This document discusses currency exchange rates and economic growth. It provides details on how exchange rates are determined between currencies, including factors that affect exchange rate spreads. It also outlines several economic theories related to what drives long-term economic growth, such as investment in physical and human capital, as well as productivity gains from technological development. Key growth accounting relationships are presented, linking output growth to contributions from capital deepening, increases in the labor force, and improvements in total factor productivity.

1. CURRENCY EXCHANGE RATES: Determination & Forecasting Economics
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 For the quote USD/EUR 1.4124 – 1.4128, the following applies:
o The bid price of one unit of EUR (base currency) in terms of USD (price currency) is 1.4124, while the
ask (offer) price is 1.4128, with a difference of 4 pips (one pip = 1/10,000).
o Down the ask & Divide rule (convert or sell the price currency and buy the base currency).
o Up the bid & Multiply rule (convert or sell the base currency and buy the price currency).
 FX Spread:
In the preceding quote the 4 pips identified as (Ask - Bid) is the FX spread, reflecting the dealer’s profit.
Spreads are narrower in the interbank market.
The spread quoted by the dealer depends on:
o The spread in the interbank market for the same currency pair.
o The size of the transaction: larger, liquidity demanding transactions have wider spreads.
o The relationship between the dealer and the client.
The interbank spread on a currency pair depends on:
o Currencies involved: the higher the volume, the lower spreads.
o Time of day: liquidity increases during the time overlap between New York and London markets
which decreases the spread.
o Market volatility: the higher the volatility, the higher the spread needed to compensate for risk.
Spreads in forward market increase with maturity to compensate for increased liquidity, credit, and interest
rate risk.
 Triangular arbitrage:
o The opportunity for triangular arbitrage profit arises when the quoted cross rate differs from the
implied one.
o Rules for Cross Rates:
[ ] [ ] [ ] [ ] [ ] [ ]
[ ]
[ ]
[ ]
[ ]
 Spot and forward rates:
Forward rate (all-in rate) F = Spot rate S0 (+) or (–) forward premium or discount respectively
Mark to market value of a forward contract: unwind the position in a new offsetting forward contract.
o At maturity: –
FPT = the forward price at maturity to sell base currency (up the bid)
FP = the all-in forward price at inception to buy the base currency (down the ask)
o Prior to maturity:
–
R is for the price currency
Currency of
concern
Overvalued
currency
Undervalued
currency
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2. CURRENCY EXCHANGE RATES: Determination & Forecasting Economics
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 Covered interest rate parity:
o For an investor to earn the same return in either currency, the forward premium or discount should
exactly offset the nominal interest rate differential. This relation is bound by arbitrage.
o For currency pair (A/B), [ ] (Follow the numerator-denominator rule)
o If parity doesn’t hold, there is an arbitrage opportunity. Supposing that currency B is overvalued:
 At spot: Borrow currency A at RA, and convert it to currency B.
 Invest the proceeds from currency B at RB.
 At maturity: Convert the currency B proceeds (principal + interest) back into currency A.
 Repay the loan and the remaining proceeds from currency A is the arbitrage profit.
 Uncovered interest rate parity:
o If forward currency contracts are not available or capital flows restricted the interest rate parity
might not hold.
o Expected spot rate (A/B) at time t = [ ] (Follow the numerator-denominator rule)
o Assumes the investor is risk-neutral, as no additional return is required to compensate for foreign
currency risk.
o The forward rate is unbiased predictor of the future spot rate. .
o Holds in the long-run to a significant extent, but not in the short-run.
 International fisher relation:
o Taking the Fisher relation and real interest rate parity (assuming free capital flows) together, gives
us the international Fisher effect: ,
meaning that nominal interest rate differentials should mirror inflation differentials.
 Purchasing Power Parity:
o The law of one price doesn’t hold in practice due to frictions such as tariffs and transportation costs.
o Absolute PPP: compares the average price of a representative basket of consumption goods
between countries.
o Relative PPP: [ ] (Follow the numerator-denominator rule)
Holds in the long-run to a significant extent, but not in the short-run.
o Ex-ante version of PPP: same as Relative PPP except using expected instead of actual inflation.
 Real exchange rate:
o Adjusting the exchange rate for inflation differentials between the two countries since a base year.
