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 Vincent
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Topic Weightings in CFA Level II
Content Weightings
Quantitative Methods 5-10

Economics 5-10

Financial Statement Analysis 10-15

Corporate Issuers 5-10

Equity 10-15
Fixed Income 10-15
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Derivatives 5-10
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Alternative Investments 5-10

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Portfolio Management 10-15

Ethical and Professional Standards 10-15

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Framework Economics

LM 1 Currency exchange rates:

Understanding Equilibrium Value
Economics
LM 2 Economic Growth

LM 3 Economics of Regulation
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 Learning
Module
1
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Currency Exchange Rates: Understanding Equilibrium Value

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 1. Bid-Offer Spread
2. Cross Rate and Triangular Arbitrage
Framework 3. Forward Discount or Premium
4. Mark-to-market value
5. The International Parity Relationships
6. FX Carry Trade
7. The impact of Balance-of-Payments
Accounts
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8. Exchange Rate Determination Models

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9. Exchange Rate Management:

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Intervention and Controls

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10. Warning Signs of A Currency Crisis

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 Notation
➢ Exchange rate (P/B) is the price of base currency(B) expressed in terms of
the price currency(P)
⚫ USD/EUR=1.1650, 1 EUR(base currency)=1.1650 USD(price currency)
⚫ EUR/USD=0.8584, 1 USD(base currency)=0.8584 EUR(price currency)
➢ Spot exchange rate is used for settlement on the second business day after
the trade date (T+2 settlement).
➢ Forward exchange rate is used for transaction that has a settlement date
longer than T+2.
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⚫ Currency forward contracts are agreements to exchange one currency

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for another on a future date at an exchange rate agreed upon today.

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 1. Bid-Offer Spread
➢ The spread on a foreign currency quotation
⚫ The bid price is the price, defined in terms of the price currency, at which
the counterparty is willing to buy one unit of the base currency.
⚫ The offer(ask) price is the price, in terms of the price currency, at which
that counterparty is willing to sell one unit of the base currency.
⚫ The offer price is always higher than bid price.
✓ Bid-offer spread=Offer price – bid price
✓ Spreads are referred as “pips”
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◆ For example: if the quote in the interbank USD/EUR spot market is

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1.3649/1.3651 (two “pips” wide, 1.3651-1.3649=0.0002).

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✓ The bid-offer spread a dealer provides is slightly wider than the bid-
offer spread in the interbank market.

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 Bid-Offer Spread
➢ The spread quoted by the dealer depends on
⚫ The bid-offer spread in the interbank foreign exchange market for the
two currencies involved.
⚫ The size of the transaction. Typically, the larger the transaction, the wider
the bid-offer spread will be. Smaller sizes can also affect the bid-offer
quote to clients.
✓ Retail quotes are for dealing sizes smaller than 1 million units of
the base currency, the bid-offer spreads for these transactions can
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be very large compared with those in the interbank market.

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⚫ The relationship between the dealer and client. In order to win the
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client’s business, the dealer might provide a tighter (i.e., smaller) bid-
offer spot exchange rate quote.

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 Bid-Offer Spread
➢ The interbank spread on a currency pair depends on
⚫ The currency pair involved. Liquidity in the major currency pairs-for
example, USD/EUR, JPY/USD, or USD/GBP can be considerable and bid-offer
spread will be smaller than some of the more obscure currency.
⚫ The 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.
✓ New York time: 8:00 ~ 11:00 a.m.
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✓ London time: 13:00 ~ 16:00

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⚫ Market volatility. When major market participants have greater uncertainty

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about the factors influencing market pricing, this response implies wider
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bid-offer spreads in both the interbank and broader markets.

✓ Geopolitical events (e.g., war, civil strife), market crashes, and major data
releases (e.g., US non-farm payrolls) are among the factors that
influence spreads and liquidity.
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 2. Cross Rate
➢ If a particular currency pair is not explicitly quoted, it can be inferred from
the quotes for each currency in terms of the exchange rate with a third
nation’s currency.
⚫ For example, given exchange rate quotes for the currency pairs A/B and
C/B, we can back out the implied cross rate of A/C. This implied A/C
cross rate must be consistent with the A/B and C/B rates.
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 Cross Rate

Calculate cross rate

Suppose IDR/USD=2400
NZD/USD=1.6
Calculate NZD/IDR

Solution 1 Solution 2
1USD=2400 IDR, 1USD=1.6 NZD (NZD/USD)/(IDR/USD)
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2400 IDR=1.6 NZD =(NZD/USD) (USD/IDR)=NZD/IDR

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1 IDR=1.6/2400 NZD =1.6/2400

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Therefore, NZD/IDR=0.00067 NZD/IDR=0.00067

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Example
Calculate cross rate with bid-offer spread

Example1: USD/AUD = 0.6000 - 0.6015

MXN/USD =10.7000 - 10.7200, MXN/AUD
Answer:
(MXN/AUD)bid = (USD/AUD) bid ×(MXN/USD)bid = 6.42
(MXN/AUD)ask = (USD/AUD) ask ×(MXN/USD)ask = 6.4481
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Example
Calculate cross rate with bid-offer spread

Example2: SFR/USD =1.5960 – 70

AUD/USD =1.8225 – 35， AUD/SFR
Answer
(AUD/SFR)bid =(AUD/USD)bid ÷ (SFR/USD)ask = 1.1412
(AUD/SFR)ask =(AUD/USD)ask ÷ (SFR/USD)bid = 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.
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Example
➢ Example: JPY/USD 81.87/81.89
CAD/USD 0.9544/0.9546
JPY/CAD 85.73/85.75
How to arbitrage from these markets?
81.87 – 81.89 JPY/USD (1)
0.9544 – 0.9546 CAD/USD (2)
85.73 – 85.75 JPY/CAD (3)

➢ Correct Answer:
:

⚫ Route One: 1$(1) → 1*0.9544CAD(2) → 1*0.9544*85.73JPY(3) →

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(1*0.9544*85.73)/81.89=0.999154$(1)
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⚫ Route Two: 1$(1) → 1*81.87JPY(1) → 1*81.87/85.75CAD(3) →

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(1*81.87/85.75)/0.9546=1.000159$(1)

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Example: Triangular Arbitrage
➢ Chris is looking a possible triangular arbitrage trade using the Swiss, U.S.
and Brazilian currencies, to be executed based on a dealer’s bid/offer rate
quote of 0.5161/0.5163 in CHF/BRL and the interbank spot rate quotes
presented in the following Exhibit.
Currency Pair Bid/Offer
CHF/USD 0.9099/0.9101
BRL/USD 1.7790/1.7792
➢ Based on Exhibit, the most appropriate recommendation regarding the
triangular arbitrage trade is to:
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A. decline the trade, no arbitrage profits are possible.

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B. execute the trade, buy BRL in the interbank market and sell it to the
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dealer.
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C. execute the trade, buy BRL from the dealer and sell it in the interbank.
➢ Correct Answer: B

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 3. Forward Discount and Premium
➢ Forward discount or premium
⚫ There is a premium(discount) on the quoted currency when the forward
exchange rate is higher(lower) than the spot rate.
✓ Example: One month forward rate is EUR: USD=1.2468, the spot rate
is 1.2500, it is a forward discount for EUR
⚫ Forward exchange rates are typically quoted in terms of points, which
can be related to the last decimal place in the spot quote.
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Example
➢ Assume that the bid-offer for the spot and forward points for the
USD/EUR exchange rate are as shown in the exhibit below.
Maturity Spot rate or forward points
Spot (USD/EUR) 1.1649/1.1651
One month -5.6/-5.1
Three months -15.9/-15.3
Six months -37.0/-36.3
➢ The three-month forward bid rate would be based on the bid for both
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the spot and the forward points, and hence would be:
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 -15.9 
1.1649+   =1.16331
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 10,000 
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➢ This means that the market participant would be selling EUR three
months forward at a price of USD 1.16331 per EUR.

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 4. Mark-to-Market Value
➢ Mark-to-market value of a forward contract
⚫ The mark-to-market value of forward contracts reflects the profit (or
loss) that would be realized from closing out the position at current
market prices.
✓ The mark-to-market value of the contract at initiation is zero.
✓ The mark-to-market value of the forward contract will change as the
spot exchange rate changes and as interest rates change in either of
the two currencies.
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 Mark-to-Market Value
➢ The process for marking to market a forward position
⚫ Step 1: Create an equal and offsetting forward position to the original
forward position.
⚫ Step 2: Determine the appropriate all-in forward rate for this new,
offsetting forward position. If the base currency of the exchange rate
quote is being sold (bought), then use the bid (offer) side of the market.
⚫ Step 3: Calculate the cash flow at the settlement day. This amount will
be based on the original contract size times the difference between the
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original forward rate and that calculated in step 2.

