Foreign Exchange: Practical Asset Pricing and Macroeconomic Theory

✍ Scribed by Adam S. Iqbal

• Publisher: Palgrave Macmillan
• Year: 2022
• Tongue: English
• Leaves: 246
• Edition: 1st ed. 2022
• Category: Library

✦ Synopsis

One of the great challenges that many participants in foreign exchange (FX) markets face is sifting through the often overwhelming amount of information that is available. Media outlets stream updates on international politics, economics, and other factors that move FX prices twenty-four hours a day. It is difficult to work out what is and what is not important. This book helps its reader overcome these challenges by combining the insights gained from a market practitioner who has traded FX at Goldman Sachs, PIMCO, and Barclays Investment Bank, with textbook-level modern financial macroeconomic theory.

The book covers macroeconomics relating to exchange rate determination. While you could obtain this information from a disparate set of sources―textbooks, academic literature, industry research notes, conversations with other market practitioners, and theories cited in media reports―this book brings all of these sources together to translate the information into concrete FX views that are firmly rooted in the macroeconomic theory of risk premiums, interest rates, and inflation, among other topics. The book promotes time consistent thought that avoids the daily temptation to jump from that day’s economic narrative to the next. Of particular interest to buy- and sell-side industry practitioners, finance and economics graduate students, academics, and others interested in FX markets, this book teaches its readers how to do this and improve their own trading and understanding of the FX markets.

