CFA Level II – Economics – QuickNotez

CFA LEVEL II – ECONOMICS – QUICKNOTEZ

LEARNING MODULE 1:
CURRENCY EXCHANGE RATES: UNDERSTANDING EQUILIBRIUM VALUE

Factors that affect the bid-offer spread quoted to dealers’ clients in FX market:
 Spread in the interbank market: Dealer spreads are directly related to spreads in the
interbank market
 Size of the transaction: Large transactions get quoted a larger spread
 Relationship between the dealer and client: Dealers give favourable rates to preferred
clients for other ongoing business relationships.
o A client with poor credit profile  wider bid-offer spread (but credit risk is not the
most important factor)

The interbank spread on a currency pair depends on:

 Volume of currencies involved: High-volume currency pairs command lower spreads
 Time of day: Spreads are narrower when New York and London currency markets are
open (most liquid)
 Market volatility: Higher volatility leads to higher spreads

Arbitrage Constraints on a Spot Exchange Rate Quotes

 If dealer bid > interbank offer
 buy base currency from interbank market and sell to dealer
 If dealer offer < interbank bid
 buy base currency from dealer and sell in the interbank market

USD/GBP Bid Price Offer Price Arbitrage Opportunities?

Interbank 1.3501 1.3510

Dealer 1 1.3490 1.3498

USD/GBP Bid Price Offer Price Arbitrage Opportunities?

Interbank 1.3501 1.3510
Noesis Exed

Dealer 2 1.3495 1.3503

USD/GBP Bid Price Offer Price Arbitrage Opportunities?

Interbank 1.3501 1.3510

Dealer 3 1.3512 1.3517

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 CFA Level II – Economics – QuickNotez

Factors that affect the spreads in forward exchange rate:

 Spread in the interbank market
 Size of the transaction
 Relationship between the dealer and client
 Maturity of forward contract(illiquid, counterparty credit risk, interest rate risk)

Cross Rates

= ×

= ×

Cross Rates with Bid-Ask Spreads

Rule 1:

= × = ×

Rule 2:
1 1
= =

Forward Premium (Discount)

Forward Premium (Discount) = F – S0

 Base currency trading at Forward Premium if: F > S0

 Base currency trading at Forward Discount if: F < S0

Forward Rate = Spot Rate + Forward point (in decimals)

Noesis Exed

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 CFA Level II – Economics – QuickNotez

Mark-to-Market of a Forward Contract

Assumption: Investor LONGS the BASE CURRENCY forward contract. Contract size is in base
currency terms.

 At initiation, the value of the forward contract = 0

 At expiration, the value of the forward contract (i.e. party that longs the base currency)
in its price currency is:
=( − )×
 Prior to expiration, the value of the long base currency forward contract:
( − )×
=
1+
360
where:
VT = value of forward contract at time T, denominated in price currency
ST = spot rate at time T, in A/B (to sell same currency)
F0 = forward price locked in at initiation to buy base currency
Ft = forward price (to sell base currency) at time t for a new contract maturing at time T
days = number of days remaining to maturity of forward contract
RA = interest rate of price currency

Covered Interest Rate Parity

 Holds when any forward premium or discount exactly offsets differences in interest
rates, so that an investor would earn the same return investing in either currency (i.e.
no-arbitrage condition)
 Investing in either a domestic money market instrument or in a fully currency-hedged
foreign money market instrument should give the same exact holding period return.

1+ 360
/ = /
1+
360

 If > , then / > / ⇒ B trades at a forward premium.

