CFA Level I Study Session

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CFA Level I Study Session 6 Topic
Investment Tools - Global Economic
AnalysisInstructor Prof. John M. Veitch, CFA

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CFA Level I Study Session 6

• Investment Tools -
• Global Economic Analysis

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CFA Level I Study Session 6.1A

• Gaining from International Trade

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Gaining from International Trade

• The candidate should be able to
• state the conditions under which a nation can
  gain from international trade
• Nations can gain from trade if they produce goods
  in which they have a comparative advantage and
  trade for goods in which they have a comparative
  disadvantage.
• Comparative Advantage is the ability to produce a
  good at a lower opportunity cost than others can
  produce it.
• As long as the relative costs of production
  differ across nations, gains from specialization
  and trade will be possible.
• When nations produce and trade based on
  Comparative Advantage trade between nations leads
  to an expansion in total world output and mutual
  gains to each nation.
• See Figure 6.1A for graphical treatment of
  comparative advantage and gains from trade
  between two nations.

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Gaining from International Trade

• The candidate should be able to
• discuss the the effects of international trade on
  domestic supply and demand
• When product can be transported long distances at
  low cost (relative to its value) then domestic
  price of the product is determined by world
  demand and supply
• Trade specialization thus results in
• Lower prices and higher domestic consumption for
  imported products
• Domestic Consumers benefit from trade
• Higher prices and higher domestic production for
  exported goods
• Domestic Producers benefit from trade.
• See diagram on following slide.

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Trade Restrictions

• c) describe commonly used trade-restricting
  devices including tariffs, quotas, voluntary
  export restraints, and exchange-rate controls
• Commonly used trade-restricting policies are
• I. Import Tariff are a tax on goods and
  services imported into the country.
• II. Import Quota puts an upper limit on the
  amount of a good or service that is allowed to be
  imported into the country.
• Voluntary Export Restriction (VER) an agreement
  by foreign firms to limit the amount of a good or
  service they will export into the country.
• Exchange Rate Controls when the government
  either sets the exchange rate at a rate above the
  market rate or it limits the access to foreign
  currency by its citizens.

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Gaining from International Trade

• The candidate should be able to
• explain why nations adopt trade restrictions
• Economic Illiteracy
• Power of Special Interests
• Trade restrictions provide concentrated benefit
  to small groups while imposing widely-dispersed
  costs on majority of nation.
• Partially Valid Economic Arguments
• National Defense
• Certain industries vital, must be protected.
• Infant Industry
• New industries need protection until
  established.
• Anti-Dumping
• Domestic producers need protection from foreign
  suppliers selling products below cost (dumping).

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Gaining from International Trade

• explain the impact of trade barriers on the
  domestic economy and identify who benefits and
  loses from the imposition of a tariff
• comment on the validity of the arguments for
  restrictions.
• Trade restrictions
• Promote inefficiency and reduce the potential
  gains from trade
• Tariff is a tax levied on imports, has following
  effects
• Domestic Price rises by amount of tariff.
• Reduction in the quantity of imports of the good.
• Loss of consumer surplus as less of good consumed
  at higher price.
• Gain of producer surplus as domestic production
  increases.
• Government revenue increases from tariff
  revenues.
• Net Deadweight loss to society.
• Effects of quota similar but larger deadweight
  loss as generates no government revenue.

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Costs and Benefits of a Tariff
Price, P
2. Consumer surplus falls by areas a
b c d
SHome
3. Producer surplus rises by area a
4. Government revenue rises by area c
5. Deadweight loss (cost of protection)
b d ( prodn loss consump loss)
DHome
PW
D0
S0
Quantity, Q
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CFA Level I Study Session 6

• 2. A. Foreign Exchange

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EXR Quote Conventions

• a) define direct and indirect methods of foreign
  exchange quotations
• Direct Method (Domestic on top)
• units of home currency per unit of foreign
  currency (0.01 US/Yen)
• Indirect Method (International on top)
• units of foreign currency per unit of home
  currency (100 Yen/US)
• One method is simply the inverse of the other.

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Bid Ask Rates in FX

• b) calculate the spread on a foreign currency
  quotation
• Bid or Buy rate
• Exchange rate at which agent (the bank) will buy
  a currency.
• Ask or Sell rate
• Exchange rate at which agent (the bank) will sell
  a currency

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Determinants of the Spread

• explain how spreads on foreign currency
  quotations can differ as a result of market
  conditions, bank/dealer positions, and trading
  volume
• Anything that increases the dealers risk of
  holding the foreign currency will increase the
  Bid-Ask spread.
• Increased volatility in spot market conditions.
• Lack of spot market liquidity.
• Bank/dealer positions are more likely to
  influence the midpoint exchange rate quote
  (bid ask)/2 than the size of the bid-ask
  spread for a currency.