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⚫ Step 4: Calculate the present value of this cash flow at the future
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settlement date. The currency of the cash flow and the discount rate
must match.

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Example
➢ Theo Capital, an hedge fund based in Tokyo, hedged a long exposure
to the New Zealand dollar by selling NZD 10 million forward against
the USD; the all-in forward price was 0.7900 (USD/NZD). Three months
prior to the settlement date, Theo Capital wants to mark this forward
position to market. The bid-offer for the USD/NZD spot rate, the three-
month forward points, and the three-month MRR (annualized) are as
follows:
Maturity Rate
Spot 0.7825/0.7830
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Three-month points -12.1/-10.0

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Three-month MRR(NZD) 3.31%

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Three-month MRR (USD) 0.31%

The mark-to-market for Theo Capital’s forward position is closest to:

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Example
➢ Correct Answer:
⚫ Theo Capital sold NZD 10 million forward to the settlement date at
an all-in forward rate of 0.7900 (USD/NZD).
⚫ To mark this position to market, it would need an offsetting
forward transaction involving buying NZD 10 million three months
forward to the settlement date.
⚫ This leads to an all-in three-month forward rate of 0.7830-
0.0010=0.7820.
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⚫ This gives a net cash flow on settlement day of 10,000,000*(0.7900-

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0.7820)=+USD 80,000.
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⚫ Calculate the mark-to-market value of the original forward position,

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80, 000
=+USD 79,938
 90 
1+0.0031 
 360 
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 5. The International Parity Relationships
➢ A Long-term Framework for Exchange Rates
⚫ International parity conditions describe the inter-relationships that
jointly determine long-run movements in exchange rates, interest
rates, and inflation.
➢ Interest Rate Parity ( - )
⚫ Covered Interest Rate Parity
⚫ Uncovered Interest Rate Parity
⚫ Forward Rate Parity
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➢ Purchasing Power Parity( - )

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➢ International Fisher Effect ( - )

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⚫ Real Interest Rate Parity

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 The International Parity Relationships
➢ Although empirical studies find that the parity conditions rarely hold in the
short term, they do help form a broadly based, long-term view of exchange
rates and accompanying risk exposures.
➢ The exception to the rule that parity conditions do not hold in the short
term is covered interest rate parity, which is the only parity condition that is
enforced by arbitrage.
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 5.1 Covered Interest Rate Parity
➢ Covered Interest rate parity (IRP)
⚫ Covered interest rate parity is based on an arbitrage relationship
among risk-free interest rates and spot and forward exchange rates.
⚫ This parity condition describes a riskless arbitrage relationship in which
an investment in a foreign money market instrument that is completely
hedged against exchange rate risk should yield exactly the same return
as an otherwise identical domestic money market investment. (fully
hedge)
➢ Interest differential ≈forward premium/discount in percentage
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➢ Interest rate parity relationship:

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⚫ F (forward), S (spot) X/Y, rX and rY is the nominal risk-free rate in X and Y

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⚫ F = 1+rX
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S 1+rY
⚫ F-S 1+rX r -r
= -1= X Y  rX -rY
S 1+rY 1+rY
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 Covered Interest Rate Parity
➢ 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
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the hedged foreign interest rate.

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 (1+rY )  F 
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( X) 
1+r -  = Covered Interest Differential
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 
⚫ The difference between the domestic interest rate and the hedged
foreign interest rate (covered interest differential) should be zero.
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 Covered Interest Rate Parity
➢ X/Y base currency Y

𝐹 1+𝑟𝑥
➢ ,
𝑆 1+𝑟𝑦
⚫ 𝑟𝑥 1 X 1/S Y
(short) Y X

1+𝑟𝑦
⚫ 𝑟𝑦 Y Y
𝑆
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1+𝑟𝑦
⚫ Y
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𝑆
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𝐹×(1+𝑟𝑦 )
X
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⚫ X 1 + 𝑟𝑥 X

𝐹
⚫ 1 + 𝑟𝑦 − (1 + 𝑟𝑥 ) X
𝑆
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 Covered Interest Rate Parity
➢ X/Y base currency Y

𝐹 1+𝑟𝑥
➢ ,
𝑆 1+𝑟𝑦
⚫ 𝑟𝑦 1 Y S X
(long) X Y
⚫ 𝑟𝑥 X S(1+𝑟𝑥 ) X
⚫ S(1+𝑟𝑥 ) X
s(1+𝑟𝑥)
:

Y
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𝐹
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⚫ Y 1 + 𝑟𝑦 Y
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𝑆
⚫ 1 + 𝑟𝑥 − (1 + 𝑟𝑦 ) Y
𝐹

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 Covered Interest Rate Parity
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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Example
➢ An investor examines the following rate quotes for the Brazilian real
and the Australian dollar:

Spot rate BRL/AUD 2.1131 BRL 1-year interest rate 4%

Forward rate BRL/AUD 2.1392 AUD 1-year interest rate 3%

If the investor shorts BRL400,000 he will achieve a risk-free arbitrage

profit (in BRL) closest to:
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A. -6,327.
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B. 1,088.
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C. 6,405.
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Example
➢ Correct Answer: B.
⚫ 𝐹𝑚𝑘𝑡 > 𝐹𝑚𝑜𝑑𝑒𝑙 , arbitrage opportunity exists.
⚫ The arbitrage profit by per unit of borrowing currency:

𝐹𝑚𝑘𝑡
𝑃𝑟𝑜𝑓𝑖𝑡 = 1 + 𝑟𝐴𝑈𝐷 − 1 + 𝑟𝐵𝑅𝐿 = 0.0027
𝑆
⚫ Arbitrage profit = BRL400,000 × 0.0027= 1,088
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 Covered Interest Rate Parity
➢ Assume a one year horizon. The risk-free assets are typically bank deposits
quoted using MRR for the currency involved. The day count convention is
Actual/360.

  Actual  
 1 + rX   
FX /Y = S X /Y   360 
 1 + r  Actual  
 Y  
  360  

  Actual  
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r −
 X Y  360  
( r )
FX /Y − S X /Y
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=  
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S X /Y  1 + r  Actual  
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 Y  
  360  

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Example
➢ The fixed income manager collects the following information, and uses
it along with the international parity conditions in order to estimate
investment returns and future exchange rate movements.
Today’s One-Year MRR Currency Pair Spot Rate Today
JPY 0.10% JPY/USD 81.30
USD 0.10% USD/GBP 1.5950
GBP 3.00% JPY/GBP 129.67

If covered interest parity holds, the all-in, one-year investment return

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to a Japanese investor whose currency exposure to the GBP is fully

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hedged is closest to:

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A. 0.10 percent.
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B. 0.17 percent.
C. 3.00 percent.

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Example
➢ Correct Answer: A.
⚫ If covered interest rate parity holds (and it very likely does, because
this is a pure arbitrage relationship), then the all-in investment
return to a Japanese investor in a one-year, fully hedged GBP MRR
position would be identical to a one-year JPY MRR position: 0.10
percent. No calculations are necessary.
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Example
➢ Calculating the forward premium (discount)
➢ The following table shows the mid-market (average of the bid and offer)
for the current CAD/AUD spot exchange rate as well as for AUD and
CAD 270-day MRR (annualized):
Spot (CAD/AUD) 1.0145
270-day MRR (AUD) 4.87%
270-day MRR (CAD) 1.41%
➢ The forward premium (discount) for a 270-day forward contract for
:

CAD/AUD would be closest to:

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A. - 0.0346
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B. - 0.0254
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C. +0.0261

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Example
➢ Correct Answer: B.
⚫ The equation to calculate the forward premium (discount) is:

  Actual  
(r -r )
 CAD AUD  360  
FCAD/AUD - SCAD/AUD = SCAD/AUD   
 1+r  Actual  
 AUD  
  360  
  270  
 (0.0141- 0.0487)  360  
=1.0145   = -0.0254
  270  
:

1+0.0487
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  360  
 
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 5.2 Uncovered Interest Rate Parity
➢ Uncovered interest rate parity states that the change in spot rate over the
investment horizon should equal the differential in interest rate between the
two countries.
⚫ Expected return on an uncovered(unhedged) foreign currency
investment should equal the return on domestic currency investment.
𝐸(𝑆𝑡 ) 1 + 𝑟𝑋 𝑒
= %∆𝑆𝑋/𝑌 ≅ 𝑟𝑋 −𝑟𝑌
𝑆0 1 + 𝑟𝑌
⚫ Uncovered interest rate parity suggests that nominal interest rates
reflect expected changes in exchange rates.
:

✓ With uncovered interest rate parity, the country with higher (lower)
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interest rate is expected to see the value of its currency depreciate

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(appreciate).
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⚫ Uncovered interest rate parity assumes that there are enough risk-
neutral investors to force equality of expected returns.