✦ Table of Contents

Preface
Acknowledgements
Contents
About the Author
Part I Risk Premiums and the Central Pricing Equation
1 Risk Premiums
1.1 Risk Premiums
1.1.1 Example (i): A Risky Corporate Bond
1.1.2 Example (ii): Bookmaker Odds
1.1.3 Example (iii): Bimodal Option Pricing in a One-Period Model
1.2 Microeconomic Foundations of Risk Premiums
1.2.1 Utility Functions
1.2.2 A One-Period Model
1.2.3 Exploring the Central Pricing Equation
1.2.4 Special Case 1: Pricing Coin Tosses and Elections
1.2.5 Special Case 2: Risk Neutral Investors
1.3 Idiosyncratic Risk
1.4 Linking P and Q Probabilities
1.5 Risk Premiums in Continuous Time Models (Optional)
1.5.1 Deriving P and Q Probabilities Through Dynamic Hedging
1.5.2 The Central Pricing Equation in Continuous Time
1.6 Interest Rates
1.6.1 CRRA Utility
1.6.2 The Real Risk-Free Interest Rate
1.7 Expected Returns (Optional)
1.7.1 The Central Pricing Equation as an Excess Return
1.7.2 The CAPM
1.8 Risk Premiums and the Efficient Market Hypothesis (EMH)
1.9 Chapter Summary
References
2 FX Forwards and the Carry Trade
2.1 Covered Interest Rate Parity
2.1.1 Forwards Basics
2.1.2 Calculating the Prices of Forwards (Optional)
2.2 Uncovered Interest Rate Parity (UIP) and the Carry Trade
2.2.1 Forward as the Expectation of the Future Spot Rate
2.3 The Carry Trade
2.3.1 UIP, Risk Premiums and the Carry Trade
2.3.1.1 Practical Consideration on Implementation of the Carry Trade
2.3.2 Carry, Carry Trading and Interest Rate Differentials
2.3.3 Analogy with Equity Investments
2.4 Chapter Summary
References
3 Exchange Rates, Interest Rates, Inflation and the Risk Premium
3.1 Fixed Real Exchange Rate Models
3.1.1 Defining the Real Exchange Rate
3.1.2 PPP and the Law of One Price
3.1.3 The Balassa-Samuelson Theory
3.2 Terms of Trade
3.3 Real Interest Rates and Expected Inflation
3.4 FX Price Dynamics
3.4.1 Example (i): FX Response to an Inflation Surprise with Fixed Real Yields
3.4.2 Example (ii): FX Response to an Inflation Surprise with Fixed Nominal Yields
3.4.3 Example (iii): An Interest Rate Hike from the Central Bank
3.4.4 Example (iv): FX Response with a Policy Rule
3.4.5 Example (v): FX Response with Changing Risk Premiums
3.4.6 The Real Interest Rate and the Risk Premium
3.5 FX Price Dynamics—The General Case
3.6 Equity Investments and FX-Equity Correlation
3.6.1 Example (vi): Taper Tantrum
3.6.2 Example (vii): An Archetypal “Risk-Off”
3.7 Chapter Summary
References
4 FX Volatility and FX Options
4.1 Option Payoff Basics
4.2 Options as Bets on Volatility
4.3 Options as Volatility Hedges
4.3.1 Dynamic Replication and the BSM Model
4.4 Extracting Probability Distributions from Options
4.4.1 The Volatility Risk Premium (VRP)
4.4.2 Practical Application with a Distributional Assumption
4.4.3 Practical Application without a Distributional Assumption
4.4.4 Correlation
4.5 Real Exchange Rate Volatility
4.5.1 Fixed Real Exchange Rates and International Risk Sharing
4.5.2 Volatility of Real Exchange Rates and Imperfect International Risk Sharing
4.6 Chapter Summary
References
Part II Macroeconomic Variables and Monetary Economics
5 Macroeconomic Aggregates and the FX Rate
5.1 Balance of Payments (BOP)
5.1.1 Example: The Current Account and the Financial Account
5.1.2 BOP Accounts
5.1.3 The Current Account
5.1.4 The Capital Account
5.1.5 The Financial Account
5.2 Analytical Presentation of the BOP
5.3 International Investment Position (IIP)
5.3.1 Relationship Between NIIP and BOP
5.4 Financing the BOP
5.5 Consumption, Investment and Government Spending
5.5.1 Current Account, Savings, Investment and Twin Deficits
5.5.2 Twin Deficits
5.6 The Government/Public Sector
5.6.1 What Constitutes the Government?
5.6.2 Statement of Government Operations (SGO)
5.6.3 Financing the Government Budget
5.6.4 Statement of Other Economic Flows (SOEF)
5.7 Chapter Summary
References
6 The Mundell-Fleming Model and the Impossible Trinity
6.1 Basic Equations of the Model
6.1.1 The Goods Market
6.1.2 The Money Market
6.1.3 The Balance of Payments
6.2 The Extended Mundell-Fleming Model
6.2.1 The LM Curve
6.2.2 The IS Curve
6.2.3 Equilibrium and Analysis
6.2.4 Monetary Policy and the LM Curve
6.2.5 Fiscal Policy and the IS Curve
6.2.6 Unaffordable Fiscal Stimulus
6.3 The Impossible Trinity
6.4 Optimal Currency Area (OCA) 
6.5 Chapter Summary
References
7 Inflation
7.1 Measuring Inflation 
7.1.1 CPI   
7.1.2 GDP Deflator
7.1.3 PCE   
7.2 AD-AS Models
7.2.1 The AD Curve
7.2.2 The AS Curve
7.2.3 Demand-Pull Inflation 
7.2.3.1 Implications for the FX Rate
7.2.4 Cost-Push Inflation
7.3 The Phillips Curve  
7.3.1 Adaptive Expectations and the Non-accelerating Inflation Rate of Unemployment (NAIRU)   
7.4 The Quantity Theory of Money and Monetarism   
7.4.1 Monetarism   
7.4.2 Monetarism, IS-LM, and Keynesian Stimulus
7.5 Fiscal Theory of the Price Level (FTPL)
7.5.1 The One-Period Model
7.5.2 A Multiperiod Model
7.5.3 Monetary Policy and Expected Inflation
7.5.4 Fiscal Policy and Unexpected Inflation
7.5.5 A Note on QE
7.5.6 A Note on Helicopter Money 
7.6 New-Keynesian Phillips Curve (NKPC) Models and Taylor Rules 
7.6.1 The New-Keynesian IS Equation
7.6.2 The New-Keynesian Phillips Curve 
7.6.3 The Taylor Rule
7.7 Chapter Summary
References
Appendix A: Exchange Rate Concepts
Exchange Rate Quotation
Appendix B: Probability
Probability Mass Functions (PMFs), Probability Density Functions (PDFs) and Calculating Expectations
Discrete Random Variables and Probability Mass Functions  
Continuous Random Variables and PDFs  
Appendix C: Calculus
Partial Derivatives
Total Derivatives
Glossary of Acronyms
References
Index