The document discusses the uncovered interest rate parity condition, which states that expected returns from investing in two currencies should be equal when interest rates and exchange rates adjust to equilibrium. It presents the basic equation and explains how it relates the interest rate differential to expected exchange rate changes. The condition is examined under fixed exchange rates, where it suggests capital flows will pressure a central bank defending a peg. Risk and liquidity premia are introduced to account for why investors currently hold a volatile currency like nubits.
Unit 2.2 Exchange Rate Quotations & Forex MarketsCharu Rastogi
This presentation deals with exchange rate quotations, common currency symbols, direct and indirect quotes, American terms, European terms, cross rates, Bid and Ask rates, Mid rate, Spread and its determinants, Spot markets, Forward Markets, Premium and Discounts, various practices of writing quotations, calculating broken period forward rates, Speculation and arbitrage, Forex futures and Currency Options.
This document provides an overview of Keynes' liquidity preference theory of interest. It defines interest as payment made by a borrower to a lender for borrowing money. It distinguishes between gross and net interest. The liquidity preference theory states that interest is determined by the interaction between the demand and supply of money, where demand is based on liquidity preference and the desire to hold cash. Demand for money has three motives: transactional, precautionary, and speculative. The demand curve is negatively sloped. The supply of money is determined by the central bank and is interest inelastic. The equilibrium interest rate is determined by the point where the demand curve intersects the vertical supply curve. Changes in liquidity preference
The document provides an outline and examples for lecture material on time value of money concepts. It discusses 1) valuing costs and benefits, 2) the time value of money and interest rates, 3) net present value decision rules, 4) arbitrage and the law of one price, and 5) applying concepts to risky securities. Worked examples are provided to illustrate key points such as calculating present and future value, comparing investment alternatives using net present value, and determining no-arbitrage prices.
Money can take many forms and serve several functions. It is generally accepted as a medium of exchange, measure of value, store of value, and standard for deferred payments. The money supply is determined by various factors including the central bank, commercial bank lending, and monetary aggregates like M0, M1, M2, and M3. The quantity theory of money posits a direct relationship between the money supply and price level in an economy.
This document discusses the international Fisher effect and interest rate parity. It explains that the Fisher effect postulates a relationship between nominal interest rates and real interest rates adjusted for inflation. According to the Fisher effect, high inflation leads to high nominal interest rates. The document also discusses how interest rate parity argues that identical securities should have the same price when quoted in a common currency, so interest rate differentials between countries tend to be offset by forward exchange rate premiums or discounts.
International Finance Practice NumericalCharu Rastogi
This document contains 13 questions regarding foreign exchange rates, calculations of spot rates, forward rates, cross rates, and arbitrage opportunities. It includes calculating bid/ask spreads, mid rates, direct/indirect quotes, percentage spreads, and using multiple exchange rates to analyze arbitrage scenarios.
This document discusses several exchange rate theories, including the traditional or elasticities approach, purchasing power parity (PPP), and interest rate parity (IRP).
The traditional approach assumes an equilibrium exchange rate where a country's imports balance its exports. If imports exceed exports, the exchange rate will fall to make the country's exports cheaper and imports more expensive, balancing trade.
PPP has both an absolute and relative form. In absolute PPP, similar goods should have the same price in different currencies. Relative PPP recognizes market imperfections but holds that inflation rates between countries will offset exchange rate changes over time.
IRP links exchange and money markets, stating that interest rate differences between countries should equal forward exchange
Unit 2.2 Exchange Rate Quotations & Forex MarketsCharu Rastogi
This presentation deals with exchange rate quotations, common currency symbols, direct and indirect quotes, American terms, European terms, cross rates, Bid and Ask rates, Mid rate, Spread and its determinants, Spot markets, Forward Markets, Premium and Discounts, various practices of writing quotations, calculating broken period forward rates, Speculation and arbitrage, Forex futures and Currency Options.
This document provides an overview of Keynes' liquidity preference theory of interest. It defines interest as payment made by a borrower to a lender for borrowing money. It distinguishes between gross and net interest. The liquidity preference theory states that interest is determined by the interaction between the demand and supply of money, where demand is based on liquidity preference and the desire to hold cash. Demand for money has three motives: transactional, precautionary, and speculative. The demand curve is negatively sloped. The supply of money is determined by the central bank and is interest inelastic. The equilibrium interest rate is determined by the point where the demand curve intersects the vertical supply curve. Changes in liquidity preference
The document provides an outline and examples for lecture material on time value of money concepts. It discusses 1) valuing costs and benefits, 2) the time value of money and interest rates, 3) net present value decision rules, 4) arbitrage and the law of one price, and 5) applying concepts to risky securities. Worked examples are provided to illustrate key points such as calculating present and future value, comparing investment alternatives using net present value, and determining no-arbitrage prices.
Money can take many forms and serve several functions. It is generally accepted as a medium of exchange, measure of value, store of value, and standard for deferred payments. The money supply is determined by various factors including the central bank, commercial bank lending, and monetary aggregates like M0, M1, M2, and M3. The quantity theory of money posits a direct relationship between the money supply and price level in an economy.
This document discusses the international Fisher effect and interest rate parity. It explains that the Fisher effect postulates a relationship between nominal interest rates and real interest rates adjusted for inflation. According to the Fisher effect, high inflation leads to high nominal interest rates. The document also discusses how interest rate parity argues that identical securities should have the same price when quoted in a common currency, so interest rate differentials between countries tend to be offset by forward exchange rate premiums or discounts.
International Finance Practice NumericalCharu Rastogi
This document contains 13 questions regarding foreign exchange rates, calculations of spot rates, forward rates, cross rates, and arbitrage opportunities. It includes calculating bid/ask spreads, mid rates, direct/indirect quotes, percentage spreads, and using multiple exchange rates to analyze arbitrage scenarios.
This document discusses several exchange rate theories, including the traditional or elasticities approach, purchasing power parity (PPP), and interest rate parity (IRP).
The traditional approach assumes an equilibrium exchange rate where a country's imports balance its exports. If imports exceed exports, the exchange rate will fall to make the country's exports cheaper and imports more expensive, balancing trade.
PPP has both an absolute and relative form. In absolute PPP, similar goods should have the same price in different currencies. Relative PPP recognizes market imperfections but holds that inflation rates between countries will offset exchange rate changes over time.
IRP links exchange and money markets, stating that interest rate differences between countries should equal forward exchange
Determination of exchange rate chapter 6Nayan Vaghela
Determination of exchange rate, mint par theory, balance of payment theory, Purchasing power parity theory, Absolute version and relative version, Criticisms
The document provides information on various concepts related to foreign exchange markets including:
1) Direct and indirect quotes, bid and ask rates, spreads, converting between quote types, and spot and forward rates.
2) Factors that influence exchange rates such as inflation, interest rates, and balance of payments.
3) Arbitrage opportunities from price differences in different markets.
The purchasing power parity (PPP) theory compares the average costs of goods and services between countries using exchange rates. PPPs are useful for inter-country comparisons of GDP in real terms and economic data expressed in national currencies. PPPs are calculated at the product group level by comparing consumption baskets, then aggregated to GDP levels using weights. PPP exchange rates are meant to converge with actual exchange rates over the long run, though various factors can cause short-term deviations. PPPs are useful for output and productivity comparisons, while market exchange rates are better for trade-related analyses.
The document provides information on various concepts related to foreign exchange including:
1) Direct and indirect quotes, bid and ask rates, spreads, spot and forward rates, currency appreciation and depreciation.