 If < , then / < / ⇒ B trades at a forward discount.
Noesis Exed

/ − / ( − )
= ≈( − )
/ 360 360
1+
360

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 CFA Level II – Economics – QuickNotez

Uncovered Interest Rate Parity

 The expected return on an uncovered foreign currency investment should equal the
return on a comparable domestic currency investment
 Currency B is expected to appreciate by approximately − .
/ − /
%∆ / = ≈ − (1 ℎ )
/
 Assumes that:
o forward currency contracts are not available and capital flows are restricted (to
prevent arbitrage)
o investor is risk-neutral

Forward rate parity

 If covered and uncovered interest rate parity holds, the forward rate is an unbiased
predictor of expected future spot rates, i.e. = ( )
 Covered interest rate parity will hold, due to arbitrage (so, you just have to check if
uncovered interest parity holds based on case scenario)

International Fisher Relation

 Fisher equation: = + ( )
 The difference between two countries’ nominal interest rates should be equal to the
difference between their expected inflation rates

− = ( )− ( )

 Real interest rate parity: Real interest rates are assumed to converge across different
markets ( = )
o Assumes free capital flows, funds will move to the country with higher real rates
until real rates are equalized

Purchasing Power Parity

 Absolute PPP: Compares the average price of a representative basket of consumption
goods between countries
o Requires that the Law of One Price be correct on average.
o = ⁄ ×
Noesis Exed

o Asserts that equilibrium exchange rate between two countries is determined entirely
by the ratio of their national price levels.

 Relative PPP: States that change in exchange rates should exactly offset the price
effects of any inflation differential between the two countries
o Currency B is expected to appreciate by approximately ( − )
%∆ / ≈ −
o Relative PPP holds approximately in the long-run.
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 CFA Level II – Economics – QuickNotez

Ex-Ante Version of PPP:

 Similar to Relative PPP except that it uses expected inflation instead of actual inflation.
o %∆ / ≈ −
 Countries that run persistently high inflation rates should expect to see their currencies
depreciate over time.
 Over longer time horizons, nominal exchange rates should converge towards their long-
run PPP equilibrium values.

FX Carry Trade:
 Investor invests in a higher yielding currency using funds borrowed in a lower yielding
currency (i.e. funding currency)
 Assumes that uncovered interest rate parity does not hold
 Performs well under low-volatility periods.
 Return distribution of the carry trade is not normal
o Negative skewness and excess kurtosis (i.e. fat tails)
o Crash risk: High probability of a large loss (in turbulent times)
 Primary reason for crash risk:
o Carry trade is leveraged.
o If investors exit at the same time (i.e. using stop-loss orders) during turbulent times,
the high-yield currency will decline in value, generating large losses
 Risk management in carry trades:
o When implied volatility (from option prices) increases above a certain threshold,
close carry trade position
o When the low-yield currency is undervalued or the high-yield currency is
overvalued (relative to PPP), close carry trade position

Real Exchange Rate

ℎ / = / ×

/ ⇑
⇑ → ℎ / → ℎ
⇓
Noesis Exed

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 CFA Level II – Economics – QuickNotez

Balance of Payments

Current account + Financial account + Official Reserve account = 0

 Current account deficits lead to a depreciation of domestic currency via:

o Flow Supply/Demand Channel:
 If country exports > imports (trade surplus) ⇒ demand for domestic currency↑
 If country imports > exports (trade deficit) ⇒ demand for domestic currency↓
 The amount by which exchange rates must adjust to restore current accounts to
balanced positions depends on a number of factors:
 The initial deficit: The larger the initial deficit, the larger the depreciation of
domestic currency needed to restore the CA balance
 The influence of exchange rates on domestic import and export prices: A
depreciation of domestic currency increases cost of import, but this increase
in cost may not be passed on to consumers
 Price elasticity of the demand of traded goods: If imports are relatively price
inelastic, quantity imported will not change
o Portfolio Balance Channel:
 When the CA surplus country decides to rebalance its investment portfolio, it
will have a negative impact on the value of the investee country currency.
o Debt Sustainability Channel:
 For deficit nations, when the level of external debt relative to GDP gets too high
(unsustainable), this will lead to a depreciation of the domestic currency.

MUNDELL-FLEMING MODEL
 Evaluates impact of monetary and fiscal policies and interest rates, and exchange rates.

