Economics

Economics – Question Sheet
Case No. 1
Sergio Reyes is an economist at Cuadrado Capital studying
how international parity conditions have held in certain
countries. He is speaking to Andrea Gómez, a senior
currency trader at Cuadrado. Reyes tells Gómez:
Statement 1: Forward rate parity states that the forward

exchange rate will be an accurate forecast of the future
spot exchange rate.
Statement 2 The international Fisher effect states that the
nominal yield spread between two markets is determined
solely by their expected inflation differential.
Statement 3 Relative purchasing power parity states that
the notional exchange rate between two markets is the
ratio of their broad price indexes.
Gómez asks Reyes what international parity conditions
mean for expected spot exchange rates. Reyes explains
that if all key international parity conditions held, the
expected spot exchange rate would track several measures
between two countries. He continues that if certain parity
conditions held, there would be no difference between the
real interest rates of the two countries.
Reyes notes that uncovered interest rate parity between

Mexico and the United States has held in recent years. He
provides Gómez with the following information:
Reyes mentions that international parity conditions do not

always hold, especially over the short term. This allows
Cuadrado to exploit certain trades, such as the carry trade.
He notes that a good carry trade opportunity is to borrow
with EUR to purchase BRL. Gómez compiles the following
information and expectations on the currencies:
Gómez asks Reyes if there is anything she should know

about the distribution of returns for carry trades.
Case No. 1
Case No. 1
Case No. 2
Rana Al-Qahtani, a senior economist for Tigris Bank, is
discussing the prospects for several foreign markets with
Amin Saleem, a newly hired junior economist. Al-Qahtani
explains to Saleem the difference between capital
deepening and technological advances in an economy, in
the context of neoclassical theory. Saleem asks how
technological advances affect the per capita production
function, which leads to a discussion of economic growth
models.
Al-Qahtani and Saleem then discuss Country 1, a developed

country with a large amount of capital per worker
compared with its neighbors. Country 1 plans to continue
investing in capital projects to improve its growth. It has
identified three areas of investment focus:
Investment 1: Highways and transportation equipment

Investment 2: Machinery and nonresidential construction
Investment 3: Computers and telecommunications
equipment
Country 2 is a developing country whose growth rate has
slowed during the last two years. Al-Qahtani asks Saleem
to calculate the potential GDP growth rate for Country 2.
Saleem compiles the following information:
Saleem notes that Country 2's GDP is growing faster than

Country 1's GDP, a trend that is consistent with
convergence theory. However, he asks Al-Qahtani why
Country 3, another developing country, is growing slower
than Country 1 although it has characteristics similar to

Country 2. Al-Qahtani replies that Country 3, although
similar overall to Country 2, does not enforce property
rights and will catch up with richer countries only when it
does so.
Saleem then asks Al-Qahtani about how different economic

models affect convergence and other topics. Al-Qahtani
makes the following statements:
Statement 1: The endogenous theory asserts that all

countries' per capita GDPs should converge, but the
neoclassical model suggests that divergences can persist
indefinitely.
Statement 2: Unlike the other models, the classical model
predicts that an increase in a country's savings rate will
result in a greater permanent rate of per capita GDP
growth.
Statement 3: The neoclassical model assumes diminishing
returns on capital; the endogenous growth model assumes
a straight-line production function.
Al-Qahtani also notes that two main criticisms of the
neoclassical model by economists have resulted in
expansions of the model, as well as new theories.
Case No. 1
Case No. 1
Case No. 3
Aulia Suryani is the head of the domestic equity research
team at FKY Capital. She is especially interested in
understanding the impact of regulation in three industries:
chemical, financial, and software.
The chemical industry is dominated by a small number of

companies. The capital expenditure requirements pose
high barriers to entry, allowing incumbents to maintain high
prices and margins. Chemical manufacturing processes
result in significant amounts of toxic waste. Regulatory
authorities are considering new rules for the chemical
industry, and Suryani is evaluating the potential impact on
the companies.
The financial industry is heavily regulated. Domestic banks