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 Interest Rate Parity
➢ Comparing covered and uncovered interest parity
⚫ Covered interest rate parity derives the no-arbitrage forward rate, while
uncovered interest rate parity derives the expected future spot rate.
⚫ Covered interest rate parity is assumed by arbitrage.
⚫ Uncovered interest rate parity does not hold in the short and medium
periods, and it does 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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 Forward Rate Parity
➢ Forward rate parity
⚫ The forward exchange rate will be an unbiased forecast of the future
spot exchange rate if both covered and uncovered interest rate parity
hold.
⚫ Forward rate = expected future spot rate (F=E(S1))

F − S0
= E (%S ),
S0
➢ Forward rate parity builds upon two other parity conditions, covered IRP
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and uncovered IRP.

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⚫ Covered IRP must hold because it is enforced by arbitrage. Uncovered

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IRP is often violated.

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⚫ Forward exchange rates are typically poor predictors of future spot

exchange rates in the short run.
✓ Over the longer term, uncovered IRP and forward rate parity have
more empirical support.
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 5.3 Purchase Power Parity (PPP)
➢ Law of one price : identical goods should trade at the same price across
countries when valued in terms of a common currency.

➢ Absolute PPP simply extends the law of one price to the broad range of
goods and services that are consumed in different countries.

⚫ The absolute version of PPP asserts that the equilibrium exchange rate
between two countries is determined entirely by the ratio of their
national price level.
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⚫ However, it is highly unlikely that one will find that this relationship
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actually holds in the real word.

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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 relative version of PPP focuses on actual changes in exchange rates

and actual differences in national inflation rates

➢ The formal equation for relative PPP is as follows:

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t
St 1 +  X  St − S 0
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=  , if t =1, = %S X /Y   X −  Y
S0  1 +  Y 
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S0
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 Ex-Ante Version of PPP
➢ Ex-ante version of PPP

⚫ The ex-ante version of purchasing power parity focuses on expected

changes in the spot exchange rate being entirely driven by expected
difference in national inflation rates.

⚫ Ex ante PPP tells us that countries that are expected to run persistently
high inflation rates should expect to see their currencies depreciate
over time.
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𝐸(𝑆𝑡 ) 1 + 𝜋𝑋𝑒 𝑒
≅ 𝜋𝑋𝑒 − 𝜋𝑌𝑒
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= %∆𝑆𝑋/𝑌
𝑆0 1 + 𝜋𝑌𝑒
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⚫ Over shorter horizons nominal exchange rate movements may appear

random, over longer time horizons nominal exchange rates tend to
gravitate toward their long-run PPP equilibrium values.
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 5.4 International Fisher Effect
➢ The nominal interest rates in both countries equal the sum of their
respective real interest rates and expected inflation rates:
𝑟𝑋𝑁 = 𝑟𝑋𝑅 + 𝜋𝑋𝑒
൞
𝑟𝑌𝑁 = 𝑟𝑌𝑅 + 𝜋𝑌𝑒

➢ Subtracting the top equation from the bottom equation shows that the
nominal yield spread between the foreign and domestic countries equals
the sum of two parts
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𝑟𝑋𝑁 − 𝑟𝑌𝑁 = (𝜋𝑋𝑒 − 𝜋𝑌𝑒 ) + (𝑟𝑋𝑅 − 𝑟𝑌𝑅 )

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➢ We can rearrange this equation to solve for the real interest rate differential
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instead of the nominal interest rate differential:

𝑟𝑋𝑅 − 𝑟𝑌𝑅 = 𝑟𝑋𝑁 − 𝑟𝑌𝑁 − (𝜋𝑋𝑒 − 𝜋𝑌𝑒 )

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 International Fisher Effect
➢ If uncovered interest rate parity and ex-ante version of PPP holds, then the
expected change in the spot rate is equal to the interest rate differential:
𝑒
∆𝑆𝑋/𝑌 = 𝜋𝑋𝑒 − 𝜋𝑌𝑒
൞
𝑒
∆𝑆𝑋/𝑌 = 𝑟𝑋𝑁 − 𝑟𝑌𝑁

➢ Therefore we can conclude that if UIRP and ex-ante PPP hold, 𝒓𝑹 𝑹

𝑿 − 𝒓𝒀 = 𝟎.

The proposition that real interest rates will converge to the same level across
different markets is known as the real interest rate parity condition.
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 International Fisher Effect
➢ Combining these two expressions, the difference in expected inflation rates
equals the expected change in the exchange rate, we derive the following:
𝑟𝑋𝑁 − 𝑟𝑌𝑁 = 𝜋𝑋𝑒 − 𝜋𝑌𝑒
➢ If real interest rates are equal across markets, then it also follows that the
foreign-domestic nominal yield spread is determined solely by the foreign-
domestic expected inflation differential, This is known as the International
Fisher effect.
:

1 + rX 1 +  X e
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=
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1 + rY 1+ Y e
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 Summary of International Parity Relationships
Expected change
in Spot Exchange
Rate %ΔSe
Ex Ante PPP fd
Forward Parity

Foreign-Domestic Forward discount

expected inflation Ff d -Sf d
differential Uncovered Interest
Rate Parity Sf d
πef - πed
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International Covered Interest

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Fisher effect Rate Parity

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Foreign-Domestic
interest rate
differentials
if -id
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 International Parity Relationships
➢ Summarize the key international parity conditions and describe how they
are all linked:
⚫ 1. According to the covered interest rate parity, arbitrage ensures that
nominal interest rates spreads must equal the percentage forward
premium (or discount).
IRP
FRP
⚫ 2. According to the uncovered interest rate parity, the expected
percentage appreciation (or depreciation) of the spot exchange rate
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should be reflected in the nominal interest rate spread.

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⚫ 3. If both covered and uncovered interest rate parity hold, then the
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forward exchange rate will be an unbiased predictor of the future spot

exchange rate (forward rate parity).

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International Parity Relationships
⚫ 4. According to the ex ante PPP, the expected change in the spot exchange
rate should equal the expected difference in domestic and foreign inflation
rate.
⚫ 5. Assuming the Fisher effect holds in each market and real interest rates
across all markets are broadly the same, then the nominal yield spread
between domestic and foreign markets will equal the domestic/foreign
expected inflation differential, which is the international Fisher effect.
⚫ 6. If ex ante PPP and Fisher effects hold, then expected inflation differentials
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should equal both the expected change in the exchange rate and the
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nominal interest rate differential. This relationship implies that the uncovered
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interest rate parity will hold.

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International Parity Relationships
⚫ 7. If all the key international parity conditions held at all times, then the
expected percentage change in the spot exchange rate would equal
✓ The forward premium or discount (expressed in percentage terms);
✓ The nominal yield spread between countries;
✓ The difference in expected national inflation rates.
Δ%S = (F-S)/S = rX - rY = Infxe – Infye
It will be impossible for a global investor to earn consistent profits on
currency movement.
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Example
1. Which of the following is a no-arbitrage condition?
A. Real interest rate parity
B. Covered interest rate parity
C. Uncovered interest rate parity
➢ Correct Answer: B

2. Forward rates are unbiased predictors of future spot rates if two parity
conditions hold. Which of the following is not one of these conditions?
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A. Real interest rate parity

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B. Covered interest rate parity

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C. Uncovered interest rate parity

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➢ Correct Answer: A

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Example
3. The international Fisher effect requires all but which of the following to
hold?
A. Ex ante PPP
B. Absolute PPP
C. Real interest rate parity
➢ Correct Answer: B

4. If all of the key international parity conditions held at all times, then the
expected percentage change in the spot exchange rate would equal all
:

except which of the following?

