.3025AUD(1)
((1*10.700)/6.3025)*0.6000USD 1.01864USD
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Forward Discount And Premium
Forward discount or premium
With the convention of giving the value of the quoted currency (the
first currency) in terms of units of the second currency, there is a
premium on the quoted currency when the forward exchange rate is
higher than the spot rate and a discount otherwise.
Example: One month forward rate is EUR: USD=1.2468, the spot rate
is 1.2500, it is a discount for EUR
When a trader announces that a currency quotes at a premium, the
premium should be added to the spot exchange rate to obtain the value
of the forward exchange rate.
The forward premium or discount
forward prmium
=F-S0
or discount for Y
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Example
Example: Spot and forward quotes

Given the following quotes for AUD/CAD, compute the bid and offer rates for a
30- day forward contract.
Maturity Rate
Spot 1.0511/1.0519
30-day +3.9/+4.1
90-day +15.6/+16.8
180-day +46.9/+52.3
Answer:
z Since the forward quotes presented are all positive, the CAD (i.e., the base
currency) is trading at a forward premium.
z 30-day bid = 1.0511 + 3.9/10,000 = 1.05149
z 30-day offer = 1.0519 + 4.1/ 10,000 = 1.05231
z The 30-day forward quote for AUD/CAD is 1.05149/1.05231.
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Mark-to-market value
Mark-to-market value of a forward contract

z The value of the forward contract will changes as forward
quotes for the currency pair change in the market.
z The value of a forward contract (to the party buying the base
currency) at maturity (time T) is
VT = ( FPT FP )( contract size )
z The value of a forward currency contract prior to expiration is

also known as the mark-to-market value.
VT =
( FPt FP )( contract size )
days
1 + R 360

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Example
Example: Valuing a forward contract prior to maturity

Yew Mun Yip has entered into a 90-day forward contract long CAD 1 million
against AUD at a forward rate of 1.05358 AUD/CAD. Thirty days after
initiation, the following AUD/CAD quotes are available
Maturity Rate
Spot 1.0612/1.0614
30-day +4.9/+5.2
60-day +8.6/+9.0
90-day +14.6/+16.8
180-day +42.3/+48.3
The following information is available (at t=30) for AUD interest rates
z 30-day rate 1.12%
z 60-day rate 1.16%
z 90-day rate 1.20%
What is the mark-to-market value in AUD of Yip's forward contract?
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Example
Answer:
z The forward bid price for a new contract expiring in T - t = 60
days is 1.0612 + 8.6/10,000 = 1.06206.
z The interest rate to use for discounting the value is also the 60-
day AUD interest rate of l.16%
VT =
( FPT FP )( contract size ) (1.06206 1.05358 )(1,000,000 )
= = 8, 463.64
days 60
1 + R 1 + 0.0116
360 360
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The International Parity Relationships
Interest Rate Parity

z Covered Interest Rate Parity
z Uncovered Interest Rate Parity
International Fisher Relation
PPP
z Absolute PPP
z Relative PPP
z Ex-Ante Version of PPP
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Covered Interest Rate Parity
Covered Interest rate parity (IRP)

