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Category: Essential Concepts for Level II

Essential Concept 11: Model Training

Model training consists of three major tasks: method selection, performance evaluation, and model tuning. Method selection: This decision is based on the following factors: Whether the data project involves labeled data (supervised learning)or unlabeled data (unsupervised learning) Type of data: numerical, continuous, or categorical; text data; image data; speech data; etc Size of the dataset Performance evaluation: Commonly used techniques are: Error analysis using confusion matrix: A confusion matrix is created with four categories – true positives, false positives, true negatives and false negatives. The following metrics are used to evaluate a confusion matrix: Precision (P) = TP/(TP + FP)… Read More

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Essential Concept 12: Comparison of Scenario Analysis, Decision Trees, and Simulations

The table below summarizes what probabilistic approach to use based on the type of risk and whether the risk elements are correlated or not: Discrete/ Continuous Correlated/ Independent Sequential/ Concurrent Risk Approach Discrete Independent Sequential Decision Tree Discrete Correlated Concurrent Scenario Analysis Continuous Either Either Simulations The table below summarizes whether the three probabilistic approaches can be used as complements or substitutes for risk-adjusted value. Complements Risk-Adjusted Value Substitute for Risk-Adjusted Value Scenario Analysis Yes No Decision Tree Yes Yes Simulations Yes Yes

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Essential Concept 13: Triangular Arbitrage

A triangular arbitrage opportunity exists if either of these conditions is violated: Dealer cross-rate bid must be lower than the implied interbank cross-rate offer Dealer cross-rate offers must be higher than the implied interbank cross-rate bid To determine whether a triangular arbitrage opportunity exists, follow these steps: Calculate the cross-rate implied by the interbank market. Compare the interbank rate with the dealer rate If dealer bid > interbank offer (DBi G IO) ? buy base currency in the interbank market and sell to the dealer If dealer offer < interbank bid (DO L IB) ? buy base currency from dealer and… Read More

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Essential Concept 14: International Parity Conditions

Covered interest rate parity states that an investment in a foreign money market instrument that is completely hedged against exchange rate risk should yield exactly the same return as an otherwise identical domestic money market investment.   Uncovered interest rate parity states that the expected return on an un-hedged foreign currency position should equal the return on a similar domestic currency investment. Forward rate parity states that the forward exchange rate will be an unbiased predictor of the future spot exchange rate if covered interest rate parity and uncovered interest rate parity hold.   The ex-ante version of PPP states… Read More

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Essential Concept 15: Effects of Monetary and Fiscal Policy on Exchange Rates

Effects of monetary and fiscal policy on exchange rates are explained through the following models: The Mundell-Fleming model: The short run impact of monetary and fiscal policies is summarized in the tables below. High Capital Mobility Expansionary Monetary Policy Restrictive Monetary Policy Expansionary Fiscal Policy Indeterminate Domestic currency appreciates Restrictive Fiscal Policy Domestic currency depreciates Indeterminate   Low Capital Mobility   Expansionary Monetary Policy Restrictive Monetary Policy Expansionary Fiscal Policy Domestic currency depreciates Indeterminate Restrictive Fiscal Policy Indeterminate Domestic currency appreciates   Monetary models of exchange rate determination: Monetary models assume that output is fixed and policies affect exchange rates… Read More

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Essential Concept 16: Growth Accounting Relations

Growth accounting is used to analyze the performance of economies. The growth accounting equation is as follows: i.e. growth rate of output = rate of technological change + α (growth rate of capital) + (1 – α) (growth rate of labor). An alternative method of measuring potential GDP is the labor productivity growth accounting equation. Under this approach, the equation for estimating the potential GDP is: Growth rate in potential GDP = Long-term growth rate of labor force + Long-term growth rate in labor productivity. The growth accounting equation is used to: Estimate contribution of technological progress Measure sources of… Read More

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Essential Concept 17: Theories of Economic Growth

Classical Model (also called Malthusian Theory) Growth in real GDP per capita is temporary. Rise in real GDP per capita above subsistence level results in a population explosion. Real GDP per capita returns to subsistence level.   Neo-Classical Model In steady state capital per worker and output per worker grow at equal sustainable rates. Long-run per capita growth depends on exogenous technological progress. Capital deepening has no impact on growth rate or on marginal product of capital. There will be convergence of per capita income in developing and developed countries. Three important relationships to remember are: Growth rate of output… Read More

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Essential Concept 18: Convergence Hypotheses

According to the convergence hypotheses, countries with low per capita incomes should grow at a faster rate than countries with high per capita income and eventually converge. The neoclassical model predicts two types of convergence: absolute and conditional. Absolute convergence implies that developing countries, regardless of their particular characteristics, will eventually catch up with the developed countries and match them in per capita output. Conditional convergence implies that convergence is conditional on the countries having the same saving rate, population growth rate and production function. If these conditions hold the model implies convergence to the same level of per capita… Read More

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Essential Concept 19: Regulatory Interdependencies

According to regulatory capture theory, the regulator is often dominated by individuals who are closely connected with the industry they should be regulating. Regulatory competition refers to a situation where regulators compete with each other to provide a regulatory environment designed to attract certain entities. Regulatory arbitrage is where entities may identify and use some aspect of regulations that allows them to exploit differences in regulatory interpretation. Regulatory arbitrage also includes situations where entities try to exploit differences in regulatory regimes in different regions.

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Essential Concept 20: Benefits and Costs of Regulation

Regulatory burden refers to the costs of regulation for the regulated entity. Net regulatory burden is the private cost of regulation less the private benefits of regulation. A cost-benefit analysis should be conducted before any new regulation is implemented. Regulators should consider both the implementation costs of regulation as well as the indirect costs. Post implementation, the actual costs and benefits should be compared with the expected costs and benefits. This ‘retrospective analysis’ allows for a more informed assessment of whether any changes need to be made to the regulation. Regulators can also make use of ‘regulatory sandboxes’, where new… Read More

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