2005 CFA ® REVIEW PROGRAM Offered by SASF Class Notes Level I Date of Class: May 9, 2005 Instructor: John Veitch, Ph.D., CFA Phone: (415) 422-6271 Email: veitchj@usfca.edu Topic: Investment Tools – Global Economic Analysis CFA Institute Study Session(s): 6 Slides used in class available on my website - www.usfca.edu/economics/veitch/ Security Analysts of San Francisco The CFA Institute does not endorse, promote, review or warrant the accuracy of the products or services offered by SASF or the verify pass rates claimed by SASF. CFA  and Chartered Financial Analyst  are a licensed trademarks owned by CFA Institute. 1 CFA Level I - Study Session 6 1. A. “Gaining from International Trade” The candidate should be able to: a. state the conditions under which a nation can gain from international trade; Nations can gain from trade if they produce goods in which they have a comparative advantage and trade for goods in which they have a comparative disadvantage. • Comparative Advantage is the ability to produce a good at a lower opportunity cost than others can produce it. • As long as the relative costs of production differ across nations, gains from specialization and trade will be possible. When nations produce and trade based on Comparative Advantage trade between nations leads to an expansion in total world output and mutual gains to each nation. b. discuss the effects of international trade on domestic supply and demand; When product can be transported long distances at low cost (relative to its value) then domestic price of the product is determined by world demand and supply Trade & specialization thus results in: 1. Lower prices and higher domestic consumption for imported products. • Domestic Consumers benefit from trade 2. Higher prices and higher domestic production for exported goods. • Domestic Producers benefit from trade. c. describe commonly used trade-restricting devices including tariffs, quotas, voluntary export restraints, and exchange-rate controls; Commonly used trade-restricting policies are: I. Import Tariff – are a tax on goods and services imported into the country. II. Import Quota – puts an upper limit on the amount of a good or service that is allowed to be imported into the country. III. Voluntary Export Restriction (VER) – an agreement by foreign firms to limit the amount of a good or service they will export into the country IV. Exchange Rate Controls – when the government either sets the exchange rate at a rate above the market rate or it limits the access to foreign currency by its citizens. Effect is to make imports into the country more expensive and reduce trade. d. explain the impact of trade barriers on the domestic economy and identify who benefits and loses from the imposition of a tariff; Trade restrictions promote inefficiency and reduce the potential gains from trade for the domestic economy. Thus trade restrictions are harmful to the wealth of the economy. Tariff is a tax levied on imports, has following effects: 2 i) Domestic Price rises by amount of tariff. ii) Reduction in the quantity of imports of the good. iii) Loss of consumer surplus as less of good consumed at higher price. iv) Gain of producer surplus as domestic production increases. v) Government revenue increases from tariff revenues. vi) Net Deadweight loss to society. Effects of an import quota are similar to those of a tariff but involve a larger deadweight loss because it generates NO revenue for the government as a result of the quota. e. explain why nations adopt trade restrictions; • Power of Special Interests : Trade restrictions provide concentrated benefit to small groups while imposing widely-dispersed costs on majority of nation. Thus politicians often have the incentive to favor trade restrictions even though they hurt economic efficiency. • Economic Illiteracy: Many fallacies associated with arguments for trade barriers. (1) Trade restrictions that limit imports save jobs for Americans. (2) Free trade with low wage countries will reduce the wages of Americans. Both statements are untrue and ignore the effects of trade based on comparative advantage on the welfare of the nation as a whole and the effects of specialization in what we are comparatively good at on our standard of living. f. discuss the validity of the arguments for restrictions. Trade barriers are generally harmful to level and growth of economic well-being in a country, with the following exceptions: Partially Valid