The word 'covered in the context of covered interest parity means
bound by arbitrage.
Covered interest rate parity 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.
Interest differential forward differential
Interest rate parity relationship:
F (forward), S (spot) X/Y, rX and rY is the nominal risk-free rate in
X and Y
F 1 + rX
=
S 1 + rY
F - S 1 + rX rX rY
= 1 = rX rY
S 1 + rY 1 + rY
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Covered interest arbitrage is a trading strategy that exploits currency
position when the interest rate parity equation is not satisfied.
When currencies are freely traded and forward contracts are available in
the marketplace, interest rate parity must hold.
If it does not hold, arbitrage trading will take place until interest rate
parity holds with respect to the forward exchange rate.
You can check for an arbitrage opportunity by using the covered interest
differential, which says that the domestic interest rate should be the same as
the hedged foreign interest rate.
(1+rY ) F
( X)
1+r - =covered interest differential
S
The difference between the domestic interest rate and the hedged foreign
interest rate (covered interest differential) should be zero.
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Summary for arbitrage
F 1 + rX F
If > , (1 + rY ) > 1 + rX ,
S 1 + rY S
F
then borrow X currency, the profit will be (1 + rY ) (1 + rX )
S
F 1 + rX S
If < , (1 + rX ) > 1 + rY
S 1 + rY F
S
then borrow Y currency, the profit will be (1 + rX ) (1 + rY )
F
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The U.S. dollar interest rate is 8%, and the euro interest rate is 6%. The spot exchange
rate is $ 1.30 per euro, and the forward rate is $ 1.35 per euro. Determine whether a
profitable arbitrage exists, and illustrate such an arbitrage if it does.
First we note that the forward value of the euro is " too high. Interest rate parity
would require a forward rate of : $ 1.30 ( 1.08 / 1.06 ) = $ 1.3245 .
The forward rate of $ 1.35 is higher than that implied by interest rate parity, and we
should hold euros rather than hold dollars for a profitable arbitrage. The dollar is
depreciating more than would be implied by interest rate parity. The steps in the
covered interest arbitrage are:
Initially :
Step1 : Borrow $ l,000 at 8% and purchased 1,000 / 1.30 = 769 . 23 euros.
Step2 : Invest the euros at 6%
Step3Sell the expected proceeds at the end of one year, 769.23 ( 1.06 ) =
815.38 euros, forward 1 year at $ 1.35 each.
After one year :
Step1 : Sell the 815.38 euros under the terms of the forward contract at $1.35 to
get $1,100.76.
Step2 : Repay the $ 1,000 8 % loan, which is $ 1,080.
Step 3: Keep the difference of $ 20.76 as an arbitrage profit.
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Forward Quotations with Bid-Ask Spreads
Example
z Spot exchange rate $:SFr = 1.2932-1.2939 (spread=0.0007)
z Annual risk-free rate
9 Swiss francs 1.42%-1.44%
9 U.S. dollar 4.50%-4.52%
z Find the forward quotation with bid-ask spreads
Solution
z A bank will quote bidask forward rates, where the bid is lower than the ask.
z The ask forward rate (ask forward $:SFr) is the SFr price at which an investor can
buy dollars forward, borrow SFr today @1.44%
z The bid forward rate is the price that an investor can obtain for dollars, borrow dollar
today @4.52%
z Buying dollars forward (paying the ask forward) is equivalent to
9 Borrowing Swiss francs, hence having to pay the ask rate=1.44%;
9 Using these Swiss francs to buy dollars spot (and hence having to pay the ask
exchange rate, ask spot $:SFr)
9 Lending those dollars and hence receiving the bid interest rate
z Forward ask=1.2939(1+1.44%)/ (1+4.5%) =1.2560
z Forward bid=1.2932(1+1.42%)/ (1+4.52%) =1.2548 (spread=0.0012)
Notes: Bid
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Uncovered Interest Rate Parity
Uncovered interest rate parity
If forward currency contracts are not available, or if capital flows are
restricted so as to prevent arbitrage, the relationship need not hold.
Uncovered interest rate parity refers to such a situation; uncovered in
this context means not bound by arbitrage.
t
1 + rX
S0 = E [ St ]
1 + rY
Uncovered interest rate parity suggests that nominal interest rates
reflect expected changes in exchange rates.
The base currency is expected to appreciate (depreciate) by
approximately Rx - RY when the difference is positive (negative).
Uncovered interest rate parity assumes that investors are risk-neutral.
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Uncovered Interest Rate Parity
Comparing covered and uncovered interest parity

z Covered interest rate parity derives the no-arbitrage forward
rate, while uncovered interest rate parity derives the expected
future spot rate.
z Covered interest parity is assumed by arbitrage.
z F = E(S1)
9If uncovered interest rate parity holds, the forward rate is an
unbiased predictor of expected future spot rates.
z Uncovered interest parity dose not hold in the short run, and it
dose hold in the long run. So longer-term expected future spot
rates based on uncovered interest rate parity are often used as
forecasts of future exchange rates.
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Foreign Exchange Expectation Relation
Foreign exchange expectation relation

The foreign exchange expectation relation says that the forward
rate is an unbiased predictor of the expected future spot rate:
Forward rate = expected future spot rate
F S0
= E (%S )
S0
There is no advantage to holding an unhedged position in a foreign

currency and speculating on how exchange rates might change.
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International Fisher relation

The international Fisher relation specifies that the interest rate
differential between two countries should be equal to the expected
inflation differential.
The condition assumes that real interest rates are stable over time
and equal across international boundaries.
The international Fisher relation is correct because differences in
real interest rates between countries would encourage capital flows
to take advantage of the differentials, ultimately equalizing real
rates across countries.
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International Fisher relation
Exact methodology:
1+rX 1+E ( i X )
=
1+rY 1+E ( i Y )
Linear approximation:
r X r Y =E[i X] E[i Y]
The relation between nominal interest rate and real interest rate:
(1+r)=(1+real r)[1+E(i)]
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Absolute PPP
Law of one price : identical goods should have the same price in all
locations.
Absolute PPP compares the price of a basket of similar goods
between countries, asks if the law of one price is correct on average.
In practice, even if the law of one price held for every good in two
economies, absolute PPP might not hold because the weights
(consumption patterns) of the various goods in the two economies
may not be the same.
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Relative PPP
Relative PPP: change in the exchange rate depends on the inflation
rates in the two countries. In its approximate form, the difference in
inflation rates is equal to the expected depreciation (appreciation)
of the currency. The country with the higher inflation should see its
currency depreciate.
The formal equation for relative PPP is as follows: S (X/Y)
t
1 + I X
S0 = St
1 + IY
Because there is no true arbitrage available to force the PPP relation
to hold, violations of the relative PPP relation in the short run are
common.
The evidence suggests that the relative form of PPP holds
approximately in the long run.
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Ex-Ante Version of PPP
Ex-Ante Version of PPP