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A. The real yield spread

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B. The nominal yield spread

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C. The expected inflation spread

➢ Correct Answer: A

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 6. FX Carry Trade
➢ FX carry trade
⚫ Involves taking on long positions in high-yield currencies and short
positions in low-yield currencies (funding currency).
✓ Historical evidence shows that such carry trade strategies often
generate attractive excess returns over extended periods.
⚫ If uncovered interest rate parity held at all times, investors would not
be able to profit from a strategy that undertook long positions in
baskets of high-yield currencies and short positions in baskets of low-
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yield currencies.
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 Carry Trade
➢ Assume a trader can borrow Canadian dollars at 1% and earn 9% on an
investment in Brazilian reals for one years, to execute the trade to earn 8%
from the interest rate differential, the trader will do the following:
⚫ Borrow Canadian dollars at t=0
⚫ Sell the dollars and buy Brizilian reals at the spot rate at t=0
⚫ Invest in a real-denominated investment at t=0
⚫ Liquidate the Brizilian investment at t=1
⚫ Sell the reals and buy dollars at the spot rate at t=1
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⚫ Pay back the dollar loan

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➢ If real appreciates, the profit will be greater than 8%

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➢ If real depreciates, the profit will be less than 8%

⚫ Trader will experience loss if real depreciates by more than 8%

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Example
➢ Carry Trade
Today’s one-year Currency Pair Exchange Rates
MRR Today One year later
JPY 0.1% JPY/USD 81.30 80.00
AUD 4.5% USD/AUD 1.0750 1.0803
➢ After one year, the all-in return to this trade, measured in JPY terms,
would be close to?
➢ Correct Answer:
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JPY / AUD spot = 81.3 1.0750 = 87.4

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JPY / AUD one year later = 80.00 1.0803 = 86.42

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1
gross return = (1 + 4.50%)  86.42 = 1.0333
87.40
net return = all − in return = 3.33% − 0.1% = 3.23%
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 FX Carry Trade
➢ Property
⚫ These carry trades are often large-scale trades initiated by trading firms
and other opportunistic investors, such as hedge funds.
➢ Return
⚫ The reward is the gradual accrual of the interest rate differential—
income that is unrelated to exchange rate volatility.
➢ Risk
⚫ The risk arises from the potential for sudden adverse exchange rate
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movements that result in instantaneous capital losses.

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 FX Carry Trade
➢ Crash risk
⚫ The primary reason for these crash risks relates to the fact that the carry
trade is by nature a leveraged position.
⚫ The upshot is that during periods of low volatility, carry trades tend to
generate positive returns, but they are prone to significant crash risk in
turbulent times.
⚫ The crashes results in a non normal distribution of returns for both
developed and emerging market (EM) carry trades.
✓ The distribution of carry trade returns tends to be more peaked and to
:

have fatter tails that are negatively skewed.

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✓ The more peaked distribution implies that carry trades have typically
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generated a larger number of trades with small gains/losses.

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✓ The negative skew and fat tails indicate that carry trades have tended to
have more frequent and larger losses than normal distribution.

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 7. Balance-of-Payments Accounts
➢ Balance-of-payments accounts
⚫ Current account represents the sum of all recorded transactions in
traded goods, services, income, and net transfer payments in a country’s
overall balance of payments.
⚫ Financial account (also known as the capital account) reflects financial
flows.
➢ Investment/financing decisions are usually the dominant factor in
determining exchange rate movements, at least in the short to intermediate
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term.
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 Balance-of-Payments Accounts
➢ Current account influence the path of exchange rates through below channels
⚫ The flow supply/demand channel. If a country was running a current
account surplus, then the demand for its currency should rise. Such shifts
should exert upward pressure on the value of the surplus nation’s currency
and downward pressure on the value of the deficit nation’s currency.
✓ At some point, domestic currency weakness should contribute to
improvement in the trade competitiveness of the deficit nation. And vise
visa. Thus, the exchange rate responses to these surpluses and deficits
should eventually help eliminate the source of the initial imbalances.
✓ The amounts by which exchange rates must adjust to restore current
accounts to balanced positions depends on:
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◆ The initial gap between imports and exports.

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 A large initial deficit may acquire a substantial depreciation of

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the currency to correct the trade imbalance.

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◆ The response of import and export prices to changes in the

exchange rate.
◆ The response of import and export demand to changes in import
and export prices.
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Balance-of-Payments Accounts
⚫ The portfolio balance channel. Countries with trade deficits will finance
their trade with increased borrowing. This behavior may lead to shifts in global
asset preferences, which in turn could influence the path of exchange rates. .
✓ Nations running account surpluses versus USA might find that they
hold excessive amount of USD-dominated assets. Once they reduced
their dollar holdings, USD might depreciate.
⚫ The debt sustainability channel. If investors believe that the deficit
country’s external debt is rising to unsustainable levels, they are likely to
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reason that a major depreciation of the deficit country’s currency will be

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required at some point to ensure that the current account deficit narrows
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significantly and that the external debt stabilizes at a level deemed

sustainable.

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 Balance-of-Payments Accounts
➢ Financial account (Capital account) influence
⚫ The increased freedom of capital to flow across national borders have
increased the importance of global financial flows in determining
exchange rate.
✓ Local currency would be appreciated by capital inflows attracted by
the persistently higher short-term interest rate.
⚫ Excessive surges in capital inflows to emerging markets have often
planted the seeds of an economic or currency crisis by contributing to:
✓ An unwarranted real appreciation of the emerging market currency;
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✓ A huge buildup in external indebtedness by emerging market

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governments, businesses, or banks;

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✓ A financial asset or property market bubble;

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✓ A consumption binge that contributed to explosive growth in

domestic credit and/or the current account deficit;
✓ An overinvestment in risky projects and questionable activities.

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 8. Exchange Rate Determination Models
➢ Exchange rate determination models
⚫ Mundell-Fleming model
⚫ The monetary approach
⚫ The asset market (portfolio balance) approach
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 Mundell-Fleming Model
➢ The Mundell-Fleming model describes how changes in monetary and fiscal
policy affect the interest rates and economic activity within a country, which
in turn leads to changes in capital flows and trade and ultimately to changes
in the exchange rate.
➢ Implicit assumption
⚫ The model focuses only on aggregate demand and assumes there is
sufficient slack in the economy to allow increases in output without price
level increases.
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 Mundell-Fleming Model
➢ Flexible exchange rate regimes
⚫ High capital mobility
✓ Monetary policy
◆Expansionary monetary policy: Downward pressure on
domestic interest rates will induce capital to flow to higher-
yielding markets, putting downward pressure on the domestic
currency. The more responsive capital flows are to interest rate
differentials, the larger the depreciation of the currency.
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◆A restrictive monetary policy: upward pressure on domestic

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interest rates will induce capital to flow from lower-yielding

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markets, putting upward pressure on the domestic currency.

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 Mundell-Fleming Model
➢ Flexible exchange rate regimes
⚫ High capital mobility
✓ Fiscal policy
◆A Expansionary fiscal policy will exert upward pressure on
domestic interest rates, which in turn induce an inflow of capital
from lower-yielding markets, putting upward pressure on the
domestic currency.
◆Expansionary fiscal policy will also increase economic activity
(growth) and inflation, leading to a deterioration of the current
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account and a decrease in demand for the domestic currency.

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◆A domestic currency will appreciate given a restrictive domestic

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monetary policy and/or an expansionary domestic fiscal policy.

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◆A domestic currency will depreciate given an expansionary

monetary policy and/or a restrictive fiscal policy.

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 Mundell-Fleming Model
➢ The specific mix of monetary and fiscal policies that a country pursues can
have a profound impact on its exchange rate.

Monetary-fiscal policy mix under conditions of high capital mobility

Expansionary Monetary Restrictive Monetary
Domestic currency
Expansionary Fiscal Indeterminate
appreciates
Domestic currency
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Restrictive Fiscal Indeterminate

depreciates
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 Mundell-Fleming Model
➢ Flexible exchange rate regimes
⚫ Low capital mobility
✓ The impact of monetary and fiscal policy changes on domestic
interest rates will operate primarily through trade flows rather than
capital flows.
✓ Expansionary fiscal policy will increase imports and hence the trade
deficit, creating downward pressure on the currency. Layering on an
expansive monetary policy will further boost spending and imports,
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worsening the trade balance and exacerbating the downward

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pressure on the currency.

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✓ The combination of restrictive monetary and fiscal policy will be

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bullish for a currency. This policy mix will tend to reduce imports,
leading to an improvement in the trade balance.

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 Mundell-Fleming Model
➢ The specific mix of monetary and fiscal policies that a country pursues can
have a profound impact on its exchange rate.

Monetary-fiscal policy mix under conditions of low capital mobility

Expansionary monetary Restrictive monetary
Domestic currency
Expansionary fiscal Indeterminate
depreciates
Domestic currency
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Restrictive fiscal Indeterminate

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appreciates
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Example
➢ Nicolas, the currency strategist at a foreign exchange dealer, is
preparing a report on the outlook for several currencies that he follows.
He begins by considering the outlook for the currency of a developed
market country with high capital mobility across its borders and a
flexible exchange rate. This DM country also has low levels of public
and private debt.
➢ Given these conditions, Nicolas tries to assess the impact of policy
:

changes.
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Example
➢ 1. For the DM currency, increasing the degree of monetary easing
(reducing interest rates and increasing money supply) will most likely:
A. cause the currency to appreciate.
B. cause the currency to depreciate.
C. have an indeterminate effect on the currency.

