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Investments Chapter 17: Macroeconomic Analysis

Gross Domestic Product: I The value of all goods and services produced in an economy in a particular period of time. The GDP has four components: 1. Consumption. 2. Investment. 3. Government spending. 4. Net trade (exports less imports).

Gross Domestic Product: II Where: C is consumption, I is investment, G is government spending, ( X – M ) is net trade.

Economic Indicators of the Business Cycle Leading Indicators Indicators that lead the business cycle. Coincident Indicators Indicators that move directly with the business cycle. Lagging Indicators Indicators that lag behind the business cycle.

Fiscal and Monetary Policy The Federal Government uses fiscal and monetary policy to promote real GDP growth, relatively full employment and stable prices.

Fiscal vs. Monetary Policy  Fiscal Policy Refers to the taxation and spending policies of the government.  Monetary Policy Refers to actions by a central bank to control the supply of money and interest rates.

The Economy and Financial Markets The semi-strong form of the EMT predicts that macroeconomic data cannot be used to earn abnormal returns. Indeed, stock market indices are among the best-performing leading indicators for the business-cycle.

International Parity Relationships: I Purchasing Power Parity The relationship between two countries’ inflation rates and their foreign exchange rates. International Fisher Relationship The relationship between nominal interest rates and inflation rates in different countries.

International Parity Relationships: II Foreign Exchange Expectations The relationship between current foreign exchange expectations and current forward foreign exchange. Interest-Rate Parity The relationship between the forward exchange rates and nominal interest rates.

P urchasing P ower P arity ( PPP ) The exchange rate between two currencies should equal the ratio of the countries’ price levels. S  P £ Relative PPP states that the rate of change in an exchange rate is equal to the differences in the rates of inflation. e =  $ -  £ If U.S. inflation is 5% and U.K. inflation is 8%, the £ should depreciate by 3% (by 3%), e = -3%

Factors which influence the PPP exchange rate PPP is derived from the Quantity Theory of Money in both countries ( M*V = P*Y), so that: - If M dom / M foreig increases, e increases (depreciation) - If Y foreig / Y dom increases, e increases (depreciation) - If V dom / V foreig increases, e increases (depreciation) The higher the deficit in trade, the higher the demand for foreign currency, i.e. e increases The lower the foreign reserves our country has to support its own currency, the higher the value of e

Evidence on PPP PPP probably doesn’t hold precisely in the real world for a variety of reasons. Haircuts cost 10 times as much in the developed world as in the developing world (not traded). Film, on the other hand, is a highly standardized commodity (traded across borders). Shipping costs, as well as tariffs and quotas can lead to deviations from PPP. PPP-determined exchange rates still provide a valuable benchmark.

Interest Rates and Exchange Rates: I nterest R ate P arity ( IRP ) IRP is an arbitrage condition. If IRP did not hold, then it would be possible for an astute trader to make unlimited amounts of money exploiting the arbitrage opportunity. Since we don’t typically observe persistent arbitrage conditions, we can safely assume that IRP holds.

IRP Defined Suppose you have $100,000 to invest for one year. You can either Invest in the U.S. at i $ . FV = $100,000 × (1 + i $ ) Trade your dollars for yen at the spot rate, invest in Japan at i ¥ and hedge your exchange rate risk by selling the FV of the Japanese investment, forward (F) . Since both of these investments have the same risk, they must have the same future value: F S × (1 + i ¥ ) = (1 + i $ ) F S × (1 + i ¥ ) FV = $100,000 ×

IRP Defined Formally, IRP is sometimes approximated as F S × (1 + i ¥ ) = (1 + i $ ) F S = (1 + i $ ) (1 + i ¥ ) or if you prefer, i $ – i ¥ = F – S S

Another example Assume a US company that buys Swedish kronor (USA = domestic country, Sweden = foreign country). Assume S = 0.15$ per SEK in New York (or 6.67SEK per $ in Stockholm). Assume also that the annual interest rates are: r SWE = 0.05 and r USA = 0.06. According to CIRP, the Forward price of SEK in terms of $ is:

Another example (cont.) It is therefore clear that if r SWE < r USA , SEK will be stronger ( F > S ). Alternatively, if F > S , Sweden does not need to keep its interest rates higher to attract foreign capital and strengthen its currency even more. If on the other hand, F < S , and SEK is expected to weaken in the future, its weakening can be stopped if r SVE > r USA . But if the US increases its rate or Sweden decreases its rate, the Spot rate will change too!

Another example (cont.) For instance, if r USA = 0.07, many would save in the US (even uncovered, i.e. without selling the $ forward). If for instance the capital inflow in the US makes the $ stronger to, say, S = 0.14$ per SEK (or 7.143 SEK per $), other things being equal, the new F is stronger and is:

IRP and Covered Interest Arbitrage If IRP failed to hold, an arbitrage would exist. It’s easiest to see this in the form of an example. Consider the following set of foreign and domestic interest rates and spot and forward exchange rates. Spot exchange rate S £ (0) = $1.25/£ 360-day forward rate F £ (360) = $1.20/£ U.S. discount rate i $ = 7.10% British discount rate i £ = 11.56%

IRP and Covered Interest Arbitrage A trader with $1,000 to invest could invest in the U.S., in one year his investment will be worth $1,071 = $1,000  (1.071) Alternatively, this trader could: exchange $1,000 for £800 at the prevailing spot rate, (note that £800 = $1,000÷$1.25/£) invest £800 at i £ = 11.56% for one year to achieve £892.48. Translate £892.48 back into dollars at F £ (360) = $1.20/£, the £892.48 will be exactly $1,071.