z The ex-ante version of purchasing power parity is the same as
relative purchasing power parity except that it uses expected
inflation instead of actual inflation.
t
1 + E ( I X )
S0 = E ( St )
1 + E ( IY )
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The International Parity Relationships Combined
Exchange rate Uncovered Interest
expectation / Rate Parity
movements
Relative Purchasing Power Parity
Foreign International
Exchange Inflation rate Fisher effect Interest rate
Expectations differential differentials
Relation
Forward Interest Rate Parity

discount or
premium
35-94
IRP
F 1 + rx
S0 1 + ry
Foreign
exchange
Fisher
expectations
relation
E ( S1 ) 1+ Ix
S0 1+ Iy
R-PPP
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Several observations can be made from the relationships among

the various parity relationships
z Covered interest parity holds by arbitrage. If forward rates are
unbiased predictors of future spot rates, uncovered interest rate
parity also holds (and vice versa).
z Interest rate differentials should mirror inflation differentials.
This holds true if the international Fisher relation holds. If that
is true, we can also use inflation differentials to forecast future
exchange rates which is the premise of the ex-ante version
of PPP
z By combining relative purchasing power parity with the
international Fisher relation we get the uncovered interest rate
parity.
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Forecast Future Spot Exchange Rates
As stated earlier, uncovered interest rate parity and PPP are not
bound by arbitrage and seldom work over the short and medium
terms. Similarly, the forward rate is not an unbiased predictor of
future spot rate. However, PPP holds over reasonably long time
horizons.
If relative PPP holds at any point in time, the real exchange rate
would be constant--called the equilibrium real exchange rate.
However, since relative PPP seldom holds over the short term, the
real exchange rate fluctuates around this mean-reverting
equilibrium value.
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Long-Run Fair Value of An Exchange Rate
Assess the long-run fair value of an exchange rate

z Macroeconomic balance approach. Estimates how much
current exchange rates must adjust to equalize a countrys
expected current account imbalance and that countrys
sustainable current account imbalance.
z External sustainability approach. Estimates how much current
exchange rates must adjust to force a countrys external debt
(asset) relative to GDP towards its sustainable level.
z Reduced-form econometric model approach. Estimates the
equilibrium path of exchange rate movements based on patterns
in several key macroeconomic variables, such as trade balance,
net foreign asset/liability, and relative productivity.
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Balance-of-Payments Accounts
Balance-of-payments accounts
Current Account measures the exchange of goods, the exchange of
services, the exchange of investment income, and unilateral transfer
(gifts to and from other nations)
Financial Account (also known as the capital account) measures the flow
of funds for debt and equity investment into and out of the country,
including direct investment made by companies; portfolio investments in
equity, bonds, and other securities; and other investments and liabilities
such as deposits or borrowing with foreign banks.
Official reserve account transactions are those made from the reserves
held by the official monetary authorities of the country. Normally the
official reserve account balance does not change significantly from year
to year.
Capital flows tend to be the dominant factor influencing exchange
rates in the short term, as capital flows tend to be larger and more
rapidly changing than goods flows.
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Influence of BOP on exchange rates

Current account influence: current account deficits lead to a depreciation of
domestic currency
z Flow mechanism. Current account deficits in a country increase the supply
of that currency in the markets. This puts downward pressure on the
exchange value of that currency.
9 The initial deficit.
9 The influence of exchange rates on domestic import and export prices.
9 Price elasticity of demand of the traded goods.
z Portfolio composition mechanism. Investor countries may find their
portfolios' composition being dominated by few investee currencies. When
rebalance, it can have a significant negative impact on the value of those
investee country currencies.
z Debt sustainability mechanism. When the level of debt gets too high relative
to GDP, investors may question the sustainability of this level of debt,
leading to a rapid depreciation of the borrowers currency.
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Capital account influence
z Capital account flows are one of the major determinants of exchange rates.
z As capital flows into a country, demand for that countrys currency
increases, resulting in appreciation.
z Capital flows into a country may be needed to overcome a shortage of
internal savings.
z Excessive capital inflows into emerging markets create problems for those
countries such as:
9 Excessive real appreciation of the domestic currency.
9 Financial asset and/or real estate bubbles.
9 Increases in external debt by businesses or government.
9 Excessive consumption in the domestic market fueled by credit.
42-94

Capital account influence
real exchange rate (A/B) = equilibrium real exchange rate
+ (real interest rateB - real interest rateA)
- (risk premiumB - risk premiumA)
z In the short term, the real value of a currency Fluctuates around its long-
term, equilibrium value.
z The real value of a currency is positively related to its real interest rate and
negatively related to the risk premium investors demand for investing in
assets denominated in the currency.
z The real interest rate increases when the nominal interest rate increases
(keeping inflation expectations unchanged) or when expected inflation
decreases (keeping nominal interest rates unchanged).
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FX Carry Trade
FX carry trade
z Uncovered interest rate parity is not bound by arbitrage. In a
FX carry trade, an investor invests in a higher yielding currency
using funds borrowed in a lower yielding currency. The lower
yielding currency is called the funding currency.
z Carry trade typically performs well during low-volatility
periods.
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FX Carry Trade
Example Carry Trade
Interest Rates Currency Pair Exchange Rates