➢ Correct Answer: B.
:

⚫ A decrease in the policy rate would most likely cause capital to re-
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allocate to higher-yielding markets. This would lead to currency

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depreciation.
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Example
➢ 2. The pursuit of an expansionary domestic fiscal policy by the DM
country will, in the short run, most likely:
A. cause the domestic currency’s value to appreciate.
B. cause the domestic currency’s value to depreciate.
C. have an indeterminate effect on the domestic currency’s value.

➢ Correct Answer: A.
⚫ An expansionary fiscal policy will lead to higher levels of
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government debt and interest rates, which will attract international

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capital flows. (In the long run, however, an excessive buildup in

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debt may eventually cause downward pressure on the domestic

currency.)

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Example
➢ Next, Nicolas turns his attention to an emerging market country that
has low levels of public and private debt. Currently, the EM country has
a fixed exchange rate but no controls over international capital mobility.
However, the country is considering replacing its fixed exchange rate
policy with a policy based on capital controls. These proposed controls
are meant to reduce international capital mobility by limiting short-
term investment flows (“hot money”) in and out of its domestic capital
markets.
:

➢ 3. Before the country replaces its currency peg with capital controls, To
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maintain the exchange rate peg while increasing the degree of

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monetary easing, the EM country will most likely have to:

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A. tighten fiscal policy.

B. decrease interest rates.
C. buy its own currency in the FX market.
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Example
➢ Correct Answer : C.
⚫ The looser monetary policy will lead to exchange rate depreciation.
To counter this effect and maintain the currency peg, the central
bank will have to intervene in the FX market, buying the country’s
own currency.
⚫ A is incorrect because tighter fiscal policy is associated with lower
interest rates and is therefore likely to increase rather than mitigate
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the downward pressure on the domestic currency.

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⚫ Similarly, B is incorrect because a move to lower interest rates

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would exacerbate the downward pressure on the currency and

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hence the pressure on the peg.

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Example
➢ 4. After the EM country replaces its currency peg with capital controls,
would its exchange rate be unaffected by a tightening in monetary
policy?
A. Yes.
B. No, the domestic currency would appreciate.
C. No, the domestic currency would depreciate.
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Example
➢ Correct Answer: B.
⚫ With limited capital mobility, monetary policy’s main influence is
likely to come through the impact on aggregate demand and the
trade balance.
⚫ A tighter domestic monetary policy will most likely lead to higher
interest rates and less domestic demand, including less demand for
imported goods. With fewer imports and with exports held
constant, there will be modest upward pressure on the currency.
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Example
➢ 5. After the EM country replaces its currency peg with capital controls,
the simultaneous pursuit of a tight monetary policy and a highly
expansionary fiscal policy by the EM country will most likely:
A. cause the currency to appreciate.
B. cause the currency to depreciate.
C. have an indeterminate effect on the currency.
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Example
➢ Correct Answer : C.
⚫ Because (1) capital mobility is low, so the induced increase in
interest rates is likely to exert only weak upward pressure on the
currency;
⚫ (2) the combined impact on aggregate demand is indeterminate;
⚫ (3) if aggregate demand increases, the downward pressure on the
currency due to a worsening trade balance may or may not fully
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offset the upward pressure exerted by capital flows.

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 Monetary Approach
➢ Monetary model
⚫ In the Mundell-Fleming model, monetary policy is transmitted to the
exchange rate through its impact on interest rates and output.
Changes in the price level and/or the inflation rate play no role.
⚫ Monetary models of exchange rate determination generally take the
opposite perspective: Output is fixed and monetary policy affects
exchange rates primarily through the price level and the rate of
inflation.
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➢ Main approaches
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⚫ Pure monetary model

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⚫ Dornbusch overshooting model

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 Monetary Approach
➢ Main approaches
⚫ Pure monetary model
✓ The monetary approach asserts that an X percent rise in the domestic
money supply will produce an X percent rise in the domestic price
level. Assuming that purchasing power parity holds, a money
supply–induced increase (decrease) in domestic prices relative to
foreign prices should lead to a proportional decrease (increase) in
the domestic currency’s value.
✓ Shortcoming: the assumption that purchasing power parity holds
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in both the short and long runs.

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✓ Because purchasing power parity rarely holds in either the short or

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medium run, the pure monetary model may not provide a realistic
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explanation of the impact of monetary forces on the exchange rate.

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 Monetary Approach
➢ Main approaches
⚫ Dornbusch overshooting model
✓ A modified monetary model that assumes prices have limited
flexibility in the short run but are fully flexible in the long run.
✓ If the domestic price level is assumed to be inflexible in the short
run, however, the model implies that the exchange rate is likely to
overshoot its long-run PPP path in the short run.
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 Portfolio Balance Approach
➢ Compare Mundell-Fleming model with portfolio balance model
⚫ The Mundell-Fleming Model is essentially a short-run model of exchange rate
determination.
⚫ Portfolio balance model makes allowance for the long-term effects of
budgetary imbalances that typically arise from sustained fiscal policy actions.
➢ Main approach:
⚫ Global investors are assumed to hold a diversified portfolio of domestic and
foreign assets, including bonds. In this framework, a growing government
budget deficit leads to a steady increase in the supply of domestic bonds
outstanding.
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⚫ In the long run, governments that run large budget deficits on a sustained basis
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could eventually see their currencies decline in value.

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⚫ The Mundell-Fleming and portfolio balance models can be combined into a

single integrated framework in which expansionary fiscal policy under
conditions of high capital mobility may be positive for a currency in the short
run but negative in the long run.
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 9. Exchange Rate Management
➢ Capital flow surges can be both a blessing and a curse.
⚫ Capital inflows can be a blessing when they increase domestic
investment and therefore increase economic growth and asset values
⚫ They can be a curse, if they fuel boom-like conditions, asset price
bubbles, and overvaluation of a country’s currency.
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 Exchange Rate Management
➢ Effectiveness
⚫ Most industrial countries hold insufficient reserves to significantly affect
the supply of and demand for their currency, hence the effect of
intervention in developed market economies is limited.
⚫ Emerging market policymakers might have greater success in
controlling exchange rates than their industrial country counterparts
✓ because the ratio of EM central bank FX reserve holdings to average
daily FX turnover in their domestic currencies is actually quite sizable.
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✓ Emerging market central banks appear to be in a stronger position

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than their developed market counterparts to influence the level and

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path of their exchange rates

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 10. Warning Signs of Currency Crisis
➢ There are several warning signs of a currency crisis
⚫ Prior to a currency crisis, the capital markets have been liberalized to allow the
free flow of capital.
⚫ There are large inflows of foreign capital (relative to GDP) in the period leading
up to a crisis, with short-term funding denominated in a foreign currency being
particularly problematic.
⚫ Currency crises are often preceded by (and often coincide with) banking crisis.
⚫ Countries with fixed or partially fixed exchange rates are more susceptible to
currency crisis than countries with floating exchange rates.
⚫ Foreign exchange reserves tend to decline sharply as a crisis approaches.
⚫ In the period leading up to a crisis, the currency has risen substantially relative to
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its historical mean.

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⚫ The ratio of exports to imports (known as “the terms of trade”) often deteriorates
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before a crisis.
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⚫ Broad money growth and the ratio of M2 to bank reserves tend to rise prior to a
crisis.
⚫ Inflation tends to be significantly higher in pre-crisis periods compared with
tranquil periods.
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 Learning
Module
2
:
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Economic Growth
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 1. Preconditions for Growth
Framework 2. Importance of Potential GDP

3. Production Function

4. Factors Affecting Economic Growth

5. Economic Growth Theories

6. Convergence Debate
:

7. Growth in an Open Economy

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 1. Preconditions for Growth
➢ Factors affecting economic growth
⚫ Savings and investment
⚫ Financial markets and intermediaries
⚫ Political stability, rule of law, and property rights
⚫ Education and health care systems
✓ Developed countries need to invest in post-secondary education to
encourage innovation and growth
✓ Developing countries should emphasize primary and secondary education.
:

⚫ Tax and regulatory systems

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✓ Limited regulations encourage entrepreneurial activity and the entry of new

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companies
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✓ Low administrative startup cost is a key factor encouraging

entrepreneurship
⚫ Free trade and unrestricted capital flows
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 Preconditions for Growth
➢ Factors limiting economic growth

⚫ Low rates of saving and investment

⚫ Poorly developed financial markets

⚫ Weak, or even corrupt, legal systems and failure to enforce laws

⚫ Lack of property rights and political instability

⚫ Poor public education and health services

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⚫ Tax and regulatory policies discouraging entrepreneurship

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⚫ Restrictions on international trade and flows of capital

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 2.1 Economic Growth and Equity Returns
➢ Potential GDP is the maximum amount of output an economy can sustainably
produce without inducing an increase in the inflation rate.
⚫ In the long run, real earning growth cannot exceed the growth rate of
potential GDP.
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 2.1 Economic Growth and Equity Returns
➢ Grinold-Kroner (2002) decomposition of the return to equity
⚫ E(Re) = dividend yield + expected capital gain
= dividend yield + expected repricing + earnings growth per share
= dividend yield + expected repricing + inflation rate + real economic
growth + change in shares outstanding
=dy + Δ(P/E) + i + g + ΔS
✓ Over time, the dividend yield, dy, has been found to be fairly stable
and a significant contributor to equity market returns.
✓ The primary impact of this repricing term, Δ(P/E), is the volatility in
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the market’s P/E ratio over market cycles.