2) It discusses arbitrage opportunities between different currency pairs in the spot and forward markets.
3) Examples are provided for calculating cross currency rates and identifying arbitrage opportunities using quotes from different markets.
The neoclassical theory of interest, or loanable funds theory, holds that the interest rate is determined by the supply and demand for loanable funds. The demand for loanable funds comes from investment, consumption/dissaving, and hoarding. The supply comes from savings, bank credit, dishoarding, and disinvestment. The interest rate reaches equilibrium when the total demand for loanable funds equals the total supply. Critics argue the theory assumes full employment, does not precisely determine the interest rate, and is impractical.
The document discusses several concepts related to international finance including:
1) Purchasing power parity, interest rate parity, and the Fisher effect which relate exchange rates, interest rates, and inflation rates between countries.
2) Arbitrage opportunities that can arise from differences in exchange rates quoted by different traders.
3) Conditions like the law of one price that must hold for arbitrage to exist.
4) Absolute and relative forms of purchasing power parity and limitations of the theory.
5) How interest rate parity explains differences between spot and forward exchange rates.
The document discusses interest rate parity and covered interest arbitrage. It provides definitions and explanations of these concepts. Specifically:
1) Interest rate parity is a condition where the interest rate differential between two countries equals the difference between the forward exchange rate and the spot exchange rate.
2) Covered interest arbitrage involves borrowing in the lower yielding currency, converting to the higher yielding currency, and hedging the exchange risk through a forward contract.
3) Market forces will eliminate opportunities for covered interest arbitrage by adjusting interest rates and exchange rates until parity is reached.
The document discusses several concepts related to foreign exchange rates:
1. Foreign exchange rates refer to the rate at which one currency is converted to another, or the price of one currency expressed in terms of another. There are two main markets - exchange traded and over-the-counter.
2. In over-the-counter markets, rates are indicative and bankers quote two rates: bid (buy) and ask (sell) rates. The difference between these rates generates profit.
3. Effective exchange rates measure the average value of a currency relative to multiple currencies, using weights based on trade significance. Comparing effective exchange rate indices shows real changes in a home currency's value.
4. Currency
The document discusses the valuation of foreign exchange forwards and energy derivatives from a fair value perspective. It begins by defining fair value and explaining the valuation building blocks used, such as discounting future cash flows using observable market inputs like yield curves. It then provides an example of valuing a currency forward contract between a US and Mexican company. Finally, it discusses some common challenges in valuation, like incorporating credit risk adjustments. The overall document focuses on explaining the methodology and concepts involved in determining the fair value of derivative contracts.
This document discusses foreign exchange concepts including forward premiums and discounts, forward contract settlement dates, and transaction exchange risk. It provides examples and explanations of how to calculate the annualized forward premium or discount given spot and forward rates. It also describes a foreign exchange swap transaction and the relationship between interest rates in the two currencies. Finally, it analyzes the transaction exchange risk faced by a company receiving payment in foreign currency in the future if it does not hedge, including the expected revenue and range capturing 95.45% of possibilities.
This document provides an overview of international finance concepts including:
1. Types of currency quotes (direct, indirect) and how to convert between them.
2. Types of exchange rates (bid, offer, spread).
3. How to determine the appropriate rate to use when exposed to foreign currency (bid for receivables, offer for payables).
4. How to calculate cross rates between currencies not directly quoted by using a common currency.
5. How forward contracts can be used to hedge and eliminate currency risk on foreign currency receivables and payables.
- The document discusses dual cryptocurrency systems where one cryptocurrency's price is pegged to an external asset like the US dollar, while the other cryptocurrency's price floats freely.
- It argues that comparing such systems to banks is misleading because in a bank, shareholders are legally obligated to liquidate assets to repay depositors if insolvent, while in a cryptocurrency system there is no such legal obligation.
- The document presents a model showing that under rational behavior, shareholders of a dual cryptocurrency system will only support maintaining the pegged cryptocurrency's price if it is in their economic self-interest to do so, and will let the peg fail otherwise rather than depleting tangible reserves.
International parity-conditions-9-feb-2010Nitesh Mandal
This document discusses several international parity conditions that can be used to predict foreign exchange rates:
1. Purchasing power parity (PPP) states that exchange rates should equalize price levels between countries based on a basket of goods.
2. The international Fisher effect (IFE) states that exchange rates adjust to equalize interest rate differentials between countries.
3. Interest rate parity (IRP) focuses on spot and forward exchange rates between countries' money and bond markets and establishes a break-even condition for returns.
4. Forward rates are expected to be an unbiased predictor of future spot rates according to the expectations theory of exchange rates.
These parity conditions are interrelated
Foreign Exchange market & international Parity Relationspalakurthiharika
The document discusses several key concepts related to foreign exchange markets and exchange rate determination. It describes the foreign exchange market as where individuals, firms, banks, and brokers buy and sell foreign currencies. Exchange rates are determined by the demand and supply of currencies based on factors like interest rates, inflation rates, purchasing power parity, and investor psychology. Theories like interest rate parity and purchasing power parity aim to explain exchange rate movements, though other short-term factors also influence rates.
Interest Rate Parity and Purchasing Power ParityMAJU
The document discusses interest rate parity (IRP) and purchasing power parity (PPP). IRP states that interest rate differences between countries equal the forward exchange rate minus the spot rate. PPP holds that currency exchange rates adjust so goods cost the same across countries when prices are converted to the same currency. Violations of IRP create arbitrage opportunities. Factors like inflation rates, economic conditions, and monetary policies influence IRP and PPP over time. Formulas are provided for calculating IRP and expected future exchange rates under PPP.
This document discusses exchange rate determination. It defines exchange rates as the price of one currency in terms of another. Exchange rates are determined by the forces of supply and demand in foreign exchange markets where currencies are bought and sold. The equilibrium exchange rate is the rate at which demand and supply for foreign currencies are equal. Demand for foreign currency arises from payments to foreign countries for imports and investments. Supply comes from exports, investments, and other receipts from abroad. Several factors can influence exchange rates, including relative inflation rates, interest rates, income levels, government controls, market expectations, speculation, and political/economic conditions.
Evolution of Interest Rate Curves since the Financial CrisisFrançois Choquet
This is a presentation given to Bloomberg end users working in front, middle and back offices in Dec. 2010. It highlights the financial crisis and the subsequent shift of financial instruments used to construct a valid interest rate curve. It outlines the methodology to build a reliable curve with Deposits, FRAs, Futures and Swaps and defines the validation principles.
Abstract: Until middle of 2007, yen carry trade was one of the lucrative options to the traders. Not only American dollar (USD) was high in terms of Japanese yen (JPY) during that time (June 18, 2007, 1 USD = 123.87 JPY) (see Fig 1), but significant differences of interest rates between US treasury and borrowing rate of Japan prompted traders to borrow Japanese currency with a relatively low interest rate and to use the funds to purchase a different currency (i.e. USD) yielding higher interest rate in order to make a significant amount of profit depending on the amount of leverage used. However, afterwards constant appreciation of JPY in terms of USD (December 4, 2009, 1 USD = 87.8 JYP) and reduction of US deposit interest rate has changed the scenario completely. As USD is depreciated in terms of other major currencies (Euro, Great Britain Pound etc.) in 2009 and deposit interest rate in some country (i.e Australia) is still higher than the borrowing rate of USA, traders now are encouraged in going for dollar carry trade instead of yen carry trade. This aspect is described at length in this report with the help of an excel based carry trade software named ‘samcarry’ (see appendix), which is developed by the author. Though major world currencies (Australian dollar, Euro, Japanese yen, Great Britain pound, American dollar) are used to make a comparison to understand which currency is beneficial for carry trade, Indian currency, rupees (INR) is also considered for this purpose.