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Converting EXR Quotes

• convert direct (indirect) foreign exchange
  quotations into indirect (direct) foreign
  exchange quotations
• If the question gives you a single exchange rate,
  i.e. no bid-ask spread, then the conversion is
• Direct Rate 1/Indirect Rate
• If instead the question gives you a Bid and an
  Ask rate then
• Direct Ask Rate 1/Indirect Bid Rate
• Rate to sell domestic currency equals the
  reciprocal of the rate to buy the foreign
  currency.
• Direct Bid Rate 1/Indirect Ask Rate
• Rate to buy domestic currency equals the
  reciprocal of the rate to sell the foreign
  currency.

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Essentials of EXR Calculations

• calculate currency cross rates, given two spot
  exchange quotations involving three currencies
• Direct Quoted Exchange Rate Always!!!!!
• units of home currency per unit of foreign
  currency (0.01 US/Yen) Domestic on top
• You always get the worst rate
• The bank always buys FX low and sells it high.
• That means you always buy FX high and sell it
  low.
• When you calculate possible EXR, you always get
  the rate that gives you the least of what you
  want OR costs you the most to get what you
  want!!!! Always!!!!

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Cross Rates - No Bid-Ask Spread
Domestic Currency
DC/VC _____
DC_________/US
Vehicle Currency (US)
DC/FC _______
FC_________/US
FC/VC ______
Foreign Currency
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Calculate forward ASK premium for Indian rupee
1-Year forward in terms of Canadian .

• Ask rate on the rupee in terms of CDN implies
  that you are in Canada and that the Indian rupee
  is the foreign currency. Remember ask/bid rates
  are to buy the foreign currency in terms of the
  home currency. How to think about the formula?
• You have Canadian and want Rupees. Buy US with
  CDN (get the bank's ask rate for US) then sell
  the US for Rs (get the bank's bid rate for US).
• Cross Ask Spot Rate Ask Rate / Bid Rate
  _______________________
• Cross Ask Forward Rate Ask Rate / Bid Rate
  _____________________
• Forward Premium Forward - Spot/Spot x 100
  ___________________

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Cross Rates with Bid/Ask Spreads

• Cross Bid Rate - Mnemonic device CBBA
• Rate at which Bank in Home buys foreign currency
• Your Alternative?
• Sell Foreign currency for US Foreign Ask
  (Foreign/US)
• Sell US for Home currency Home Bid (Home/US)
• Your Exchange Rate? Cross Bid Home
  Bid/Foreign Ask
• Cross Ask Rate - Mnemonic device CAAB
• Rate at which Bank in Home sells foreign currency
• Your Alternative?
• Sell Home currency for US Home Ask (Home/US)
• Sell US for Foreign currency Foreign Bid
  (Foreign/US)
• Your Exchange Rate? Cross Ask Home
  Ask/Foreign Bid
• It is NEVER Bid/Bid or Ask/Ask with Direct
  quotes!!
• You always get the worst rate of the two
  possible!!!!

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You Sell FC to get DCCross Bid Rate with Bid-Ask
Spread
Home Currency
DC_________/US
Vehicle Currency (US)
DC/FC _______
FC_________/US
Foreign Currency
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You Buy FC with DCCross Ask Rate with Bid-Ask
Spread
Home Currency
DC_________/US
Vehicle Currency (US)
DC/FC _______
FC_________/US
Foreign Currency
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Cross Rate Arbitrage
Domestic Currency
DC/VC _______
DC_________/US
Vehicle Currency (US)
DC/FC _______
FC_________/US
FC/VC _______
Foreign Currency
RULE Buy FC Low, Sell FC High! If DC/FC lt
(DC/)/(FC/) then buy FC on direct side and
sell through cross.
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Cross Rates Visually
Cross Bid Rate DC Bid/FC Ask (CBBA)
Cross Ask Rate DC Ask/FC Bid (CAAB)
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Triangular Currency Arbitrage
New York
Start 1,000,000
London
Frankfurt
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Spot and Forward FX Markets

• distinguish between the spot and forward markets
  for foreign exchange
• Spot market
• Market where Currencies are traded for immediate
  delivery.
• Generally two-day delivery.
• Forward Market
• Trade contracts to buy or sell a specified amount
  of currency at a specified future date at the
  specified forward exchange rate.
• Forward contracts are customized to customer
  needs in contrast to futures contracts which have
  fixed sizes and maturity dates.

