Monday, July 24, 2017

Leverage and Cost of Capital

Leverage
- the effects that fixed costs have on the returns that shareholders earn
- magnify returns and risks

Operating leverage
- relationship between sales revenue and EBIT

Financial leverage
- relationship between EBIT and EPS

Total leverage
- relationship between sales revenue and EPS

operating leverage and financial leverage influence a firm's beta

breakeven point = fixed costs / contribution margin
                             = fixed costs / (price - variable costs)

When contribution margin (CM) is higher, profit rises faster
The higher the fixed costs, and low variable cost, the higher the beta

Operating leverage
- comes from mix of fixed and variable cost




if sales up by 10%

Lite heavy Lite heavy
sales volume 10000 10000 11000 11000
price 1000 1000 1000 1000
total revenue 10000000 10000000 11000000 11000000
fixed cost 5000000 2000000 5000000 2000000
variable cost
(per unit)
400 700 400 700
total cost 9000000 9000000 9400000 9700000
EBIT 1000000 1000000 1600000 1300000
Degree of Operating leverage = %ΔEBIT / %ΔSales

if sales up by 10%,
DOL of Lite = 60%/10% = 6
DOL of heavy = 30%/10% = 3
- more fixed cost , DOL increases

if DOL > 1, the firm has operating leverage

Financial leverage
- comes from use of debt



Unlevered levered
debt 0 10000
equity 20000 10000
asset 20000 20000
tax rate 0.4 0.4
interest rate 0.12 0.12
EBIT 3000 3000
interest(12%) 0 1200
EBT 3000 1800
tax 1200 720
NI 1800 1080
ROE 9% 11%
- more EBIT goes to investors in levered firm (as in NI + interest)
- for financially leveraged firm, NI is lower, but equity base is lower too, so ROE is higher

Basic Earning Power
BEP = EBIT/total assets
- BEP is not affected by financial leverage, because EBIT is the same whether you borrow or not
- BEP is affected by operating leverage, because change in EBIT is affected by DOL

Implications
- for leverage to be positive (increase ROE), BEP must be > rd
- for firms with high profit , use more debt, to shield the profit using debt (tax shield)

Sunday, July 23, 2017

Financial Derivatives

Forward and Futures

pricing:
F(t, T) = S(t) e ^ (r + u - d -y) (T-t)
where T: expiration date
r : risk free rate
u : storage cost
d : dividend yield
y : convenience yield

OTC central clearing to lower counterparty risk, such as London clearing house (LCH)

futures contracts are settled by cash settlement
futures contracts are closed  by entering into an offsetting position relative to your original position

Interest Rate Forward

notation:
2f1 - 1 year from now, 6 month rate
14f6 - 7 year from now, 3 year rate

By the principle of no arbitrage,
 (1+r1/2)(1+1f1 /2) = (1+r2/2)2, solve for 1f1
r1: 6 month spot
r2: 1 year spot

Interest Rate Swap

interest rate is implied in swap
USD/THB spot
USD LIBOR
# of days
swap point = fwd - spot
Σ PV (fixed) = Σ PV(floating)

money market rate, and bond rate affect swap rate

bank use PV01 to calculate risk
if gap > threshold, bank charge more

DV01 or PVBP
- 30 yr bond with 5.5% coupon
at yield of 5.5%, price = 100
at yield of 5.51%, price = 99.8540
DV01 = 0.146% of par
or DV01(per $1 mm par) = $1460

** take note **
- PV01 is change in market value from bumping the coupon rate by 1 bp
- DV01 is the change in market value for a 1 bp parallel shift of the yield curve

**hedge bond investment with bond futures
- use DV01
DV01 of 6 year bond with coupon of 5.5%: 712.5 per $1million par value
DV01 of 6 year bond with coupon of 5.0%: 613.1 per $1million par value
- the hedge ratio  (futures contract to sell) of 6 year bond investment against interest rate risk is
  hedge ratio = 712.5/613.1

Cross Currency Swap

- agreement between two parties to exchange principal and interest payments in two currencies over specified period
- may have or my not have initial principal exchange
- interest payments are usually not netted

basis swap (floating vs floating)

FX Forward

EUR/USD  ; ieur < iusd
EUR/USD forward, EUR appreciate
=> swap point +ve
=> EUR/USD > spot