This document provides a summary of useful formulas from a finance textbook. It includes formulas for interest rates, annuities, bonds, options, and other financial instruments. The document lists key terms, concepts, and formulas for topics such as compound interest, present value calculations, yield curves, duration, immunization strategies, and derivative pricing. It is intended as a handy reference sheet for students and practitioners of finance and investment management.
This document discusses discount factors and mark-to-market valuation of cross currency swaps. It begins by explaining how discount factors are derived from risk-free bonds and how rates like Libor and OIS are used as proxies. However, it notes that swap rates cannot be directly used as discount factors since they do not guarantee a fixed payment amount at maturity. The document then discusses how to model the cash flows of interest rate swaps and cross currency swaps, and how to calculate stochastic and implied swap rates to value them using mark-to-market approaches.
1) The document discusses constructing multiple swap curves to price financial products consistently with different swap markets, including those with and without collateral.
2) It explains how to construct swap curves for a single currency market based on interest rate swaps alone. It then expands this to incorporate cross-currency swaps by deriving separate discounting and index curves.
3) The method is further expanded to consistently incorporate basis spreads observed in tenor swaps between different tenors (e.g. 3-month and 6-month rates) into the construction of discounting and multiple index curves.
Determination of exchange rate chapter 6Nayan Vaghela
Determination of exchange rate, mint par theory, balance of payment theory, Purchasing power parity theory, Absolute version and relative version, Criticisms
The document provides information on various concepts related to foreign exchange markets including:
1) Direct and indirect quotes, bid and ask rates, spreads, converting between quote types, and spot and forward rates.
2) Factors that influence exchange rates such as inflation, interest rates, and balance of payments.
3) Arbitrage opportunities from price differences in different markets.
The purchasing power parity (PPP) theory compares the average costs of goods and services between countries using exchange rates. PPPs are useful for inter-country comparisons of GDP in real terms and economic data expressed in national currencies. PPPs are calculated at the product group level by comparing consumption baskets, then aggregated to GDP levels using weights. PPP exchange rates are meant to converge with actual exchange rates over the long run, though various factors can cause short-term deviations. PPPs are useful for output and productivity comparisons, while market exchange rates are better for trade-related analyses.
The document provides information on various concepts related to foreign exchange including:
1) Direct and indirect quotes, bid and ask rates, spreads, spot and forward rates, currency appreciation and depreciation.
2) It discusses arbitrage opportunities between different currency pairs in the spot and forward markets.
3) Examples are provided for calculating cross currency rates and identifying arbitrage opportunities using quotes from different markets.
The neoclassical theory of interest, or loanable funds theory, holds that the interest rate is determined by the supply and demand for loanable funds. The demand for loanable funds comes from investment, consumption/dissaving, and hoarding. The supply comes from savings, bank credit, dishoarding, and disinvestment. The interest rate reaches equilibrium when the total demand for loanable funds equals the total supply. Critics argue the theory assumes full employment, does not precisely determine the interest rate, and is impractical.
The document discusses several concepts related to international finance including:
1) Purchasing power parity, interest rate parity, and the Fisher effect which relate exchange rates, interest rates, and inflation rates between countries.
2) Arbitrage opportunities that can arise from differences in exchange rates quoted by different traders.
3) Conditions like the law of one price that must hold for arbitrage to exist.
4) Absolute and relative forms of purchasing power parity and limitations of the theory.
5) How interest rate parity explains differences between spot and forward exchange rates.
The document discusses interest rate parity and covered interest arbitrage. It provides definitions and explanations of these concepts. Specifically:
1) Interest rate parity is a condition where the interest rate differential between two countries equals the difference between the forward exchange rate and the spot exchange rate.
2) Covered interest arbitrage involves borrowing in the lower yielding currency, converting to the higher yielding currency, and hedging the exchange risk through a forward contract.
3) Market forces will eliminate opportunities for covered interest arbitrage by adjusting interest rates and exchange rates until parity is reached.
The document discusses several concepts related to foreign exchange rates:
1. Foreign exchange rates refer to the rate at which one currency is converted to another, or the price of one currency expressed in terms of another. There are two main markets - exchange traded and over-the-counter.
2. In over-the-counter markets, rates are indicative and bankers quote two rates: bid (buy) and ask (sell) rates. The difference between these rates generates profit.
3. Effective exchange rates measure the average value of a currency relative to multiple currencies, using weights based on trade significance. Comparing effective exchange rate indices shows real changes in a home currency's value.
4. Currency
The document discusses the valuation of foreign exchange forwards and energy derivatives from a fair value perspective. It begins by defining fair value and explaining the valuation building blocks used, such as discounting future cash flows using observable market inputs like yield curves. It then provides an example of valuing a currency forward contract between a US and Mexican company. Finally, it discusses some common challenges in valuation, like incorporating credit risk adjustments. The overall document focuses on explaining the methodology and concepts involved in determining the fair value of derivative contracts.
This document discusses foreign exchange concepts including forward premiums and discounts, forward contract settlement dates, and transaction exchange risk. It provides examples and explanations of how to calculate the annualized forward premium or discount given spot and forward rates. It also describes a foreign exchange swap transaction and the relationship between interest rates in the two currencies. Finally, it analyzes the transaction exchange risk faced by a company receiving payment in foreign currency in the future if it does not hedge, including the expected revenue and range capturing 95.45% of possibilities.
This document provides an overview of international finance concepts including:
1. Types of currency quotes (direct, indirect) and how to convert between them.
2. Types of exchange rates (bid, offer, spread).
3. How to determine the appropriate rate to use when exposed to foreign currency (bid for receivables, offer for payables).
4. How to calculate cross rates between currencies not directly quoted by using a common currency.
5. How forward contracts can be used to hedge and eliminate currency risk on foreign currency receivables and payables.
- The document discusses dual cryptocurrency systems where one cryptocurrency's price is pegged to an external asset like the US dollar, while the other cryptocurrency's price floats freely.
- It argues that comparing such systems to banks is misleading because in a bank, shareholders are legally obligated to liquidate assets to repay depositors if insolvent, while in a cryptocurrency system there is no such legal obligation.
- The document presents a model showing that under rational behavior, shareholders of a dual cryptocurrency system will only support maintaining the pegged cryptocurrency's price if it is in their economic self-interest to do so, and will let the peg fail otherwise rather than depleting tangible reserves.
International parity-conditions-9-feb-2010Nitesh Mandal
This document discusses several international parity conditions that can be used to predict foreign exchange rates:
1. Purchasing power parity (PPP) states that exchange rates should equalize price levels between countries based on a basket of goods.
2. The international Fisher effect (IFE) states that exchange rates adjust to equalize interest rate differentials between countries.
3. Interest rate parity (IRP) focuses on spot and forward exchange rates between countries' money and bond markets and establishes a break-even condition for returns.
4. Forward rates are expected to be an unbiased predictor of future spot rates according to the expectations theory of exchange rates.