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Bid/Ask Spread on Forwards

• calculate the spread on a forward foreign
  currency quotation
• The calculation is identical to the one performed
  earlier for the spot exchange rate.
• Make sure that the Bid and the Ask rates are for
  the same forward delivery date in a question.
• The spread does not apply across Bid and Ask on
  different forward delivery dates.

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Forward Spreads

• explain how spreads on forward foreign currency
  quotations can differ as a result of market
  conditions, bank/dealer positions, trading
  volume, and maturity/length of contract
• All the same considerations that determine
  spreads in the spot FX market affect the spread
  in the forward FX market.
• In the forward market, however, an additional
  source of risk is the length of the forward
  contract the longer the maturity of the forward
  contract the higher is the spread on the contract
  due to increased bank/dealer risk.

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Forward Discount or Premium

• calculate a forward discount or premium and
  express it as an annualized rate
• Exchange rate fixed by the forward contract is
  called the forward rate or the outright rate.
• Difference between forward rate and current spot
  rate is the swap rate. There is a forward premium
  if the forward rate quoted in dollars is above
  the spot rate. There is a forward discount if
  forward rate is below the current spot rate.
• Annualized forward premium or discount to current
  spot rate adjusts difference between forward
  and spot rate for length of forward contract.

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Interest Rate Parity

• explain the interest rate parity theory
• Interest rate parity theory ensures that return
  on a hedged foreign exchange rate position is
  just equal to the domestic interest rate on an
  investment of identical risk.
• Normally compare returns on same maturity
  government bonds across countries to control
  default risk.
• If the returns are not identical then an
  arbitrage opportunity exists, and capital will
  flow to take advantage of the mispricing.
• Involves borrowing funds in the country where the
  interest cost is lowest and then relending them
  at the higher return available in the other
  country.
• Since risk of each is the same you have locked in
  interest arbitrage profits.

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Covered Interest Rate Parity

• illustrate covered interest arbitrage.
• Strategy 1 Domestic Investment Invest in home
  govt bond yielding nominal interest rate, rDC.
• Return in HC is (1 rDC)
• Strategy 2 Hedged Foreign Investment - Convert
  HC at current exchange rate, S0, invest in
  Foreign govt bond yielding rFC, convert proceeds
  back to HC at current forward rate, F1.
• Return in HC is (1 rFC)S0/F1
• Riskless Arbitrage Profits available if (1 rDC)
  ? (1 rFC)S0/F1
• How to take advantage of this mispricing?
• Borrow low Lend high.
• If (1 rDC) lt (1 rFC)S0/F1, borrow in home
  country, lend (hedged foreign investment) foreign
  and vice versa
• Be careful! Interest rates must match the forward
  contract in duration!

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Covered Interest Parity Arbitrage
New York
t 0
t 1
t 0
t 1
London

• Arbitrage Profit 1,030,000 - 1,017,360
  12,640 if borrow in London and lend in U.S.
• Transaction costs (bid-ask spreads, etc.) will
  reduce these profits.

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Types of Exchange Rate Questions

• Simple Calculations
• Bid-Ask Spread
• Forward Premium or Discount
• Harder Calculations
• 2 currencies plus transaction costs Bilateral
  Arbitrage points.
• 3 currencies plus 2 exchange rates Cross Rate
  calculation (bid or ask)
• 3 currencies and 3 exchange rates Triangular
  Currency Arbitrage
• 2 currencies, 1 exchange rate, and 2 interest
  rates calculate forward rate
• 2 currencies, 2 exchange rates, and 2 interest
  rates covered interest arbitrage

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CFA Level I Study Session 6

• 2. B. Foreign Exchange Parity Relations

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Foreign Exchange Markets

• explain how exchange rates are determined in a
  flexible or floating exchange rate system
• Demand for foreign currency from domestic
  individuals buying goods, services, or assets
  from ROW.
• Supply of foreign currency from foreign
  individuals buying goods, services, or assets in
  domestic economy.
• Equilibrium
• Flexible Exchange Rate System Demand and supply
  for foreign currency determine exchange rate
  (value of foreign currency in terms of domestic
  currency).
• Fixed Exchange Rate System Govt sets exchange
  rate and then fixes this level by intervening to
  buy or sell foreign currency depending on demand
  and supply at the fixed rate.

