What is the theoretical relation among various rates in Economics?

I have been reviewing study session 4 in CFA Level 2 Economics and I can’t seem to get my head around all the parity relations… hence a post to clarify my thoughts and develop a clear understanding.

All parity relations are a function of exchange rates, nominal interest rates, real interest rates and inflation rates between the a pair of countries/currencies.

Interest Rate Parity – Exchange Rate > Nominal Interest Rate

Covered Interest Rate Parity:

forward exchange rate as a function of the spot exchange rate and nominal interest rates.

Uncovered Interest Rate Parity:

expected spot exchange rate as a function of the current spot exchange rate and nominal interest rates

International Fischer Relation – Inflation Rate > Nominal Interest Rate

difference in nominal interest rates should be equal to difference in expected inflation rates because real rates as equal

Purchasing Power Parity (PPP) – Exchange Rate > Inflation Rate

Absolute PPP

price of a basket of similar goods between two countries should be equal (rarely is in practice)

Relative PPP

expected spot exchange rate as a function of the current spot exchange rate and inflation rates (note similarity to uncovered interest rate parity)

Approximate Relative PPP

difference in inflation rates is equal to the expected appreciation/depreciation of the currency

The above stuff is easy on its own but gets tricky when combined with International Asset Pricing reading from study session 18 on Portfolio Management.

Real Exchange Rate

explains the changes in nominal exchange rate not explained by the difference in price levels i.e.

(Note here that the price levels are already adjusted for inflation, hence if real exchange rates are constant then any change in nominal exchange rate is explained by the difference in inflation)

Also,

% Change in Real Exchange Rate = % Change in Nominal Exchange rate – (Inflation in DC – Inflation in FC)

Foreign Currency Risk Premium – Exchange Rate > Real Interest rates

is the difference between the % change in exchange rates and the difference in real interest rates

I think that should clarify the interplay of different rates.

Emerging Markets – Can’t get past the (inflation) hump?

Where are emerging markets going? Do the emerging market central banks and Treasurers have the balls to stop inflation or they can’t live without the growth on stereoids?

The MSCI iShares Emerging Markets index has failed twice to break the 2008 highs… are we heading lower to test May 2010 levels or break the 2008 highs?

Implications for Financial Statements & Ratios of Inventories

Summary of new* chapter in 2011 – Inventories  & Implications for Financial Statements & Ratios (longish…)

CFA Level 2 – Financial Reporting & Analysis

Study Session 5, Chapter 21 in textbook

*(I am certain I have read this material before for CFA, don’t remember if it was Level 1 or 2)

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Terminology & Formula:

• Inventory Valuation Method = Cost Formula (IFRS) = Cost Flow Assumption (US GAAP)
• Cost of Sales = Cost of Goods Sold (COGS) = Beginning Inventory + Purchases – Ending Inventory
• Inventory Turnover = Activity Ratio = COGS ÷ Ending Inventory (sometime Average Inventory)
• Gross Profit Margin = Gross Profit ÷ Sales
• LIFO Reserve = FIFO Inventory Value – LIFO Inventory Value (needed to convert COGS under LIFO to FIFO)
• Days of Inventory on Hand = # of Days in Period ÷ Inventory Turnover Ratio

Converting from LIFO to FIFO

• Inventory in FIFO = Inventory in LIFO + LIFO Reserve
• COGS in FIFO = COGS in LIFO – Change in LIFO Reserve
• Total Assets in FIFO = Total Assets in LIFO + LIFO Reserve – Cash Paid for Additional Income Tax

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Table1: Allowed methods of Inventory Accounting under IFRS & US GAAP

Methods of Inventory Valuation	IFRS, US GAAP or Both
FIFO (first-in first-out)	Both
LIFO (last-in first-out)	US GAAP only
WAC (Weighted Average Cost)	Both
SI (Specific Identification)	Both

CFA Economics – Productivity & Foreign Exchange & Interest Rate Parity Relations

Post 2 on Economics

Study Session 4

Chapters: 14, 15, 16 & 17

Productivity Curve

Productivity curve = Real GDP/Labour Hour (y-axis) vs Capital / Labour Hour (x-axis) for a given level of technology

· Follows law of diminishing returns

· Increase in capital increases productivity i.e. movement along the productivity curve

· Technological advances shifts productivity curve upwards and increases productivity/labour hour for the same level of capital/labour hour

1/3rd rule à 1 % increase in capital = 1/3 % increase in real GDP (assuming constant technology)

Foreign Exchange Parity Relations

Impact of Current Account Deficit on FX

All else constant, a country with a current account deficit experiences currency depreciation and vice versa… why?

· Current account deficit implies Imports are greater than Exports

· Importers sell domestic currency and buy foreign currency to pay for imports

Impact of Capital (or Financial) Account Surplus on FX

All else constant, a country with a capital account surplus experiences currency appreciation and vice versa…why?