Economic Arguments i) National Defense: Certain industries “vital”, must be protected. • Argument has some validity but often abused as relatively few industries are truly vital to our national defense. ii) Infant Industry: New industries “need protection” until established. • Argument is valid as stated but generally abused. More often used to cushion industries from international competition rather than provide temporary shelter while they become internationally competitive. iii) Anti-Dumping: Domestic producers “need protection” from foreign suppliers selling products below cost (dumping). • Often considerable ambiguity about whether true dumping is occurring or not. Dumping aimed at eliminated domestic competitors should be met with tariffs. Other types of dumping should not be met with tariffs but other policies, such as income supplements to affected industries. 3 2. A. “Foreign Exchange” **** New Text and Changed LOS for 2004 The candidate should be able to a) define direct and indirect methods of foreign exchange quotations; Direct Method: (Domestic on top) • # units of home currency per unit of foreign currency ($0.01 US$/Yen) Indirect Method: (International on top) • # units of foreign currency per unit of home currency (100 Yen/US$) One method is simply the inverse of the other. b) calculate the spread on a foreign currency quotation; Bid or Buy rate: Exchange rate at which agent (the bank) will buy a currency. Ask or Sell rate: Exchange rate at which agent (the bank) will sell a currency. [ ] Ask Rate - Bid Rate Bid-Ask Spread= 100 Ask Rate × c) explain how spreads on foreign currency quotations can differ as a result of market conditions, bank/dealer positions, and trading volume; Anything that increases the dealer’s risk of holding the foreign currency will increase the Bid- Ask spread. • Increased volatility in spot market conditions or lack of spot market liquidity. • Bank/dealer positions are more likely to influence the midpoint exchange rate quote [ = (bid+ask)/2 ] than the size of the bid-ask spread for a currency. d) convert direct (indirect) foreign exchange quotations into indirect (direct) foreign exchange quotations; • When there is NO Bid-Ask spread o 1 Direct Exchange Rate = Indirect Exchange Rate • When there is a Bid-Ask Spread o 1 Direct ASK Exchange Rate = Indirect BID Exchange Rate • Rate to sell domestic currency equals the reciprocal of the rate to buy the foreign currency. o 1 Direct BID Exchange Rate = Indirect ASK Exchange Rate • Rate to buy domestic currency equals the reciprocal of the rate to sell the foreign currency. 4 e) calculate currency cross rates, given two spot exchange quotations involving three currencies; Please see my slides for what I think is a better way to do this. The following is a summary of the book’s approach which I think is confusing. Let FC 1 and FC 2 be the two foreign currencies for which the cross-rate is desired. Let DC be the vehicle currency against which each foreign currency is quoted. The vehicle currency is generally the US dollar (USD). I will take FC 1 = Japanese Yen (¥) and FC 2 = Euros (€) for concreteness below. Cross – Ask 1 1 2 2 ask ask ask FC FC DC = FC DC FC        ÷  ÷  ÷       or ( ) ( ) ( ) ask ask ask USD ¥ ¥ = € USD € Cross – Bid 1 1 2 2 bid bid bid FC FC DC = FC DC FC        ÷  ÷  ÷       or ( ) ( ) ( ) bid bid bid USD ¥ ¥ = € USD € The nice thing about the above is that to calculate a cross - ask (bid) you use ask (bid) rates. The confusing thing is that one is quoted as indirect and the other is quoted as direct. As long as you keep the units straight I guess you’ll be ok. If you don’t like this approach, go to my slides. Everything there is quoted in DIRECT terms and the formulas are laid out with only Direct quoted exchange rates. f) distinguish between the spot and forward markets for foreign exchange; Spot market: Currencies traded for immediate delivery. Forward Market: Trade contracts to buy or sell a specified amount of currency at a specified future date at the specified forward exchange rate. Forward contracts are customized to customer needs in contrast to futures contracts which have fixed sizes and maturity dates. 