This document appears to be a student project on interest rate parity submitted for a university course. It includes a title page with the student's name and details, a declaration signed by the student, an acknowledgements section thanking the professor for guidance, and a table of contents listing the various sections of the project. The sections discuss concepts like covered and uncovered interest rate parity, the assumptions of interest rate parity, and covered interest rate parity specifically. Diagrams and equations are provided to illustrate the concepts.
Interest rate parity is a theory stating that the interest rate differential between two countries should equal the forward exchange rate premium or discount relative to the spot exchange rate. This establishes a break-even condition where returns on domestic and foreign currency investments are equal after accounting for exchange risk. If interest rate parity is violated, an arbitrage opportunity exists where investors can borrow, invest, and exchange currencies to earn risk-free profits. Kim Deal, a European portfolio manager, should choose to invest in 1-year Japanese yen deposits covered by a 1-year forward contract to hedge exchange risk, as this option provides the highest euro return of €352,005 compared to €352,000 from euro deposits.
The document discusses the international Fisher effect (IFE), which predicts that differences in nominal interest rates between two currencies will cause an equal but opposite change in their spot exchange rates. It provides the simple formula for calculating future spot exchange rates based on current rates and expected inflation and interest rates. An example calculation is shown where the US dollar is expected to depreciate against the South Korean won due to the higher nominal interest rate in the US.
The Interest Rate Parity states that the difference between interest rates of two countries equals the difference between the forward and spot exchange rates. It plays an essential role in foreign exchange markets by preventing arbitrage opportunities. When returns on two currencies are equal, interest rate parity prevails. Factors like expected inflation, monetary policy, and economic conditions influence market interest rates. Interest rate parity implies that if the domestic interest rate is lower than the foreign rate, domestic investors will invest abroad to benefit, and vice versa if the domestic rate is higher.
The document discusses interest rate parity and covered interest arbitrage. It provides definitions and explanations of these concepts. Specifically:
1) Interest rate parity is a condition where the interest rate differential between two countries equals the difference between the forward exchange rate and the spot exchange rate.
2) Covered interest arbitrage involves borrowing in the lower yielding currency, converting to the higher yielding currency, and hedging the exchange risk through a forward contract.
3) Market forces will eliminate opportunities for covered interest arbitrage by adjusting interest rates and exchange rates until parity is reached.
International parity-conditions-9-feb-2010Nitesh Mandal
This document discusses several international parity conditions that can be used to predict foreign exchange rates:
1. Purchasing power parity (PPP) states that exchange rates should equalize price levels between countries based on a basket of goods.
2. The international Fisher effect (IFE) states that exchange rates adjust to equalize interest rate differentials between countries.
3. Interest rate parity (IRP) focuses on spot and forward exchange rates between countries' money and bond markets and establishes a break-even condition for returns.
4. Forward rates are expected to be an unbiased predictor of future spot rates according to the expectations theory of exchange rates.
These parity conditions are interrelated
The document discusses the concept of purchasing power parity (PPP). It defines PPP as the exchange rate between two currencies that would equalize the purchasing power of the currencies in their respective countries. The document notes that under PPP, a given amount of one currency should have the same purchasing power whether used directly to purchase goods in that country or converted to the other currency at the PPP rate. It then asks several questions about how inflation, interest rates, and other factors may impact exchange rates. The rest of the document provides explanations of absolute and relative PPP, how PPP is used to make cross-country comparisons, and some limitations of the PPP theory.
The document discusses several concepts related to international finance including:
1) Purchasing power parity, interest rate parity, and the Fisher effect which relate exchange rates, interest rates, and inflation rates between countries.
2) Arbitrage opportunities that can arise from differences in exchange rates quoted by different traders.
3) Conditions like the law of one price that must hold for arbitrage to exist.
4) Absolute and relative forms of purchasing power parity and limitations of the theory.
5) How interest rate parity explains differences between spot and forward exchange rates.
This document discusses the international Fisher effect and interest rate parity. It explains that the Fisher effect postulates a relationship between nominal interest rates and real interest rates adjusted for inflation. According to the Fisher effect, high inflation leads to high nominal interest rates. The document also discusses how interest rate parity argues that identical securities should have the same price when quoted in a common currency, so interest rate differentials between countries tend to be offset by forward exchange rate premiums or discounts.
Interest rate parity is a theory stating that the interest rate differential between two countries should equal the forward exchange rate premium or discount relative to the spot exchange rate. This establishes a break-even condition where returns on domestic and foreign currency investments are equal after accounting for exchange risk. If interest rate parity is violated, an arbitrage opportunity exists where investors can borrow, invest, and exchange currencies to earn risk-free profits. Kim Deal, a European portfolio manager, should choose to invest in 1-year Japanese yen deposits covered by a 1-year forward contract to hedge exchange risk, as this option provides the highest euro return of €352,005 compared to €352,000 from euro deposits.
The document discusses the international Fisher effect (IFE), which predicts that differences in nominal interest rates between two currencies will cause an equal but opposite change in their spot exchange rates. It provides the simple formula for calculating future spot exchange rates based on current rates and expected inflation and interest rates. An example calculation is shown where the US dollar is expected to depreciate against the South Korean won due to the higher nominal interest rate in the US.
The Interest Rate Parity states that the difference between interest rates of two countries equals the difference between the forward and spot exchange rates. It plays an essential role in foreign exchange markets by preventing arbitrage opportunities. When returns on two currencies are equal, interest rate parity prevails. Factors like expected inflation, monetary policy, and economic conditions influence market interest rates. Interest rate parity implies that if the domestic interest rate is lower than the foreign rate, domestic investors will invest abroad to benefit, and vice versa if the domestic rate is higher.
The document discusses interest rate parity and covered interest arbitrage. It provides definitions and explanations of these concepts. Specifically:
1) Interest rate parity is a condition where the interest rate differential between two countries equals the difference between the forward exchange rate and the spot exchange rate.
2) Covered interest arbitrage involves borrowing in the lower yielding currency, converting to the higher yielding currency, and hedging the exchange risk through a forward contract.
3) Market forces will eliminate opportunities for covered interest arbitrage by adjusting interest rates and exchange rates until parity is reached.
International parity-conditions-9-feb-2010Nitesh Mandal
This document discusses several international parity conditions that can be used to predict foreign exchange rates:
1. Purchasing power parity (PPP) states that exchange rates should equalize price levels between countries based on a basket of goods.
2. The international Fisher effect (IFE) states that exchange rates adjust to equalize interest rate differentials between countries.
3. Interest rate parity (IRP) focuses on spot and forward exchange rates between countries' money and bond markets and establishes a break-even condition for returns.
4. Forward rates are expected to be an unbiased predictor of future spot rates according to the expectations theory of exchange rates.