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✓ Earnings growth per share is the primary channel through which

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economic growth can impact equity returns.

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◆ The change in shares outstanding, ΔS, termed the dilution

effect, plays an important role in determining expected equity
returns.
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 2.1 Economic Growth and Equity Returns
➢ Grinold-Kroner (2002) decomposition of the return to equity
⚫ ΔS dilution effect term focus on two components
✓ publicly traded companies either buy back their shares and increase
equity returns by decreasing shares outstanding, or issue new shares
and dilute existing shareholder returns. Net buybacks, or nbb,
captures the net result of buybacks and new equity issuance at the
national stock market level.
✓ some part of economic growth coming from small- and medium-
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sized entrepreneurial firms that are not traded publicly on the stock
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market. The greater this effect, termed the relative dynamism of the
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economy, rd, the greater the divergence between economic growth

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in the economy as a whole and the earnings growth of companies

listed on the stock market

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 2.2 Importance of Potential GDP
➢ Growth in potential GDP
⚫ Actual GDP growth above (below) the potential GDP growth rate puts
upward (downward) pressure on inflation, which puts corresponding
pressure on nominal interest rates and bond prices.
⚫ Faster growth in potential GDP translates into higher real interest rates
and higher expected real asset returns in general.
✓ Higher real interest rates are required to induce savings to fund
capital accumulation, which in turn can fuel higher potential GDP
growth rates.
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 2.3 Potential GDP Growth and Fixed Income
➢ Potential GDP and its growth rate enter into fixed income analysis in other
ways as well.
⚫ A higher rate of potential GDP growth improves the general credit
quality of fixed income securities.
✓ Slower potential GDP growth raise the credit risk of bonds
⚫ Monetary policy decisions are affected by the difference between an
economy’s estimated potential output and its actual operating level.
✓ Assess the likelihood of a change in central bank policy
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⚫ Government budget deficits typically increase during recessions and

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decrease during expansions.

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 3. Production Function
➢ Cobb-Douglas production function
Y = AK  L(1− )
⚫ α: the shares of GDP paid to the supplier of capital (0-1)
⚫ 1-α: the shares of income paid to labor
⚫ A: total factor productivity (TFP).
✓ TFP reflects the general level of productivity or technology in the
economy.
➢ Properties
⚫ The Cobb–Douglas production function exhibits diminishing marginal
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productivity and constant returns to scale.

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✓ Extra output obtained from each additional unit of the input will decline,
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keeping the other inputs unchanged.

✓ If all the inputs into the production process are increased by the same
percentage, then output rises by same percentage.

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 Production Function
➢ The Cobb–Douglas production function exhibits diminishing marginal
productivity with respect to each individual input. Diminishing marginal
productivity means that at some point the extra output obtained from each
additional unit of the input will decline.
⚫ A value of α close to zero means diminishing marginal returns to
capital are very significant and the extra output made possible by
additional capital declines quickly as capital increases.
⚫ A value of α close to one means that the next unit of capital increases
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output almost as much as the previous unit of capital. Diminishing

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marginal returns still occur but the impact is relatively small.

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 Production Function-Growth Accounting
➢ The growth accounting equation states that the growth rate of output
equals the rate of technological change plus α times the growth rate of
capital plus (1 – α) times the growth rate of labor.
ΔY/Y = ΔA/A + αΔK/K + (1 – α)ΔL/L
⚫ The growth accounting equation is used to empirically measure the
sources of growth in an economy
⚫ The difficult task is estimating the growth rate of TFP
✓ The standard methodology treats TFP as exogenous and estimates
its growth rate using various time-series models.
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➢ Labor productivity growth accounting equation

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Growth rate in potential GDP = long-term growth rate of labor force +

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long-term growth rate in labor productivity

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⚫ The disadvantage is that it incorporates both capital deepening and TFP

progress in the productivity term
✓ Difficult to analyze and to predict
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 Production Function
➢ Output per worker (labor productivity)

y = Y / L = A ( K / L ) = Ak 


⚫ The amount of goods a worker can produce (labor productivity)

depends on
✓ Amount of capital available for each worker (capital-to-labor ratio)
(capital deepening)
✓ Technology or TFP
✓ The share of capital in GDP (α)
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⚫ Growth in per-capita potential GDP (growth in labor productivity)

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= growth in technology + α (growth in the capital-to-labor ratio)

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∆𝑦/𝑦 = ∆𝐴/𝐴 + 𝛼 ∆𝑘/𝑘

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 Production Function
➢ Two sources of growth in per capita output
⚫ Capital deepening: an increase in the capital-to-labor ratio, is reflected in
exhibit by movement along the production function. Adding more and
more capital to a fixed number of workers increases per capita output but at
a decreasing rate.
✓ At the point where the marginal product of capital equals its marginal
cost, profit maximizing producers will stop adding capital (stop
increasing the capital-to-labor ratio)
◆ MPK = αAKα–1L1–α = αY/K = r = MCK
:

 r is the rental price of capital

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⚫ Technological progress: an improvement in TFP causes a proportional

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upward shift in the entire production function. In addition, continued

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growth in per capita output is possible even in the steady state as long as
there is ongoing technological progress (increases in TFP).
➢ Therefore, sustained growth in per capita output requires progress in TFP.

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Production Function

Output per worker

(Y/L)C
Effect of Increase in TFP
(Y/L)B

Effect of Capital Deepening

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(Y/L)A
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K/LA K/LB Capital per worker

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 Production Function
➢ Two sources of growth in per capita output
⚫ 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.
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Country Sources of growth

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Developing countries Capital deepening & technological progress

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Developed countries Largely driven by technological progress.

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Example

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Example

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Example
➢ Based upon the country factors provided in Exhibit 1, the country most
likely to be considered a developing country is:
A. Country A.
B. Country B.
C. Country C.
➢ Correct Answer: C

➢ Based upon Exhibit 1, capital deepening as a source of growth was

most important for:
:

A. Country A.
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B. Country B.
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C. Country C.
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➢ Correct Answer: A

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 4. Factors Affecting Economic Growth
➢ 1. Natural resources
⚫ The relation between natural resources endowment and growth is not
so straightforward, ownership and production of natural resources is not
necessary for a country to achieve a high level of income.
⚫ The presence of natural resources may even restrain growth, resulting in
a “resource curse”. There are two main reasons why this may occur.
✓ First, countries rich in natural resources may fail to develop the
economic institutions necessary for growth.
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✓ Second, countries rich in resources may suffer the Dutch disease,

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where currency appreciation driven by strong export demand for

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resources makes other segments of the economy, in particular

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manufacturing, globally uncompetitive.

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 Factors Affecting Economic Growth
➢ 2. Labor supply factors

⚫ Population growth
✓ Population growth is determined by fertility rates and mortality
rates.
✓ Population growth may increase the growth rate of the overall
economy, it has no impact on the rate of increase in per capita GDP.
✓ The age mix of the population is also important. The percentage of
the population over the age of 65 and the percentage below the
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age of 16 are key considerations.

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labor force
⚫ Labor force participation =
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working age population

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✓ An increase in the participation rate may raise the growth of per

capita GDP

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Factors Affecting Economic Growth
⚫ Net migration

✓ Heightened immigration is a possible solution to the slowing labor

force growth being experienced by many developed countries with
low birthrates within the native population.

⚫ Average hours worked

✓ The long-term trend in average hours worked has been toward a

shorter workweek in the advanced countries.
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⚫ Human Capital
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✓ Better educated and more skilled workers will be more productive and
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more adaptable to changes in technology or other shifts.

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 Factors Affecting Economic Growth
➢ 3. Capital: ICT&Non-ICT, Technology and Public Infustructure
⚫ Countries with a higher rate of investment should have a growing physical
capital stock and a higher rate of GDP growth.
⚫ ICT (information, computers, and telecommunications equipment)
✓ The greater use of IT equipment has resulted in network externalities,
which are largely captured in TFP. A growing share of ICT
investments in the economy, through their externality impacts, may
actually boost the growth rate of potential GDP.
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⚫ Non-ICT(non-residential, transport equipment, and machinery)

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✓ High levels of capital spending for this category should eventually

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result in capital deepening and thus have less impact on potential GDP
growth.