These parity conditions are interrelated
Foreign Exchange market & international Parity Relationspalakurthiharika
The document discusses several key concepts related to foreign exchange markets and exchange rate determination. It describes the foreign exchange market as where individuals, firms, banks, and brokers buy and sell foreign currencies. Exchange rates are determined by the demand and supply of currencies based on factors like interest rates, inflation rates, purchasing power parity, and investor psychology. Theories like interest rate parity and purchasing power parity aim to explain exchange rate movements, though other short-term factors also influence rates.
Interest Rate Parity and Purchasing Power ParityMAJU
The document discusses interest rate parity (IRP) and purchasing power parity (PPP). IRP states that interest rate differences between countries equal the forward exchange rate minus the spot rate. PPP holds that currency exchange rates adjust so goods cost the same across countries when prices are converted to the same currency. Violations of IRP create arbitrage opportunities. Factors like inflation rates, economic conditions, and monetary policies influence IRP and PPP over time. Formulas are provided for calculating IRP and expected future exchange rates under PPP.
This document discusses exchange rate determination. It defines exchange rates as the price of one currency in terms of another. Exchange rates are determined by the forces of supply and demand in foreign exchange markets where currencies are bought and sold. The equilibrium exchange rate is the rate at which demand and supply for foreign currencies are equal. Demand for foreign currency arises from payments to foreign countries for imports and investments. Supply comes from exports, investments, and other receipts from abroad. Several factors can influence exchange rates, including relative inflation rates, interest rates, income levels, government controls, market expectations, speculation, and political/economic conditions.
Evolution of Interest Rate Curves since the Financial CrisisFrançois Choquet
This is a presentation given to Bloomberg end users working in front, middle and back offices in Dec. 2010. It highlights the financial crisis and the subsequent shift of financial instruments used to construct a valid interest rate curve. It outlines the methodology to build a reliable curve with Deposits, FRAs, Futures and Swaps and defines the validation principles.
Abstract: Until middle of 2007, yen carry trade was one of the lucrative options to the traders. Not only American dollar (USD) was high in terms of Japanese yen (JPY) during that time (June 18, 2007, 1 USD = 123.87 JPY) (see Fig 1), but significant differences of interest rates between US treasury and borrowing rate of Japan prompted traders to borrow Japanese currency with a relatively low interest rate and to use the funds to purchase a different currency (i.e. USD) yielding higher interest rate in order to make a significant amount of profit depending on the amount of leverage used. However, afterwards constant appreciation of JPY in terms of USD (December 4, 2009, 1 USD = 87.8 JYP) and reduction of US deposit interest rate has changed the scenario completely. As USD is depreciated in terms of other major currencies (Euro, Great Britain Pound etc.) in 2009 and deposit interest rate in some country (i.e Australia) is still higher than the borrowing rate of USA, traders now are encouraged in going for dollar carry trade instead of yen carry trade. This aspect is described at length in this report with the help of an excel based carry trade software named ‘samcarry’ (see appendix), which is developed by the author. Though major world currencies (Australian dollar, Euro, Japanese yen, Great Britain pound, American dollar) are used to make a comparison to understand which currency is beneficial for carry trade, Indian currency, rupees (INR) is also considered for this purpose.
This document provides a summary of useful formulas from a finance textbook. It includes formulas for interest rates, annuities, bonds, options, and other financial instruments. The document lists key terms, concepts, and formulas for topics such as compound interest, present value calculations, yield curves, duration, immunization strategies, and derivative pricing. It is intended as a handy reference sheet for students and practitioners of finance and investment management.
This document discusses discount factors and mark-to-market valuation of cross currency swaps. It begins by explaining how discount factors are derived from risk-free bonds and how rates like Libor and OIS are used as proxies. However, it notes that swap rates cannot be directly used as discount factors since they do not guarantee a fixed payment amount at maturity. The document then discusses how to model the cash flows of interest rate swaps and cross currency swaps, and how to calculate stochastic and implied swap rates to value them using mark-to-market approaches.
1) The document discusses constructing multiple swap curves to price financial products consistently with different swap markets, including those with and without collateral.
2) It explains how to construct swap curves for a single currency market based on interest rate swaps alone. It then expands this to incorporate cross-currency swaps by deriving separate discounting and index curves.
3) The method is further expanded to consistently incorporate basis spreads observed in tenor swaps between different tenors (e.g. 3-month and 6-month rates) into the construction of discounting and multiple index curves.
7_Analysing and Interpreting the Yield Curve.pptMurat Öztürkmen
The document discusses analysing and interpreting the yield curve. It covers the importance of the yield curve, constructing the curve from discount functions, theories like the expectations hypothesis and liquidity preference theory, the formal relationship between spot and forward rates, interpreting the shape of the curve, and fitting the curve from market data. Specifically, it notes the challenges of fitting the curve given a lack of liquid market data inputs and impact of bid-offer spreads, and recommends using a non-parametric interpolation method like the Svensson model to produce a smoother forward curve.
The document discusses key concepts related to the time value of money including compound interest, discounting, and annuities. It defines compound interest as interest earned on interest and explains how this allows an investment to grow faster over time compared to simple interest. Formulas are provided for calculating future and present values using different compounding periods. Annuities are introduced as insurance products that can provide a steady retirement income stream, with deferred annuities accumulating funds for later withdrawal and immediate annuities beginning payouts after the initial investment.
This chapter discusses mechanics, duration, and hedging strategies related to interest rate futures. It covers the mechanics of Treasury bond and note futures contracts, including delivery options that provide value to short positions. Eurodollar and Treasury bill futures are also discussed. Duration is introduced as a measure of how long, on average, a bondholder must wait to receive cash flows from a bond. The chapter derives the duration formula and provides an example calculation. It discusses limitations of duration related to assumptions of parallel yield curve shifts and ignores convexity for large shifts.
Basis risk refers to the mismatch in performance between a position hedged using a futures contract versus the underlying asset. The more dissimilar the hedged position and underlying asset are, the greater the basis risk. Factors like interest rates, yields, and the composition of a portfolio can cause the hedge to be imperfect, resulting in basis risk. Basis is the difference between the futures and spot price, and is impacted by costs like storage and interest rates. Unexpected changes in basis over the hedging period represent basis risk.
This document discusses exchange rate determination and the factors that influence exchange rates. It begins by defining exchange rates and how they are measured in terms of currency appreciation and depreciation. It then explains how the equilibrium exchange rate is determined by the demand and supply of a currency. Several factors are described as influencing exchange rates, including relative inflation rates, interest rates, income levels, and expectations about government policies. The sensitivity of exchange rates to these various factors depends on the volume of international trade and capital flows between countries. Speculators attempt to profit from anticipated exchange rate movements.
The document discusses several key concepts in finance including:
1) Finance involves allocating resources across time through borrowing, lending, and investing. Markets provide information to compare returns and risks of different investments.
2) Interest rates reflect the exchange between present and future resources, with higher rates translating to a steeper slope and greater future resources needed to exchange for present amounts.
3) Net present value, internal rate of return, and other concepts are used to evaluate investments based on discounted cash flows.
The document discusses several key concepts in finance including:
1) Finance involves allocating resources across time through borrowing, lending, and investing. Markets provide information to compare returns and risks of different investments.
2) Interest rates reflect the exchange between present and future resources, with higher rates translating to a steeper slope and greater future resources needed for a present amount.
3) Net present value, internal rate of return, and other concepts are used to evaluate investments based on discounted cash flows.