These parity conditions are interrelated
The document discusses the concept of purchasing power parity (PPP). It defines PPP as the exchange rate between two currencies that would equalize the purchasing power of the currencies in their respective countries. The document notes that under PPP, a given amount of one currency should have the same purchasing power whether used directly to purchase goods in that country or converted to the other currency at the PPP rate. It then asks several questions about how inflation, interest rates, and other factors may impact exchange rates. The rest of the document provides explanations of absolute and relative PPP, how PPP is used to make cross-country comparisons, and some limitations of the PPP theory.
The document discusses several concepts related to international finance including:
1) Purchasing power parity, interest rate parity, and the Fisher effect which relate exchange rates, interest rates, and inflation rates between countries.
2) Arbitrage opportunities that can arise from differences in exchange rates quoted by different traders.
3) Conditions like the law of one price that must hold for arbitrage to exist.
4) Absolute and relative forms of purchasing power parity and limitations of the theory.
5) How interest rate parity explains differences between spot and forward exchange rates.
This document discusses the international Fisher effect and interest rate parity. It explains that the Fisher effect postulates a relationship between nominal interest rates and real interest rates adjusted for inflation. According to the Fisher effect, high inflation leads to high nominal interest rates. The document also discusses how interest rate parity argues that identical securities should have the same price when quoted in a common currency, so interest rate differentials between countries tend to be offset by forward exchange rate premiums or discounts.
The document discusses several parity conditions in international finance that provide an intuitive explanation of the movement of prices and interest rates in different markets in relation to exchange rates. It introduces key concepts like purchasing power parity (PPP), which states that inflation rates should equal changes in exchange rates, and the law of one price, which says identical goods should have the same price when expressed in a common currency. The document contrasts the absolute and relative forms of PPP and provides examples of how PPP can be used to forecast future exchange rates and calculate real exchange rates.
This document discusses several international parity conditions:
- The law of one price states that identical goods should have the same price when expressed in a common currency.
- Purchasing power parity suggests that exchange rates will adjust to compensate for differences in prices of the same goods between countries.
- Covered interest parity implies that interest rate differentials should be offset by changes in forward exchange rates to prevent arbitrage opportunities.
- Reasons for deviations from these conditions include trade barriers, non-traded goods, measurement issues, and political/tax differences.
Foreign Exchange market & international Parity Relationspalakurthiharika
The document discusses several key concepts related to foreign exchange markets and exchange rate determination. It describes the foreign exchange market as where individuals, firms, banks, and brokers buy and sell foreign currencies. Exchange rates are determined by the demand and supply of currencies based on factors like interest rates, inflation rates, purchasing power parity, and investor psychology. Theories like interest rate parity and purchasing power parity aim to explain exchange rate movements, though other short-term factors also influence rates.
The document discusses the Purchasing Power Parity (PPP) theory, which states that exchange rates between currencies are determined by their relative purchasing power. It explains that under PPP, exchange rates adjust to changes in inflation so that the same goods cost the same in each country when prices are converted to a common currency. The document outlines the absolute and relative versions of PPP theory and notes some limitations, such as differences in goods baskets between countries. An example is provided to demonstrate how exchange rates adjust proportionally according to changes in domestic and foreign inflation rates under relative PPP.
This document summarizes several international parity conditions:
1) Purchasing power parity states that identical goods should sell for the same price worldwide when accounting for transportation costs, taxes, and other factors. It is a manifestation of the law of one price applied internationally.
2) Absolute and relative purchasing power parity refer to comparing the price of a standard basket of goods across currencies and changes in inflation affecting exchange rates.
3) Interest rate parity or the Fisher effect relates nominal interest rates, real interest rates, and expected inflation rates both within and between countries. It posits that nominal rates equal real rates plus inflation.
Interest rate parity is a no-arbitrage condition representing an equilibrium state under which investors will be indifferent to interest rates available on bank deposits in two countries. A theory in which the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate. Covered interest arbitrage allows an investor to exploit interest rate differentials between currencies by investing in the higher yielding currency while hedging exchange rate risk through a forward contract. The international fisher effect suggests that interest rate differentials between countries may be the result of differences in expected inflation, and that exchange rates will adjust to changes in expected inflation differentials.
This document discusses uncovered interest rate parity (UIRP) and covered interest rate parity (CIRP), which relate interest rates between countries to exchange rates. UIRP refers to parity when exposed to exchange rate risk, while CIRP uses forward contracts to eliminate exchange rate risk. The document provides an example where UK interest rates are 2% and Japanese rates are 1%, requiring the pound to depreciate 1% against the yen to avoid arbitrage opportunities. It also discusses purchasing power parity (PPP), which estimates exchange rates needed for currencies to have equal purchasing power based on market baskets of goods. PPP helps minimize misleading international comparisons that can arise from using market exchange rates alone.
The document discusses several foreign exchange parity conditions and arbitrage activities:
1) Purchasing power parity states that exchange rates will adjust to reflect differences in inflation rates between countries. Absolute PPP says price levels should be equal globally, while relative PPP says exchange rates adjust for domestic and foreign price levels.
2) Interest rate parity establishes that forward rates differ from spot rates by an amount offsetting interest rate differentials, eliminating arbitrage profits.
3) Arbitrage activities seek to profit from temporary deviations from these parity conditions by exploiting differences in currency prices across locations or markets. This helps drive prices back into alignment.
The document discusses the theory of purchasing power parity (PPP). It defines PPP as the principle that identical baskets of goods should have the same price when expressed in a common currency if not for trade barriers. Absolute PPP suggests prices levels should be equal across countries, while relative PPP suggests inflation differentials should equal exchange rate depreciation. The document provides examples of how PPP can be used to estimate exchange rate levels and changes. It also discusses factors like transaction costs and non-traded goods that can cause deviations from PPP in practice.
Interest Rate Parity and Purchasing Power ParityMAJU
The document discusses interest rate parity (IRP) and purchasing power parity (PPP). IRP states that interest rate differences between countries equal the forward exchange rate minus the spot rate. PPP holds that currency exchange rates adjust so goods cost the same across countries when prices are converted to the same currency. Violations of IRP create arbitrage opportunities. Factors like inflation rates, economic conditions, and monetary policies influence IRP and PPP over time. Formulas are provided for calculating IRP and expected future exchange rates under PPP.
The document discusses the Fisher effect, which states that the real interest rate equals the nominal interest rate minus the expected inflation rate. It provides examples of how nominal interest rates on savings accounts incorporate expected inflation. The document also defines nominal interest rates as actual rates provided by lenders and real interest rates as rates adjusted for purchasing power. Finally, it discusses how the Fisher effect shows that changes in the money supply will affect nominal interest rates and inflation in tandem, without impacting real interest rates.
The ppt gives a description of how different theories define working of forex market. ?
when & where do these theories fail?
What is the impact of macro-economic factors like inflation, unemployment etc on forex exchange.?
A nicely formatted presentation.
What are the different types of forex market?