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 Factors Affecting Economic Growth
➢ Capital: ICT&Non-ICT, Technology and Public Infustructure
⚫ Technology
✓ The most important factor affecting growth of per capita GDP is
technology, especially in developed countries. Technology allows an
economy to overcome some of the limits imposed by diminishing
marginal returns and results in an upward shift in the production
function.
✓ The developed countries spend the highest percentage of GDP on
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R&D because they must rely on innovation and the development of

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new products and production methods for growth.

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✓ Developing countries spend less on R&D because these countries

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can acquire new technology through imitation or copying the

technology developed elsewhere.

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 Factors Affecting Economic Growth
➢ Capital: ICT&Non-ICT, Technology and Public Infustructure
⚫ Public Infrastructure
✓ Roads, bridges, municipal water, dams and electric grids are all
examples of public capital.
✓ As with R&D spending, the full impact of government infrastructure
investment may extend well beyond the direct benefits of the
projects because improvements in the economy’s infrastructure
generally boost the productivity of private investments.
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 5. Economic Growth Theories
➢ Classical growth theory

⚫ Per capita economic growth is only temporary because an

exploding population with limited resources brings growth to an
end

➢ Neoclassical growth theory

⚫ Long-run per capita growth depends solely on exogenous

technological progress
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➢ Endogenous growth theory

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⚫ Attempts to explain technology within the model

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 Classical Growth Theories
➢ Classical theory
⚫ Per capita economic growth under the classical model is only
temporary.
⚫ 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
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⚫ No matter how much technology advances, real wages will eventually be

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driven back to the subsistence level, and no permanent productivity

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growth or improvement in the standard of living will occur.

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 Neoclassical Growth Theories
➢ Long-term steady state growth rate
⚫ The equilibrium is the balanced or steady state rate of growth that
occurs when the output-to-capital ratio is constant
✓ the growth rate of capital per worker is equal to the growth rate of
output per worker. (∆𝑘/𝑘 = ∆𝑦/𝑦)
⚫ The equilibrium sustainable growth rate of output per capita (g*) is a
constant that depends only on the growth rate of TFP (θ) and the
elasticity of output with respect to capital (α).

g* =
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(1 −  )
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⚫ Adding back the growth rate of labor gives the sustainable growth rate
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of output (G*). 
G* = + %L
(1 −  )
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 Steady State
➢ Once the economy reaches this steady state, capital deepening cannot be a
source of sustained growth in the economy.
➢ Only when the economy is operating below the steady state and when the
marginal product of capital exceeds its marginal cost can capital deepening
raise per capita growth.
Output per worker
B
LP2 Effect of change
in technology
C
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LP1
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A
LP0
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Capital per
worker
C0 C1
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 Neoclassical Growth Theories
➢ Implications
⚫ Capital Accumulation
✓ Capital accumulation affects the level of output but not the growth
rate in the long run
⚫ Capital Deepening vs. Technology
✓ Because of diminishing marginal returns to capital, the only way to
sustain growth in potential GDP per capita is through technological
change or growth in total factor productivity.
⚫ Convergence
✓ Regardless of its initial capital-to-labor ratio or initial level of
productivity, a growing economy will move to a point of steady state
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growth.
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⚫ Effect of Savings on Growth

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✓ The initial impact of a higher saving rate is to temporarily raise the

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rate of growth in the economy. In response to the higher saving rate,

growth exceeds the steady state growth rate during a transition
period. However, the economy returns to the balanced growth path
after the transition period.
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Example
➢ Calculate the steady state growth rates from the neoclassical model for
China, Japan, and Ireland.

Labor Cost in Total TFP Growth Labor Force

Factor Cost (%) (%) Growth (%)
China 46.5 2.5 1.2
Japan 57.3 0.2 0.0
Ireland 56.7 0.8 0.0
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Example
➢ Solution:
⚫ The steady state growth rate in the neoclassical model is given by


G* = + %L
(1 −  )
⚫ Using the above equation and data, steady state growth rates for
the three countries are estimated as follows:
✓ China: Steady state growth rate = 2.5%/0.465 + 1.2% = 6.58%
:

✓ Japan: Steady state growth rate = 0.2%/0.573 + 0.0% = 0.35%

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✓ Ireland: Steady state growth rate = 0.8%/0.567 + 0.0% = 1.41%

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 Endogenous Growth Theory
➢ Endogenous growth theory focuses on explaining technological progress
rather than treating it as exogenous.
⚫ In these models, self-sustaining growth emerges as a natural
consequence of the model and the economy does not necessarily
converge to a steady state rate of growth.
⚫ Unlike the neoclassical model, there are no diminishing marginal returns
to capital for the economy as a whole in the endogenous growth model.
The endogenous growth model allows for the possibility of constant or
even increasing returns to capital in the aggregate economy.
⚫ So increasing the saving rate permanently increases the rate of economic
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growth.
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⚫ In the endogenous growth model, expenditures made on R&D and for

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human capital may have large positive externalities or spillover effects.

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Private spending by companies on knowledge capital generates benefits

to the economy as a whole that exceed the private benefit to the
economy.

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 6. Convergence Debate
➢ Neoclassical growth theory predicts two types of convergence: absolute
convergence and conditional convergence.
⚫ Absolute convergence hypothesis
✓ The neoclassical model assumes that all countries have access to the
same technology.
✓ As a result, per capita income in all countries should eventually grow
at the same rate. Thus, the model implies convergence of per capita
growth rates among all countries.
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✓ However, it does not imply the level of per capita income will be the
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same in all countries.

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Convergence Debate
⚫ Conditional convergence hypothesis
✓ Convergence is conditional on the countries having the same
saving rate, population growth rate, and production function.
✓ If these conditions hold, the neoclassical model implies convergence
to the same level of per capita output as well as the same steady
state growth rate.
⚫ Club convergence hypothesis
✓ Only rich and middle-income countries that are members of the
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club are converging to the income level of the richest countries in

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the world.
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✓ Poor countries can join the club if they make appropriate

institutional changes.

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 Convergence Debate
➢ Convergence between the developed and developing countries can
occur in two ways
⚫ Convergence takes place through capital accumulation and capital
deepening
⚫ Developing countries can imitate or adopt technology already widely
utilized in the advanced countries
➢ In contrast to the neoclassical model, the endogenous growth model makes
no prediction that convergence should occur.
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 7. Growth in an Open Economy
➢ Benefits of opening up the economy to trade and financial flows
⚫ A country can borrow or lend funds in global markets, and domestic
investment can be funded by global savings. Thus, investment is not
constrained by domestic savings.
⚫ Countries can shift resources into industries in which they have a
comparative advantage and away from industries in which they are
relatively inefficient, thereby increasing overall productivity.
⚫ Companies have access to a larger, global market for their products,
allowing them to better exploit any economies of scale and increasing
the potential reward for successful innovation.
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⚫ Countries can import technology, thus increasing the rate of

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technological progress.
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⚫ Global trade increases competition in the domestic market, forcing

companies to produce better products, improve productivity, and keep
costs low.

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 Learning
Module
3
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Economics of Regulation

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 1. Economic Rational for Regulation

Framework • Reason for Economic Regulation

• Regulation of Financial Markets
• Regulation of Commerce
• Antitrust Regulation
2. Regulations and Regulatory Tools
• Classifications of Regulations
• Classifications of Regulators
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• Regulatory Interdependencies
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• Regulatory Tools
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3. Analysis of Regulation

123-142
 1.1 Economic Rationale for Regulation
➢ The case for regulatory intervention rests on the presence of informational
frictions, externalities, weak competition, and social objectives.
➢ 1. Informational frictions are market inefficiencies that lead to sub-optimal
outcomes.
⚫ Lack of access to information and inadequate information. Such
frictions result in a variety of issues ( adverse selection, moral hazard )
that regulators attempt to address.
⚫ Asymmetrical information, in general, may give one entity an inherent
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advantage over another entity with which interaction occurs. The

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resulting regulation focuses on establishing rights and responsibilities of

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entities and on seeking to establish a level playing field in the

dissemination of information in the market.

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 Economic Rationale for Regulation
➢ 2. Externalities are spillover effects of production and consumption
activities onto others who are not directly involved in a particular
transaction, activity, or decision.
⚫ A positive externality provides a spillover benefit.
⚫ A negative externality generates a spillover cost.
✓ Systemic risk (the risk of failure of the financial system) and
financial contagion (a situation in which financial shocks spread
from their place of origin to other regions; in essence, a faltering
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economy infects other, healthier economies) are examples of

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negative externalities.
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 Economic Rationale for Regulation
➢ 3. Weak competition can also give rise to regulatory intervention.
⚫ Weak competition is considered to be detrimental to consumers owing
to high prices, less choice, and lack of innovation.
⚫ It is associated with scenarios in which a dominant firm has significant
market power or where firms collude and agree to keep prices high.
➢ 4. Social objectives are typically resolved by the provision of public goods
that would not be provided by the market.
⚫ An important feature of public goods is that consumption by one
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individual does not reduce the availability of the good for others.
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⚫ Usually funded by the government, examples include defense, police

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protection, and education.

