Econ

Question 1

What is Covered Interest Rate Parity?

Answer 1

• This is the only parity where international parity holds.
• This is a risk-free, arbitrage relationship

Under this condition:

1. Capital flow freely
2. Market stress free condition
3. Spot & Forward Market is liquid

Question 2

What is Uncovered Interest Rate parity?

Answer 2

interest rate differential: I(f) - I(d) = % of change in expected spot rate F / spot rate D

Expected return on an uncovered foreign currency investment should equal to the return on a comparable domestic currency investment.

Question 3

Under UIRP, country with higher interest rate is expected to see the value of the currency?

Answer 3

Decreased.

Question 4

If UIRP held, what does that mean?

Answer 4

No excess return could be gained by going long a high yielding currency & Short a low yielding currency
No incentive to shift capital from one currency to another

Question 5

Empirical studies of UIRP, what does it show?

Answer 5

1. Fail to hold over short & Medium terms
2. Interest rate differentials are generally a poor predictor of future fx rate changes
3. high yield currencies tend to strengthen instead of weaken
4. forward fx rate are a poor indication of future spot fx rates
5. Current spot fx rates are also poor predictors of future fx rates

Question 6

Purchasing power Parity (PPP)

Answer 6

Fx rates and Inflation differentials

Basing on law of one price - identical goods should trade at the same price across countries when valued in terms of a common currency

Pf(x) = Sf/d * Pd(x)

Question 7

Absolute PPP

Answer 7

Assumes that all domestic & foreign goods are tradable & that price indices are identical

Same good & Service, same weights

Pf = Sf/d * Pd

Sf/d = Pf/Pd

Question 8

Relative PPP

Answer 8

Assumes these costs are constant over time

Different in Sf/d equals or similar to π f - π d (changes in fx rate = inflation differential)

Question 9

The currency of high inflation country should ___ relative to currency of low inflation country.

Answer 9

Increase

Question 10

ex ante version of PPP

Answer 10

Expected changes in spot rate are driven by expected differences in inflation rates

Question 11

Real fx rate PPP

Answer 11

q (f/d) = S(f/d)*Pd/Pf = Sf/d (CPId/CPIf)

Question 12

The fisher effect & Real interest rate parity formula

Answer 12

i(f)-i(d) = (r(f)-r(d)) - (expected π(f) - expected π(d))

Question 13

Real interest parity need what condition to hold?

Answer 13

1. UIRP

2. ex ante PPP

Question 14

International fisher effect

Answer 14

When real interest differential = 0

interest rate differential = expected inflation rate differential

Question 15

IMF 3 approach to derive long-run equilibrium

Answer 15

1. Macroeconomic balance approach
2. External sustainability approach
3. Recued form econometric mode

Question 16

Macroeconomic balance approach

Answer 16

Estimate how much fx rates need to adjust in order to close the gap between medium-term expectation for a country’s current account imbalance and that country’s normal current account imbalance (Focus on ‘real’ flows)

Question 17

External sustainability approach

Answer 17

focuses on stocks of outstanding asset/debt - how much fx rates need to adjust to ensure that a country’s net foreign asset/GDP ratio or net foreign liability/GDP ratio stabilizes at some bench mark level (focus on financial flows)

Question 18

Reduced form econometric model

Answer 18

estimate the equilibrium path that a currency should take on the basis of the trends in several key macro variables (e.g. net foreign asset position, terms of trade, relative productivity)

Question 19

1. Currency overvalued, trade surplus
2. Currency Overvalued, trade deficit
3. Currency undervalued, trade surplus
4. Currency undervalued, trade deficit

What action do we need to bring fx - rate close to long run fair value?

Answer 19

1. Unclear
2. Encourage depreciation
3. Unclear
4. Encourage appreciation

Question 20

Carry trade

Answer 20

When UIRP doesn’t hold over short and medium term, it opens up FX Carry trade.

• take long position in high yield currencies and short positions in low yield currencies (funding currencies)
• earn positive excess returns in most market conditions (low volatility

Question 21

Carry trade crash risk

Answer 21

volatility/Perceived risk can cause these positions to unwind fast

Question 22

Current account

Answer 22

Sum of all recorded transactions in traded good, services, income & Net transfer payment
(Similar to PnL)

Question 23

Current account deficits will affect currency how?

Answer 23

Currency depreciation overtime

Question 24

Which account is the dominant factor in determining exchange rate movement? and why?

Answer 24

Capital account - financial flow

1. It is quicker to move comparing to the price of goods and services.
2. Production of real goods and service takes time
3. Current spending/production decisions reflect only purchases/sales of current production
4. Expected exchange rate movement can induce very large short-term capital flows (actual fx rate sensitive to the view held by owners and managers of liquid assets.

Question 25

Trade surplus - __ demand for currency – ___ pressure

Trade deficit - __ demand for currency – ___ pressure

Answer 25

more, upward

less, downward

Question 26

Persistent surpluses/Deficits should __

Answer 26

Revert; surplus country currency would appreciate to the point that exports would drop, import would increase

Question 27

Capital responds to interest rate differentials, risk premia and expectation fx rate movement

Answer 27

Capital account will rise when yield spread widens, inflation expectations tightens and risk premia spread tightens

risk premia - perceived sustainability of the country’s external balance

Question 28

High yield high inflation rate country wants price stability + long term sustainable growth, what can they do?

Answer 28

1. combat inflation by raising interest rates (Monetary)
2. Lower gov debt, financial market liberalization, removal of capital flow restrictions and attraction of FDI. (economic and fiscal)

Question 29

Expansionary Mundell - fleming model, what does it do and what’s the impact with it’s monetary policy and fiscal policy?

Answer 29

increase AD and output (GDP)

Monetary policy:

a. reduce interest rate -> increase investment & consumption spending
b. leads to capital outflows -> downward pressure on fx rates

Fiscal policy:

a. Increase spending and lower taxes
b. exerts upward pressure on interest rates (larger deficits need to be financed)
c. leads to capital inflows - upward pressure on fx rates.

Question 30

Expansionary Mundell - fleming model with fixed rate, what does central bank need to do?

Answer 30

expansionary monetary policy:

a. central bank will have to buy its own currency & deplete fx reserves (to support currency) -> this tightens domestic credit conditions -> offsets intended expansionary policy.

Fiscal policy with fixed rate expansionary:
a. central bank will have to sell it’s currency and build reserves -> this expands domestic money supply and reinforces expansionary policy.

Question 31

Under Mundell-Fleming Model, can domestic policymaker

a. Pursue independent monetary policy
b. permit capital to flow freely across national boarders
c. defend fx rate

can all three achieve at the same time?

Answer 31

No. to have A and c we need to put capital control on b