Real exchange rate (A/B) at time t [ ] (exception to the numerator-denominator rule)
o If relative PPP holds, the real exchange rate would be constant (the equilibrium real exchange rate).
However, since relative PPP rarely holds in short term, the real exchange rate fluctuates around this
long-term mean-reverting equilibrium value.
o Real exchange rate (A/B) = equilibrium rate + (real interest rateB – real interest rateA)
– (FX risk premiumB – FX risk premiumA)
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3. CURRENCY EXCHANGE RATES: Determination & Forecasting Economics
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 Balance of payments (BOP):
o Accounting method to keep track of transactions between a country and the rest of the world.
o The current account shows the net selling and buying of goods and services, the financial (capital)
account shows the net flow of funds, the official reserve usually doesn’t change significantly,
accordingly, for a current account deficit there should be a surplus in the capital account (otherwise,
local currency will depreciate).
o Capital flows tends to be the dominant factor over exchange rates in short term (more than goods
flows). Surplus of current or capital accounts leads to appreciation and vice versa.
o Current account influences:
 Flow mechanism:
Deficit leads to increased supply of the currency in the FX market, leading to depreciation.
This depreciation in turn encourages exports and makes imports costly, which could restore
the currency value depending on:
 The initial deficit.
 The influence of exchange rates on domestic import and export prices.
 Price elasticity of demand of the traded goods.
 Portfolio composition mechanism:
When investor countries decide to rebalance their investment portfolios, it can have a
significant negative impact on the value of the investee countries’ currencies.
 Debt sustainability mechanism:
Deficit is usually associated with borrowing from abroad (capital account surplus). When the
level of debt gets too high, investors may question its sustainability, leading to rapid
depreciation.
o Capital account influences:
 Capital flows into the country may be needed to overcome a shortage of savings to fund
investments needed for economic growth, this increases the demand for currency and leads
to appreciation.
 However, excessive flows might be problematic, especially for emerging markets, due to:
 Excessive real appreciation.
 Financial assets and/or real estate bubbles.
 Increases in external debt.
 Excessive consumption fueled by credit.
To overcome this threat, impose capital controls or directly intervene in the FX markets.
 Taylor Rule:
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4. CURRENCY EXCHANGE RATES: Determination & Forecasting Economics
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 Assessing the long-run fair value of an exchange rate:
Three complementary approaches are used by IMF:
o Macroeconomic balance approach:
Estimate required adjustment in exchange rate to equalize expected current account imbalance to
its sustainable level.
o External sustainability approach:
Estimate required adjustment in exchange rate to equalize external debt (asset) relative to GDP to
its sustainable level.
o Reduced-form econometric model approach: Based on patterns in key macroeconomic variables.
 FX carry trade:
o An investor invests in a higher yielding currency using funds borrowed from lower yielding currency
(funding currency), speculating that the uncovered interest rate parity will not hold.
o The return distribution of carry trade is not normal; it’s characterized by negative skewness and
excess kurtosis (fat tails), increasing the probability of a large loss (crash risk). This is caused by the
leverage in carry trade and that increased volatility may lead to herding behavior to exit the position
by selling the high yielding currency pushing its value further and exacerbating trader’s loss.
o Risk management in carry trades:
 Volatility filter: increase in implied volatility (options on currencies) ⟹ close the position
 Valuation filter: overweigh the undervalued currency based on valuation band (i.e. PPP).
 Mundell-Fleming model:
Evaluate the impact of monetary and fiscal policies on interest rates and consequently on exchange rates.
The model doesn’t account for inflation effects.
o Flexible exchange rate regimes:
Expansionary monetary will always depreciate the currency, through decreasing interest rates, and
thus, the capital flows into the country. Expansionary fiscal policy has two opposite effects;
increasing the real interest rates leading to appreciation, and deteriorating current account leading
to depreciation. The net effect depends on the level of restriction on capital flows as follows:
 High capital mobility (low capital restriction):
The impact of interest rates (financial flows effect) is dominant ⟹ expansionary fiscal
policy will lead to appreciation. Accordingly, under high capital mobility especially in
developed markets, monetary and fiscal policies will have opposite effects.
