Term
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Definition
| the act of simultaneously buying and selling the same or equivalent assets or commodities for the purpose of making certain, guaranteed profits. |
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Term
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Definition
| involves no net investment and no risk, derives IRP by considering three separate positions that should not generate any net cash flow in equilibrium: borrow, lend, and sell forward |
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Term
| Covered Interest Arbitrage |
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Definition
| a situation which occurs when IRP does not hold, thereby allowing certain arbitrage profits to be made without the arbitrageur investing any money out of pocket or bearing any risk |
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Term
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Definition
| - buying a high-yielding currency and funding it with a low-yielding currency without any hedging. Profitable as long as the interest rate spread is greater than the rate of appreciation. |
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Term
| Efficient market hypothesis |
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Definition
| financial markets are informationally efficient in that the current asset prices reflect all the relevant and available information |
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Term
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Definition
| nominal interest rate is the sum of the real interest rate and the expected inflation rate |
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Term
| Forwards Expectations Parity |
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Definition
| any forward premium or discount is equal to the expected change in the exchange rate |
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Term
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Definition
| arbitrage equilibrium condition holding that the interest rate differential between two countries should be equal to the forward exchange premium or discount. Violation of IRP gives rise to profitable arbitrage opportunities. |
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Term
| International Fisher Effect |
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Definition
| the expected change in the spot exchange rate between two countries is the difference in the interest rates between the two countries |
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Term
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Definition
| requirement that similar commodities or securities should be trading at the same or similar prices. an asset traded in functioning markets should only have one price. |
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Term
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Definition
| based on PPP and quantity theory of money |
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Term
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Definition
the exchange rate between currencies of two countries should be equal to the ratio of the countries’ price levels of a commodity basket.
A given amount of wealth should, in a well functioning FX markets, purchase the same amount of goods and services across currencies. The exchange rates adjusts to equate the purchasing power of the currencies involved. A generalization of the law of one price to the general purchasing power of a currency. |
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Term
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Definition
| an identity stating that for each country, the general price level times the aggregate output should be equal to the money supply times the velocity of money |
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Term
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Definition
| in an efficient market, asset prices change randomly (independently of historical trends) or follow a random walk. Thus, the expected future exchange rate is equivalent to the current exchange rate. |
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Term
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Definition
| measures the degree of deviation from PPP over a period of time, assuming PPP held at the beginning of the period |
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Term
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Definition
| method of predicating the future behavior of asset prices based on their historical patterns |
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Term
| Uncovered Interest Rate Parity |
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Definition
holds that the difference in interest rates between two countries is equal to the expected change in exchange rate between the countries’ currencies
The conversion of the currency in the future is done at the future (unknown today) spot rate |
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Term
| Derivative (Contingent claim) |
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Definition
| a security whose value is contingent upon the value of the underlying security. Ex: futures, forwards, options. |
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Term
| Arbitrage provides links among markets and rices |
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Definition
Goods markets-product prices
Money Markets-interest rates
Currency markets-exchange rates
In perfect markets, the prices will interact until buyers and sellers are indifferent as to where to buy and sell |
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Term
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Definition
| The quality or state of being equal or in equivalent |
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Term
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Definition
Exchange-rate adjusted interest rates will be identical across countries
Domestic and foreign financial mkts are linked through FX rates and interest rates. A diference between domestic interest rates in two countries will be matched by an equal but opposite different in the forward market. Spot and future rates affected. |
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Term
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Definition
| Exchange-rate adjusted product prices will be identical across countries |
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Term
| Covered Interest Difference (4) |
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Definition
The actual forward premium/discount deviates from what we should expect in equilibrium. Arbitrage is not fully effect. Exists because of:
Transaction cost
Political risk
Taxes
Liquidity needs
Covered hedged position won't work perfectly because of these factors |
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Term
| The spot rate is affected by (2) |
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Definition
Expectations about future exchange rates
Interest rates over the appropriate time period |
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Term
| Interest rates and future exchange rates |
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Definition
Interest rate parity and covered interest differences focus = forward rates
Uncovered IRP focus = spot rate |
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Term
| Absolute PPP (one point in time) |
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Definition
| The exchange rate is a ratio of the amt of currencies necessary to purchase a defined basket of goods and services. |
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Term
Deviations from absolute PPP
Frictions (4) Differences (3) |
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Definition
Frictions
1. Transaction costs--a borrower (vs investor) faces higher interest rate at bank. Intermediation spread makes arbitrage not as smooth. Arbitrage works only up to transaction costs. Cannot be arbitraged away.