· Capital account surplus implies high demand for domestic assets

· Buyers require domestic currency to purchase these assets and sell foreign currency

Official Reserve Account (i.e. Official Settlement Account)

As the name implies, it includes all reserves i.e. gold, foreign exchange, SDRs, etc. Central banks accumulate and drain reserves by intervening in the FX market (China gets the most coverage here!)

Parity Relations (do not hold in the real world, only holds in economics la-la-land!)

1. Purchasing Power Parity (PPP) states that a basket of goods and services should cost the same all over after adjusting for exchange rates…the Economist’s Big Mac Index is proof that PPP does not hold!

2. Relative Purchasing Power Parity states that expected foreign exchange rates in the future is a ratio of inflation rates between the two countries… the higher inflation currency depreciates relatively.

3. Interest Rate Parity states that forward foreign exchange rate i.e. expected future spot rate is a ratio of interest rates between the two countries

4. International Fischer Relation states that the difference between nominal interest rates is approximately equal to the difference in expected inflation rates

I will try to post some examples of parity relations in another post…

Update: I obviously haven’t had a chance to post examples but go read this post on Currency Wars by BBC’s Paul Mason.

Inflation… still no chance

Couple months ago I posted a chart on inflation in Canada… even though interest rates have risen since the QE2 announcement, this hasn’t changed inflation expectations dramatically…

Here is the updated long-term chart of inflation expectations as implied by Real-Return bonds…

And here is the above data since the formal QE2 announcement (3-Nov-2010)… the green line is flat implying inflation expectations haven’t changed in Canada…

…although your daily bills (grocery, gas, insurance, etc) have only gone up! How does that add up? Paul Krugman does an excellent job of explaining core inflation (excluding food & energy) vs total inflation.

Update [7-Jan-2010]: Paul Amery at SeekingAlpha talks about (non-existent) inflation expectations globally

Rising Interest Rates – thanks to QE?

If you haven’t already heard so…interest rates have reversed their downward trend to dramatically move up since the November Federal Reserve meeting, Quantitative Easing (QE2) announcement… QE2 is supposed keep US interest rates low… would you have thought that it would affect rates elsewhere?

Year-to-Date chart of Canadian interest rates…

As marked on the chart, interest rates in Canada have risen significantly over the last 6 weeks… especially the medium to long term rates in the 2-10 year terms. The 5-year rate is at 2.56%, same as in mid-July.

Here is the term chart or the Canadian yield curve… see the parallel shift in yield across all terms!

This means, borrowing costs will increase in proportion… yes, including mortgage rates, particularly fixed rates.

The 5-year fixed rates are as low as they have ever been… but they will be rising shortly; see this

The Bank of Canada hasn’t indicated any shift in monetary policy since the last rate hike in Sep-2010… so why are rates in Canada rising? Possible reasons:

· Higher inflation expectation

· Better than expected economic growth

· Bond markets are overbought

· Rising risk of default (!)

Stay tuned… I will explore each of these possibilities in the coming days…

GTA Housing Update – Real vs Nominal

As previously mentioned, I have been posting some stats/chart on Greater Toronto Area (GTA) housing market and only now am I trying to fully understand the dynamics…

David Leonhardt at Economix (NY Times) has an interesting post on mortgage rates and (real) house prices

“Anyone who argues that home prices do not seem headed for another big decline will probably hear some version of this question. Interest rates are historically low right now. They will surely rise at some point. All else equal, higher rates should push down home prices.”

This got me thinking about the Canadian housing market – is there a correlation between mortgage rates and house prices? The following chart plots the average (nominal) house prices in Greater Toronto Area (GTA) against the 5-year (undiscounted) mortgage rates… the right half of the graph i.e. circa 1990 onwards, there is clear negative correlation between house prices and rates i.e. rates going down pushes house prices up.

David correctly points out that this relation didn’t hold in 1980s when mortgage rates shot up… house prices kept increasing!

David concludes:

“My best guess for why the two don’t correlate more closely is the role that psychology plays in housing markets. Prices just don’t move as quickly as economic theory suggests they should.”

Jake at EconomPic compares real house prices with real mortgage rates… see chart for GTA below

Note: The right scale showing real mortgage rates is inverted to better emphasize the correlation

Caveat: I’m using really crude data here: Average house prices instead of an index like the Teranet House Price Index… Unfortunately there is no index for Canadian house prices prior to 1990s.

The only conclusion I can draw from the real prices/rates chart is that Real Rates lead real house prices… the green line follows the direction and trend of the red line with a lag factor. This reinforces my conclusion from yesterday’s post that another demand push might be in the cards due to “ultra low mortgage rates”

No Chance of Inflation in Canada – Long Term

Do you really think we are in inflation? When was the last time you paid for something that costs less than it did a year ago?… Never, that’s right… here is Canada’s historical inflation rate

If you want to know whether the bond market expects inflation or deflation, you don’t need to be a rocket scientist to figure out… it is very simple.