The document discusses forward volatility agreements (FVAs). It defines an FVA as a volatility swap contract where the buyer and seller agree to exchange a straddle option at a future date based on a specified volatility level. The key motivation for trading FVAs is that it allows investors to speculate on future volatility levels. The document provides details on pricing and hedging FVAs, including using volatility gadgets and forward start straddle options to isolate exposure to future local volatility.
bothSolutions.docx1 The Empirics of Purchasing Power Parity an.docxhartrobert670
both
Solution
s.docx
1 The Empirics of Purchasing Power Parity and
Exchange Rates
The foreign exchange intervention by the French government involves the sale of a
U.S. asset, the dollars it holds in the United States, and thus represents a debit item in
the U.S. financial account. The French citizens who buy the dollars may use them to
buy American goods, which would be an American current account credit, or an
American asset, which would be an American financial account credit
Suppose the company issuing the traveler’s check uses a checking account in France to
make payments. When this company pays the French restaurateur for the meal, its
payment represents a debit in the U.S. current account. The company issuing the
traveler’s check must sell assets (deplete its checking account in France) to make this
payment. This reduction in the French assets owned by that company represents a
credit in the American financial account.
2 The QQ-DD Model
The DD-curve in the Netherlands, a smaller and more open economy than the US, is atter than the DD-curve in the US because of the following QQ-DD diagram
3 Import Tariffs and the Current Account
output growth volatility tends to increase temporarily as an economy transitions from a steady-state with a low level of capital and high markups to a steady-state with high level of capital and low markups.
Equation can be written as CA = (Sp - I) + (T - G).
Higher U.S. barriers to imports
may have little or no impact upon private savings, investment, and the budget deficit.
If there were no effect on these variables then the current account would not improve
with the imposition of tariffs or quotas. It is possible to tell stories in which the effect
on the current account goes either way. For example, investment could rise in
industries protected by the tariff, worsening the current account. (Indeed, tariffs are
sometimes justified by the alleged need to give ailing industries a chance to modernize
their plant and equipment.) On the other hand, investment might fall in industries that
face a higher cost of imported intermediate goods as a result of the tariff. In general,
permanent and temporary tariffs have different effects. The point of the question is that
a prediction of the manner in which policies affect the current account requires a
general-equilibrium, macroeconomic analysis.
4 Monetary and Fiscal Policy under Different
Exchange Rate Regimes
Figure can be used to show that any permanent fiscal expansion worsens the
current account. In this diagram, the schedule XX represents combinations of the
exchange rate and income for which the current account is in balance. Points above and to the left of XX represent current account surplus and points below and to the
right represent current account deficit. A permanent fiscal expansion shifts the DD
curve to D'D' and, because of the effect on the long run exchange rate, the AA curve
shifts to A'A'. The equilibrium point moves from 0, where the current a ...
Week- 5 Interest Rates and Stock MarketMoney and Banking Econ .docxalanfhall8953
Week- 5 Interest Rates and Stock Market
Money and Banking Econ 311
Thursday 7 - 9:45
Instructor: Thomas L. Thomas
Response over Time to an Increase in Money Supply Growth
2
Risk Structure of Interest Rates
Bonds with the same maturity have different interest rates due to:
Default risk
Liquidity
Tax considerations
Long-Term Bond Yields, 1919–2011
Sources: Board of Governors of the Federal Reserve System, Banking and Monetary Statistics, 1941–1970; Federal Reserve; www.federalreserve.gov/releases/h15/data.htm.
4
Risk Structure of Interest Rates (cont’d)
Default risk: probability that the issuer of the bond is unable or unwilling to make interest payments or pay off the face value
U.S. Treasury bonds are considered default free (government can raise taxes).
Risk premium: the spread between the interest rates on bonds with default risk and the interest rates on (same maturity) Treasury bonds
5
Bond Ratings by Moody’s, Standard and Poor’s, and Fitch
6
Risk Structure of Interest Rates (cont’d)
Liquidity: the relative ease with which an asset can be converted into cash
Cost of selling a bond
Number of buyers/sellers in a bond market
Income tax considerations
Interest payments on municipal bonds are exempt from federal income taxes.
Term Structure of Interest Rates
Bonds with identical risk, liquidity, and tax characteristics may have different interest rates because the time remaining to maturity is different
Yield curve: a plot of the yield on bonds with differing terms to maturity but the same risk, liquidity and tax considerations
Upward-sloping: long-term rates are above
short-term rates
Flat: short- and long-term rates are the same
Inverted: long-term rates are below short-term rates
Facts that the Theory of the Term Structure of Interest Rates Must Explain
Interest rates on bonds of different maturities move together over time
When short-term interest rates are low, yield curves are more likely to have an upward slope; when short-term rates are high, yield curves are more likely to slope downward and be inverted
Yield curves almost always slope upward
9
Three Theories to Explain the Three Facts
Expectations theory explains the first two facts but not the third
Segmented markets theory explains fact three but not the first two
Liquidity premium theory combines the two theories to explain all three facts
10
Expectations Theory
The interest rate on a long-term bond will equal an average of the short-term interest rates that people expect to occur over the life of the long-term bond
Buyers of bonds do not prefer bonds of one maturity over another; they will not hold
any quantity of a bond if its expected return
is less than that of another bond with a different maturity
Bond holders consider bonds with different maturities to be perfect substitutes
11
Expectations Theory: Example
Let the c.
1) Interest rates can be represented by a term structure or yield curve that shows the relationship between interest rates and time to maturity. Hedging interest rate risk requires considering the entire term structure.
2) There are various types of interest rates including Treasury rates, LIBOR, overnight rates, repo rates, and swap rates that are used for different borrowing and lending activities between banks and institutions.
3) The overnight indexed swap (OIS) rate is now often used as the "risk-free" rate since the 2007-2008 financial crisis raised default concerns about other rates like LIBOR. OIS rates allow overnight borrowing/lending to be swapped for a fixed rate.
This document discusses interest rate parity theory. It begins by defining spot and forward rates. Spot rates are prices for immediate settlement, while forward rates refer to rates for future currency delivery adjusted for cost of carry. Interest rate parity theory states that interest rate differentials between currencies will be reflected in forward premiums or discounts. The theory prevents arbitrage opportunities by making returns equal whether investing domestically or abroad when measured in the home currency. The document provides an example of covered and uncovered interest rate parity. Covered parity involves hedging exchange rate risk while uncovered parity does not. Empirical evidence shows uncovered parity often fails while covered parity generally holds for major currencies over short time horizons.
Options Pricing The Black-Scholes ModelMore or .docxhallettfaustina
*
Options Pricing: The Black-Scholes ModelMore or less, the Black-Scholes (B-S) Model is really just a fancy extension of the Binomial Model.
(Fancy enough, however, to win a Nobel Prize…).
*
How B-S extends the Binomial Model1. Instead of assuming two possible states for future exchange rates, and thus returns (i.e., “up” and “down”), B-S assumes a continuous distribution of returns, R, so that returns can take on a whole range of values.
Binomial B-S
*
How B-S extends the Binomial ModelIn fact, exchange rate returns are approximately normally distributed, so this is a “reasonable” assumption:
*
How B-S extends the Binomial Model2. Instead of just one time period, B-S assumes multiple time periods and that the time between periods is instantaneous (i.e., continuous).
(See lecture)
Also, the time between periods t=0, t=1, t=2, etc. shrinks to zero, so that spot rate is changing at every instant.
*
How B-S extends the Binomial ModelThis is more realistic, since actual currency trades take place on a second-to-second, nearly continuous basis.
*
How B-S extends the Binomial ModelIt turns out that these two extensions are enough to make the math very hard. Thus, deriving the B-S model is no easy task.