This document discusses international finance concepts including exchange rates, forward rates, purchasing power parity, interest rate parity, and exchange rate risk. It provides examples and explanations of these topics. For instance, it explains that if the yen spot price is 108.173 yen per dollar and the 1-year forward rate is 111.715 yen per dollar, then the dollar is selling at a 3.27% premium relative to the yen. It also works through examples of calculating forward rates and converting cash flows between currencies.
This document discusses theories related to foreign exchange rates, including purchasing power parity (PPP), interest rate parity (IRP), and the international Fisher effect (IFE). PPP states that exchange rates should adjust over time to account for inflation differences between countries. IRP suggests that interest rate differentials should equal expected changes in exchange rates. IFE describes how real interest rates should move with inflation according to nominal interest rates. Deviations from these theories can occur due to factors like trade barriers, market imperfections, and expectations of future exchange rates.
The purchasing power parity (PPP) theory compares the average costs of goods and services between countries using exchange rates. PPPs are useful for inter-country comparisons of GDP in real terms and economic data expressed in national currencies. PPPs are calculated at the product group level by comparing consumption baskets, then aggregated to GDP levels using weights. PPP exchange rates are meant to converge with actual exchange rates over the long run, though various factors can cause short-term deviations. PPPs are useful for output and productivity comparisons, while market exchange rates are better for trade-related analyses.
The document discusses theories of Purchasing Power Parity (PPP) and Interest Rate Parity. It explains that PPP holds that identical baskets of goods should cost the same in different countries after accounting for exchange rates. It also discusses how PPP is measured using concepts like the Big Mac Index and OECD PPP Index. The document notes limitations of PPP theory and also provides an overview of Interest Rate Parity, stating that it asserts that interest rate differences between countries should equal the spread between spot and forward exchange rates.
Relation between interest and exchange rateUtkarsh Shivam
This document summarizes a macroeconomics project on the relationship between inflation, interest rates, and exchange rates. It defines key terms like foreign exchange markets, exchange rates, and interest rate parity theory. It then discusses theories of interest rate parity, purchasing power parity, and the balance of payments. Case studies on Albania and Kenya analyze the relationship between domestic interest rates and currency exchange rates. The impact on the Indian economy and future policy suggestions are also covered.
Axis Ltd, a European company, hedges against adverse currency movements by entering forward exchange contracts after the euro plunges against the dollar, causing lost revenues from prices set in euros. The foreign exchange market allows conversion of one currency to another and helps reduce risk through tools like forward exchange rates, currency swaps, and hedging. Exchange rates are determined by demand and supply of currencies as well as theories including purchasing power parity and interest rate differentials.
This document discusses interest rate parity theory. It begins by defining spot and forward rates. Spot rates are prices for immediate settlement, while forward rates refer to rates for future currency delivery adjusted for cost of carry. Interest rate parity theory states that interest rate differentials between currencies will be reflected in forward premiums or discounts. The theory prevents arbitrage opportunities by making returns equal whether investing domestically or abroad when measured in the home currency. The document provides an example of covered and uncovered interest rate parity. Covered parity involves hedging exchange rate risk while uncovered parity does not. Empirical evidence shows uncovered parity often fails while covered parity generally holds for major currencies over short time horizons.
The document summarizes the concepts of international arbitrage and interest rate parity. It defines different types of arbitrage opportunities including locational, triangular, and covered interest arbitrage. It also derives the formula for interest rate parity and shows how it ensures arbitrage profits are not possible. The document notes that while interest rate parity generally holds, deviations may exist due to transaction costs, political risk, and tax differences across countries. It concludes by discussing how arbitrage forces can impact the valuation of multinational companies.
The document discusses arguments against using purchasing power parity (PPP) as the best measure to compare prices and economies. It outlines some uses and users of PPP but notes there are issues with using it to compare prices between countries given variations in international prices. The document analyzes examples showing PPP can be sensitive to international prices and questions whether it is the best measure for comparing economies and building economic models.
The eclectic paradigm proposes that there are three main advantages that influence a firm's international production:
1) Ownership-specific advantages such as trademarks, production techniques, or entrepreneurial skills.
2) Location-specific advantages like raw materials, low wages, or taxes in a particular country.
3) Internalization advantages where firms choose to internally produce rather than through partnerships to exploit firm-specific advantages.
The paradigm also notes that the significance of these ownership, location, and internalization (OLI) advantages varies across industries, countries, and firms. It provides a framework to analyze what drives international production rather than making predictions.
The document discusses several parity conditions in international finance that provide an intuitive explanation of the movement of prices and interest rates in different markets in relation to exchange rates. It introduces key concepts like purchasing power parity (PPP), which states that inflation rates should equal changes in exchange rates, and the law of one price, which says identical goods should have the same price when expressed in a common currency. The document contrasts the absolute and relative forms of PPP and provides examples of how PPP can be used to forecast future exchange rates and calculate real exchange rates.
This document discusses several international parity conditions:
- The law of one price states that identical goods should have the same price when expressed in a common currency.
- Purchasing power parity suggests that exchange rates will adjust to compensate for differences in prices of the same goods between countries.
- Covered interest parity implies that interest rate differentials should be offset by changes in forward exchange rates to prevent arbitrage opportunities.
- Reasons for deviations from these conditions include trade barriers, non-traded goods, measurement issues, and political/tax differences.
Foreign Exchange market & international Parity Relationspalakurthiharika
The document discusses several key concepts related to foreign exchange markets and exchange rate determination. It describes the foreign exchange market as where individuals, firms, banks, and brokers buy and sell foreign currencies. Exchange rates are determined by the demand and supply of currencies based on factors like interest rates, inflation rates, purchasing power parity, and investor psychology. Theories like interest rate parity and purchasing power parity aim to explain exchange rate movements, though other short-term factors also influence rates.
The document discusses the Purchasing Power Parity (PPP) theory, which states that exchange rates between currencies are determined by their relative purchasing power. It explains that under PPP, exchange rates adjust to changes in inflation so that the same goods cost the same in each country when prices are converted to a common currency. The document outlines the absolute and relative versions of PPP theory and notes some limitations, such as differences in goods baskets between countries. An example is provided to demonstrate how exchange rates adjust proportionally according to changes in domestic and foreign inflation rates under relative PPP.
This document summarizes several international parity conditions:
1) Purchasing power parity states that identical goods should sell for the same price worldwide when accounting for transportation costs, taxes, and other factors. It is a manifestation of the law of one price applied internationally.
2) Absolute and relative purchasing power parity refer to comparing the price of a standard basket of goods across currencies and changes in inflation affecting exchange rates.
3) Interest rate parity or the Fisher effect relates nominal interest rates, real interest rates, and expected inflation rates both within and between countries. It posits that nominal rates equal real rates plus inflation.
Interest rate parity is a no-arbitrage condition representing an equilibrium state under which investors will be indifferent to interest rates available on bank deposits in two countries. A theory in which the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate. Covered interest arbitrage allows an investor to exploit interest rate differentials between currencies by investing in the higher yielding currency while hedging exchange rate risk through a forward contract. The international fisher effect suggests that interest rate differentials between countries may be the result of differences in expected inflation, and that exchange rates will adjust to changes in expected inflation differentials.
