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Finance Exam (Balance of Payments
CA + KA + FA + RA = 0 (Influence on Int…
Finance Exam
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Trilemma
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(1)+(2) = China
(1)+(3) = EU, USA
(2)+(3) = Hong Kong
Currency Derivations
Transaction Exposure
Forward Contracts
Obligation to buy or sell, traded OTC, individual terms & conditions, default possible, asset delivery & settlement due date
Future Contracts
Oblugation to buy and sell, traded on Exchnages, standardized terms & conditions, clearing houses pay in case of default, daily resettlement
Option Contracts
Option, but not obligation, to buy (call) and sell (put) a given quantity of an asset in the future at prices agreed upon
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Parity Relationships
International Arbitrage
Locational Arbitrage
- Process of buying a currency at the location where it is priced cheap and immediatly selling it at another location where it is priced higher
Triangular Arbitrage
- Curreny transactions in the spot market to capitalize on discrepancies in the cross exchange rates between two currencies
(1. Use $ to buy pounds; 2. Use these pounds to buy Peso; 3. Use Peso to buy $)
Covered Interest Arbitrage
- Process of capitalization on the interest rate differential bewteen two countries while covering the exchange rate risk with a forward contract
Interest Rate Parity
The forward rate of one currency with respect to another will contain a premium (discount) that is determined by the differential in interest rates. As a result, covered interest arbitrage will provide a return that is not higher than domestic returns
Purchasing Power Parity
Absolute Form of PPP
Prices of the same basket of products in two countries should be equal in common currency
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Rational
Exchange rate adjustment is necessary for relative purchasing power to be the same whether buying goods locally or from another country
If the purchasing power is not equal, consumers would shift purchases of goods wherever products are cheaper until purchasing power is equal
Why PPP may not hold
- Confounding Effects (change in spot rates driven by more than the inflation differential btw. two countries
- No substitutes for traded goods
The spot rate of one currency with respect to another will change in reaction to the differential in inflation rates. Consequently, the purchasing power for consumers will be similar when buying goods local or in another country
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