AUD/USD  ; iaud > iusd
AUD/USD forward, AUD depreciate

=> swap point -ve
=> AUD/USD < spot

Case study:
Delox imports machine from Japan. Its revenue is in EUR, while its expense is in JPY. It expects to pay JPY 1000 million in 6 months. How to manage its FX risk?
Ans: one way is to buy JPY forward
EURJPY spot rate 129.45
6 month EURJPY forward rate 128.26
forward: bank charge bid offer spread
swap: bank will not charge bid offer spread


Friday, July 21, 2017

Financial Options

Options

components of option price
m.v of option = time premium + intrinsic value
intrinsic value: the difference of m.v of underlying and strike price of call option

Minimum value of call
American call : Ca(S0, T, X) >= max(0, S0 - X)
European call : Ce(S0, T, X) >= max(0, S0 - X(1+r)-T)

Minimum value of put
American put : max(0, X - S0 )
European put : max(0, X(1+r)-T - S0 )

Ca(S0, T, X) > Ce(S0, T, X) 
but prior to expiration, S0 - X(1+r)-T > S0 - X

early exercise?
- for call , if dividend > time premium, then you exercise the call option
- for put , if interest rat is large enough

Maximum value of put
American put : X
European put: X(1+r)-T

Put call parity

S= C(S0, T, X) - P(S0, T, X) + X/(1 + r )

ATM european call or ATM european put, which one has higher price?
S = c - p + pv(x)
c - p = S - pv(x)   ;   S=X for ATM option
c - p =  S - pv(S)  ;  S - pv(S) > 0
So : c > p

Put call forward parity
S= C(S0, T, X) - P(S0, T, X) + X/(1 + r )
F = S0(1+r)
S= F/(1+r)
So : F/(1+r)  = C(S0, T, X) - P(S0, T, X) + X/(1 + r )
  P(S0, T, X) = C(S0, T, X) + (X-F)/(1+r)

Binomial Model
- discrete time model
- if infinite samples, converges to BSM model
- if interval time getting smaller, converges to BSM model
p = (1+r-d) / (u -d)
c = [ pCu + (1-p)Cd ] / (1+r)
if stock price up by 20%, and down by 10%, then: u = 1.2, d = 0.9
S+ = Su; S- = Sd, find Cu, Cd, then find c

Black Scholes Model
- continuous time model
- assume rf and vol are constant
- no taxes and transaction fee
- assume options are european
- assume stock price is normally distributed
- S, T, X, rf, vol -> find c

calculate implied vol
- work backwards to find it
- C, S, X, T, rf ->BSM model -> find implied vol

volatility smile
- shows implied vol is not consistent
- implied vol depends on exercise price
- violates the constant vol assumption of BSM
Implied vol > forecast vol
- option overvalued
- sell option

selling options, the trade is short volatility. if actual vol is lower than what he priced it at, he makes money

Interest rate Cap
- series of interest rate call options

Interest rate Floor
- series of interest rate put options

Wednesday, July 12, 2017

Macroeconomics (Part 2)

Marshall-Lerner condition

A depreciation has two good effects (substitution of imports , more demand for exports) and one bad effects (imports are more expensive). Marshall-Lerner condition is real depreciation leads to an increase in NX if sum of export and import elasticity is > 1. Initially, the condition is not met, devaluation worsens the trade balance. In the long run, trade balance will improve, it is called the  J curve effect.
PED (x-m) > 1, devaluation improves current account balance.

PED: price elasticity of demand

Mundell-Fleming model

An extension of IS-LM model, the Mundell–Fleming model describes the short-run relationship between an economy's nominal exchange rate, interest rate, and output. It is used in open economy. This model has been used to argue that an economy cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. This principle is frequently called the "impossible trinity," "unholy trinity," or the "Mundell–Fleming trilemma."

It is also known is IS-LM-BoP model. BoP is (Balance of Payments).
In perfect capital mobility, the BoP curve is horizontal.

In perfect capital mobility and fixed exchange rate, the increase in gov spending (expansionary fiscal policy) forces the central bank to supply more local currency, to keep the interest rate unchanged. At the same interest rate, the output has increased.