The most important thing to recognize is that despite the above complications, the basic underlying approach of the B-S model remains the same…
*
How B-S extends the Binomial Model3. Create a replicating portfolio and price the option using a no-arbitrage argument.Calculate NS and NB: Now, since these are constantly changing over time, this process is called “dynamic hedging”.Replicating portfolio:It turns out that it is possible to use a combination of foreign currency and USD, and now in addition, options themselves, to form a riskless portfolio (i.e., return is known for sure).No-arbitrage: Riskless portfolios must have the same price as risk-free securities, otherwise arbitrage is possible. Use this fact to figure out c.
*
The Black-Scholes Options Pricing FormulaPutting the above all together, we get the Black-Scholes formula for pricing a European call option on foreign currency:
where
and S, X, T as before
r = domestic risk-free rate, r* = foreign risk-free rate
s = volatility of the foreign currency (sd of returns).
*
The Black-Scholes Options Pricing Formula
Also, N(x) = Prob that a random variable will be less than x under the standard normal distribution (i.e., cumulative distribution function).Calculate in EXCEL using “=NORMSDIST(x)”.
represents discounting when interest rates are continuously compounded, so basically it corresponds to:
)
(
)
(
2
1
*
d
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-
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.
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S
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u
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The document provides a basic overview of forward FX concepts including:
1) How zero coupon curves are built using overnight indexed swap (OIS) rates and futures contracts to extrapolate interest rates.
2) How bill futures and eurodollar contracts settle based on 3-month rates and can be thought of as forward-forward rates.
3) How "bootstrapping" uses cash rates and futures to build the 3-month zero coupon curve.
4) How OIS discounting is now preferred to value instruments given its risk-free nature under credit support annexes.
This document discusses yield curves and term structure theory. It defines key terms like yield curve, spot rates, and forward rates. The yield curve plots bond yields against maturity and typically slopes upward. Spot rates are zero-coupon bond yields, while forward rates are implied by the yield curve for rates in the future. The document also summarizes three theories that attempt to explain the shape of the yield curve: expectations theory, liquidity preference theory, and market segmentation theory.
Similar to Analysis of nubits custodial system (20)
A toxic combination of 15 years of low growth, and four decades of high inequality, has left Britain poorer and falling behind its peers. Productivity growth is weak and public investment is low, while wages today are no higher than they were before the financial crisis. Britain needs a new economic strategy to lift itself out of stagnation.
Scotland is in many ways a microcosm of this challenge. It has become a hub for creative industries, is home to several world-class universities and a thriving community of businesses – strengths that need to be harness and leveraged. But it also has high levels of deprivation, with homelessness reaching a record high and nearly half a million people living in very deep poverty last year. Scotland won’t be truly thriving unless it finds ways to ensure that all its inhabitants benefit from growth and investment. This is the central challenge facing policy makers both in Holyrood and Westminster.
What should a new national economic strategy for Scotland include? What would the pursuit of stronger economic growth mean for local, national and UK-wide policy makers? How will economic change affect the jobs we do, the places we live and the businesses we work for? And what are the prospects for cities like Glasgow, and nations like Scotland, in rising to these challenges?
An accounting information system (AIS) refers to tools and systems designed for the collection and display of accounting information so accountants and executives can make informed decisions.
South Dakota State University degree offer diploma Transcriptynfqplhm
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Economic Risk Factor Update: June 2024 [SlideShare]Commonwealth
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China’s official organizer of the Expo, CCPIT (China Council for the Promotion of International Trade https://en.ccpit.org/) has chosen Dr. Alyce Su as the Cover Person with Cover Story, in the Expo’s official magazine distributed throughout the Expo, showcasing China’s New Generation of Leaders to the World.
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1. Section 1: The Interest Rate Parity Condition
RUSD =
Et["t+1]
"t
(1 + RNB) (1)
Equation 1 shows the basic expression for the uncovered interest parity con-
dition. Economists use this equation to explain the relationship between interest
rates and current exchange rates. The uncovered interest parity condition is an
arbitrage condition for investment in risk-free assets. The basic form of the
equation focues on entirely on investment as a source of demand for currency
and also ignores risk. We will consider risk and alternative sources of demand
later in the document. Here, we just focus on an investor choosing between two
risk-free investment assets.
To understand the Equation 1, consider an investor who is deciding whether
to invest 1 USD in a USD-denominated bank deposit or invest 1 USD in nubits.
The investor plans to spend USD one year from now, so regardless of which
option he chooses, he will need USD in the future. The investor is assumed
to choose whichever option yields the highest expected return. If the investor
decides to choose USD, then he will receive 1+RUSD USD one year from now.
If the investor picks nubits, he will exchange his 1 USD for 1
"t
Nubits, where
"t is the current USD/Nubits exchange rate measured in terms of USD per
Nubit. He will then hold his 1
"t
Nubits for one year, yielding 1
"t
(1 + RNB). He
is not certain of what the exchange rate one year from now will be, but expects
that on average this exchange rate will be Et["t+1]. This expression, Et["t+1],
denotes the exhange rate investors making decisions at time t expect to obtain
one year from now at time t+1. Based on this expected exchange rate, an
investor choosing nubits will expect to obtain Et["t+1]
"t
(1 + RNB) USD when he
converts his 1
"t
(1 + RNB) nubits back into USD next year.
The investor chooses whichever option yields the highest return. Therefore,
if 1 + RUSD > Et["t+1]
"t
(1 + RNB), then USD yield a higher expected return
than nubits and the investor should choose the USD deposit. If 1 + RUSD <
Et["t+1]
"t
(1 + RNB), then Nubits yield a higher expected return and the investor
choose Nubits. As long as investors are free to choose between the two assets,
market forces will tend to equalize returns between the new assets, so that
1 + RUSD = Et["t+1]
"t
(1 + RNB). To see why, suppose that all investors prefer
USD to Nubits. If this is the case, then demand for USD will exceed supply
of USD at the current exchange rate "t. Demand for USD comes from people
seeking to sell nubits. Supply of USD comes from people seeking to buy nubits.
To match people seeking to sell nubits with people seeking to buy nubits, the
current exchange rate "t will have to fall, i.e. Nubits will have to depreciate. If
we examine Equation 1, we can see that a fall in "t increases the expected return
on investments in Nubits. Through this mechanism, the current exchange rate
adjusts to a level where If 1 + RUSD = Et["t+1]
"t
(1 + RNB). At this equilibirum
exchange rate, both investment strategies yield the same expected return and
investors are indierent between the two assets.
To highlight some key points, it is useful to rewrite Equation 1 as shown
1
2. in Equation 2. Here, I have just used algebra to rewrite Et[t+1]
t
(1 + RNB) as
RNB + Et[t+1]t
t
+ RNB
Et[t+1]t
t
:
RUSD = RNB +
Et[t+1] t
t
+ RNB
Et[t+1] t
t
(2)
The right-hand side of Equation 2 contains three additive terms. The
3. rst
term is the interest rate oered on nubits. All other things equal, an increase
in the interest rate on nubits will cause nubits to appreciate right now. That is,
if RNB increases, then t will have to rise in order for the equation to continue
to hold with equality. The second additive term,Et[t+1]t
t
is the expected
appreciation of nubits against the USD. If we expect nubits to appreciate over
time, we will be willing to invest in nubits even if they oer a lower interest
rate than USD deposits. The third additive term captures interactions between
the interest rate and expected appreciation. As long as the level of expected
appreciation (or depreciation) is small and the interest rate is low, the third
term tends to be very small in magnitude. To simplify things, the interest
parity condition is often approximated by dropping the third term as shown in
Equation 3. I will use this approximation in the remainder of the document.