Capital Mobility
Monetary Policy/Fiscal Policy High Low
Expansionary/Expansionary ? DC depreciate
Expansionary/Restrictive DC depreciate ?
Restrictive/Expansionary DC appreciate ?
Restrictive/Restrictive ? DC appreciate
Noesis Exed

HIGH Capital Mobility

 Expansionary monetary policy
o Reduce interest rates  decrease in financial inflows  reduces demand for the
domestic currency (domestic currency depreciates)
 Restrictive monetary policy
o Increase interest rates  increase in financial inflows  increase in demand for the
domestic currency (domestic currency appreciates)

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 CFA Level II – Economics – QuickNotez

 Expansionary fiscal policy

o Increase in fiscal deficit, increase in government borrowings  increase in real
interest rates  increase in financial inflows  increase in demand for domestic
currency (domestic currency appreciates)
 Restrictive fiscal policy
o Decrease in fiscal deficit, decrease in government borrowings  decrease in real
interest rates  decrease in financial inflows  decrease in demand for domestic
currency (domestic currency depreciates)

LOW Capital Mobility

 Impact of trade balance on exchange rates > Impact of interest rates
 Expansionary fiscal or monetary policy leads to increase in net IMPORTS
 domestic currency depreciates
 Restrictive fiscal or monetary policy leads to increase in net EXPORTS
 domestic currency appreciates

Monetary Models of Exchange Rate Determination

1. Pure monetary model:
 Assumes that output is fixed, so that monetary policy affects inflation
 PPP holds at any point in time
 Expansionary (restrictive) monetary or fiscal policy leads to an increase (decrease) in
prices and a decrease (increase) in the value of domestic currency
 Drawback: PPP does not hold in the short or medium runs

2. Dornbusch modified monetary model:

 Assumes that prices are sticky (not flexible) in the short term, but are fully flexible
in the long run.
 In the short-term, exchange rates overshoot the long-run PPP implied values
 In the short-term, under an expansionary monetary policy, depreciation of currency
is greater than the depreciation implied by PPP
 In the long-term, exchange rates gradually increase toward their PPP implied
values
 In the short-term, under restrictive monetary policy, appreciation of currency is
greater than the appreciation implied by PPP
Noesis Exed

 In the long-term, exchange rates gradually decrease toward their PPP implied
values

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 CFA Level II – Economics – QuickNotez

Capital Controls
 Objectives:
o Ensure domestic currency does not appreciate excessively
o Allow central bank to pursue independent monetary policies without being held up
by impact on currency values
 Effectiveness:
o For developed markets, central banks are ineffective at intervening in the FX
markets due to lack of sufficient resources
o For emerging markets, central banks may have sufficient FX reserves (relative to
trading volumes) to affect the supply and demand of their currencies in the FX
markets.
 Large and persistent capital flows are harder to mitigate for central banks

Warning Signs of a Currency Crisis

 Terms of trade deteriorates
 Official foreign exchange reserves decline significantly
 Real exchange rate is substantially higher than the mean-reverting level
 Inflation increases
 Equity markets experience a boom-bust cycle
 Money supply relative to bank reserves increases
 Nominal private credit grows
Noesis Exed

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 CFA Level II – Economics – QuickNotez

LEARNING MODULE 2:
ECONOMIC GROWTH AND THE INVESTMENT DECISION

Factor Limiting Growth Favoring Growth

Rate of savings and investment Low rate High rate
Financial markets Poorly developed Well developed
Legal system Corrupt or weak Well developed
Property rights Lacking Well defined
Education and health services Poor Good
High tax and restrictive Low tax and few
Policies regarding entrepreneurship
regulations regulations
International trade and flow of capital Restrictive Open

Aggregate value of equities = = GDP

GDP

Percentage change Percentage Percentage change Percentage change in

= + +
in stock market values change in GDP in earnings share of GDP earnings multiple

Approximately zero
over long horizons

Cobb-Douglas Production Function:

=
where:
Y = Output
K = capital
L = labor
= share of output allocated to capital (K), < 1
1 – = share of output allocated to labor (L)
T = total factor productivity (TFP), represents technological progress of the economy

 Cobb-Douglas function exhibits:

Noesis Exed

o Constant return to scales: if all the inputs into the production process are increased
by x%, then output rises by x%
o Diminishing marginal productivity with respect to each input
 Labor productivity, or output per worker,

=
 < 1: The lower the value of , the lower the benefit of capital deepening

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 CFA Level II – Economics – QuickNotez