In perfect capital mobility and fixed exchange rate, the increase in local currency  (expansionary monetary policy) will drop the exchange rate. It forces the government to buy local currency to maintain fixed exchange rate. This reduces the money supply. This means monetary policy has no effect.

So it is impossible to have fixed exchange rate, perfect capital movement, and independent monetary policy.

Minimum wage policy

Why minimum wage is not good for the country?
If wage > productivity,
1) πe ↑ => P↑
w ↑ => C ↑, Pe ↑
Pe => πe ↑ => P ↑

2) P ↑ => X ↓ & IM ↑ => NX ↓
P ↑ => ε = EP/P* => ε↑ => NX ↓

Purchasing power of currency and Purchasing power parity

The purchasing power of a currency refers to the quantity of the currency required to purchase a unit of a good, or basket of goods and services. Purchasing power is determined by the relative cost of living and inflation rates in different countries.

Purchasing power parity means equalising the purchasing power of two currencies by taking into account these cost of living and inflation differences. The basis of PPP is law of one price. In the absence of transportation and other transaction costs, competitive markets will make the price of an identical good the same in two countries, expressed in the same currency.

For example, a particular TV set that sells for 400Rp in India should cost 800Rp in Pakistan if the exchange rate between India and Pakistan is 2 Pak/India. If the price of the TV in Pakistan was only 700 Rp, consumers in India would prefer buying the TV set in Pakistan. If this process (called "arbitrage") is carried out at a large scale, the India consumers buying Pakistan goods will bid up the value of the Pakistan Dollar, thus making Pak goods more costly to them. This process continues until the goods are again the same price.

For example again, if we convert GDP in China to US dollars using market exchange rates, relative purchasing power is not taken into account. By adjusting rates to take into account local purchasing power differences, known as PPP adjusted exchange rates, international comparisons are more valid.

Money illusions and Money neutrality

The illusions of money : people think of money in nominal terms, the nominal value of money is mistaken for its purchasing power.

Neutrality of money : change in stock of money affects nominal variables, such as price, wages, exchange rate, doe not affect real variables, such as employment, GDP, consumption.

Microfoundations in Macroeconomics

It is a macro model that is built up from a formal analysis of the behaviour of individual agents in a consistent way. There may be just a single representative agent, or increasingly heterogeneous agents. So this way of macro analysis will involve lots of optimisation by individual agents, to derive aggregate relationships.

Differences between Micro and Macroeconomics
The difference between micro and macro economics is easy to tell. Microeconomics is the study of economics at an individual, group or company level. Microeconomics focuses on issues that affect individuals and companies. Micro looks at supply and demand and the setting of price level.

Macroeconomics, on the other hand, is the study of a national economy as a whole. Macro studies the GDP and how it is affected by national income, unemployment, growth rate.

Monday, July 10, 2017

Fiscal Policy

Fiscal policy
- automatic stabilizer: tax revenue, unemployment benefit
- discretionary policy

tax revenue is endogenous, sensitive to the state of economy than spending

fiscal policy is planned with horizon larger than monetary policy

fiscal consolidation may increase AD, eg. expansionry fiscal contraction
- people expect lower debt, lower taxes in future
- spending cut, wage cut -> labor cost down, Investment up , profit up
- structure reform complement fiscal contraction

Interaction of fiscal and monetary policy

use stackelberg game to model the interaction of policy makers
C- cooperation , Pareto efficient equilibrium 
OM -monetary leadership, OF -fiscal leadership

Government Budget Deficit

deficitt = rBt-1 + Gt -Tt
where r: real interest rate
    Bt-1: government debt at the end of year t-1

let deficitt = Bt - Bt-1
therefore:
B- Bt-1 = = rBt-1 + Gt -Tt
Bt = (1+r)Bt-1 + (Gt -Tt)

-if government spending is unchanged, a decrease in taxes today will have to be offset by an increase in taxes in the future.
-the longer the government waits to increase taxes, the higher the real interest rate, and higher the increase in future taxes

Debt to GDP Ratio

Bt/Yt = (1+r)Bt-1/Yt + (Gt -Tt)/Yt
after mathematics munipulation:
Bt/Yt - Bt-1/Yt-1 = (r-g)Bt-1/Yt-1 + (Gt -Tt)/Yt
where g: GDP growth rate