Keep in mind that the approximation breaks down for very high interest rates
and very high levels of expected appreciation (or depreciation).
RUSD = RNB +
Et[t+1] t
t
(3)
Section 2: The Interest Rate Parity Condition under Fixed Ex-
change Rates
Taken literally, the uncovered interest parity condition says that exchange
rates will adjust instaneously. In practice, investors take some time to reallocate
their portfolios, so that we should not expect Equations 1,2, and 3 to obtain
instataneously, i.e. there may be some time delay before the exchange rate fully
responds to a movement in interest rates or shift in expectations. This time
delay is useful for thinking about
4. xed exchange rate regimes.
Consider a Nubits central bank that holds reserves of Nubits and USD in
a vault. The Nubits central bank promises to maintain a 1 to 1 exchange rate
perpetually. To back up this promise, the central bank oers to use its reserves
to trade Nubits and USD at the pegged exchange rate. If investors, expect the
central bank to keep this promise, then they will believe that Et[t+1] = t = 1:
If this is the case, expected appreciation is equal to 0 and investment decisions
are based entirely on whichever currency oers a higher nominal interest rate.
If Nubits oers a higher interest rate, then all investors will want to trade their
USD for nubits. Since anyone holding nubits will want to keep them, the only
party willing to satisfy this demand will be the central bank. Accordingly,
investors will take their USD to the central bank and trade them for Nubits.
The central bank will accumulate USD reserves and will release Nubits into
circulation.
2
5. Importantly, this process cannot be kept forever. The central bank can
earn some interest on its USD assets at a rate RUSD: However, the central
banks liabilities will grow at a faster rate, RNB: Eventually, the central bank's
liabilities will grow so large relative to its assets that investors will begin to
question the central bank's solvency. In particular, they will note that if a bank
run occurs, the central bank will not be able trade all outstanding nubits for USD
at a 1 to 1 exchange rate peg. This means that investors will begin to anticipate a
future devaluation of nubits. Rather than believing Et[t+1] = t = 1; they will
come to expect Et[t+1] t = 1. To avoid losses, they will want to withdraw
money from nubits now before the devaluation occurs. Referring to Equation
3, expectations of a devaluation drive down expected returns to investments in
nubits and encourage investors to
ee to USD. To stem the
ight from USD, the
central bank can increase the interest rate on nubits even further. Ultimatelly,
however, this just postpones the inevitable. If investors are con
6. dent that a
collapse will eventually occur, they will not view increases in the interest rate as
credible, i.e. any increase in the interest rate will be oset by an accompanying
decrease in Et[t+1]: I will elaborate on this issue further in a subsequent section
of the document.
Section 3: The Risk and Liquidity Premia
Equations 1,2, and 3 are not entirely satisfactory because they ignore issues
of risk and liquidity. In general, investors will demand an interest rate premium
on risky assets such as Nubits. To capture this interest rate premium, we modify
Equation 3 to incorporate a variable in Equation 4, . We refer to as the risk
premium on nubits. If is positive, then investors view USD as safer than
nubits and will only be willing to hold nubits if they oer a higher interest rate
than investments in USD.
RUSD + = RNB +
Et[t+1] t
t
(4)
If we look at Equation 4, the current willingness of investors to hold Nubits
would seem puzzling. Since Nubits currently trade at parity, investors cannot
expect a depreciation. Indeed, it is far more likely that investors believe a future
devaluation of nubits is a possible outcome. To state this more explicitly, let's
say that investors believe that Nubits parity will hold (t+1 = t) until next
year with probability (1-p) and that nubits value will drop to 0 (t+1 = 0) with
probability p. If this is the case, we can rewrite expectations of future exchange
rates as shown in Equation 5.
Et[t+1] = (1 p)t + p(0) = (1 p)t (5)
If we substitute Equation 5 into Equation 4, we get Equation 6.
RUSD + = RNB p (6)
Equation 6 is no more helpful in explaining demand for nubits. If investors
place some positive probability on a future devaluation, then nubits will need
3
7. to oer an even larger interest rate premia to convince investors to hold nubits
over USD deposits.
To explain demand for nubits, we need to introduce demand for currency as
a means of txns. Nubits allow for online exchanges that would be impossible
or much more dicult to perform using value held in USD bank accounts. To
incorporate this demand, we can introduce a liquidity premium that is a function
of the level of demand for nubits. This liquidity premium can be expected to
grow as the number of business accepting nubits increases and the reputation
of nubits as a stable unit of account improves. I denote this liquidity premium
as l(D), where D represents demand for Nubits txns, f is the level of txn fees,
and l(D; f; v) is the liquidity premium as a function of demand, txn fees, and
historical volatility of the nubits/USD exchange rate. The more demand for
Nubits txns, the higher the liquidity premium. The lower txn fees on nubits are,
the higher the liquidity premium. If nubits fail to hold to 1 to 1 peg with the
USD, then volatility will increase and nubits will lose their distinguish property.
This would cause the liquidity premium to become negative. In Equation 7, I
add the liquidity premium to Equation 6.
RUSD + = RNB p + l(D; f; vnubits) (7)
In Equation 7, the liquidity premia justi
8. es a positive demand for nubits
even though they are relatively risky and low-return asset. As demand for
nubits grows, one would expect the liquidity premium on nubits to increase as
well. In the long-run, this may lead to a situation where people are willing to
hold nubits even if they pay a negative interest rate or require txn fees. Both txn
fees and negative interest rates are potential mechanisms for generating revenue
from nubits that could be paid to holders of nushares.
Section 4: Application of Liquidity Premia to understand why
BitUSD consistently trade at a discount relative to USD and Nubits
BitUSD dier from nubits in that they are not backed by central bank inter-
vention. Or at least not explicitly. Unlike Nubits, the exchange rate on BitUSD
oats according to market demand. Historically, we have seen BitUSD consis-
tenty trading below USD parity. Our equation is eective in explaining this. In
Equation 8, I add the liquidity premium to Equation 4 to illustrate this point.
RUSD + = RBitUSD +
Et[t+1] t
t
+ +l(D; f; vbitUSD) (8)
Our goal here is to explain why the market price of bitUSD is consistently
below 1 USD. Speci
9. cally, why are people willing to purchase Nubits at par and
in larger volumes, while bitUSD trade at a discount and in smaller volumes.
The key point here is that the current exchange rate of bitUSD, t,
oats.
Because of these exchange rate movements, the liquidity premium on bitUSD
is likely much lower than that on Nubits. BitUSD are simply not that useful
as a means of exchange. Investors, however, may hope that this situation is
temporary, and that eventually bitUSD will stablize at parity. To capture this,
let's suppose that investors believe that t+1 = 1 with probablity 1-p and that
4
10. bitUSD will collapse to 0 with probability p, so that Et[t+1] = (1)(1p) = 1p:
If we substitute this into Equation 8, we get Equation 9.