This document discusses uncovered interest rate parity (UIRP) and covered interest rate parity (CIRP), which relate interest rates between countries to exchange rates. UIRP refers to parity when exposed to exchange rate risk, while CIRP uses forward contracts to eliminate exchange rate risk. The document provides an example where UK interest rates are 2% and Japanese rates are 1%, requiring the pound to depreciate 1% against the yen to avoid arbitrage opportunities. It also discusses purchasing power parity (PPP), which estimates exchange rates needed for currencies to have equal purchasing power based on market baskets of goods. PPP helps minimize misleading international comparisons that can arise from using market exchange rates alone.
The document discusses several foreign exchange parity conditions and arbitrage activities:
1) Purchasing power parity states that exchange rates will adjust to reflect differences in inflation rates between countries. Absolute PPP says price levels should be equal globally, while relative PPP says exchange rates adjust for domestic and foreign price levels.
2) Interest rate parity establishes that forward rates differ from spot rates by an amount offsetting interest rate differentials, eliminating arbitrage profits.
3) Arbitrage activities seek to profit from temporary deviations from these parity conditions by exploiting differences in currency prices across locations or markets. This helps drive prices back into alignment.
The document discusses the theory of purchasing power parity (PPP). It defines PPP as the principle that identical baskets of goods should have the same price when expressed in a common currency if not for trade barriers. Absolute PPP suggests prices levels should be equal across countries, while relative PPP suggests inflation differentials should equal exchange rate depreciation. The document provides examples of how PPP can be used to estimate exchange rate levels and changes. It also discusses factors like transaction costs and non-traded goods that can cause deviations from PPP in practice.
Interest Rate Parity and Purchasing Power ParityMAJU
The document discusses interest rate parity (IRP) and purchasing power parity (PPP). IRP states that interest rate differences between countries equal the forward exchange rate minus the spot rate. PPP holds that currency exchange rates adjust so goods cost the same across countries when prices are converted to the same currency. Violations of IRP create arbitrage opportunities. Factors like inflation rates, economic conditions, and monetary policies influence IRP and PPP over time. Formulas are provided for calculating IRP and expected future exchange rates under PPP.
The document discusses the Fisher effect, which states that the real interest rate equals the nominal interest rate minus the expected inflation rate. It provides examples of how nominal interest rates on savings accounts incorporate expected inflation. The document also defines nominal interest rates as actual rates provided by lenders and real interest rates as rates adjusted for purchasing power. Finally, it discusses how the Fisher effect shows that changes in the money supply will affect nominal interest rates and inflation in tandem, without impacting real interest rates.
The ppt gives a description of how different theories define working of forex market. ?
when & where do these theories fail?
What is the impact of macro-economic factors like inflation, unemployment etc on forex exchange.?
A nicely formatted presentation.
What are the different types of forex market?
This document discusses international finance concepts including exchange rates, forward rates, purchasing power parity, interest rate parity, and exchange rate risk. It provides examples and explanations of these topics. For instance, it explains that if the yen spot price is 108.173 yen per dollar and the 1-year forward rate is 111.715 yen per dollar, then the dollar is selling at a 3.27% premium relative to the yen. It also works through examples of calculating forward rates and converting cash flows between currencies.
This document discusses theories related to foreign exchange rates, including purchasing power parity (PPP), interest rate parity (IRP), and the international Fisher effect (IFE). PPP states that exchange rates should adjust over time to account for inflation differences between countries. IRP suggests that interest rate differentials should equal expected changes in exchange rates. IFE describes how real interest rates should move with inflation according to nominal interest rates. Deviations from these theories can occur due to factors like trade barriers, market imperfections, and expectations of future exchange rates.
The purchasing power parity (PPP) theory compares the average costs of goods and services between countries using exchange rates. PPPs are useful for inter-country comparisons of GDP in real terms and economic data expressed in national currencies. PPPs are calculated at the product group level by comparing consumption baskets, then aggregated to GDP levels using weights. PPP exchange rates are meant to converge with actual exchange rates over the long run, though various factors can cause short-term deviations. PPPs are useful for output and productivity comparisons, while market exchange rates are better for trade-related analyses.
The document discusses theories of Purchasing Power Parity (PPP) and Interest Rate Parity. It explains that PPP holds that identical baskets of goods should cost the same in different countries after accounting for exchange rates. It also discusses how PPP is measured using concepts like the Big Mac Index and OECD PPP Index. The document notes limitations of PPP theory and also provides an overview of Interest Rate Parity, stating that it asserts that interest rate differences between countries should equal the spread between spot and forward exchange rates.
Relation between interest and exchange rateUtkarsh Shivam
This document summarizes a macroeconomics project on the relationship between inflation, interest rates, and exchange rates. It defines key terms like foreign exchange markets, exchange rates, and interest rate parity theory. It then discusses theories of interest rate parity, purchasing power parity, and the balance of payments. Case studies on Albania and Kenya analyze the relationship between domestic interest rates and currency exchange rates. The impact on the Indian economy and future policy suggestions are also covered.
Axis Ltd, a European company, hedges against adverse currency movements by entering forward exchange contracts after the euro plunges against the dollar, causing lost revenues from prices set in euros. The foreign exchange market allows conversion of one currency to another and helps reduce risk through tools like forward exchange rates, currency swaps, and hedging. Exchange rates are determined by demand and supply of currencies as well as theories including purchasing power parity and interest rate differentials.
This document discusses interest rate parity theory. It begins by defining spot and forward rates. Spot rates are prices for immediate settlement, while forward rates refer to rates for future currency delivery adjusted for cost of carry. Interest rate parity theory states that interest rate differentials between currencies will be reflected in forward premiums or discounts. The theory prevents arbitrage opportunities by making returns equal whether investing domestically or abroad when measured in the home currency. The document provides an example of covered and uncovered interest rate parity. Covered parity involves hedging exchange rate risk while uncovered parity does not. Empirical evidence shows uncovered parity often fails while covered parity generally holds for major currencies over short time horizons.
The document summarizes the concepts of international arbitrage and interest rate parity. It defines different types of arbitrage opportunities including locational, triangular, and covered interest arbitrage. It also derives the formula for interest rate parity and shows how it ensures arbitrage profits are not possible. The document notes that while interest rate parity generally holds, deviations may exist due to transaction costs, political risk, and tax differences across countries. It concludes by discussing how arbitrage forces can impact the valuation of multinational companies.
The document discusses arguments against using purchasing power parity (PPP) as the best measure to compare prices and economies. It outlines some uses and users of PPP but notes there are issues with using it to compare prices between countries given variations in international prices. The document analyzes examples showing PPP can be sensitive to international prices and questions whether it is the best measure for comparing economies and building economic models.
The eclectic paradigm proposes that there are three main advantages that influence a firm's international production:
1) Ownership-specific advantages such as trademarks, production techniques, or entrepreneurial skills.