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Market for Foreign Exchange
Exchange
Rate
/Foreign Currency
Quantity of Foreign Currency Exchanged
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Balance of Payments

• explain the role of each component of the
  balance-of-payments accounts
• Balance of Payments Current Account Capital
  Account
• Current Account
• Merchandise Trade Balance Exports of goods
  Imports of Goods
• Balance on Services Export of Services
  Imports of Services
• Income from Investments Net Income from to
  foreigners
• Unilateral Transfers Net Gifts from to
  foreigners
• Balance on Current Account Sum of items i.
  iv.
• Financial Account
• Net changes in ownership of assets to from
  foreigners
• Official Reserve Account
• Official Reserve Assets held in form of foreign
  currencies, gold, and Special Drawing Rights
  (SDRs) held at IMF.

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• explain how current-account deficits or surpluses
  and financial account deficits or surpluses
  affect an economy.

• Current Account balance reflects primarily trade
  in goods services.
• Current account deficit means nation is net
  buyer of goods services from the Rest of the
  World.
• Current Account Deficit must be financed,
• For a Current Account Deficit to be sustained it
  must be accompanied by an offsetting Financial
  Account Surplus, i.e. capital flowing into the
  country from the Rest of the World think the
  United States.
• For a Current Account Surplus to be sustained it
  must be accompanied by an offsetting Financial
  Account Deficit, i.e. capital flowing out of the
  country to the Rest of the World think Japan .
• Be careful about causality. Current Account
  Deficits may cause capital inflows (Financial
  Account Surpluses) OR capital inflows may cause
  current account deficits. The latter is likely
  true for the U.S. in recent years.

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Macro Events that change EXR

• describe the factors that cause a nations
  currency to appreciate or depreciate
• Factors causing Nations Currency to Appreciate
  (Strengthen)
• Slow growth of domestic income relative to
  trading partners causes exports to increase more
  than imports. (decrease in Demand for FX)
• Inflation rate lower than trading partners will
  cause foreign goods to become expensive. (Demand
  for FX falls, Supply of FX rises) As result
  foreign currency weakens, its goods become
  competitive.
• Domestic real interest rates higher than trading
  partners will attract inflows of foreign capital,
  increasing demand for domestic currency. (Demand
  for FX falls, Supply of FX rises)
• Factors causing Nations Currency to Depreciate
  (Weaken)
• Opposite of the factors above for appreciation of
  domestic currency.

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• explain how monetary and fiscal policy affect the
  exchange rate and balance-of-payments components

• Monetary Policy Expansionary
  Restrictive
• Real Interest rates Decline
  Rise
• Exchange Rate Depreciates Appreciates
• Flow of Capital Outflow
  Inflow
• Current Account Move to surplus Move to
  deficit
• Fiscal Policy Expansionary Restrictive
• Real Interest rates Rise
  Decline
• Exchange Rates Uncertain but Uncertain but
• likely appreciate likely depreciate
• Flow of Capital Inflow
  Outflow
• Current Account Move to deficit
  Move to surplus

You can try to memorize these or simply
understand how the FX Market works.
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EXR Regimes

• describe a fixed exchange rate and a pegged
  exchange rate system.
• Fixed Exchange Rate System
• When a nation absolutely fixes its exchange rate
  between its own currency and the currency of
  another country or region. Example Countries
  that have a currency board.
• Pegged Exchange Rate System
• When a nation sets a desired level and bands
  around that level for the exchange rate between
  its currency and the currency of another country
  or region.
• Key difference is that in a pegged system the
  nations exchange rate can vary within the bands
  without central bank intervention. Example Many
  European countries prior to the euro belonged to
  the Exchange Rate Mechanism (ERM).

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Purchasing Power Parity, PPP

• discuss absolute purchasing power parity and
  relative purchasing power parity
• Absolute Purchasing Power Parity
• Simplest theory of how exchange rates are
  determined.
• Law of One Price A good should not sell for
  different prices in different places at same
  time.
• Using Indirect Quoted Exchange rate !!!! S
  FC/DC
• In long run should have
• S PFC / PDC
• Relative Purchasing Power Parity
• If PPP holds in terms of percent changes then
• DS DPFC - DPDC
• And so nominal exchange rate change, s DS,
  approximated as
• s IFC IDC
• Where IDC Inflation Rate in Domestic Country,
  etc.

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Example Calculation - PPP

• IDC Inflation Rate for the U.S. 1.9
• IFC Inflation rate for Brazil 9.3
• S0 Spot EXR at beginning of year R 2.85/USD
• You can practice these types of questions using
  data from the last three pages in any issue of
  The Economist.