Economics

The equation that links nominal and real interest rates is:

(1 + nominal rate) = (1 + real interest rate) (1 + inflation rate).

covered interest rate parity

(covered means bound by arbitrage) -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. derives the no-arbitrage forward rate

real interest parity

-real interest rates are assumed to converge across different markets

pips

1 pip = 1/10,000 so 4 pips = $0.0004

real interest rate

An interest rate that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower, and the real yield to the lender. The real interest rate of an investment is calculated as the amount by which the nominal interest rate is higher than the inflation rate. =nominal interest rate - inflation

arbitrage constraints on spot exchange quotes

First, the bid shown by a dealer in the interbank market cannot be higher than the current interbank offer, and the offer shown by a dealer cannot be lower than the current interbank bid. Second, the cross-rate bids (offers) posted by a dealer must be lower (higher) than the implied cross-rate offers (bids) available in the interbank market.

portfolio balance approach

Focuses on long-term implications of fiscal policy on exchange rate.

warning sign of currency crisis

Inflation increases; Nominal credit relative to bank reserves increase.; real exchange rate is substantially higher than the mean reverting level. ; money supply relative to bank reserves grows (not shrinks).Terms of trade deteriorate; Equity markets experience a boom-bust cycle; nominal private credit grows substantially

International Fisher Effect

Nominal rate of A - Nominal rate of B = E(Inflation of A) - E(Inflation of B). This tells us that the difference between two countries' nominal interest rates should be equal to the difference between their expected inflation rates

International Fisher Relation

Nominal rate of return = real rate of return + the expected rate of inflation.

External sustainability approach

The assessment of sustainable levels of debt relative to GDP

nominal interest rate

The interest rate before taking inflation into account. The nominal interest rate is the rate quoted in loan and deposit agreements. Central banks set short-term nominal interest rates, which then form the basis for other interest rates charged by banks and financial institutions. Nominal interest rates may be held at artificially low levels after a major recession to stimulate economic activity through low real interest rates. A necessary condition for such stimulus measures is that inflation should not be a present or near-term threat. Conversely, during inflationary times, central banks may overestimate the inflation level and keep nominal interest rates too high. The resulting elevated level of real interest rates may have serious economic repercussions.

forward discount

a currency is quoted at a forward discount relative to a second currency if the forward price (in units of the second currency) is less than the spot price

forward premium

a currency is quoted at a forward premium relative to a second currency if the forward price (in units of the second currency) is greater than the spot price.

Taylor rule

a higher output gap in U.S. would translate into higher real interest rates in US leading to appreciation of the USD (and hence higher pounds/dollar).

balance of paymenets

an accounting method used to keep track of transactions between a country and its international trading partners. It includes govt transactions, consumer transactions, and business transactions. current account + financial acct + official reserve account = 0

appreciation of aggregate stock market

depends on GDP growth rate, growth of share of capital in GDP and growth in P/E multiples. In the long run, stock market appreciation depends only on GDP growth rate as the other two factors cannot increase (or decrease) in perpetuity.

foreign exchange (FX) carry trade

entail going long a basket of high-yielding currencies and simultaneously going short a basket of low- yielding currencies. Although the empirical evidence suggests that the excess returns on this strategy have been fairly attractive, investors need to be mindful that they are prone to crash when market conditions become volatile. Hence, investors need to overlay simple strategies with well-thought-out risk management systems to help protect against downside risks.

Mundell Fleming Model

evaluates the impact of monetary and fiscal policies on interest rates - and consequently on exchange rates

carry trade

funding currency is the lower yielding currency

endogenous growth theory of economic growth

hypothesizes that expenditures on R&D and knowledge capital generate benefits to the economy as a whole, beyond the private benefit to the investing company. Under the endogenous growth model, the resulting increase in growth is likely to be enduring.No diminishing returns to knowledge capital

law of one price

identical goods should have the same price in all locations, adjusted for exchange rate; does not hold in practice, due to tariffs/transportation costs

absolute purchasing power parity

instead of focusing on individual products, it compares the average price of a representative basket of consumption goods between countries; law of one price can be correct on average. Absolute PPP is based on a number of unrealistic assumptions that limits its real-world usefulness. These assumptions are: that all goods and services can be transported among countries at no cost; all countries use the same basket of goods and services to measure their price levels; and all countries measure their rates of inflation the same way.

uncovered interests rate parity

interest rates and exchange rates will adjust so the risk adjusted return on assets between any two countries and their associated currencies will be the same. uncovered means not bound by arbitrage; derives the expected future spot rate; assumes an investor is risk-neutral; UIRP rests on the idea of equal real interest rates across international borders. Real interest rate differentials would result in capital flows to the higher real interest rate country, equalizing the rates over time. Another way to say this is that differences in interest rates are equal to differences in expected changes in exchange rates.

regulatory arbitrage

occurs when the firms exploit the difference between the economic substance and interpretation of a regulation.

regulatory capture

occurs when the regulatory body gets influenced (or even controlled) by the regulated industry.

bid price

price at which the dealer will buy the currency

ask (offer) price

price at which the dealer will sell the currency

flexible (floating) exchange rate regimes

rates are determined by supply and demand in the foreign exchange markets

Dutch disease

refers to situation where a country with large endowments of natural resources finds its currency appreciating driven by foreign demand for those resources. This increase in currency value may render other domestic industries uncompetitive globally. Countries with abundant natural resources may devote disproportionate amount of its economic energy in pursuing those resource industries at the expense of other industries.

relative PPP

states that changes in exchange rates should exactly offset the price effects of any inflation differential between the two countries.

mark-to-market

the value of a forward currency contract prior to expiration.