2) Location-specific advantages like raw materials, low wages, or taxes in a particular country.
3) Internalization advantages where firms choose to internally produce rather than through partnerships to exploit firm-specific advantages.
The paradigm also notes that the significance of these ownership, location, and internalization (OLI) advantages varies across industries, countries, and firms. It provides a framework to analyze what drives international production rather than making predictions.
Purchasing power parity (PPP) theory focuses on the relationship between inflation and exchange rates. It is based on the law of one price, which states that identical goods should have the same price in different markets. Absolute PPP postulates that the equilibrium exchange rate between two currencies equals the ratio of their price levels. Thus, similar products should have equal prices when measured in a common currency according to absolute PPP. In reality, deviations from absolute PPP can occur due to things like transport costs or trade barriers.
INTERNATIONAL ARBITRAGE & INTEREST RATE PARITYICAB
1) International arbitrage involves capitalizing on price discrepancies between currencies in different locations without taking on risk. Locational arbitrage occurs when a currency can be bought cheaper in one location and immediately sold at a higher price elsewhere.
2) Triangular arbitrage exploits temporary differences between cross-exchange rates of three currencies. Covered interest arbitrage takes advantage of interest rate differentials between countries while hedging against exchange rate risk.
3) Interest rate parity exists when the forward exchange rate offsets the interest rate advantage of one country over another, eliminating riskless profits from covered interest arbitrage. This equalizes returns between countries.
International movements-meaning-Export & import of merchandise & services-International investment-International Payments, Rate of exchange, Economic integration
UV4252 Rev. Aug. 13, 2015 This technical note was p.docxdickonsondorris
This document provides a comprehensive overview of exchange rate determination models. It begins by defining key terms and discussing short-term parity conditions that are not predictive models themselves. It then examines interest rate parity and covered interest parity in more detail. The document presents a framework for understanding exchange rate drivers in the short, medium and long run, with different factors dominating each time horizon. Finally, it summarizes a complete model of exchange rate determination that incorporates short-term speculative forces, medium-term macroeconomic fundamentals from open-economy models, and long-term trends and structural factors.
The choice of the exchange policies in the primary commodity exporting countr...Alexander Decker
This document analyzes the exchange rate policies of Morocco and estimates the equilibrium real exchange rate of the Moroccan Dirham. It uses an autoregressive distributed lag model to estimate the long-run relationship between the real exchange rate and macroeconomic fundamentals like terms of trade, degree of openness, government expenditure, and net capital flows. The results suggest that Morocco's fixed exchange rate regime adopted in 1973 is not responsible for its trade deficit or low export growth, as the Dirham's value is close to its equilibrium level. However, other factors may be contributing to Morocco's low economic performance. The document examines theories on how exchange rates and macroeconomic variables interact and equilibrium exchange rates are estimated.
Chapter6 International Finance ManagementPiyush Gaur
The document contains sample questions and solutions related to international parity relationships and foreign exchange rates. It includes definitions of concepts like arbitrage and purchasing power parity. It also derives relationships such as interest rate parity, purchasing power parity, and the international Fisher effect. Sample problems are provided and solved related to covered interest arbitrage opportunities between currencies.
The document provides sample questions and solutions related to international parity relationships and foreign exchange rates.
It includes 10 questions about concepts like arbitrage, interest rate parity, purchasing power parity, and the random walk model for exchange rates. It also includes 4 sample problems related to covered interest arbitrage opportunities between currencies.
The questions and problems serve to help students understand key concepts in foreign exchange markets and how to apply analytical tools like parity relationships and arbitrage to evaluate exchange rate determinants and potential profit opportunities.
The market fundamental of an asset is the discounted present value of its expected future cash flows. An asset's value depends positively on expected cash flows and negatively on the discount rate. While asset prices may deviate from fundamentals, fundamentals tend to be less volatile. For stocks, cash flows are dividends derived from earnings, while the discount rate includes expected returns. Expected returns and excess returns above bonds can drive stock price movements. Valuation ratios like price-earnings incorporate information on future returns and growth. Fundamentals of other assets like housing and currencies also depend on expected cash flows and discount rates.
Interest rate parity is a no-arbitrage condition representing an equilibrium state under which investors will be indifferent to interest rates available on bank deposits in two countries. A theory in which the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate. Covered interest arbitrage allows an investor to exploit interest rate differentials between currencies by investing in the higher yielding currency and hedging exchange risk through a forward contract. Once market forces eliminate arbitrage opportunities, interest rate parity is achieved where exchange rates align so that covered interest arbitrage is no longer feasible.
This document discusses a study analyzing the historical fair value of foreign exchange (FX) options. It examines daily option premium and payout data for various currency pairs and tenors going back to 1995. The study finds that short-dated FX options tend to be overpriced, while long-dated options offer better value. It presents analysis showing the premium, forward point contribution, and actual spot contribution to returns for carry trades. The document also discusses how to calculate option values using Black-Scholes and the costs to include, and considers what results might indicate options are fairly or unfairly priced.
The document discusses the asset approach model of exchange rates. It begins by introducing the idea that currencies can be viewed as assets, with the exchange rate being the price of one currency in terms of another. It then presents the uncovered interest parity equation, which is the fundamental equation of the asset approach model. This model uses interest rates and expected future exchange rates as inputs to predict the current spot exchange rate. The document provides examples of how changes in interest rates or expected exchange rates would lead to adjustments in the spot exchange rate to maintain equal expected returns across currencies.
Firms forecast exchange rates for hedging decisions, short-term financing decisions, capital budgeting decisions, and long-term financing decisions. There are two main approaches - fundamental analysis, which studies macroeconomic variables like inflation and GDP growth, and technical analysis, which analyzes historical exchange rate data. Factors like inflation rates, purchasing power parity, GNP growth, monetary policy, and relative economic strength between countries can influence exchange rate forecasts. No single approach can perfectly predict future exchange rates.
This document discusses future contracts and the binomial tree model for pricing derivatives. It analyzes the stock prices of Apple and Facebook to compare theoretical forward prices to observed future prices. For Apple, the theoretical forward price is calculated and compared to the future price, finding small differences. For Facebook, future and spot prices are analyzed and seen to converge at maturity as expected. The second part uses the binomial tree model to calculate prices and delta values for European call and put options on the underlying asset. It finds that option prices increase with more periods to maturity but decrease as expiration approaches. The model is also used to price American put options and compare to European puts.
This document provides an overview of exchange rate theories and derivatives. It discusses traditional exchange rate theories based on trade flows and the purchasing power parity theory. It also covers interest rate parity theory, international fisher effect theory, and the uncovered and unbiased forward rate theories. Types of derivatives discussed include forwards, futures, options, and swaps. Forward rate agreements are introduced as cash-settled over-the-counter contracts where one party fixes an interest rate for a future period.