RUSD + = RBitUSD +
(1 p) t
t
+ +l(D; f; vbitUSD) (9)
Examining this equation, let's suppose that the risk premium on bitUSD and
nubits are the same, and that the percieved probability of collapse of the two
systems is the same. We can also note that they both oer almost 0 interest,
so that interest rates are the same as well. Based on these assumptions, we
can substitute Equation 7 into Equation 9, cancel terms, and obtain Equation
10. In Equation 10, the exchange rate is the current price of nubits in terms of
USD.
p + l(D; f; vnubits) =
(1 p) t
t
+ +l(D; f; vbitUSD) (10)
Note that l(D; f; vnubits) l(D; f; vbitUSD) implies that we must have (1p)t
t
+
p = (1p)(1t)
t
0; which is only possible if t1. In other words, since bitUSD
are less useful for txn purposes than nubits but oer similar yields and expose
investors to similar risks, they must trade at a discount relative to both nubits
and USD. In order for bitUSD to reach USD parity, the bitUSD will have to
either use intervention to reduce volatility as in Nubits, or alternatively raise
interest rates to make investments in bitUSD more attractive. As discussed pre-
viously, the latter mechanism is costly and dicult to sustain for a prolonged
period. The upshot of this is that the use of an active stabilization mechanisms
gives Nubits a strong competitive advantage over bitUSD.
Section 5: Losing Control: The relationship between the level of
reserves, the risk premium, and the expected exchange rate
In section 2, I discussed how excessive accumulation of central bank liabilities
can lead to expectations of a devaluation and a collapse in the exchange rate.
Here, I model these ideas more formally by showing how the ratio of central bank
assets to liabilities aects the risk premium and the expected future exchange
rate.
To start o, let's consider assets and liabilities of the nubits central bank. I
show these in Table 1. Assets are for our purposes anything the central bank
can sell to holders of nubits to support the nubits price. I am going to suppose
that the nubits central bank has authority to issue nushares at will to repurchase
nubits, so that the USD market cap of nushares is one of these assets. The second
asset that the nubits central bank can use is USD held in trust by custodians.
These USD can also be used to repurchase nubits. Both types of repurchases
are referred to as open market operations in central bank speak.
Table 1
Central Bank Assets Central Bank Liabilities
USD Market Capitalization of Nushares Number of Outstanding Nubits
USD held in reserve by Custodians
5
11. Nushares and USD held in reserves are very dierent in character. Essen-
tially, as long as 1 USD is held in reserve for every nubit, there is no risk of a
collapse in the system. On the other hand, maintenance of a large USD reserve
is also unpro
12. table. To simplify things, I am going to net out USD reserves from
assets and describe central bank net liabilities as the nubits less USD reserves.
I incorporate this modi
13. cation in Table 2. [Note: We should keep in mind that
these USD could be stolen by an exchange or misappropriated by a custodian.
I ignore this risk in this document.]
Table 2
Central Bank Assets Central Bank Net Liabilities
USD Market Capitalization of Nushares Outstanding Nubits Net of USD Reserves
To capture these concepts, I am going to de
14. ne a ratio of assets to liabilities,
as the 'reserve ratio', s = USDMarketCapitalizationofNushares
OutstandingNubitsNetofUSDReserves :
Note here that a ratio of s=1 here would represent a highly unstable situa-
tion. If s=1, then any decline in the price of nushares would make it impossible
to repurchase all outstanding net liabiliites even if the central bank was to print
up an in
15. nite quantity of nushares. Moreover, since massive central bank sales
of nushares would greatly depress the USD price of nushares, it probably be
impossible to repurchase all outstanding net liabilities at a higher ratio as well,
such as s=2.
Now let's consider a much higher ratio, such as s=21. In this case, we can
imagine the central bank printing up nushares equal to 5% of the outstanding
quantity of nushares. At the initial market price of nushares, this would yield
21*0.05 = $1.05 of nushares for every net USD liabilitity. Printing of new
nushares issues equal to 5% of the outstanding volume would dilute existing
shares by 5% and lead to a nushares price drop of approximately 5%, provided
the sale conducted slowly. After adjusting for the price drop, printing these
nushares would yield enough revenue to purchase all outstanding net liabilities.
Accordingly, a very high reserve ratio such as s=21 could would ensure parity
of the USD.
Now that we've de
16. ned the reserve ratio, s. Let's consider incorporating how
we can incorporate it in Equation 7. The
17. rst place I think we can incorporate
it is in p, the market's percieved probability of a future collapse in the exchange
rate to 0. We can think of p as a function of s, p(s). The percieved probability
of collapse is also likely to increase in the interest rate, particularly when s is
low. To see why s matters for eects of changes in the interest rate, suppose
that s=100 and nubits decides to oer 100% annual interest. Even though this
is a very high interest rate, interest payments could be supported for a very
long time through sales of nushares. Therefore, the probability of collapse will
not be very sensitive to the interest rate when s is high. When s is low however,
high interest payments could shift the system into insolvency over a short time
scale. Therefore, you would expect p to be extremely sensitive to the interest
rate when s is low, e.g. say s=2. In mathmatical terms, we write the probability
of collapse p(RNB,s), as function of the interest rate RNB and the reserve ratio
s. The assumed behavior of this function is shown in Equation 11.
6
18. @p(RNB,s)
@s
0;
@p(RNB,s)
@RNB
0;
@d2p(RNB,s)
@RNB@s
0 (11)
The second place we can think of incorporating s, is in the risk premia, .
The risk premium essentially depends on the amount of risk of collapse, p. Risk
increases as p goes from 0 to 0.5, so for all practical purposes we can also think
of the risk premium as decreasing in s and increasing in RNB: We can write
the risk premium as (p((RNB; s))): In Equation 12, I substitute both of these
expressions into Equation 7.
RUSD + (p((RNB; s))) = RNB p(RNB; s) + l(D; f; vnubits) (12)
Equation 12 implies that an increase in the interest rate can actually de-
crease demand for nubits under certain circumstances. When the reserve ratio
s is very low, the perceived probability of collapse can be very sensitive to the
interest rate. Due to this sensitivity, an increase in the interest rate could cause
negative eects on expectations that outweigh the attraction of a higher interest
rate. On the other hand, an increase in the interest rate is most eective at
attracting investors to nubits when the reserve ratio s is very high. In this case,
investors do not need to fear near-term insolvency of the nubits system even if
a very high interest rate is oered.
Some Implications:
1) The system can degenerate into an unrecoverable state if the reserve ratio
falls to too low of a level. Interest rate changes become completely ineective
in this case.
2) Nubits should target an explicit healthy reserve ratio range. This is just
as important to Nubits viability as maintaining USD parity. In fact it can be
more important. A fall from USD parity would likely be a temporary situation.
Once the reserve ratio falls to an excessively low level, it could be very dicult
for nubits to recover.
3) Interest rates increases are most eective at supporting prices of nubits
when the reserve ratio is quite high. You might want to use interest rates to
oset a temporary shortfall in deman for nubits. Such a temporary shortfall
would not have much eect on the price of nushares, but could lead to pressure
for nubits to fall below parity. Interest rate increases are appropriate in this
case
4) Interest rates are also useful as a temporary incentive to get new users
to try out nubits. Provided the reserve ratio is high enough to support this. A
temporarily high level of interest on nubits might be a good means of expanding
the user base. For example, when paypal
19. rst formed they oered new users 10
USD for free to expand market share. Nubits could achieve this by oering new
users high interest rates as a temporary promotion. As long as high interest rates
are temporary and the reserve ratio is monitored carefully, such an incentive
would not compromise the sustainability of nubits.
I'm stopping here for now. Later, I will add to this to consider the role of
txn fee policy in maintaining a stable reserve ratio and a stable exchange rate.
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20. Before doing that, however, I want to get some comments on the document.
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