According to IRP only one 360-day forward rate, F £ (360), can exist. It must be the case that F £ (360) = $1.20/£ Why ? If F £ (360) = $1.23/£, an astute trader could make money with the following strategy: ( Notice that if you do not cover (hedge) your foreign position with F, your foreign money might not be enough to buy back your own currency) (A similar strategy would be made if F £ (360) = $1.15/£) IRP & Exchange Rate Determination

Borrow $1,000 and buy £800 spot Save £800 in UK and sell your £ forward At the end of the year you gain with 100% probability $27 per $1,000, or 2.7%. IRP & Exchange Rate Determination

Arbitrage Invest £800 at i £ = 11.56% In one year £800 will be worth £892.48 = £800  (1+ i £ ) Step 4: repatriate to the U.S.A. If F £ (360) > $1.20/£ , £892.48 will be more than enough to repay your dollar obligation of $1,071; the excess is your profit. Step 1: borrow $1,000 Step 2: buy pounds Step 3: Step 5: Repay your dollar loan with $1,071<$1,098 £892.48 $1,098 $1,000 £800 £800 = $1,000× $1.25 £1 $1,071 < £892.48 × £1 $1.23

You are a U.S. importer of British woolens and have just ordered next year’s inventory. Payment of £100,000,000 is due in one year. IRP and Hedging Currency Risk IRP implies that there are two ways that you fix the cash outflow a) Put yourself in a position that delivers £100M in one year — a long forward contract on the pound. You will pay (£100,000,000) × ($1.2/£) = $120,000,000 b) Form a forward market hedge as shown below. Spot exchange rate S £ (0) = $1.25/£ 360-day forward rate F £ (360) = $1.20/£ U.S. discount rate i $ = 7.10% British discount rate i £ = 11.56%

IRP and a Forward Market Hedge To form a forward market hedge: Borrow $ 112.05 million in the U.S. (in one year your debt will be $120 million). Translate $ 112.05 million into £ at the spot rate S £ (0) = $1.25/ £ to receive £89.64 million . Invest £ 89.64 million in the UK at i £ = 11.56% for one year. In one year your investment will have grown to £100 million = $120 million, i.e. exactly enough to pay your supplier.

Forward Market Hedge Where do the numbers come from? We owe our supplier £100 million in one year—so we know that we need to have an investment with an FV of £100 million. Since i £ = 11.56% we need to invest £89.64 million at the start of the year. How many dollars will it take to acquire £89.64 million at the start of the year if S £ (0) = $1.25/ £? £89.64 = £100 1.1156 $112.05 = £89.64 × $100 £1.25

Lufthansa’s decision (A true case,1985) On January 1985, signed Lufthansas CEO Heinz Ruhnau to buy 20, 737 Boeing, for $500 million. Lufthansa would pay in $ in a year (at delivery). Meanwhile, $ had increased continiously since Reagan became president and cost around 3.20 DM. By the delivery of planes it could cost up to 3.50 DM and made the purchase of planes 0.3*500 = DM150 million more expensive. At Lufthansa’s board meetings the following alternative strategies were discussed: (a) No hedge and pay what the dollar value will be at delivery (risky) (b) Hedge the entire amount with forward contract at 3.2 DM/$ (c) Hedge half amount only with forward contract at 3.2 DM/$ (d) Hedge the entire amount with currency options at exercise rate 3.2 DM/$

Finally, the CEO hedged half the amount ($ 250 m) at 3.2 DM/$, i.e. the alternative (c) was selected. In (d) case, a put option on DM with strike 3.2 DM/$ and 1 year to maturity, cost 6 pfennig, i.e. the right to sell their DM and buy $ at that rate, would cost 0.06*1.6DM billion) = DM96 million. Lufthansas decision (1985) What happened one year later? DM was strengthened dramatically to 2.3 DM/$ and Mr Ruhnau lost his jobb, because his political opponents argued that he ” speculated” with currencies !!! (although in fact he hedged !)

DM/$ actual & PPP exchange rate, 1977-2000

Billion DM 1.5 1.6 1.375 Non-hedged (a) 2.8 1.7 1.8 3.0 3.4 3.2 DM/$ Currency forward (b) Lufthansa’s alternatives Hedge half (c) 3.6 Put option (d) 1.150 2.3 Here it ended… At a rate of 3.6 DM/$, pay 250*3.6 + 250*3.2 = 1.7 billion Below 3.2 do not exercise the option (buy $ cheaper)

Reasons for Deviations from IRP Transactions Costs The interest rate available to an arbitrageur for borrowing, i b , may exceed the rate he can lend at, i l . There may be bid-ask spreads to overcome, F b /S a < F/S Thus ( F b / S a )(1 + i ¥ l )  (1 + i ¥ b )  0 Capital Controls Governments sometimes restrict import and export of money through taxes or outright bans.

Equilibrium Exchange Rate Relationships  $ –  £ IRP PPP Fisher Effect Forward PPP Intern. FisherEffect Forward Premium i $ – i ¥ F – S S E ( e )

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