How countries reduced their debt ratios
- run budget surplus, (Gt -Tt) < 0
- have low real interest rate and high GDP growth, (r - g) > 0, real interest low can be low or even negative when inflation is high.
- a large part of the decrease in debt ratios was achieved by paying bond holders a negative real interest rate on the bonds

Balanced Budget

- It means Gt = Tt
If economy is good, T up -> G up -> cause overheating

If economy is not good, T down -> G down -> econ could not recover

Therefore, balanced budget is not practical

Ricardian Equivalence

David Ricardo developed a theory about government spending and private spending. When government stimulate demand bu debt financed spending, the people will save money to pat for future tax increases (to be used to pay off the debt).
- So overall demand is unchanged

Cyclically Adjusted Deficits

It is used to indicate whether tax/revenue system is going to create deficit at Yn (output at natural full employment). If it is negative at Yn, deficit is *not* going to go down.
- We never know exact Yn, and Yn changes, so Cyclically Adjusted Deficits is not useful

Money Finance
1. Debt Monetization
Fiscal dominance of monetary policy: Central bank must do what the government tells it to do. Government issues bonds and forces CB to buy. The central bank then pays the government with the money it creates, and the government uses that money to finance its deficit. This process is called debt monetization.

2. Seignorage
The amount of good and services that government can obtain by printing money. The revenue from money creation is called seignorage.

seignorage = ΔH/P = ΔH/H * H/P
seignorage/ Y =  (ΔH/H * H/P ) / Y

If government uses seinorage to finance budget deficit of 10% of GDP, seignorage/ Y = 10%, so ΔH/H = 10% and (H/P)/Y = 1,  the growth rate of nominal money must be 10%.









Friday, July 7, 2017

Unconventional Monetary Policy

Quantitative Easing
QE is Large Scale Asset Purchase (LSAP). The Fed buying a set quantity of bonds from private financial institutions
The goal :
to facilitate bank lending and increase money supply
to increase broad money supply even without further bank lending


to lower interest rates for types of risky financial assets
- enlarge the balance sheet of the Fed

misconceptions about QE
- QE gives banks free money
the money is not free because while banks earns interest on the newly created reserves, it also need to pay interest on the newly created deposit


As seen in figure above, pension fund sells gov bond, get cash, buy more risky assets (portfolio rebalancing), support asset prices because of search of yields.

- QE leads to high quantity of M2
customer can use the money to repay loan, and reduce money supply
( customer borrow cheaply, to repay expensive loan)

Monetary Finance
or helicopter money as coined by Milton Friedman
running fiscal deficit, not financed by debt, but by increase in monetary base
such as CB directly credits gov current account, free of interest
- enlarge the balance sheet of CB

Negative Interest Rates
CB charge banks that hold reserve at CB
bank cannot transfer negative rates to deposits, for fear of losing customers
new loans are priced at lower rates
banks net interest income falls
the profit margin between lending and deposit rates is squeezed
banks unwilling to lend -> less bank income -> bank shares fall

the existence of paper currency makes it difficult for CB to take policy rate below zero

Negative Interest Rates policy could be contractionary, as it is a reduction of money supply

Forward Guidance
Management of expectations
let business estimate how long low interest rates may be around
a way of converting low ST interest rates into lower LT interest rates
time inconsistency can be a problem of forward guidance

Financial Crisis
initial phase (credit boom and bust, asset price boom and bust)
->banking crisis->debt deflation
debt deflation: debt become bigger in real terms during deflation

initial phase (credit boom and bust, severe fiscal imbalances)
->currency crisis->financial crisis

wholesale deposits: a deposit at a bank made by institutional investors, such as mutual bank, pension, large business, another bank. It involves large amount of money, and usually short term

** if banks use whole funds as a source of funds, and make long term loan. If wholesale funding dries up, banks could have liquidity problem.