Does the theory of uncovered interest parity hold for nigeriaAlexander Decker
This document examines whether the theory of uncovered interest parity holds between Nigeria and the United States. It first provides background on uncovered interest parity theory and how it relates to covered interest parity and expectations of future exchange rates. It then discusses previous literature that both supports and rejects uncovered interest parity. The study aims to test whether uncovered interest parity holds between Nigeria and the US over time and to examine the causal relationship between interest rates and exchange rates. It finds varying interest rates between Nigeria and the US over time, raising the possibility of interest arbitrage opportunities.
1) The document examines international currency exchange markets and drivers of deviations from purchasing power parity in the short run through econometric analysis. It establishes key terms and notation used, and reviews equilibrium conditions in domestic money markets and their relationship to foreign exchange markets.
2) Graphs and equations are used to show the relationship between nominal exchange rates, interest rates, income levels, price levels, and money supplies in domestic and foreign economies. Shifts in supply and demand curves are explained by changes in these factors.
3) The paper analyzes how permanent changes in money supplies affect equilibrium conditions in domestic money markets and foreign exchange markets in both the short run and long run, with a focus on how movements toward purchasing power parity occur
This document discusses testing the strong and weak forms of purchasing power parity (PPP) between Jordan and its major trading partners (Japan, UK, Turkey, and US) from 2000-2012. It first examines the strong form of PPP by testing if the real exchange rate is stationary, finding it is nonstationary, implying long-run PPP does not hold. It then uses Johansen cointegration tests to examine the weak form of PPP, finding a cointegrating relationship between exchange rates and domestic/foreign price levels, providing evidence that weak PPP holds between Jordan and its trading partners. The document reviews literature on PPP testing and discusses the methodology used, including specifications for testing the strong and weak forms.
This document discusses currency exchange rates and economic growth. It provides details on how exchange rates are determined between currencies, including factors that affect exchange rate spreads. It also outlines several economic theories related to what drives long-term economic growth, such as investment in physical and human capital, as well as productivity gains from technological development. Key growth accounting relationships are presented, linking output growth to contributions from capital deepening, increases in the labor force, and improvements in total factor productivity.
The document discusses various concepts related to derivatives pricing including:
- Compounding rates used for interest rates underlying fixed income securities can be annual, semiannual, daily, etc. Continuously compounded rates help derive closed form solutions.
- Short selling involves borrowing and selling securities not owned with the obligation to buy them back later to return to the lender.
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The document provides an overview of chapters 10-12 from the textbook for the course MBA 531 Business in Today's Global Environment. Specifically, it summarizes key concepts about the foreign exchange market, including how exchange rates are determined and the difference between spot and forward rates. It also discusses the international monetary system and covers historic systems like the gold standard and the Bretton Woods system. International firms are advised to consider transaction, translation, and economic exposure when managing foreign exchange risk.
3 Parity Relations_Dr Kaaya.pdf Relationship in international Marketrenmichael09
The document discusses several international parity theories that attempt to explain fluctuations in exchange rates. It describes theories related to inflation rates, interest rates, economic growth, trade balances, and more. Specifically, it outlines theories of supply and demand, purchasing power parity (PPP), the Fisher effect, interest rate parity, and rational expectations. PPP suggests that exchange rates should adjust over time to reflect differences in inflation between countries. The Fisher effect also links exchange rates and interest rates to inflation rates.
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Economics sem 2- interest rate parity
1. JAI HIND COLLEGE
BASANTSING INSTITUTE OF SCIENCE
&
J.T. LALVANI COLLEGE OF COMMERCE
A PROJECT ON
INTEREST RATE PARITY
IN THE SUBJECT OF
ECONOMICS
SUBMITTED TO
UNIVERSITY OF MUMBAI
For Semester 1 of M.Com Part 1
By
NAME: RUPEN CHALWA
ROLL NO.: 10
MCOM- PART-1
2. DECLERATION
I, Rupen Chawla, student of M.Com Part 1,
Roll no. 10 hereby declare that the project
for the Paper Economics titled Interest Rate
Parity submitted by me for Semester- 2
during the academic year 2014-15, is based
on actual work carried out by me.
I further state that this work is original and
not submitted anywhere else for any
examination.
NAME: RUPEN CHALWA
MCOM- PART-1
ROLL NO.: 10
DATE OF SUBMISSION: , 2014
Acknowledgement
3. I wish to thank Professor Vadehi for his
encouragement and support throughout the
project it is due to his best effort and
continued guidance that I was able to
prepare this project.
Rupen Chawla
4. JAI HIND COLLEGE
‘A’ ROAD, CHURCHGATE, MUMBAI- 400020
CERTIFICATE
This is to certify that Mr. Rupen Chawla of M.Com
Accountancy and Finance Semester 2 (2014-15) has
successfully completed the project Interest Rate Parity
under the guidance of Professor Vadehi.
__________ __________
Course coordinator Principal
__________ ___________
Internal Examiner External Examiner
__________
College Seal
6. 1) INRODUCTION
Interest rate parity is a no-arbitrage condition representing
an equilibrium state under which investors will be indifferent
to interest rates available on bank deposits in two countries.[1] The
fact that this condition does not always hold allows for potential
opportunities to earn riskless profits from covered interest
arbitrage. Two assumptions central to interest rate parity are capital
mobility and perfect substitutability of domestic and foreign assets.
Given foreign exchange market equilibrium, the interest rate parity
condition implies that the expected return on domestic assets will
equal the exchange rate-adjusted expected return on foreign
currency assets. Investors then cannot earn arbitrage profits by
borrowing in a country with a lower interest rate, exchanging for
foreign currency, and investing in a foreign country with a higher
interest rate, due to gains or losses from exchanging back to their
domestic currency at maturity.[2] Interest rate parity takes on two
distinctive forms: uncovered interest rate parity refers to the parity
condition in which exposure to foreign exchange risk (unanticipated
changes in exchange rates) is uninhibited, whereas covered interest
rate parity refers to the condition in which a forward contract has
been used to cover (eliminate exposure to) exchange rate risk. Each
form of the parity condition demonstrates a unique relationship with
implications for the forecasting of future exchange rates:
the forward exchange rate and the future spot exchange rate.[1]
Economists have found empirical evidence that covered interest
rate parity generally holds, though not with precision due to the
effects of various risks, costs, taxation, and ultimate differences in
liquidity. When both covered and uncovered interest rate parity
hold, they expose a relationship suggesting that the forward rate is
an unbiased predictor of the future spot rate. This relationship can
be employed to test whether uncovered interest rate parity holds,
for which economists have found mixed results. When uncovered
interest rate parity and purchasing power parity hold together, they
illuminate a relationship named real interest rate parity, which
suggests that expected real interest ratesrepresent expected
adjustments in the real exchange rate. This relationship generally
holds strongly over longer terms and among emerging
7. market countries.
EXAMPLES
For our illustration purpose consider investing € 1000 for 1 year.
We'll consider two investment cases viz:
Case I: Domestic Investment
In the U.S.A., consider the spot exchange rate of $1.2245/€ 1.