and other financial institutions are required to diversify
assets, prepare recovery plans, and keep funds in reserve as
insurance against losses. In addition, these institutions
comply with the rules and standards of the industry's self-
regulating organization (SRO).
The software industry is currently undergoing a significant

transformation:
Two major competitors recently announced their intention

to merge, and the federal antitrust agency analyzed the
case. The agency concluded that the merger may
substantially reduce competition and suggested some
remedies to resolve this issue.
A neighboring country recently reduced its financial

disclosure requirements and employees' statutory benefits,
aiming to attract foreign companies to its jurisdiction. As a
result, some software companies are considering making
this country their corporate domicile.
Case No. 1
Case No. 1
Case No. 4
Vadim Sederko and Isabel Moray are trainees with Forex
Global Partners. The company actively participates in the
interbank foreign exchange market and also trades with
individuals and corporate clients. Exhibit 1 shows the
intermarket bid-offer spreads for selected currency pairs:
Sederko and Moray are discussing factors that may lead to

changes in the bid-offer spreads. Sederko offers the
following as reasons why the JPY/USD spread would
narrow:
Reason 1: "The JPY/USD spread will narrow when the

Tokyo market is open, since the New York and London
markets will be closed and the yen is Japan's domestic
currency."
Reason 2: "For large orders where investors want to
receive JPY in exchange for USD, the spread will narrow
since the large orders demonstrate a lot of demand for JPY."
Forex Global also trades in the forward currency markets.
Thirty days ago, Sederko bought USD 5 million in exchange
for SGD with delivery in 90 days at the 90-day forward rate
of SGD/USD 1.3250–1.3350. He observes that today's
SGD/USD spot rate is 1.3450–1.3650, and that the forward
points and risk-free rates for both currencies are as follows:
Sederko believes that covered interest rate parity exists

between the USD and GBP. He compiles the following
information:
Sederko and Moray then discuss aspects of interest rate

parity:
Sederko: "For uncovered interest rate parity to hold,

investors are assumed to be risk neutral."
Moray: "If uncovered interest rate parity holds, the current
spot rate is the best predictor of the future spot rate.“
Remember to put first question

Case No. 1
Case No. 1
Case No. 5
Botan Saito is a portfolio manager for Spire Financial.
Spire's investments are largely domestic, and Saito plans to
diversify Spire's holdings by adding investments in
international markets. Saito identifies three countries that
he will research further. He collects the following economic
data for each country, using average year-on-year growth
rates:
During his research, Saito realizes that numbers are not

fully explaining the economic differences in these countries.
He further researches institutional economic information,
shown in Exhibit 2:
Country 2 is planning to implement new policies that create

a more open trade policy. Saito expects that this will result
in a higher permanent steady-state GDP growth rate.
Saito is interested in how economic factors will ultimately

impact each country's stock market. He notes that Country
3's:
GDP growth is slightly above the country's steady-state GDP

growth rate in 20X4;
earnings-to-GDP ratio was above the country's historical
average in 20X4; and
price-to-earnings ratio of the country's publicly traded
stocks was below its historical average in 20X4.
Saito is also interested in how potential GDP will affect each
country's bonds. He arrives at the following conclusions:
Conclusion 1 Actual GDP growth relative to a country's

potential GDP growth rate is an important factor in central
bank decision-making and the likelihood of changes to the
central bank's policies.
Conclusion 2 A decrease in a country's potential GDP
growth rate increases the likelihood that the credit ratings
on its sovereign debt will be downgraded.
Case No. 1
Case No. 1
Case No. 6
Ishita Rani is a currency trader at Inspire Bank discussing
exchange rates with a newly hired junior trader, Raj Pawar.
Rani asks Pawar about the balance of payment accounts and its
impact on exchange rates. Pawar replies that the accounts can
have different effects in the short term and long term. He
elaborates by stating that over the long term, the current
account affects exchange rates through three channels:
Channel 1:A current account deficit will result in decreased