 Developed Market: High capital to labor ratio, low

 Developing Market: Low capital to labor ratio, high (gains more from capital
deepening)

Capital deepening – Movement along the productivity curve

Technological progress – Shift in productivity curve

Marginal Product of Capital (MPK) =

Investment in capital increases as long as > (i.e. marginal cost of capital)

Growth Accounting
∆ ∆ ∆ ∆
= + + (1 − )

Growth rate in potential GDP

= long-term growth rate of technology + (long-term growth rate of capital)
+ (1 – ) (long-term growth rate of labor)

Growth rate in potential GDP

Noesis Exed

= long-term growth rate of labor force + long-term growth rate in labor productivity

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 CFA Level II – Economics – QuickNotez

How Natural Resources affect Economic Growth

 Resource-poor countries can get access to natural resources via trade
 Ownership of natural resources may constrain growth (if focus is on extracting the
resources)
o High demand for the natural resources  increases demand for country’s currency
 makes exports more expensive and domestic industry becomes uncompetitive in
global markets (i.e. Dutch disease)

How Demographics, Immigration, and Labor Force Participation affect the Rate and
Sustainability of Economic Growth

Demographics
 Younger population and Higher fertility rates  Higher potential growth

Labor force participation

 =
 Increases as more people enter the workforce

Immigration
 Potential solution for declining labor force, low population growth, older population

Average Hours Worked

 General trend is downwards (due to legislation, or wealth effect, high tax rates on labor
income, increase in part-time or temp workers)

How Human Capital, Physical Capital, and Technological Development affects Economic
Growth

Human Capital
 Increase in human capital (through education/work experience) increases productivity
and economic growth

Physical Capital
 Infrastructure, computers, and telecommunication capital (ICT)
Noesis Exed

o The higher the capital spending in this sector, the higher the impact of the IT sector
on economic growth
 Non-ICT capital (i.e. machinery, transportation, construction)
o High levels of capital spending for this category have less impact on potential GDP
growth (vs. ICT capital)
 Strong positive correlation between investment in physical capital and GDP growth
rates

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 CFA Level II – Economics – QuickNotez

Technological Development
 Leads to increases in productivity
 Developed countries spend more on R&D for technological development

Public Infrastructure
 Enhances total productivity to the economy by complementing the private
investment and increasing TFP.
 e.g. construction of public roads, bridges

Theories of Growth

Classical Growth Theory (Malthusian theory)

 Growth in real GDP per capita is not permanent due to high population growth
 Real GDP per capita increases above the subsistence level  Population growth
increases  diminishing marginal returns to labor  productivity declines  real GDP
per capita declines to subsistence level

Neoclassical Growth Theory

 Focus is on estimating steady state growth rate (sustainable or equilibrium growth

rate) when the output-to-capital ratio is constant.
 Sustainable growth of output per capita, g*
= Growth rate in TFP/Labor’s share in GDP

=
1−
 Sustainable growth rate of output, G*
= g* + growth of labor

= +
1−

1
Equilibrium , = + +
1−

= , . . ℎ
Noesis Exed

= ℎ
1−
= ℎ
∆
= ℎ=

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 CFA Level II – Economics – QuickNotez

 Capital deepening affects the level of output but not the growth rate of the economy
(or on MPK) once steady state has been reached.
 In the steady state:
o Output-to-capital ratio is constant
o Capital-to-labor ratio (k) and output per worker (y) grow at the same rate,
o MPK is constant = = ℎ
 An economy’s growth rate will move towards its steady state regardless of the initial
capital-to-labor ratio or level of technology
 Higher saving rate will enjoy higher capital-to-labor ratio and higher productivity
o …but will NOT permanently increase economic growth
 Developing countries will be impacted less by diminishing marginal productivity of
capital  higher growth rates

Steady State in the Neoclassical Model

Endogeneous Growth Theory

 Technological growth emerges as a result of investment in both physical and human

capital

Noesis Exed

Does not assume steady state growth rate.