Today One year later
U.K. 3% USD/GBP 1.50 1.50
U.S. 1%
Compute the profit to an investor borrowing in the United States and investing in
the U.K.
Answer:
return=interest earned on investment funding cost - currency depreciation
=3% - 1% - 0%
=2%
45-94
FX Carry Trade
Risks of the carry trade

z The risk is that the funding currency may appreciate significantly against the
currency of the investment.
z Crash risk
9 The return distribution of the carry trade is not normal; it is
characterized by negative skewness and excess kurtosis (i.e., fat tails),
meaning that the probability of a large loss is higher than the probability
implied under a normal distribution. We call this high probability of a
large loss the crash risk of the carry trade.
Risk management in carry trade
z Volatility filter: Whenever implied volatility increases above a certain
threshold, the carry trade positions are closed (i.e., reversed).
z Valuation filter: A valuation band is established for each currency based on
PPP or other models. If the value of a currency falls below (above) the band,
the trader will overweight (underweight) that currency in the traders carry
trade portfolio.
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Exchange Rate Determination Models
Exchange rate determination models

z Mundell-Fleming model
z The monetary approach
z The asset market (portfolio balance) approach
47-94
Mundell-Fleming Model
Flexible Exchange Rate Regimes

High capital mobility
z Monetary policy
9Expansionary monetary policy will reduce the interest rate and,
consequently, the inflow of capital investment in physical and
financial assets. This decrease in financial inflows reduces the
demand for the domestic currency, resulting in depreciation of the
domestic currency.
9Restrictive monetary policy should have the opposite effect,
increasing interest rates and leading to an appreciation in the
value of the domestic currency
48-94

High capital mobility
z Fiscal policy
9 Expansionary fiscal policy will increase government borrowing and,
consequently, real interest rates. An increase in real interest rates will
attract foreign investors, improve the financial account, and
consequently, increase the demand for the domestic currency.
9 Expansionary fiscal policy will also increase economic activity (growth)
and inflation, leading to a deterioration of the current account and a
decrease in demand for the domestic currency.
9 With these two opposite effects on currency demand, the net effect of
expansionary fiscal policy on exchange rates is subject to some debate.
If the flow of capital is sensitive to the interest rate differential, then the
financial flows effect will dominate the goods flow effect, and the
currency will typically appreciate as a result of expansionary fiscal
policy.
49-94

Low capital mobility
z In that case, the impact of trade imbalance on exchange rates (goods How
effect) is greater than the impact of interest rates (financial flows effect). In
such a case, expansionary fiscal or monetary policy leads to increases in net
imports, leading to depreciation of the domestic currency. Similarly,
restrictive monetary or fiscal policy
Money Policy/Fiscal Policy Capital Mobility

High Low
Expansionary/Expansionary Uncertain Depreciation
Expansionary/Restrictive Depreciation Uncertain
Restrictive/Expansionary Appreciation Uncertain
Restrictive/Restrictive Uncertain Appreciation
50-94
Fixed Exchange Rate Regimes

Monetary policy
z An expansionary (restrictive) monetary policy would lead to depreciation
(appreciation) of domestic currency as stated above.
z Under a fixed rate regime, the government would then have to purchase (sell)
its own currency in the foreign exchange market. This action essentially
reverses the expansionary (restrictive) stance.
z This explains why in a world with mobility of capital, governments cannot
both manage exchange rates as well as pursue independent monetary policy.
Fiscal policy
z Expansionary (restrictive) fiscal policy leads to appreciation (depreciation)
of domestic currency.
z Under a fixed exchange rate regime, the government would then sell (buy)
its own domestic currency to keep exchange rates stablereinforcing the
impact of its fiscal policy on aggregate demand.
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Monetary Approach
Compare Mundell-Fleming model with monetary model

z With the Mundell-Fleming model, we assume that inflation (price levels)
play no role in exchange rate determination.
z Under monetary models, we assume that output is fixed, so that monetary
policy primarily affects inflation, which in turn affects exchange rates.
Main approaches
z Pure monetary model. PPP holds at any point in time and output is held
constant. An expansionary (restrictive) monetary or fiscal policy leads to an
increase (decrease) in prices and a decrease (increase) in the value of the
domestic currency.
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Monetary Approach
Main approaches
z Pure monetary model.
z Dornbusch overshooting model.
9 This model assumes that prices are sticky (inflexible) in the short term
and, hence, do not immediately reflect changes in monetary policy.
9 In the case of an expansionary monetary policy, prices increase over
time. This leads to a decrease in real interest ratesand depreciation of
the domestic currency due to capital outflows.
9 In the short term, exchange rates overshoot the long-run PPP implied
values. In the long term, exchange rates gradually increase toward their
PPP implied values.
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Portfolio Balance (Asset Market) Models
Compare Mundell-Fleming model with portfolio balance model