relative demand for that country's currency, leading to
currency depreciation.
Channel 2:Countries with current account surpluses may
rebalance their unbalanced foreign currency portfolios,
positively impacting the foreign currencies.
Channel 3:Investors in countries running persistent current
account deficits will revise their exchange rate expectations
upward until the country stabilizes its debt-to-GDP ratio.
Rani also wants to gauge Pawar's knowledge of how monetary
and fiscal policies can affect exchange rates. She tells Pawar
that Country X, an emerging market, has recently instituted
more expansionary monetary and fiscal policies. She adds that
Country X has had high capital mobility in recent years.
Pawar remembers reading about a currency crisis that

happened several years ago in Country X. Rani states that
although not all currency crises show all the expected warning
signs, the crisis in Country X did in fact show some warning
signs that investors ignored at the time.
Pawar notes that some governments have taken steps to

control their exchange rates. He asks Rani if countries can
actually influence their exchange rates, and if so, whether
countries with developed or developing economies would be
more effective in doing so.
Rani also wants to test Pawar's skills at valuing currency-based

transactions. She tells Pawar that 3 months ago, Inspire
initiated a forward contract to purchase NOK 7.5 million in 6
months. At the initiation of the contract, the 6-month forward
exchange rate was INR/NOK 8.0000. She gives Pawar the
current exchange rate information for the two currencies and
asks him to mark the contract to market:
Rani notes that the INR risk-free rate is 2.5% and that
Inspire uses a 360-day count convention.
Case No. 1
Case No. 1
Case No. 7
The chief investment officer (CIO) of New Horizon Global
Investments (New Horizon) wants to understand how
existing and new regulations may affect potential
investments in a country covered by New Horizon's equity
research team. The CIO is particularly interested in the
mining and financial sectors and meets with Olivier Bodin
and Sofia Esposito, equity analysts at New Horizon.
Bodin explains that several international mining companies

intend to invest in the country but have expressed concern
regarding the legal protection of the substantial long-term
investments required. Local government is planning new
laws and enforcement procedures to improve its legal
environment, encouraging companies to commit to such
investments.
Bodin adds that the local regulator, a government agency, is

concerned about the pollution generated by iron ore
processing activities. The agency proposed a new
regulation, imposing a limit on industry pollution,
distributing tradable emission rights to mining companies.
The agency is currently investigating the costs and possible
unintended consequences of the proposed regulation as
part of its cost-benefit analysis. The CIO requests more
information about this process, and Bodin explains that:
Statement 1: Implementation costs relate to changes in

economic decisions and behaviors.
Statement 2: Unintended consequences may influence
both implementation costs and indirect costs.
Statement 3: The cost-benefit analysis is limited to the
firms and industries directly affected by the proposed
regulation.
Afterward, Esposito speaks about the country's financial

sector. She explains that its main regulatory body, the
Financial Oversight Authority (FOA), was created by statute
as an autonomous agency with rulemaking and
enforcement powers but is not funded by the government.
In addition, the Association of Commercial Banks (ACB), a
private organization, establishes and enforces rules and
standards in the financial industry. ACB does not derive its
authority from legislation or from a government body, but
exclusively from its members, who include most of the
country's financial institutions.
She adds that the financial industry is highly concentrated,

with three major banks holding more than 70% of the
assets of the financial system. In the previous year, a small
bank suffered a bank run after considerable trading losses,
and FOA intervened by forcing creditors and depositors to
cancel their claims in exchange for shares of the bank.
As a result, FOA is proposing stricter regulation of short

sales and leveraged trading. FOA's regulators must decide
the best approach to conduct a cost-benefit analysis: an
after-the-fact analysis or a regulatory sandbox approach.
Case No. 1
Case No. 1
Case No. 8
Jerczy Walinski is a senior economist working for an
international bank. He is responsible for analyzing currency
markets to support the bank's proprietary currency trading
and the advisory services provided to bank clients. Sonya
Sanchez is a newly hired junior economist assigned to assist
Walinski.
Walinski asks Sanchez to assess the forward value of JPY

compared with EUR using the exchange rate and interest
rate data presented in Exhibit 1.
The two economists discuss the implications of the

international parity relationships and their use in
forecasting future exchange rates. Walinski asks Sanchez to
summarize the key aspects of the international Fisher
relationship. In response, Sanchez notes two important
implications of the international Fisher effect regarding the
behavior of key economic variables across countries:
Implication 1: Real interest rates should converge on the