5 g) calculate the spread on a forward foreign currency quotation; The calculation is identical to the one performed earlier for the spot exchange rate. Make sure that the Bid and the Ask rates are for the same forward delivery date in a question. The spread does not apply across Bid and Ask on different forward delivery dates. [ ] Ask Rate - Bid Rate Bid-Ask Spread= 100 Ask Rate × h) explain how spreads on forward foreign currency quotations can differ as a result of market conditions, bank/dealer positions, trading volume, and maturity/length of contract; All the same considerations that determine spreads in the spot FX market affect the spread in the forward FX market. In the forward market, however, an additional source of risk is the length of the forward contract – the longer the maturity of the forward contract the higher is the spread on the contract due to increased bank/dealer risk. i) calculate a forward discount or premium and express either as an annualized rate; Forward foreign exchange contract: • Calls for delivery, at a fixed future date, of a specified amount of one currency against US$ payment. Exchange rate fixed by the forward contract is called the forward rate or the outright rate. Swap Rate: • Difference between forward rate and current spot rate is the swap rate. There is a forward premium if the forward rate quoted in dollars is above the spot rate. There is a forward discount if forward rate is below the current spot rate. Annualized forward premium or discount to current spot rate adjusts % difference between forward and spot rate for length of forward contract: Forward Premium Forward Rate - Spot Rate 360 or Discount Spot Rate # days in Forward Contract = × Forward Premium Calculation F 1-year = Cdn$ 1.3216/US$ S 0 = Cdn$ 1.3078/US$ [ ] ( ) ( ) 0 0 360 1.3216 1.3078 .0105 1.3078 360 − − ≅ × = = F S E s S The Canadian $ is at a premium to the US$ on the 1-year forward. Thus the US$ is expected to strengthen slightly (1.05%) over the period. From Financial Times January 27, 2004. j) explain covered interest rate parity; Interest rate parity theory ensures that return on a hedged foreign exchange rate position over a certain period of time is just equal to the domestic interest rate on an investment of identical risk over the same period of time. If the returns on the two positions are not identical then an arbitrage opportunity exists, and capital will flow to take advantage of the mispricing of the forward rate. 6 k) illustrate covered interest arbitrage. Strategy 1: Domestic Investment – • Invest in home gov’t bond yielding nominal interest rate, r DC . o Return in DC is = (1 + r DC ) Strategy 2: Hedged Foreign Investment – • Convert DC to FC at current indirect exchange rate, S 0 ; invest in Foreign government bond yielding r FC for given period; convert proceeds back to DC at current forward rate, F 1 . o Return in HC is = (1 + r FC )S 0 /F 1 Riskless Arbitrage Profits available if (1 + r DC ) ≠ (1 + r FC )S 0 /F 1 : How to take advantage of this mispricing? Look at the returns above. ALWAYS BORROW LOW AND LEND HIGH!!!!! (1) If (1 + r DC ) < (1 + r FC ) S 0 /F 1 • borrow in Domestic currency, lend (hedged foreign investment) in Foreign currency. (2) If (1 + r DC ) > (1 + r FC ) S 0 /F 1 • borrow in Foreign currency (hedged foreign borrowing), lend Domestic currency. Be careful! The interest rates must match the forward contract in duration! 2. B. “Foreign Exchange Parity Relations” 7 The candidate should be able to: a. explain how exchange rates are determined in a flexible or floating exchange rate system; Demand for foreign currency from domestic individuals buying goods, services, or assets from ROW. Supply of foreign currency from foreign individuals buying goods, services, or assets in domestic economy. Equilibrium Flexible Exchange Rate System: Demand and supply for foreign currency determine exchange rate (value of foreign currency in terms of domestic currency). Fixed Exchange Rate System: Gov’t sets exchange rate and then fixes this level by intervening to buy or sell foreign currency depending on demand/supply at the fixed rate. b. explain the role of each component of the balance-of-payments accounts; Balance of Payments = Current Account + Capital Account i) Current Account • Merchandise Trade Balance = Exports of goods – Imports of Goods • Balance on Services = Export of Services – Imports of Services • Income from Investments = Net Income from – to foreigners • Unilateral Transfers = Net Gifts from – to foreigners • Balance on Current Account = Sum of items 1. – 5. ii) Capital Account • Net changes in ownership of assets to – from foreigners iii) Official Reserve Account • Official Reserve Assets held in form of foreign