Yield Curve
term spread = 10 yr yield - 2 yr yield  (slope of the yield curve)
stock market is poor indicator of recessions
(the link between stock prices and GDP growth is weak)
yield curve is better indicator of recessions

Breakeven inflation
the rate that make you indifferent between TIPS and nominal bond, if CPI inflation averages to that level over the years
eg. 10 yr breakeven rate = 10 yr nominal treasure yield - 10 yr TIPS yield

if CPI inflation > breakeven inflation, buys TIPS

Thursday, July 6, 2017

The Money Supply Process

Players in the money supply process
- Central Bank
- Commercial Bank
- Depositors: individuals and institutions

Monetary Base = Currency + Reserves
(MB: aka High powered money)

Reserves = RR + excess reserves

Reserves are bank's deposit with CB, plus currency in bank's vault

Monetary Base Changes
To change MB, CB uses OMO, or lending to banks
- to increase MB, buy gov bond
- to decrease MB, sell gov bond

Example: Open market purchase from a bank
CB
Asset                         Liabilities
Securities +100m     Reserves +100m
Commercial Bank
Asset                          L
Securities -100m       no change
Reserves  +100m

Example: Open market sales to a bank
CB
Asset                         L
Securities -100m     Reserves  -100m
Commercial Bank
Asset                          L
Securities +100m       no change
Reserves  -100m

Example: CB lends to bank
CB
Asset                         L
Loans +100m           Reserves  +100m
Commercial Bank
Asset                         L
Reserves +100m       Loans + 100m

MB = MBn + BR
BR: borrowed reserves by banks, cannot controlled by CB
MBn: non borrowed monetary base

Money Creation
CB control MB, but not the overall money supply
commercial banks are creators of deposit money

Bank A
Asset                   L
Reserves +100   checkable deposit +100
(after bank A makes a loan to bank B)
Bank A
Asset                  L
Reserves +100   checkable deposit +100
newloan  +90     newdeposit   +90
(after borrower withdraws cash)
Bank A
Asset                 L
Reserves +10    checkable deposit +100
newloan  +90  
Bank B
Asset                 L
Reserves +90    checkable deposit +90

R = rr x D     ; rr : required reserve ratio, D : deposit, R : reserve
M = m x MB   ; m : money multiplier
M = C + D
MB = C + R = C + rrD + ER
m = (C + D) / (C + rrD + ER)

Definition of Money
narrow money
M0: notes and coins in circulation
MB: M0 + reserves
M1: M0 + checkable deposits + traveler cheques
broad money
M2: M1 + savings deposit, time deposits,




Wednesday, July 5, 2017

Central Bank and Monetary Policy

The Monetary Policy Objectives
Price stability - control inflation
Economic stability - push for sustainable economic growth
Financial stability - efficient payments system

Inflation is bad because:
erode purchasing power
cause uncertainty in economy
reduce country's competitiveness - goods and services become expensive
worse income inequality - the rich can always keep their financial assets in stock market, real estate, foreign assets
other economic costs -  rent seeking behavior, inflation make credit cheap

FX intervention is costly
control depreciation - not enough FX reserve
control appreciation - negative carry, FX valuation loss
- negative carry:  the difference of interest payment on foreign assets and interest payment on domestic gov bonds
- FX valuation loss: the valuation of FX assets reduce when FX depreciate against domestic currency

FX sterilization: to offset the effect of FX intervention. For example, CB sells domestic currency, and buys foreign currency to support its currency. To mop up excess liquidity in the market , do so by selling gov bonds,

Monetary Policy Tools
Reserve requirement (RR):
for liquidity management and monetary control
increase the cost of operation on banks, distort market system if the reserve does not pay interest (it is a tax on banks)

Open Market Operations (OMO):
- repo, reverse repo

1 day bilateral repo rate: policy rate
7 day, 14 day repo rate, auction

- outright purchase/sale of gov bands
- foreign exchange swap

Discount window and discount rate
- discount window also known as standing facility
lending facility , deposit facility
CB lending rate : policy rate + 0.5%
CB borrowing rate : policy rate - 0.5%
iU (CB lending rate ), iL (CB borrowing rate)
iU - iL : interest rate corridor
important to have corridor, CB wants to influence the market rate around the policy rate

- discount rate is usually set at fed fund rate + 100bp. The purpose is the Fed prefers banks to borrow from each other in the federal funds market, so that they can monitor each other's credit risk.

corridor too wide: more volatility in market rate
corridor too narrow: too little penalty for commercial bank when they come to lend/borrow

standing facility and OMO are market based , RR is not market based. If banks don't transmit well, use RR