same level.
Implication 2: Nominal interest rates should converge with
expected inflation rates.
Walinski then asks Sanchez to evaluate the usefulness of
the interest rate parity relationships regarding exchange
rates. Sanchez makes two observations regarding currency
market participants' views on the theories:
Observation 1:Covered interest rate parity accurately
describes the relationship of the spot and forward
exchange rates between two currencies and the interest
rates in those currencies. Its validity is proven by the

arbitrage trading that occurs anytime the spot/forward
difference is inconsistent with interest rate difference.
Observation 2:Uncovered interest rate parity does not
accurately capture the relationship of interest rate
differences between currencies and expected changes in
spot exchange rates. This is borne out by the frequent use
of carry trades to earn higher returns by taking unhedged
positions in high interest rate currencies.
Walinski and Sanchez analyze the economic outlook for two
countries and their currency values relative to a global
reserve currency. One of the countries is a large developed
market (DM), the other a small emerging market (EM).
Both countries have recently begun pursuing expansionary
monetary policies to spur economic recoveries during a
period of stagnant growth following a recent global
slowdown. Both countries are also raising taxes and cutting
government spending to prevent expansion of budget
deficits. However, Walinski notes that capital mobility and
other economic policies differ between the countries:
DM has well-developed financial markets and places no

restriction on foreign ownership of domestic assets nor any
restrictions on capital inflows or outflows. The country's
trade balance is usually at a small deficit relative to GDP.
DM uses a free-floating-rate currency regime, its currency is
fully convertible, and the central bank generally does not
intervene in currency markets.
EM has much less developed financial markets, places
restrictions on foreign ownership of domestic assets, and
restricts both inflows and outflows of capital. The country
usually has a sizeable trade surplus, though the size of the
surplus has been very sensitive to the exchange value of its
currency. DM is both the largest market for EM's exports
andthe largest source of its imports. Until recently, EM had
a fixed-exchange-rate regime, maintaining a specified parity
to DM's currency. EM has recently introduced a crawling

peg intending to manage the value of its currency relative
to DM's in line with any difference in inflation between the
two currencies. DM is also considering easing restrictions
on capital inflows to enable increased foreign investment as
a tool to spur domestic growth.
Walinski asks Sanchez to identify factors that may indicate

an increased possibility of a currency crisis for EM.
Case No. 1
Case No. 1
Case No. 9
Sylvia Yang manages a team of currency analysts for an
international bank. Abe Kim is applying for a position as a
junior analyst on Yang's team. During an interview, Yang
asks Kim to discuss arbitrage pricing relationships and the
international parity relationships that influence currency
values.
To assess Kim's familiarity with the relationship between

spot and forward exchange rates, Yang asks Kim to
determine the forward discount or premium of MXN
relative to INR based on the information in Exhibit 1:
Yang then asks Kim to interpret the implications reflected in

the spot and forward rate quotes for CHF/EUR shown in
Exhibit 2:
Yang follows up by asking Kim to describe and evaluate

international parity relationships. During the discussion,
Kim makes the following statements regarding different
versions of purchasing power parity (PPP):
Statement 1: In the long run, currency exchange rates

tend to move toward values implied by absolute PPP.
Statement 2: Under relative PPP, spot exchange rate

changes are completely determined by differences in actual
inflation, whereas under ex-ante PPP, expected spot
exchange rate changes are based on differences in expected
inflation.
Yang wants to assess Kim's understanding of arbitrage
pricing. She shows him Currency Dealer Z's quotes (Exhibit
3) and asks him to determine the potential arbitrage profit
from investing EUR 1 million if Dealer X quotes NOK/EUR at
9.6200/9.6530.
Case No. 1
Case No. 1
Case No. 10
Lucas Evans is an independent economic consultant. Two
economic ministers from different developing countries
have asked to meet with him to discuss their countries'
economic growth prospects. Evans first meets with Lena
Kowalczyk of Country 1.
Country 1 has significant natural resources. Despite an