z The Mundell-Fleming approach focuses on the short-term implications of
fiscal policy.
z The portfolio balance model focuses on the long-term implications of
sustained fiscal policy (deficit or surplus) on currency values.
Main approach:
z Continued increases in fiscal deficits are unsustainable and investors may
refuse to fund the deficitsleading to currency depreciation.
z Portfolio balance model:
9 In the long term, the government has to reverse course (tighter
budgetary policy) leading to depreciation of the domestic currency.
9 If the government does not reverse course, it will have to monetize its
debt (i.e., print money), which would also lead to depreciation of the
domestic currency.
z Mundell-Fleming model: in the short term, with free capital flows, an
expansionary fiscal policy leads to domestic currency appreciation.
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Central Bank Intervention
Excessive capital inflows to a country can also lead to a currency crisis when
such capital is eventually withdrawn from the country.
Objectives
z Ensure that the domestic currency does not appreciate excessively.
z Allow the pursuit of independent monetary policies without being hindered
by their impact on currency values.
z Reduce excessive inflow of foreign capital.
Effectiveness
z Evidence has shown that for developed markets, central banks are relatively
ineffective.
z Central banks of emerging market countries may have accumulated
sufficient foreign exchange reserves (relative to trading volume) to affect
the supply and demand of their currencies in the foreign exchange markets.
9 The success of capital controls in emerging markets depends on
persistence and size of capital flows.
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Signs of Currency Crisis
Terms of trade deteriorate.

Official foreign exchange reserves dramatically decline.
Real exchange rate is substantially higher than the mean-reverting
level.
Inflation increases.
Equity markets experience a boom-bust cycle.
Money supply relative to bank reserves increases.
Nominal private credit grows.
56-94
Technical Analysis
Trend-Following Trading Rules

FX Dealer Order Books
z In FX markets, volume and price data are not immediately
available to all parties. For this reason, an FX dealers order
book may have predictive value for exchange rates
Currency Options Market
z Implied volatility estimates from foreign exchange options can
give insight into markets expectations of future increases or
decreases in the value of the currency.
z For example, if the implied volatility in a call option is higher
than the implied volatility in the corresponding put option, the
market expects that the currency is more likely to appreciate
than depreciate.
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Reading 15: Economic Growth and

investment decision
58-94
Preconditions for Growth
Preconditions for Growth

z Savings and investment
z Financial markets and intermediaries
z The political stability, rule of law, and property rights
z Investment in human capital
z Tax and regulatory systems
z Free trade and unrestricted capital flows
59-94
Stock Market and Sustainable Growth Rate of Economy
P = GDP + (E/GDP) + (P/E)

z Over the long-term, we have to recognize that growth in
earnings relative to GDP is zero; labor will be unwilling to
accept an ever decreasing share of GDP.
z Growth in the P/E ratio will also be zero over the long term;
investors will not continue to pay an ever increasing price for
the same level of earnings forever.
z Hence over a sufficiently long time horizon, the potential GDP
growth rate equals the growth rate of aggregate equity
valuation.
60-94
Importance of Potential GDP
Growth in potential GDP

z When consumers expect their incomes to rise, they increase
current consumption and save less for future consumption (i.e.,
they are less likely to worry about funding their future
consumption).
z To encourage consumers to delay consumption (i.e., to
encourage savings), investments would have to offer a higher
real rate of return. Therefore, higher potential GDP growth
implies higher real interest rates and higher real asset returns in
general.
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Importance of Potential GDP
The relationship between actual GDP and potential GDP

z Since actual GDP in excess of potential GDP results in rising
prices, the gap between the two can be used as a forecast of
inflationary pressures.
z Central banks are likely to adopt monetary policies consistent
with the gap between potential output and actual output.
z It is more likely for a government to run a fiscal deficit when
actual GDP growth rate is lower than its potential growth rate.
Potential GDP growth rate
z A higher potential GDP growth rate reduces expected credit
risk and generally increases the credit quality of all debt issues.
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Factor Inputs and Economic Growth
Cobb-Douglas production function

(1 )
Y = TK L
where:
and (1 )= the share of output allocated to capital (K) and labor (L),
respectively [ and (1 ) are also referred to as capitals and
labors share of total factor cost, where < 1]
T = a scale factor that represents the technological progress of the
economy, often referred to as total factor productivity (TFP)
z It exhibits constant returns to scale
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Output per worker (labor productivity)