Monetary Policy Regime
1. exchange rate targeting:
-CB must have sufficient reserves
-CB and gov must be ready to use capital controls

2. monetary targeting:
-target the supply of money in economy

3. inflation targeting:
-public announcement of medium term inflation target,
-easy to understand
-reduces time inconsistency problem
-stresses transparency and accountability
-take time to have effect ( 6 - 8 quarters)
-too much rigidity, eg. inflation nutter

Monetary Policy and Financial Stability
Time inconsistency problem: CB deviate from a policy after it was announced, destroys CB's creditability
Nominal anchor: money supply or inflation rate

** use nominal anchor because the public can observe nominal variable, such as price increase

** second round effect: if wage goes up, price goes, up, wages goes up, wage-price spiral. If CB can anchor inflation expectations, the second round effect is minimal

**if monetary policy is credible enough to anchor inflation expectation, the inflation overall will be  maintained.

Clean vs lean debate:
Lean
besides price stability risk, CB respond to other risk, such as asset bubble risk
because cost of cleaning up is too high
Clean
It is impossible to lean against credit bubbles using monetary policy
difficult to identify asset price bubbles
only clean up after bubble burst

Two types of asset price bubbles:
- credit driven bubble
bank extends BS to investors, debt overhang problem
- "irrational exuberance" bubble
overly optimistic view of the investors

interest rate is a blunt tool, affecting other economic variables
and raising interest rate may not be effective in restraining bubbles

macroprudential policy can be used to reign in asset price bubbles, policy tools such as LTV, leverage ratio, and the below:
countercyclical buffer: good times banks hold more reserves
liquidity ratio: the ratio of liquid assets to total net cash outflows, that banks need to have

It is dangerous to associate easing/tightening of monetary policy with a fall/rise in ST nominal rates. It is important to look at other assets prices as well.
Case study:
In Japan, in the two lost decades, although the nominal rate is low, deflation means real rate remained high. The high real interest rate is reflected in the lower asset prices of real estate and stock valuation.

Monetary Policy and Transmission Channels
Interest rate: real interest rate affects consumers and business, LT interest rate has major impact on spending
Credit supply:
- bank lending channel: policy rate affects banks marginal cost of funds, increase in cost of funds make banks reduce loan
- balance sheets channel: interest rate affects firms balance sheet, firms can borrow more when their balance sheet improves
Asset prices: stock price up, financial wealth up, consumption rises
Exchange rate: FX changes lead to changes in relative prices of domestic and foreign goods and services
Expectations: anchor expectations

Money and Inflation
Nominal Rigidity
- known as price stickiness or wage stickiness
- lags in the adjustment of prices and wages to changes in demand
- so money affects real variables in the short run, and prices in the long run

there are no explicit relationship between money aggregates and inflation but correlation exists

Tuesday, July 4, 2017

International Financial Systems

Balance of Payments
The BoP accounts record all transactions between residents of a country and residents of all foreign nations.

It is composed of
- current account
- capital and finance account
- official reserve account
- statistical discrepancy : net errors and omission

Current Account
- export/import of goods and services
- net income: interest earned on foreign assets, interest paid on foreign debt
- Unilateral transfers: workers remittances from abroad, official grants

Capital and Finance Account
- capital transfer: debt forgiveness, transfer of ownership of fixed assets (it is in capital account and the amount is small)
- direct investment: greenfield investments, FDI
- portfolio investment:  debt and equity securities
- other investments: deposits and loans
- financial derivatives

CA + KA = Δ reserve

Under a flexible exchange rate regime
CA + KA = 0

BoP is a double entry system of accounts

CA: Surplus + / Deficit -
  export + / import -
KA: Net borrowing + / Net lending -
  increase in financial assets -   ; because money going out
  increase in financial liabilities +

Example: import oil
import - ; increase in financial assets +

Example: company export
export + ; increase in financial assets -

Example: borrowing from abroad
 increase in financial liabilities +
 increase in financial assets -

BoP effect on exchange rate
export ↑ -> CA surplus ↑ -> FX rate ↑

KA surplus ↑ -> demand for local currency ↑ -> FX rate ↑

reduce appreciating pressure on local currency, sell local currency, buy USD
-> reserve ↑