The implied or expected inflation rate is the difference between the yield on a nominal Government of Canada bond and the equivalent maturity real-return (see definition below) Government of Canada bond. The chart below clearly shows that markets expect inflation to hover in the 2% range in the long-term.

Real-return bonds are Government of Canada bonds on which the principal and coupon are adjusted based on the inflation rate as measured by the Consumer Price Index. If inflation is increasing, then the coupon and principal on a real-return bond increases proportionally.

Deflation means persistent negative year-over-year change in Consumer Price Index… from a historical perspective, Canada had 2 bouts of deflation – both during the Great Depression of the 1920s/30s.

Short term uptrend in Gold broken, Correlation to USD & more

The 1-year uptrend channel (blue lines) is violated… The recent new (nominal) high did not make a new high in RSI or MACD…(negative divergence for the technically inclined & the dotted red lines on the chart) means the recent high was made on declining momentum – not a good sign.

I have drawn out the various support levels from here down and my short term (< 1 year) bias is to the downside especially for August… Demand is slow during the summer months because most jewelery manufacturers are shut down and don’t reopen till September…

Source:stockcharts.com

US Dollar & Gold Correlation

In theory, a commodity priced in USD dollars will move inversely to the value of USD e.g.- if Gold goes up in USD, then the value of USD in other currencies goes down and vice versa. Among all commodities, Gold particularly exhibits a strong negative correlation in a “normal” volatility year… during highly volatile or uncertain economic periods, this correlation deviates significantly from the norm…

Lately Gold & USD have been moving in lock-step… i.e. positively correlated as illustrated in this nice chart from Bespoke Investment Group

Source: Bespoke Investment Group

Eventually the correlation has to revert to its mean… which would mean that USD & Gold move in opposite directions. Couple weeks ago I posted a chart of the US Dollar Index positing that USD will reverse the downtrend and rally… hasn’t happened yet but I still think the USD is at a key support level and will rally from here and expect Gold to continue the downtrend…

Also, Gold has risen 21% from 1044 in Feb 2010 to its intraday high of 1265 in June 2010 without a 10% correction… of course it can go higher without correcting but the subsequent correction will be just as severe…

Lastly… Inflation

Historically, Gold is also meant to be a hedge against inflation… if you have been reading the news lately, you know well that prices are declining not rising so I believe the argument of buying Gold right now as a hedge against inflation is bogus!

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Update: Gold during Deflation via ZeroHedge

According to Casey Reseach

There’s lots of data about what gold does during periods of high inflation, but less so with deflation, partly because we don’t see a true deflation all that often. But of course we’ve got the biggie we can look at, and the seriousness of the Great Depression can give us a big clue as to how gold stocks behave in a true deflationary environment

This chart from the above post is quite interesting:

Source: zerohedge.com

From 1929 until January 1933, the stock of Homestake Mining, the largest gold producer in the U.S., rose 474%. Dome Mines, the largest Canadian producer, advanced 558%. In spite of the gold price being fixed at the time, gold stocks rose dramatically.

At the same time, the DJIA lost 73% of its value

…

The bottom line is that the two largest gold producers – during a time of soup lines and falling standards of living – handed investors five and six times their money in four years.

What about gold itself? On April 5, 1933, President Roosevelt issued an executive order forcing delivery (i.e., confiscation) of gold owned by private citizens to the government in exchange for compensation at the fixed price of $20.67/oz (you can read the original order here). And less than nine months later, he raised the gold price to $35, effectively diluting every dollar 41% overnight and swindling everyone who had turned in his gold.We don’t know exactly what an untethered gold price would have done during the depression, but given its distinction in history as a store of value, we believe it would retain its purchasing power in a deflationary setting regardless of its nominal price. In other words, while the price of gold might not rise, or could even fall, your best protection is still gold.

 

 This is the only quasi-convincing article I have seen on owning Gold in deflation. A lot of well-respected economists (David Rosenberg, Roubini, etc) and financial bloggers (Mish) are urging investors to own gold during deflation but without an objective reasoning… Perhaps that is as noted above due to the lack of true deflation in a fiat monetary system.

Performance of Canadian assets this decade

How have various Canadian Assets performed since the heydays of 2000?

Which asset do you think appreciated the most?

stocks
bonds
commodities
your house

The chart below answers your question…

For the curious, here is the table with the relevant values:

Asset Class	Proxy	Annualized Return	Total Return (Unannualized)	Value of $100 at Start of Period
Stocks	S&P TSX Composite Index	3.67%	45.13%	$145
Bonds	iShares Canada DEX Universe Bond Index	3.94%	43.95%	$144
Commodities	Bank of Canada Commodity Price Index	5.78%	78.68%	$179
Existing Homes	Teranet House Price Index	6.22%	86.51%	$187
Inflation	Consumer Price Index	1.89%	21.30%	$121

Data Source:

Bank of Canada, Teranet, iShares & Yahoo Finance