So we can exchange our € 1000 @ $1.2245 = $1224.50
Now we can invest $1224.50 @ 3.0% for 1 year which yields
$1261.79 at the end of the year.
Case II: Foreign Investment
Likewise we can invest € 1000 in a foreign European market, say at
the rate of 5.0% for 1 year.
But we buy forward 1 year to lock in the future exchange rate at
8. $1.20025/€ 1 since we need to convert our € 1000 back to the
domestic currency, i.e. the U.S. Dollar.
So € 1000 @ of 5.0% for 1 year = € 1051.27
Then we can convert € 1051.27 @ $1.20025 = $1261.79
Thus, in the absence of arbitrage, the Return on Investment (RoI) is
same regardless of our choice of investment method.
There are two types of IRP.
2) ASSUMPTIONS
Interest rate parity rests on certain assumptions, the first being
that capital is mobile - investors can readily exchange domestic
assets for foreign assets. The second assumption is that assets
have perfect substitutability, following from their similarities
in riskiness and liquidity. Given capital mobility and perfect
substitutability, investors would be expected to hold those assets
offering greater returns, be they domestic or foreign assets.
However, both domestic and foreign assets are held by investors.
Therefore, it must be true that no difference can exist between the
returns on domestic assets and the returns on foreign
assets.[2] That is not to say that domestic investors and foreign
investors will earn equivalent returns, but that a single investor on
any given side would expect to earn equivalent returns from either
investment decision.[3]
3)COVERED AND UNCOVERED INTEREST
RATE PARITY
Key relationships
In international economics, key macroeconomic variables include
the following (symbols are in parentheses; * means a foreign
variable):
Exchange rate (e)
Prices (p, p*)
Interest rates (i, i*)
Current account (CA)
Capital account (KA)
GDP (y, y*)
9. How these variables are related is the central question of open
macroeconomics. In this lecture, interest parities, or the
relationships between the exchange rate (e) and interest rates (i,
i*), are investigated. Please note that the arguments presented
below are valid only among countries whose financial sectors are
sufficiently developed and externally open. If a country is financially
closed or its financial sector lacks depth, liquidity and institutional
development (for example, without well-functioning spot and
forward currency markets), interest parities do not hold.
There are two versions of interest parities: covered and uncovered.
The covered version involves no exchange risks, while the
uncovered version entails such risks and elements of speculation.
Both interest parities (especially the uncovered version) are key
building blocks of many open macroeconomic models.
In the next lecture, purchasing power parity (PPP), namely the
relationship between the exchange rate (e) and prices (p, p*), will
be discussed. That is also a key input to open macroeconomic
modeling. This lecture will also make references to it.
The law of one price (LOOP) and arbitrage
Interest parities (as well as PPP presented in the next lecture) are a
type of the law of one price in an integrated world. The law of one
price says that identical commodities (or anything) bought and sold
in different markets should bear the same price. Otherwise, there
will be a profit opportunity in buying the commodity in one market
and selling it in the other, and someone will surely do it (this
activity of pursuing gain by combined purchase and sale, without
changing the physical characteristics of the commodity, is
called arbitrage). In an integrated and properly functioning market,
arbitrage will surely continue until the law of one price is
established, eliminating any further opportunity for excess profit.
Then the two markets are really one.
Some markets show LOOP, but others do not. Whether they do or
do not depends on (i) the characteristics of the merchandise
(especially the transportation cost; heavy and bulky items are
difficult to arbitrage); (ii) the characteristics of market competition
and strategies of traders; and (iii) policy intervention (e.g., capital
control, tax and tariff policies and other regulatory measures to
artificially increase transaction costs or even entirely ban such
trade).
If you are checking the prices of digital cameras or DVD players in
different outlets in the electronic town of Akihabara, Tokyo, you are
also a potential arbitrager. You will soon realize that the same
models bear almost exactly the same price, namely LOOP holds
quite firmly in Akihabara. A shuttle trader, or an individual who
carries merchandise, say, from China to Kyrgyzstan, is also
10. engaged in arbitrage. In this case, however, LOOP probably does
not hold exactly due to uncertainty and transportation cost. Sellers
may overcharge without the buyer knowing it. Integrated global
financial markets also exhibits LOOP, and their arbitrage is
extremely fast and tight.
In the case of interest parities, what are equalized are the rates of
return across various interest-bearing financial instruments (bank
deposits, bonds, bills, etc). Under free capital mobility, LOOP holds
firmly and trivially for covered interest parity, but the validity of
LOOP for uncovered interest parity is empirically very questionable.
The difference is explained by the absence or presence of exchange
risk (see below).
Assumptions
In order for interest parities to hold, the following assumptions are
required.
(1) Free capital mobility--there is no official hindrance to arbitrage
across countries.
(2) No transaction cost--there is no natural (market) hindrance to
arbitrage across countries. Transaction is without charge or carries
only a negligible charge.
(3) No default risk--financial investment is safe against business
defaults, country risks, etc.
The above are necessary conditions for covered interest parity.
There are no exchange, default or other risks related to financial
investment. We are assuming a perfectly safe, risk-free world.
In the case of uncovered interest parity, the following assumption is
added.
(4) Risk neutrality--investors care only about the long-run average
return and do not care about the outcome of each investment.
Here, exchange risk is present although all other risks of financial
investment are still assumed away. Investors are assumed to be
neutral against this risk. That means they care only about the
average results. Whether the variance (volatility) of the return of
each investment is large or small does not concern them.
Covered and uncovered interest parities should not be confused
with each other. They refer to two completely different situations.
4)COVERED INTEREST RATE PARITY
{CIP}
What is CIP?
Covered Interest Parity (CIP) is also called covered interest rate
parity. Under the assumption of free capital flow, it states that the
11. forward premium of a foreign currency should be equal to the
interest rate differential between a domestic asset and a
substitutable foreign asset.
CIP implies the equality of returns on comparable financial assets
denominated in different currencies. The underlying mechanism for
CIP is covered interest arbitrage.
What is Covered Interest Arbitrage?
Covered interest arbitrage is the transfer of liquid funds from one
monetary center to another to take advantage of higher rates of
return or interest, while covering the transaction with a forward
currency hedge.
Suppose the 3-month T-bill rate in the U. S. is 12%, higher than
the 3-month T-bill rate of 8% in Canada. Attracted by the higher
interest rate, investors would tend to change their Canadian dollar
into U.S. dollar and invest their funds in the U.S. Simultaneously,
they buy contracts to sell dollars in 3 months in the forward market.