 Low Capital mobility (high capital restriction):
The impact of trade imbalance (goods flow effect) is dominant ⟹ expansionary fiscal policy
will lead to depreciation. Accordingly, under low capital mobility especially in emerging
markets, monetary and fiscal policies will have the same effect.
o Fixed exchange rate regimes:
Governments will keep exchange rates stable by buying (selling) its own currency in FX markets with
depreciation (appreciation).
 Monetary models:
Assuming the output is fixed; the monetary policy will primarily affect inflation which affects exchange rates.
o Pure monetary model: Assumes that PPP holds at any point expansionary monetary or fiscal policy
will increase inflation, hence, depreciate the currency and vice versa.
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5. CURRENCY EXCHANGE RATES: Determination & Forecasting Economics
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o Dornbusch overshooting model:
 Prices are sticky in the short term and, hence, don’t immediately reflect monetary policy.
 Expansionary monetary policy will decrease real interest rates and thus the capital flows,
leading to depreciation.
 In the short-term, as a result of a monetary policy decision, exchange rates overshoot the
long-run PPP implied value. (i.e. depreciation from expansionary monetary policy in greater
in the short-term and appreciates gradually toward the PPP value).
 Portfolio balance (Asset market) models:
Budget deficit, due to expansionary fiscal policy, is not sustainable in the long-run (with the increased
sovereign risk). Accordingly, if the Mundell-Fleming model, under high capital mobility, assumes that
expansionary fiscal policy will lead to appreciation in the short-term; in the long-term the government has
to reverse course through restrictive fiscal policy leading to depreciation, or otherwise, monetize it debt
leading also to depreciation through higher inflation.
 Central bank intervention and capital controls:
o Objectives:
 Ensure that the currency doesn’t appreciate excessively,
 Pursue an independent monetary policy (i.e. to curb inflation through restrictive policy
without fear from unwanted appreciation of the currency).
o Effectiveness depends on:
 Foreign exchange reserves relative to trading volume: makes emerging markets more
effective than developed markets.
 Persistence and size of capital flows: the higher; the ineffective are the capital controls.
 Warning signs of a currency crisis: (according to IMF)
o Terms of trade deteriorate.
o Dramatic decline in the official foreign reserves.
o Real exchange rate is substantially higher than the mean reverting level.
o Equity markets experience a boom-bust cycle.
o Inflation increases
o Nominal private credit grows.
 Technical analysis tools to forecast foreign exchange rates:
o Trend-following trading rules:
Such as moving average crossover trading rules, performs better in the less followed emerging
markets and can be used in combination with FX carry trade strategies to reduce downside risk.
o FX dealer order books:
Due to the fact that price and volume data are not immediately available in FX markets (unlike
equity market), a strong positive contemporaneous (not-lagged) correlation between order flow and
currency value has been observed.
o Currency options market:
Implied volatilities from FX options can give insight into the expected appreciation or depreciation.
Be cautious, as evidence shows that those indicators only confirms the trend (contemporaneous
relationship), without having a predictive power.
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6. ECONOMIC GROWTH & THE INVESTMENT DECISION Economics
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 Preconditions of growth:
1. Savings and investment
2. Financial markets and intermediaries
3. Political stability, rule of law, and property laws
4. Investment in human capital:
Developed countries: post-secondary education to foster innovation – developing countries: primary
and secondary to apply the technology developed elsewhere.
5. Tax and regulatory systems:
Lower levels of regulation foster entrepreneurial activity (startups), which is positively correlated to
the overall level of productivity.
6. Free trade and unrestricted capital flows
 Equity prices are positively related to earnings growth (whether caused by GDP growth or increase in
corporate earnings share of GDP), formulated as: ⁄⁄
Since, in the long term ⁄⁄ , the stock market growth rate equals potential GDP
(upper limit of real growth for an economy) growth rate.
 Potential GDP and investors:
Growth in potential GDP and the relation between actual vs. potential GDP have implications for both fixed
income and equity investors through the following:
o ↑ potential GDP growth⇒ ↑ current consumption⇒ ↑ real interest rates and required asset returns
o ↑ potential GDP growth⇒ ↑ credit quality ( credit risk)
o Actual GDP > Potential GDP ⇒ inflationary pressures⇒ restrictive monetary policy (↑ interest rates)
o Actual GDP < Potential GDP ⇒ fiscal deficit
 Factor inputs and economic growth:
o Cobb-Douglas production function:
 It exhibits constant returns to scale; increasing all inputs by a fixed percentage leads to the
same percentage increase in output.