Output per worker=Y/L=T(K/L)
z Assuming the number of workers and a remain constant, increases in output
can be gained by increasing capital per worker (capital deepening) or by
improving technology (increasing TFP).
z Since a is less than one, additional capital has a diminishing effect on
productivity.
z Lower the value of a, lower the benefit of capital deepening. Developed
markets typically have a high capital to labor ratio and a lower a as
compared to developing markets, and therefore developed markets stand to
gain less in increased productivity from capital deepening.
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In steady state (i.e., equilibrium), the marginal product of capital

and marginal cost of capital (i.e., the rental price of capital, r) are
equal; hence
Y/K=r, =rK/Y
z r is rate of return and K is amount of capital. rK measures the
amount of return to providers of capital. The ratio of rK to
output (Y) measures the amount of output that is allocated to
providers of capital.
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Productivity Curve
Two important properties of productivity curves:

z Growth in capital per labor hour causes movement along a
productivity curve. (capital deepening)
9The curvature of the relationship derives from the
diminishing marginal productivity of capital.
9Economies will increase investment in capital as long as
MPK > r. At the level of K/L for which MPK = r, capital
deepening stops and labor productivity becomes stagnant.
z Technological growth causes the productivity curve to shift
upwards.
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Productivity Curve
Productivity Curve
Labor productivity More technology
LP2 Effect of change in

technology
Economic Less technology
LP1
Growth
Effect of increase in capital
LP0
C0 C1 Capital per labor hour
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Productivity Curve
For developed countries, the capital per worker ratio is relatively

high, so those countries gain little from capital deepening and must
rely on technological progress for growth in productivity.
In contrast, developing nations often have low capital per worker
ratios, so capital deepening can lead to at least a short-term
increase in productivity.
68-94
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)
z The change in total factor productivity (technology) must be
estimated as a residual: the ex-post (realized) change in output minus
the output implied by ex-post changes in labor and capital.
Growth rate in potential GDP = long-term growth rate of labor force +
long-term growth rate in labor productivity
69-94
Natural Resources
The role of natural resources in economic growth is complex. In

some instances, countries with abundant natural resources (e.g.,
Brazil) have grown rapidly. Yet other countries (e.g., some of the
resource-rich countries of Africa) have not. Conversely, some
resource-poor countries have managed impressive growth.
Dutch disease: global demand for a countrys natural resources
drives up the country's currency values, making all exports more
expensive and rendering other domestic industries uncompetitive
in the global markets.
70-94
Labor Supply Factors
Demographics.
z As a countrys population ages and individuals live beyond working age, the
labor force declines. Conversely, countries with younger populations have
higher potential growth.
z Countries with low or declining fertility rates will likely face growth
challenges from labor force declines.
labor force
Labor force participation=
working age population
z Labor force participation can increase as more women enter the workforce.
Immigration.
z Since developed countries tend to have lower fertility rates than less
developed countries, immigration represents a potential source of continued
economic growth in developed countries.
Average hours worked. The general trend in average hours worked is downward.
71-94
Factors Affecting Economic Growth
Human capital.
z Increasing human capital through education or work experience
increases productivity and economic growth.
Physical capital.
z Physical capital is generally separated into infrastructure, computers,
and telecommunications capital (ICT) and non-ICT capital (i.e.,
machinery, transportation, and non-residential construction).
z Why capital increases may still result in economic growth
9Many countries (e.g., developing economies) have relatively low
capital to labor ratios
9Some capital investment actually influences technological
progress, thereby increasing TFP and economic growth.
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Factors Affecting Economic Growth
Technological development.
z Developed countries tend to spend the most on R&D since they rely
on technological progress for growth given their high existing capital
stock and slower population growth.
z In contrast, less developed countries often copy the technological
innovations of developed countries and thus invest less in R&D as a
percentage of GDP.
Public infrastructure.
z Investments in public infrastructure such as the construction of
public roads, bridges, and municipal facilities, provide additional
benefits to private investment.
73-94
Economic Growth Theories
Classical growth theory

Neoclassical growth theory
Endogenous growth theory
74-94
Classical Growth Theories
Classical theory
The growth in real GDP is not permanent.
Technological advances investment in new capital labor
productivity and new business start and demand for labor real
wages and employment population explosion real GDP
Subsistence real wage: minimum real wage necessary to support life

No matter how much technology advances, real wages will
eventually be driven back to the subsistence level, and no permanent
productivity growth or improvement in the standard of living will
occur.
Adam.Smith 1776, David.Richado 1817 & Thomas.Malthus 1798
75-94
Classical Growth Theories
Classical theory and the productivity curve
76-94
Neoclassical Growth Theories
Long-term steady state growth rate

z The economy is at equilibrium when the output-to-capital ratio is
constant. When the output-to-capital ratio is constant, the labor-to-
capital ratio and output per capita also grow at the equilibrium
growth rate, g*.
z Sustainable growth of output per capita (or output per worker) (g*) is
equal to the growth rate in technology () divided by labors share
of GDP (1-)

g* =
(1 )
z Sustainable growth rate of output (G*) is equal to the sustainable
growth rate of output per capita, plus the growth of labor (L)