2. Barriers to arbitrage--tariffs
3. Government subsidies--agricultural
4. Taxes--A value added tax (VAT) factored into price b/c hits @ every level of production. In Europe.
Differences
1. Heterogeneous baskets--baskets different between countries. US=coffee UK=tea
2. Measuring the baskets--differences between official and unofficial economy. Off the books transactions means cannot determine economy size from reported taxes (Greeks dont' pay taxes, Americans do)
3. Traded/non-traded items--Services, like hair-cuts, are not traded so do not affect exchange rate |
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Term
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Definition
| the value of assets owned by a person or commnity |
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Term
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Definition
A means of facilitation economic activity
Three functions
1. medium of exchange--b/c bartering inefficient
2. unit of account or price--reflect utility of stuff
3. store of purchasing power--no longer true |
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Term
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Definition
Specie: money w/ intrinsic value (gold)
Fiat: money w/ no intrinsic value, but is created by government decree
Moved from specie to fiat over 20th century.
Article 1 Section 8 of constitution gives government fixed exchange specie money (dollars and eagles).
Roosevelt changed to fiat money. Specie now illegal. Government has more control over money. |
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Term
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Definition
An increase in the purchasing power of a currency over a given period of time. Discourage economic activity--bad.
(imagine a circle...) Price drop delay purchase->Delay purchase less demand->less demand lower production->lower production workers laid off->workers laid off still lower demand->still lower demand prices drop->
think prices will drop more so wait to buy
Japan in cycle. Hard to get out of but must shock economy by inserting money. Air on side of inflation over deflation. |
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Term
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Definition
A decrease in the purchasing power of a currency over a given time period.
60's and war on poverty marked time where government increased money supply/inflation. Where we are now for expansive spending on social programs. |
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Term
| Consumer Price Index (CPI) |
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Definition
Created 1919. Measures average change in prices over time in a "market basket" of goods and services purchased either by urban wage earners and clerical workers or by all urban consumers. Revisions throughout time. Basked changed over time as value and goods have changed.
Very imperfect measurement. CPI gone up hugely (prices going up) since breakup of Bretton Woods. Also goes up in recession. |
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Term
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Definition
CPI less volatile elements of food and energy.
More stable picture of what money is. Better idea of how pries change. Food used to be larger/more volatile part of spending, now technology stabilized out food pries.
Energy more volatile w/ natural gas price changes from increased supply |
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Term
| Producer Price Index (PPI) |
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Definition
1890 --> PPI frontier settle and started taking records
Measures average changes in prices received by producers of all commodities, at all stages of processing produced in the US
Will lead to a change in consumer price to a smaller degree
All measures show same story of unstable prices in the 60s |
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Term
| Asset price inflation (3) |
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Definition
Gives insight not available w/ consumer/producer prices
Financial assets--real rate of return much lower. Inflation hedge (why stock mkt so high right now...not in real terms)
Housing--Has save value in real terms but not nominal over time. Not a real rate of return but protecting against inflation.
Gold--inverse relationship to economy. Was stable during BW until 70s when less trust in US government. Investors pay a lot for gold w/o a real reate of return. |
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Term
| Inflation-adjusted tax rate |
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Definition
| Taxed on nominal returns not real returns. |
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Term
| Two relationships that connect exchange rates and inflation, based on how inflation is measured |
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Definition
Relative PPP via basked of goods
International Fisher Effect via interest rates |
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Term
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Definition
Changes in the purchasing power of two currencies will cause a proportional change in the exchange rate between those countries
More useful for long-run predictions of exchange rates because need time to gather data and trends of PP |
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Term
| Deviations from relative PPP (3) |
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Definition
1. Economic Reasons-- Differences in baskets (frictions differences)
2. Prices--of stuff in baskets. Not all inclusive of Goods/services. Capital--interest rates
3. Measurement--price index and base period will mess up measurements. Doesn't give great over/under value b/c based on which index you use. |
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Term
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Definition
Nominal interest rates contain an inflation premium to compensate investors for expected inflation
Nominal rate = real rate + inflation rate |
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Term
| International Fisher Effect |
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Definition
| The expected future spot exchange rate should reflect the differences in interest rates between the two countries (like uncovered position) |
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Term
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Definition
| Expected inflation does not match actually realized inflation because of inflation shocks (world event shocks). Not perfect b/c of parity. |
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Term
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Definition
| State, observed, contractual rate. Can commit only to nominal rates. Given |
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Term
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Definition
Inflation-adjusted rate. Have to estimate real rates, no one knows real rates. Understand purchasing power.
Real rate more important than nom b/c picture of how economy is able to compete |
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Term
| Relative PPP--real exchange rates |
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Definition
| The nominal future exchange rate, St, should relate to the nominal current exchange rate via relative inflation. The real exchange rate, qt, checks to see if the change in nominal exchange rates fully reflects the changes that inflation should cause in exchange rates--it measures the inflation-adjusted exchange rate |
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Term
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Definition
| a change in the nominal exchange rate exactly offsets the difference in inflation. -->a change in the nominal exchange rates does not change the real value of assets across the two economies. |
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Term
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Definition
| German unification and UK depression. The UK nom exchange rate decreased while the real exchange rate increased. Pound strengthened in real terms. British products were non competitive, producing recession. UK had to leave the Euro ERM to lower pound's real value. |
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