increase in exports of its natural resources and the
installation of economic institutions necessary for growth,
Country 1's GDP growth has been sluggish. After reviewing
data about Country 1's economy, Evans suggests the slow
growth stems from the Dutch disease, since that would
explain the following factors demonstrated by Country 1's
economy:
Factor 1: Persistently strong currency growth leading

to a weakening manufacturing sector
Factor 2: Additional regulations to disincentivize the
entrance of new domestic competitors
Factor 3: Accelerating population growth as per capita
income rises above subsistence income, causing labor
productivity to fall
Kowalczyk explains that Country 1's government is planning
additional reforms to improve growth and asks Evans to
review the options:
Option 1: Encourage lenders to improve screening of

those seeking investment funding
Option 2: Limit foreign investment so domestic
investors receive capital gains
Option 3: Promote greater domestic consumption in
lieu of saving
After reviewing the options, Evans points out that Country
1's R&D spending is below that of its peers. He suggests
providing subsidies and tax breaks for private companies to
fund R&D investment.
Evans then meets with Alejandro Guerrero of Country 2,

which is a developing country with a low capital-per-worker
ratio. Guerrero presents the following data about Country
2:
Country 2 is planning to close its borders and restrict

immigration to improve the employment rate for its
citizens. The country also plans to subsidize part-time labor
for companies to encourage the hiring of more workers
who do not have time for full-time work.
Evans notes that Country 2 can also improve growth by

adjusting its trade policies with other countries.
Case No. 1
Case No. 1

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Economics – Question Sheet

Statement 1: Forward rate parity states that the forward

Reyes notes that uncovered interest rate parity between

Reyes mentions that international parity conditions do not

Gómez asks Reyes if there is anything she should know

Al-Qahtani and Saleem then discuss Country 1, a developed

Investment 1: Highways and transportation equipment

Saleem notes that Country 2's GDP is growing faster than

than Country 1 although it has characteristics similar to

Saleem then asks Al-Qahtani about how different economic

Statement 1: The endogenous theory asserts that all

The chemical industry is dominated by a small number of

The financial industry is heavily regulated. Domestic banks

The software industry is currently undergoing a significant

Two major competitors recently announced their intention

A neighboring country recently reduced its financial

Sederko and Moray are discussing factors that may lead to

Reason 1: "The JPY/USD spread will narrow when the

Sederko believes that covered interest rate parity exists

Sederko and Moray then discuss aspects of interest rate

Sederko: "For uncovered interest rate parity to hold,

Remember to put first question

During his research, Saito realizes that numbers are not

Country 2 is planning to implement new policies that create

Saito is interested in how economic factors will ultimately

GDP growth is slightly above the country's steady-state GDP

Conclusion 1 Actual GDP growth relative to a country's

Channel 1:A current account deficit will result in decreased

Pawar remembers reading about a currency crisis that

Pawar notes that some governments have taken steps to

Rani also wants to test Pawar's skills at valuing currency-based

Bodin explains that several international mining companies

Bodin adds that the local regulator, a government agency, is

Statement 1: Implementation costs relate to changes in

Afterward, Esposito speaks about the country's financial

She adds that the financial industry is highly concentrated,

As a result, FOA is proposing stricter regulation of short

Walinski asks Sanchez to assess the forward value of JPY

The two economists discuss the implications of the

Implication 1: Real interest rates should converge on the

rates in those currencies. Its validity is proven by the

DM has well-developed financial markets and places no

to DM's currency. EM has recently introduced a crawling

Walinski asks Sanchez to identify factors that may indicate

To assess Kim's familiarity with the relationship between

Yang then asks Kim to interpret the implications reflected in

Yang follows up by asking Kim to describe and evaluate

Statement 1: In the long run, currency exchange rates

Statement 2: Under relative PPP, spot exchange rate

Country 1 has significant natural resources. Despite an

Factor 1: Persistently strong currency growth leading

Option 1: Encourage lenders to improve screening of

Evans then meets with Alejandro Guerrero of Country 2,

Country 2 is planning to close its borders and restrict

Evans notes that Country 2 can also improve growth by

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