G* = + L
(1 )
77-94
Neoclassical Growth Theories
Capital deepening affects the level of output but not the growth rate in the long
run. Capital deepening may temporarily increase the growth rate, but the growth
rate will revert back to the sustainable level if there is no technological progress.
An economys growth rate will move towards its steady state regardless of the
initial capital to labor ratio or level of technology. In the steady state, the growth
rate in productivity (i.e., output per worker) is a function only of the growth rate
of technology () and labors share of total output (1 - ).
In the steady state, marginal product of capital (MPK) = Y/K is constant, but
marginal productivity is diminishing.
An increase in savings will only temporarily raise economic growth. However,
countries with higher savings rates will enjoy higher capital to labor ratio and
higher productivity.
Developing countries (with a lower level of capital per worker) will be impacted
less by diminishing marginal productivity of capital, and hence have higher
growth rates as compared to developed countries; there will be eventual
convergence of per capita incomes.
78-94
Endogenous Growth Theory
Assumption
z The driving force behind the endogenous growth theory result is the
assumption that certain investments increase TFP (i.e., lead to technological
progress) from a societal standpoint.
z Increasing R&D investments, for example, results in benefits that are also
external to the firm making the R&D investments.

z In contrast to the neoclassical model, endogenous growth theory contends
that technological growth emerges as a result of investment in both physical
and human capital (hence the name endogenous which means coming from
within). Technological progress enhances productivity of both labor and
capital.
z Unlike the neoclassical model, there is no steady state growth rate, so that
increased investment can permanently increase the rate of growth.
79-94
Endogenous Growth Theory
The difference between neoclassical and endogenous growth

theory relates to total factor productivity.
z Neoclassical theory assumes that capital investment will
expand as technology improves (i.e., growth comes from
increases in TFP not related to the investment in capital within
the model).
z Endogenous growth theory assumes that capital investment
(R&D expenditures) may actually improve total factor
productivity.
80-94
Convergence Hypotheses
Whether productivity, and hence, living standards tend to converge over time
z Absolute convergence hypothesis
9 Less developed countries will achieve equal living standards over time
z Conditional convergence hypothesis
9 Convergence in living standards will only occur for countries with the
same savings rates, population growth rates, and production functions.
z club convergence hypothesis
9 Countries may be part of a club (i.e., countries with similar
institutional features such as savings rates, financial markets, property
rights, health and educational services, etc.).
9 Countries can join the club by making appropriate institutional
changes. Those countries that are not part of the club may never achieve
the higher standard of living.
9 Increased markets for domestic products, resulting in economies of scale.
81-94
Rationals to Provide Incentives to Private Investment
Under endogenous growth theory, private sector investments in

R&D and knowledge capital benefit the society overall.
Government incentives that effectively subsidize R&D
investments can theoretically increase private spending on R&D
investments to its optimal level.
82-94
Expected Impact of Removing Trade Basrriers
Benefit
z Increased investment from foreign savings.
z Allows focus on industries where the country has a comparative advantage.
z Increased markets for domestic products, resulting in economies of scale.
z Increased sharing of technology and higher total factor productivity growth.
z Increased competition leading to failure of inefficient firms and reallocation
of their assets to more efficient uses.
The neoclassical models predictions in an open economy (i.e., an
economy without any barriers to trade or capital flow) focus on the
convergence.
The endogenous growth model also predicts greater growth with
free trade and high mobility of capital since open markets foster
increased innovation.
83-94
Reading 16: Economics of Regulation
84-94
Classifications of Regulations And Regulators
Regulations
z Statutes: laws made by legislative bodies
z Administrative regulations: rules issued by government agencies or other
bodies authorized by the government
z Judicial law: findings of the court
Regulators
z Independent regulators are given recognition by government agencies and
have power to make rules and enforce them,but not funded by the
government and hence are politically independent.
z Some independent regulators are self-regulating organizations (SROs) that
regulate as well as represent their members. Not all SROs are independent
regulators (i.e., have government recognition). Also, not all independent
regulators are SROs.
z SROs may have inherent conflicts of interest.
z Outside bodies are not regulators themselves but their product is referenced
by regulators.
85-94
Types of Regulators
Regulators
Government Independent Outside

agencies regulators bodies
SROs Non-SROs
86-94
Uses of Self-Regulation in Financial Markets
SROs without government recognition are not considered

regulators.
The use of independent SROs in civil-law countries is not common;
in such countries, formal government agencies fulfill the role of
SROs.
In common-law countries such as the U.K. and the United States,
independent SROs have historically enjoyed recognition.
87-94
Economic Rationale for Regulatory Intervention
Informational frictions occur when information is not equally

available or distributed.
z A situation where some market participants have access to
information unavailable to others is called information
asymmetry.
Externalities deal with the consumption of public goods.
z A public good is a resource, like parks or national defense,
which can be enjoyed by a person without making it
unavailable to others.
z Since people share in the consumption of public goods but
dont necessarily bear a cost that is proportionate to
consumption, regulations are necessary to ensure an optimal
level of production of such public goods.
88-94
Regulatory Interdependencies
Regulatory capture theory

z A regulatory body will be influenced or even possibly controlled by the
industry that is being regulated.
z The rationale is that regulators often have experience in the industry, and
this affects the regulators' ability to render impartial decisions.
Regulatory competition
z Regulators compete to provide the most business-friendly regulatory
environment
Regulatory arbitrage
z Occurs when businesses shop for a country that allows a specific behavior rather
than changing the behavior.
z Regulatory arbitrage also entails exploiting the difference between the economic
substance and interpretation of a regulation.
z To avoid regulatory arbitrage, cooperation at a global level to achieve a cohesive
regulatory framework is necessary.
z Even within a country, there may be a conflict between the objectives of different
regulatory bodies.
89-94
Tools of Regulatory Intervention
Price mechanisms. Price mechanisms such as taxes and subsidies