Interpretation of CA
- Trade balance: CA deficits reflect living beyond one's mean
- Difference in national savings and investment
Y = C + I + X - M ; ignore G
Y - C - I = X - M
S - I = X - M
it reflects high investment and low savings rate

- Timing of trade
CA deficit means choose to consume now by borrowing from abroad
CA surplus means choose to consume later by lending to abroad

consumption smoothing
- borrow from future income, and spend today

Role of International Reserves
- reduces currency speculation
- precautionary purpose, as insurance cover to smooth temporary stops in capital flows

FX Intervention
Unsterilized FX intervention
- domestic currency is sold to purchase foreign assets -> increase in international reserves - > increase in money supply -> domestic currency depreciation
Sterilized FX intervention
To counter the effect of FX intervention above, CB sells gov bond, reduces the money supply

Reserves adequacy
Traditional measures:
- Trade based : reserves to monthly import , 3-4 months
- Debt based : reserves to ST external debt ,  > 100%
- Money based : reserves to M2 ; 5-10% if flexible exchange rate
 (flexible exchange rate act as automatic stabilizer)

Drawbacks of Traditional measures
- reserves to months of imports, neglect international financial linkages
- reserves to ST external debt, neglect other liabilities (stock holdings, bond holdings)
- reserves to broad money, neglect external drain on reserves

Having reserves means intervening in FX market?

New approaches:
- BoP stress testing: scenarios looking at all BoP items
- insurance model : cost benefits of holding reserves, eg. negative carry, valuation loss
- balance sheet analysis

**BoP is flow concept, need to look at stock holdings

Case study: China's FX reserves
China's exports are larger than its imports, it is running a positive trade balance. Foreign currency flows into China via trade flows and investment flows. The more foreign currency is floating in its economy, the lower the price of that currency relative to domestic currency will be. This will have appreciation pressure on domestic currency.  To offset, the CB will sell domestic currency and buys up the foreign currency. The intervention will build up the FX reserves.

Capital Controls
- produces misallocation and corruption
- not effective in the long run (people will find a way to circumvent the restrictions)
- delay reform, money flow out because domestic investment opportunity maybe not attractive
- better to strengthen econ fundamentals, and improve bank regulation

Saturday, July 1, 2017

Labor Economics (Part 2)

Demand for Labor

Principles
Labor demand = derived demand (product demand comes first, labor demand comes second)

government influences:
- min wages
- welfare laws
- retirement , pension regulation
- safety protection laws
- immigration control
increase the cost of hiring labor

profit maximization
2 preconditions
- price are influenced by the market ( profit max is done thru output decision)
- most decisions are marginal (incremental)

max profit = incrementally optimise output
- if income of one additional input unit > expense of unit => add more input
- if income of one additional input unit < expense of unit => reduce input

2 input factors: labor , capital

marginal product
  MPL = dQ/dL ( holding capital constant)
  MPK = dQ/dK ( holding labor constant)

marginal revenue
  MR = P in competitive mkt

marginal revenue product
  MRPL = MPL * MR     =>     MRPL = MPL * P

marginal expense of labor
  MEL = w  ( forms are wage takers in competitive mkt)

Employee Value Proposition
- what ppl can get out of the company
- why ppl would want to work there

Labor demand in the SR
(capital is fixed, only labor can be adjusted)
assume declining MPL, diminishing marginal returns

from profit max to labor demand, MRPL = MEL
MPL*P = w ; in dollar term
MPL = w/P ; in physical quantity
at E2, MPL < (w/p)0, make a loss, reduce employees
at E1, MPL > (w/p)0, make a profit, increase employees

not making judgement about individual, labor are interchangeable

criticism (to the marginal productivity theory of demand)
- firms don not really understand MPL, firm guess the value added of a worker
- adding labor without increasing capital does not work
 (not entirely true: holiday coverage. shift breaks)

Labor demand in the LR
LR: other input factors can be varied and affect the demand for labor
Two equations must be fulfilled:
MPL = W/P   ;   MPK = C/P

so   W/MPL = C/MPK
- marginal cost of producing an extra unit, using capital , same as marginal cost of producing an extra unit, using labor
- to maximise profit, firm must adjust the labor and capital inputs, so that MC of an extra unit is equal, whether using L or K

(to be continued...)