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⚫ Alternatively, social objectives may be achieved by placing regulatory

obligations on firms.

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 1.2 Regulation of Financial Markets
➢ The regulation of securities markets and financial institutions is essential
because of the consequences to society of failures in the financial system.
(prudential supervision of institutions, capital requirements, and insider trading)
⚫ A key focus of regulators is maintaining the integrity of markets, ensuring
that they operate efficiently and that consumers and investors are informed
and not exploited.
⚫ Disclosures are wide ranging and have high importance. Disclosure
requirements tend to be oriented toward the protection of investors and the
provision of information to investors.
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⚫ Prudential supervision is regulation and monitoring of the safety and

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soundness of financial institutions in order to promote financial stability,

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reduce system-wide risks, and protect customers of financial institutions. It is

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part of prudential regulation, which includes setting capital adequacy and

liquidity standards for such financial institutions as banks and insurers.

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 1.3 Regulation of Commerce
➢ Government regulation in certain areas of commerce, such as consumer
protection, commercial law, and antitrust, is critical to setting out an
underlying framework for the operation of private markets and facilitating
business decisions that involve a considerable degree of coordination.
➢ Including:
⚫ Safety (for example, food and products)
⚫ Privacy (for example, financial information)
⚫ Protection (for example, intellectual property)
⚫ Environmental (for example, pollution)
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⚫ Labor or employment (for example, workers’ rights and employment

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practices)
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⚫ Commerce or trade (for example, consumers’ rights and protection,

investors’ protection, and antitrust)

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 1.4 Antitrust Regulation
➢ In a domestic context, a regulatory goal often pursued is to promote
competition in most economic sectors (this goal can alternatively be viewed
as monitoring and preventing activities that restrict or distort competition).
⚫ Regulatory approval or notification is typically required for mergers and
acquisition of major companies in a specific market.
⚫ Competition and antitrust laws also typically prohibit anticompetitive
arrangements or practices, such as price collusion or exchanging certain
information, and anticompetitive behavior by companies that dominate
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a market.
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 2.1 Classifications of Regulations
➢ Regulations

⚫ Regulations can be classified as

✓ Statutes: reflecting laws enacted by legislative bodies

✓ Administrative regulations or administrative law: rules issued by

government agencies or other regulators

✓ Judicial law: interpretations of courts

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 2.2 Classifications of Regulators
➢ The relatively simple classification of regulators:
⚫ legislative bodies
⚫ government agencies
⚫ independent regulators
⚫ courts
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 Classifications of Regulators
➢ Either governmental departments and agencies or independent
regulators, which derive their power and authority from the state.
⚫ Government-backed regulatory bodies have legal authority to enact and
enforce regulations within the parameters of the mandate given to them.
⚫ Independent regulators: authority come from their recognition,
autonomy, and powers given to them by a statute, government
department, or government agency, but they are not government
agencies per se.
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⚫ One distinction between government agencies and independent

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regulators is that the latter typically do not rely on government funding

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and are often given a degree of autonomy in terms of decision making.

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 Classifications of Regulators
➢ Industry self-regulatory bodies are private organizations that both
represent and regulate their members.
⚫ Although these organizations are independent of the government and
to an extent are isolated from political pressure, they may be subject to
pressure from their members.
⚫ Industry self-regulatory bodies derive authority from their members,
who agree to comply with the organization’s rules and standards and
their enforcement.
⚫ This authority does not have the force of law, but industry self-
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regulatory bodies do have the power to exclude or expel parties from

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being members.
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⚫ In order to ensure minimum standards are maintained, certain entry

requirements (such as training or ethical standards) may be imposed.

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 Classifications of Regulators
➢ Some industry self-regulatory bodies, particularly in the securities industry,
are known as self-regulating organizations (SROs).
⚫ SROs differ from standard industry self-regulatory bodies in that they
are given recognition and authority, including enforcement power, by a
government body or agency.
⚫ SROs are funded independently, rather than by the government.
➢ Regulatory authorities may reference the work of outside bodies in their
regulations.
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⚫ Examples of these outside bodies are accounting standard–setting

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bodies, such as the International Accounting Standards Board (IASB) and

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the Financial Accounting Standards Board (FASB), and credit-rating

agencies.

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 2.3 Regulatory Interdependencies
➢ Regulatory capture theory
⚫ In the interactions between regulated entities and their regulators, the
regulated entities may possess considerable expertise and knowledge
and some of the individual regulators may have worked in the industry
or aspire to be in the industry in which the regulated entities operate.
These interactions may reinforce regulatory capture.
➢ Regulatory competition
⚫ Regulators may compete to provide a regulatory environment designed
to attract certain entities.
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➢ Regulatory arbitrage
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⚫ Entities may identify and use some aspect of regulations that allows
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them to exploit differences in economic substance and regulatory

interpretation or in foreign and domestic regulatory regimes to the
companies’ benefit.

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 2.4 Regulatory Tools
➢ Regulatory tools and government interventions
⚫ Price mechanisms: to create the appropriate marginal incentives and an
efficient allocation of resources.
⚫ Restricting some activities, for example, insider trading, short selling.
⚫ Mandating some activities, for example, capital requirements for
banks
⚫ Providing public goods, for example, national defense, transportation
infrastructure
⚫ Financing private projects, for example, loans to individuals or
:

companies for specified activities that the government deems desirable

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to encourage.
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⚫ Bail-in tools: dealing with failure of large systemic banks after 2008.
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✓ Divest shareholders’ shares and canceled claims of creditors

✓ Ensure shareholders and creditors, rather than taxpayers, pay the
cost of the failure.

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 2.4 Regulatory Tools
➢ Systematic risk (the risk of failure of the financial system) and financial
contagion (financial shocks spread from their place of origin to other
regions) are examples of negative externalities.
➢ Bail-in tools
⚫ A bail-in tool is seen as improving the toolkit for dealing with the failure
of large, globally systematic banks.
⚫ Bail-in policies are intended to ensure that shareholders and creditors of
the failed institution, rather than taxpayers, pay the cost of the failure.
✓ Bail-in involves shareholders of a failing institution being divested of
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their shares and creditors of the institution having their claims

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canceled or reduced to the extent necessary to restore the

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institution to financial viability.

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 3.1 Cost-Benefit Analysis of Regulation
➢ In assessing regulation and regulatory outcomes, it is common practice for
regulators to assess the overall benefits and costs of regulatory proposals
to assess the trade-offs associated with a particular regulatory action and to
assess alternative solutions.
⚫ Regulatory burden refers to the costs of regulation for the regulated
entity; this cost is sometimes viewed as the private costs of regulation or
government burden.
⚫ Net regulatory burden is the private costs of regulation less the private
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benefits of regulation.
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 3.1 Cost-Benefit Analysis of Regulation
➢ Regulators view some of the costs associated with regulations as
“unintended” ,but it is important to distinguish between two types of such
costs.
⚫ Intended consequence: address problems
⚫ Unintended consequence: reflect underlying policy risk and may
results in high unanticipated cost
✓ Unanticipated implementation cost, e.g. hire more lawyer
✓ Indirect cost
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✓ Some unintended consequence will be identified prior to

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implementation of new legislation.

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➢ Regulatory costs and benefits are especially difficult to assess on a

prospective basis relative to a retrospective basis.

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 3.2 Analysis of Regulation
➢ An analyst or investor could take into account when evaluating the effects of
a specific regulation on a particular industry or company for the purpose of
making an investment recommendation.
⚫ Assessment of the likelihood of regulatory change
✓ The extent of engagement with the regulated companies will help
the analyst draw conclusions about the likelihood of the
implementation of the proposed regulation.
✓ Where relevant, public and political pressure may also play a role in
determining the likelihood that regulatory intervention will
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materialize.
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⚫ Assessment of the impact of regulatory change on a sector

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✓ Impact on revenues
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✓ Cost impact
✓ Business risk

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 It’s not the end but just beginning.
Your life can be enhanced, and your happiness enriched, when you choose
to change your perspective. Don't leave your future to chance, or wait for things
to get better mysteriously on their own. You must go in the direction of your
hopes and aspirations. Begin to build your confidence, and work through
problems rather than avoid them. Remember t hat power is not necessarily
control over situations, but the ability to deal with whatever comes your way.
:
育
教
程
金

141-142
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育

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教

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程
金

142-142