can be used to further specific regulatory objectives.
Restricting/requiring certain activities. Regulators may ban
certain activities (e.g., use of specific chemicals) or require that
certain activities be performed (e.g., filing of 1 0-k reports by
publicly listed companies) to further their objectives.
Provision of public goods or financing of private projects.
Regulators may provide public goods (e.g., national defense) or
fund private projects (e.g., small business loans) depending on
their political priorities and objectives.
90-94
Purposes in Regulating Commerce And Financial Markets
Regulating commerce.
z To facilitate business decision making. Examples of regulations covering
commerce include company laws ,tax laws, contract laws, competition laws,
banking laws, bankruptcy laws, and dispute resolution systems.
Regulating financial markets.
z Regulation of securities markets
9 Disclosure requirements
9 Mitigating agency problem
9 Protecting small (retail) investors
z Regulation of financial markets
9 Prudential supervision refers to the monitoring and regulation of
financial institutions to reduce system-wide risks and to protect
investors.
9 The cost-benefit analysis of financial market regulations should also
include hidden costs.
91-94
Antitrust Regulation
Antitrust laws work to promote domestic competition by

monitoring and restricting activities that reduce or distort
competition.
When evaluating an announced merger or acquisition, an analyst
should consider the anticipated response by regulators as part of
the analysis.

Cost Benefit Analysis of Regulation
Regulatory burden (also known as government burden) refers to

the cost of compliance for the regulated entity. Regulatory burden
minus the private benefits of regulation is known as the net
regulatory burden.
Regulators should be aware of unintended consequences of
regulations.
Many regulatory provisions include a sunset clausethat
requires regulators to revisit the cost-benefit analysis based on
actual outcomes before renewing the regulation.
93-94
Effects of A Specific Regulation
Regulations can help or hinder a company or industry.

z Regulations may shrink the size of one industry (e.g., if it is
heavily taxed) while increasing the size of another (e.g., an
industry receiving subsidies).
Regulations are not necessarily always costly for those that end up
being regulated.
Regulations may introduce inefficiencies in the market.
Some regulations may be specifically applicable to certain sectors
while others may have broad implications affecting a number of
sectors.
94-94

02 Economics

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2013CFA

2-94 100% Contribution Breeds Professionalism

Study Session 1-2 Ethics & Professional Standards 10

Study Session 3 Quantitative Analysis 5-10

Study Session 4 Economics 5-10

Study Session 5-7 Financial Reporting and Analysis 15-25

Study Session 8-9 Corporate Finance 5-15

Study Session 18 Portfolio Management and Wealth Planning 5-15

Study Session 10-12 Equity Investment 20-30

Study Session 14-15 Fixed Income 5-15

Study Session 16-17 Derivatives 5-15

Study Session 13 Alternative Investments 5-15

3-94 100% Contribution Breeds Professionalism

Reading 14: Currency exchange rate:

Warm-up: Foreign exchange quotations

Warm-up: FX Appreciation and Depreciation

The spread quoted by the dealer depends on

The interbank spread on a currency pair depends on

Calculate cross rate 2

Calculate cross rate with bid-ask spreads

Example: Spot and forward quotes

Mark-to-market value of a forward contract

z The value of a forward currency contract prior to expiration is

Example: Valuing a forward contract prior to maturity

Interest Rate Parity

Covered Interest rate parity (IRP)

Comparing covered and uncovered interest parity

Foreign exchange expectation relation

There is no advantage to holding an unhedged position in a foreign

International Fisher relation

Ex-Ante Version of PPP

Forward Interest Rate Parity

The International Parity Relationships Combined

Several observations can be made from the relationships among

Assess the long-run fair value of an exchange rate

Influence of BOP on exchange rates

Influence of BOP on exchange rates

Influence of BOP on exchange rates

Example Carry Trade

Interest Rates Currency Pair Exchange Rates

Risks of the carry trade

Exchange rate determination models

Flexible Exchange Rate Regimes

Flexible Exchange Rate Regimes

Flexible Exchange Rate Regimes

Money Policy/Fiscal Policy Capital Mobility

Fixed Exchange Rate Regimes

Compare Mundell-Fleming model with monetary model

Compare Mundell-Fleming model with portfolio balance model

Terms of trade deteriorate.

Trend-Following Trading Rules

Reading 15: Economic Growth and

Preconditions for Growth

P = GDP + (E/GDP) + (P/E)

Growth in potential GDP

The relationship between actual GDP and potential GDP

Cobb-Douglas production function

Output per worker (labor productivity)

In steady state (i.e., equilibrium), the marginal product of capital

Two important properties of productivity curves:

Labor productivity More technology

LP2 Effect of change in

C0 C1 Capital per labor hour