 Dividing both sides by L, we get the output per worker (labor productivity)
Assuming the number of workers and α remain constant, increase in output can be gained
by increasing either capital per worker (capital deepening) or TFP (improving technology).
Since α < 1, additional capital has a diminishing effect on productivity. The lower the value
of α, the lower the benefit of capital deepening. (the case of developed markets which also
have high capital per worker).
 In steady state (equilibrium), the marginal product of capital (MPK = α Y/K) equals marginal
cost of capital (the rental price of capital) ⇒ α Y/K = r ⇒ α = r K/Y. Economies will increase
investment in capital as long as MPK > r, at the level of K/L for which MPK = r, capital
deepening stops and labor productivity becomes stagnant.
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7. ECONOMIC GROWTH & THE INVESTMENT DECISION Economics
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 Productivity curves:
Shows the positive relationship between (K/L) and (Y/L) which also exhibits diminishing
marginal productivity of capital (upward concave curve). Technological progress shifts the
productivity curve upward and will lead to increased productivity at all levels of capital per
worker.
 Growth accounting relations:
o Using the Cobb-Douglas production function, the growth in potential GDP can be expressed using
the growth accounting relation as:
o Labor productivity growth accounting equation:
ΔY/Y = long-term growth rate of labor force + long-term growth rate in labor productivity
The growth in labor productivity reflects both capital deepening and technological progress.
 Factors affecting economic growth:
o Natural resources:
 The role of natural resources in economic growth is complex.
 Limited natural resources doesn’t necessarily constrain growth, as access to resources
doesn’t require ownership, instead, trade is an alternative.
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8. ECONOMIC GROWTH & THE INVESTMENT DECISION Economics
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 Ownership of natural resources may actually inhibit growth, as a country rich in natural
resources may focus on recovering those resources rather than developing other industries.
Also, the “Dutch disease” refers to a situation where global demand for a country’s natural
resources leads to currency appreciation, which renders domestic industries uncompetitive
in global markets.
o Labor:
Quantity of Labor = Labor force * Average hours worked. Labor force is the number of working age
people available to work, both employed and unemployed.
Labor supply factors:
 Demographics: Aging population and low fertility rates poses a challenge on growth.
 Labor force participation: Labor force / working age population. ↑ as women participate.
 Immigration.
 Average hours worked: on a downward trend due to legislation and wealth effect.
o Investment in growth factors:
 Human capital: a qualitative measure of labor force; leads to innovation.
 Physical capital: could increase technological progress and thus TFP.
 Technological development:proxies include spending on R&D and number of patents issued
 Public infrastructure: complements private investment and increases TFP.
 Theories of economic growth:
o Classical growth theory:
 Based on Malthusian economics, growth in real GDP per capita is not permanent, as when it
rises above the subsistence level, a population explosion occurs which leads to diminishing
marginal returns to labor driving GDP per capita back to its subsistence level. This prevents
long-term growth in per capita income.
 Not supported by empirical evidence.
o Neoclassical growth theory:
Based on the Cobb-Douglas function:
 Sustainable growth rate of output per capita (or productivity (output per worker)) =
growth rate in technology / labor’ share of GDP
 Sustainable growth rate of output =
sustainable growth rate of output per capita + growth of labor
 Capital deepening affects the level of output but not the growth rate once steady state is
achieved, if there is no technological progress.
 In the steady state, MPK (α Y/K) is constant, but marginal productivity is diminishing.
 An increase in savings will raise economic growth on a temporarily basis. However, countries
with higher saving rates will enjoy higher (K/L) and (Y/L) ratios.
 Developing countries will be impacted less by the diminishing marginal productivity of
capital, and hence have higher growth rates which will eventually converge its GDP per
capita towards developed countries level.
o Endogenous growth theory:
There is no steady state growth rate, as:
 Capital investment (R&D) may lead to technological progress, in contrast to the neoclassical
theory assumes that capital investment will expand as technology improves.
 Returns to capital are constant ⇒ increase in savings will permanently increase the growth
rate.