currencies, gold, and Special Drawing Rights (SDR’s) held at IMF. c. explain how current-account deficits or surpluses and financial account deficits or surpluses affect an economy. Current Account balance reflects primarily trade in goods & services. Current account deficit means nation is buying more goods & services from the Rest of the World than the Rest of the World is buying from it. • Current Account Deficit must be financed, • For a Current Account Deficit to be sustained in over some period of time it must be accompanied by an offsetting Financial Account Surplus, i.e. capital flowing into the country from the Rest of the World – think the United States. • For a Current Account Surplus to be sustained in over some period of time it must be accompanied by an offsetting Financial Account Deficit, i.e. capital flowing out of the country to the Rest of the World – think Japan . • Be careful about causality. Current Account Deficits may cause capital inflows (Financial Account Surpluses) OR capital inflows may cause current account deficits. The latter is likely true for the U.S. in recent years. 8 If nation is running a Current Account Deficit but has no offsetting Financial Account Surplus, then its currency will fall in value against the Rest of the World. - A trade deficit will reduce the country’s international reserves. - This should lead to depreciation in the value of the local currency as the government will be unable to support its currency in the FX market as its international reserves dwindle. - This depreciation makes the country’s goods and services cheaper to the rest of world. This will increase the country’s exports. - Depreciation makes imported goods more expensive reducing imports also. - Net result is an increase in the trade balance until the trade deficit is reversed. d. describe the factors that cause a nation’s currency to appreciate or depreciate; Factors causing Nation’s Currency to Appreciate (Strengthen) i) Slow growth of domestic income relative to trading partners causes exports to increase more than imports. (decrease in Demand for FX) ii) Inflation rate lower than trading partner’s will cause foreign goods to become expensive. (Demand for FX falls, Supply of FX rises) As result foreign currency weakens, its goods become competitive. iii) Domestic real interest rates higher than trading partners will attract inflows of foreign capital, increasing demand for domestic currency. (Demand for FX falls, Supply of FX rises) Factors causing Nation’s Currency to Depreciate (Weaken) i) Opposite of the factors above for appreciation of domestic currency. e. explain how monetary and fiscal policies affect the exchange rate and balance-of-payments components; Monetary Policy Expansionary Restrictive Real Interest rates Decline Rise Exchange Rate Depreciates Appreciates Flow of Capital Outflow Inflow Current Account Move to surplus Move to deficit Fiscal Policy Expansionary Restrictive Real Interest rates Rise Decline Exchange Rate Uncertain but Uncertain but likely appreciate likely depreciate Flow of Capital Inflow Outflow Current Account Move to deficit Move to surplus f. describe a fixed exchange rate and a pegged exchange rate system. Fixed Exchange Rate System: • When a nation absolutely fixes its exchange rate between its own currency and the currency of another country or region. 9 o Example: Countries such as Hong Kong that have a currency board that exchanges HK$ for US$ at a fixed rate. Pegged Exchange Rate System: • When a nation sets a desired level and bands around that level for the exchange rate between its currency and the currency of another country or region. • Key difference between a fixed exchange rate regime and a pegged exchange rate regime is that in a pegged system the nation’s exchange rate can vary within the bands without central bank intervention. o Example: Many European countries prior to the euro belonged to the Exchange Rate Mechanism (ERM). Each nation in the ERM set its exchange rate with the Deutschemark (DM) but allowed their exchange with DM to fluctuate within established bands. g) discuss absolute purchasing power parity and relative purchasing power parity; Absolute Purchasing Power Parity (PPP): - Basic idea is the “Law of One Price”, i.e. the real price of a good should be the same in all countries at any point in time otherwise arbitrage opportunities exist through trade. - Absolute PPP relates overall price indexes for two