 Increasing R&D investments increases TFP  higher growth rates for the entire
economy
 Theorizes that returns to capital are constant.
o Increase in savings will permanently increase the growth rate

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 CFA Level II – Economics – QuickNotez

 More open trade policy will permanently increase the rate of economic growth
o Selection effect:
 increased competition from foreign companies forces less efficient domestic
companies to exit and more efficient ones to innovate and raises the efficiency
of the overall national economy.
o Scale effect:
 allows producers to more fully exploit economies of scale by selling to a larger
market.
o Backwardness effect:
 arising from less advanced countries or sectors of an economy catching up with
the more advanced countries or sectors through knowledge spillovers.

Convergence Hypotheses

 Absolute Convergence Hypothesis:

o States that less developed countries will achieve equal living standards over time
 Conditional Convergence Hypothesis:
o Convergence in living standards will only occur for countries with the same savings
rates, population growth rates, and production functions
o Growth rate will be higher for less developed countries until they catch up (which
will then stabilize to the steady state growth rate of developed countries)
 Club Convergence Hypothesis:
o Countries may be part of a ‘club’ with similar institutional features
o Poorer countries that are part of the club will grow rapidly to catch up with their
richer peers
o Countries can ‘join the club’ by making appropriate institutional changes

Removing Trade Barriers

 Removing trade barriers and allowing for free flow of capital is likely to have the
following benefits for countries:
o Increased investment from foreign savings
o Allows focus on industries where the country has a comparative advantage
o Increased sharing of technology and higher total factor productivity growth
Noesis Exed

o Increased competition leading to failure of inefficient firms and reallocation of their

assets to more efficient users
 Removing barriers on capital and trade flows may speed the convergence of standard
of living of less developed countries to that of developed countries

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 CFA Level II – Economics – QuickNotez

LEARNING MODULE 3:
ECONOMICS OF REGULATION

State-backed Regulations

Statutes – Law enacted by legislative bodies

Administrative law – Rules issued by government agencies or other regulators
Judicial Law – Interpretations of court

Independent Regulators
 Make regulations based on powers and objectives; have autonomy
 Do not rely on government funding
 Immune from political influence

Industry Self-regulatory Bodies

 Private organizations – represent and regulate members
 Independent of government; derive authority from members
 May impose entry requirements for members

Self-regulating Bodies (SROs)

 Given recognition and enforcement power by a government body
 Funded independently
 Has authority to enforce industry rules
 Set standards of behavior or codes of conduct

Statutory Board
 Separate from the government; have specific legislation governing their operations
 May impose charges for their services; may receive government grants

Regulatory Interdependencies

Regulatory capture theory:

 Regulatory body influenced/controlled by the industry that is being regulated.
Noesis Exed

Regulatory arbitrage theory:

 Occurs when business shop for a country that allows a specific behaviour rather than
changing the behaviour (e.g. greenhouse gas, pollutions)

Regulatory Competition:
 Refers to regulatory differences between jurisdictions, in which regulators compete to
provide the most business-friendly regulatory environment.

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 CFA Level II – Economics – QuickNotez

Coase Theorem:
 If an externality (e.g. pollution) can be traded and there are no transaction costs, then
the allocation of property rights will be efficient and the resource allocation will not
depend on the initial assignment of property rights

Tools of Regulatory Intervention

 Price mechanisms
o Taxes and subsidies to achieve specific regulatory objectives
o e.g. taxes on alcohol and subsidies on green energy
 Restricting/requiring certain activities
o Ban on certain activities (e.g. use of certain chemicals) or require certain activities be
performed (e.g. filing of annual report by PLCs)
 Provision of public goods or financing of private projects
o Regulators may provide public goods (e.g. national defense, hospital) or fund private
projects (e.g. SME loans, PICs) depending on their political priorities and objectives

Substantive law – Focuses on rights & responsibilities of entities (and relationships among
them)

Procedural law – Focuses on protection and enforcement of the entities

Antitrust Regulations
 Antitrust laws seek to promote domestic competition by monitoring and restricting
activities that reduce or distort competition
 Regulators often block a merger that leads to excessive concentration of market share

Regulatory burden – Cost of regulation for regulated entity

Net regulatory burden – Regulatory burden less private benefits of regulation

Noesis Exed

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