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9. ECONOMIC GROWTH & THE INVESTMENT DECISION Economics
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 Convergence hypotheses:
o Absolute convergence: less developed countries will achieve equal living standards (GDP per capita)
over time.
o Conditional convergence: convergence will occur for countries with the same saving rates,
population growth rates, and production functions.
o Club convergence: poorer countries that are part of the club will grow rapidly to catch up with their
richer peers. Countries can join the club by making appropriate institutional changes.
o Empirical evidence support convergence hypothesis.
 Rationale for governments to subsidize private R&D:
According to endogenous growth theory; government incentives that effectively subsidize R&D investments
for their social returns (externalities), can theoretically increase private spending on R&D to its optimal level.
 Free trade and capital flows impact:
o Convergence speeds up as long as countries follow out-ward oriented policies of integrating their
industries with the world economy and increasing exports.
o The neoclassical model supports convergence with open markets through increased capital flow to
less developed countries, while endogenous theory support the same conclusion through increased
innovation.
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10. ECONOMICS OF REGULATION Economics
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 Regulations can be classified as:
o Statutes: laws made by legislative bodies.
o Administrative regulations: rules issued by governmental agencies or other bodies authorized by
the government
o Judicial law: findings of the court
 Regulators:
o Government agencies.
o Independent regulators:
 Recognized by government agencies and have power to make and enforce rules, usually
they are not funded by the government and hence politically independent.
 Either Self Regulating Organizations (SROs), or non-SROs (e.g. Public Company Accounting
Oversight Board (PCAOB). Noting that, not all SROs are independent regulators.
 Independent SROs are common in common-law countries (e.g. UK and US); such
organizations are not common in civil-law countries.
o Outside bodies: not regulators themselves, but their product is referenced by regulators (e.g. FASB,
IASB)
 Economic rationale for regulation: needed in the presence of:
o Informational frictions (information asymmetry): to ensure fair treatment.
o Externalities: related to consumption of public goods, to ensure optimal production level.
 Regulatory interdependencies:
o Regulatory capture theory: eventually, a regulatory body will be influenced or even controlled by
the regulated.
o Regulatory competition: regulators compete to provide the most business-friendly environment.
o Regulatory arbitrage: shop for a country that allows a specific behavior, or exploit the difference
between economic substance and interpretation of a regulation. Accordingly, a cohesive regulatory
framework is needed, which is challenged by the conflict between the objectives of different
regulatory bodies (i.e. fuel efficiency vs. driving safety).
 Tools of regulatory intervention:
o Price mechanisms: through taxes and subsidies.
o Restricting/requiring certain activities.
o Provision of public goods or financing of private projects.
The effectiveness of regulatory tools depends on the enforcement abilities (e.g. sanctioning the
violators). The enforcement should comply with the regulation objective by not hurting unintended
parties.
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11. ECONOMICS OF REGULATION Economics
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 Commerce and financial market regulation:
o Commerce: provide a framework to facilitate decision making (e.g. tax laws, competition laws,
bankruptcy laws, banking laws).
o Financial markets:
 Financial institutions: to prevent failure of the financial system though prudential
supervision. Hidden costs should be taken into regulators account, for example, FDIC
insurance for banks could lead to excessive risk-taking behavior (a moral hazard problem).
 Security markets: ensure integrity of capital markets to protect investors and create
confidence through:
 Disclosure requirements.
 Impose fiduciary duties to mitigate agency problems.
 Protect small (retail) investors; hence the lax regulation for hedge funds (qualified
investors).
 Antitrust regulation:
Promote domestic competition by monitoring and restricting activities that reduce or distort competition
(anticompetitive behavior such as discriminatory pricing, bundling, and exclusive dealing) or block a merger
that leads to excessive concentration risk.
 Cost-benefit analysis of regulation:
o Regulatory (government) burden: the cost of compliance for the regulated entity. Regulatory
burden minus private benefits equals net regulatory burden.
o Regulators costs are difficult to quantify or measure ex-ante. For this reason, many regulatory
provisions include a “sunset clause” that requires regulators to revisit the cost-benefit analysis
based on actual outcomes before renewing the regulation.
 Regulation and company evaluation:
o Regulation can help an industry (through subsidies) or hinder its activities (through taxes).
o Regulations are not always costly for the regulated (e.g. in presence of regulatory capture).
o Regulations may introduce inefficiencies in the market (e.g. bailouts).
o Some regulations may especially apply for certain sectors (e.g. environment laws for mining, oil&gas
sectors, and labor law for labor intensive industries).
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