countries to the level of the nominal exchange rate. ● P DC = Price level for the domestic country ● P FC = Price level for the foreign country ● S = Spot Exchange rate between DC and FC in FC/DC units - Let S be the INDIRECT quoted exchange rate. Then the Absolute PPP relationship is then written as FC DC P S P = . Relative Purchasing Power Parity (PPP): - Focuses on the general relationship between inflation rates in two countries and the movements in the exchange rate necessary to offset the effects of differential inflation on goods prices. - Relative PPP relates overall inflation rates in two countries and changes in the nominal exchange rate. ● I DC = Inflation Rate for the domestic country ● I FC = Inflation rate for the foreign country ● S 0 = Spot Exchange rate at beginning of year between DC and FC in DC/FC units ● S 1 = Spot Exchange rate at end of year between DC and FC in FC/DC units - Relative PPP relationship is then written as ( ) ( ) 1 0 1 1 FC DC I S S I + = + . - Relative PPP calculation can also be adjusted for more than one year periods. ● I DC = Average Annual Inflation Rate over the period for the domestic country ● I FC = Average Annual Inflation Rate over the period for the foreign country ● S 0 = Spot Exchange rate at beginning of year between DC and FC in DC/FC units ● S t = Spot Exchange rate at end of t years between DC and FC in FC/DC units 10 [...]... CFA Institute, Charlottesville, VA All rights reserved Reprinted with permission from the 19 96 Level I CFA Study Guide Copyright (19 96) , CFA Institute, Charlottesville, VA All rights reserved Reprinted with permission from the 1997 Level I CFA Study Guide Copyright (1997), CFA Institute, Charlottesville, VA All rights reserved Reprinted with permission from the 1998 Level I CFA Study Guide Copyright... (1998), CFA Institute, Charlottesville, VA All rights reserved Reprinted with permission from the 1999 Level I CFA Study Guide Copyright (1999), CFA Institute, Charlottesville, VA All rights reserved Reprinted with permission from the 2000 Level I CFA Study Guide Copyright (1999), CFA Institute, Charlottesville, VA All rights reserved Reprinted with permission from the 2001 Level I CFA Study Guide Copyright... Copyright (2000), CFA Institute, Charlottesville, VA All rights reserved Reprinted with permission from the 2002 Level I CFA Study Guide Copyright (2001), CFA Institute, Charlottesville, VA All rights reserved Reprinted with permission from the 2003 Level I CFA Study Guide Copyright (2002), CFA Institute, Charlottesville, VA All rights reserved Reprinted with permission from the 2004 Level I CFA Study. .. in general, hold in either the short run or long run Permission to print questions & answers from past AIMR Study Guides has been granted as indicated by the following statements Reprinted with permission from the 1994 Level I CFA Study Guide Copyright (1994), CFA Institute, Charlottesville, VA All rights reserved Reprinted with permission from the 1995 Level I CFA Study Guide Copyright (1995), CFA. . .- Relative PPP relationship is then written as St S0 = ( 1 + IFC ) t ( 1 + IDC ) t Approximation for Relative Purchasing Power Parity - Useful approximation for Relative PPP (especially on CFA exam) is to re-arrange above in terms of change in exchange rate, i. e s = (S1 – S0)/S0 ( S1 − S0 ) Relative PPP becomes s = - Under Relative PPP, the approximate change in the exchange rate is equal... the difference between foreign and domestic inflation rates (the inflation differential) S0 = S1 - S0 − 1 ≅ IFC − IDC If Relative Purchasing Power Parity holds then real returns on an asset are the same for investors in any country, as the change in the exchange rate offsets any inflation differential between countries Relative PPP does not necessarily hold in the short run but should provide a guide... Charlottesville, VA All rights reserved Reprinted with permission from the 2004 Level I CFA Study Guide Copyright (2003), CFA Institute, Charlottesville, VA All rights reserved Reprinted with permission from the 2005 Level I CFA Study Guide Copyright (2004), CFA Institute, Charlottesville, VA All rights reserved 11 . Level I CFA ® Study Guide. Copyright (1995), CFA Institute, Charlottesville, VA. All rights reserved. Reprinted with permission from the 19 96 Level I CFA. industries from international competition rather than provide temporary shelter while they become internationally competitive. iii) Anti-Dumping: Domestic