If the spot exchange rate is 1.00CAD/USD at present, and the 3-
month forward exchange rate is 0.99CAD/USD at present, then the
investors' losses in exchange conversion will be 1%. From the
interest rate differential, they will earn 1% in 3 months (since
annually they earn (12%-8%)=4% by investing in U.S. rather than
in Canada). This profit is just offset by the loss. However, if the
interest rate in U.S. is higher, making the earning in interest rate
differential much larger in absolute value than the loss in foreign
exchange, this arbitrage process will continue. Then, large amount
of funds flow from Canada into U.S., putting pressures for U.S. to
lower its interest rate and for Canada to raise its interest rate. In
addition, the increasing demand of U.S. dollar in the current market
tends to raise the spot rate for U.S. dollar. The increasing demand
of Canada dollar in the forward market tends to decrease the future
rate for U.S. dollar. The process continues until returns from
investing in the two countries reach the same level. Then the CIP
conditions will be satisfied again.
When the no-arbitrage condition is satisfied with the use of a forward
contract to hedge against exposure to exchange rate risk, interest rate
parity is said to be covered. Investors will still be indifferent among the
available interest rates in two countries because the forward exchange rate
sustains equilibrium such that the dollar return on dollar deposits is equal
to the dollar return on foreign deposit, thereby eliminating the potential
for covered interest arbitrage profits. Furthermore, covered interest rate
parity helps explain the determination of the forward exchange rate. The
following equation represents covered interest rate parity.[1][4]
12. where
is the forward exchange rate at time t
The dollar return on dollar deposits, , is shown to be equal to the dollar
return on euro deposits, .
Empirical evidence[edit]
Covered interest rate parity (CIRP) is found to hold when there is open
capital mobility and limited capital controls, and this finding is confirmed
for all currencies freely traded in the present-day. One such example is
when the United Kingdom and Germany abolished capital controls
between 1979 and 1981. Maurice Obstfeld and Alan Taylor calculated
hypothetical profits as implied by the expression of a potential inequality
in the CIRP equation (meaning a difference in returns on domestic versus
foreign assets) during the 1960s and 1970s, which would have constituted
arbitrage opportunities if not for the prevalence of capital controls.
However, given financial liberalization and resulting capital mobility,
arbitrage temporarily became possible until equilibrium was restored.
Since the abolition of capital controls in the United Kingdom and
Germany, potential arbitrage profits have been near zero. Factoring
in transaction costs arising from fees and other regulations, arbitrage
opportunities are fleeting or nonexistent when such costs exceed
deviations from parity.[1][5] While CIRP generally holds, it does not hold
with precision due to the presence of transaction costs, political
risks, tax implications for interest earnings versus gains from foreign
exchange, and differences in the liquidity of domestic versus foreign
assets.[5][6][7] Researchers found evidence that significant deviations from
CIRP during the onset of the global financial crisis in 2007 and 2008 were
driven by concerns over risk posed by counter parties to banks and
financial institutions in Europe and the US in the foreign exchange
swap market. The European Central Bank's efforts to provide US dollar
liquidity in the foreign exchange swap market, along with similar efforts
by theFederal Reserve, had a moderating impact on CIRP deviations
between the dollar and the euro. Such a scenario was found to be
13. reminiscent of deviations from CIRP during the 1990s driven by
struggling Japanese banks which looked toward foreign exchange swap
markets to try and acquire dollars to bolster their creditworthiness.[8]
When both covered and uncovered interest rate parity (UIRP) hold, such a
condition sheds light on a noteworthy relationship between the forward
and expected future spot exchange rates, as demonstrated below.
Dividing the equation for UIRP by the equation for CIRP yields the
following equation:
which can be rewritten as:
This equation represents the unbiasedness hypothesis, which states that
the forward exchange rate is an unbiased predictor of the future spot
exchange rate.[9][10] Given strong evidence that CIRP holds, the forward
rate unbiasedness hypothesis can serve as a test to determine whether
UIRP holds (in order for the forward rate and spot rate to be equal, both
CIRP and UIRP conditions must hold). Evidence for the validity and
accuracy of the unbiasedness hypothesis, particularly evidence
for cointegration between the forward rate and future spot rate, is mixed
as researchers have published numerous papers demonstrating both
empirical support and empirical failure of the hypothesis.[9]
UIRP is found to have some empirical support
in tests for correlation between expected rates of currency
depreciation and the forward premium or discount.[1] Evidence suggests
that whether UIRP holds depends on the currency examined, and
deviations from UIRP have been found to be less substantial when
examining longer time horizons.[11] Some studies of monetary policy have
offered explanations for why UIRP fails empirically. Researchers
demonstrated that if a central bank manages interest rate spreads in
strong response to the previous period's spreads, that interest rate
spreads had negative coefficients in regression tests of UIRP. Another
study which set up a model wherein the central bank's monetary policy
14. responds to exogenous shocks, that the central bank's smoothing of
interest rates can explain empirical failures of UIRP.[12] A study of central
bank interventions on the US dollar and Deutsche mark found only
limited evidence of any substantial effect on deviations from
UIRP.[13] UIRP has been found to hold over very small spans of time
(covering only a number of hours) with a high frequency of bilateral
exchange rate data.[14] Tests of UIRP for economies experiencing
institutional regime changes, using monthly exchange rate data for the
US dollar versus the Deutsche mark and the Spanish peseta versus
the British pound, have found some evidence that UIRP held when US
and German regime changes were volatile, and held between Spain and
the United Kingdom particularly after Spain joined the European Union in
1986 and began liberalizing capital mobility.[15]
Covered Interest Rate theory states that exchange rate forward
premiums (discounts) offset interest rate differentials between two
sovereigns.
In another words, covered interest rate theory holds that interest
rate differentials between two countries are offset by the
spot/forward currency premiums as otherwise investors could earn
a pure arbitrage profit.
Covered Interest Rate Examples
Assume Google Inc., the U.S. based multi-national company,
needs to pay it's European employees in Euro in a month's time.
Google Inc. can achieve this in several ways viz:
Buy Euro forward 30 days to lock in the exchange rate. Then
Google can invest in dollars for 30 days until it must convert
dollars to Euro in a month. This is called covering because now
Google Inc. has no exchange rate fluctuation risk.
Convert dollars to Euro today at spot exchange rate. Invest
Euro in a European bond (in Euro) for 30 days (equivalently loan
out Euro for 30 days) then pay it's obligation in Euro at the end of
the month.
Under this model Google Inc. is sure of the interest rate that it will
earn, so it may convert fewer dollars to Euro today as it's Euro will
grow via interest earned.
This is also called covering because by converting dollars to Euro
at the spot, the risk of exchange rate fluctuation is eliminated.
15. When people and firms are permitted to buy and sell foreign
assets, they can hold various exchange "positions," which are net
holding balances in foreign currency. The positions are classified
below.
Position Balance sheet situation
If home
currency
depreciates
If home
currency
appreciates
Open"
"Long" Foreign assets > foreign liabilities Gain Loss
"Short" Foreign assets < foreign liabilities Loss Gain
"Square" Foreign assets = foreign liabilities No impact
For example, suppose you have foreign securities worth $500 but
have also borrowed $700 from the bank.. This means that you
have the short position of $200. For simplicity, we assume all
foreign assets and liabilities are denominated in USD. This allows
us to concentrate on the movement of the domestic currency
against USD, without worrying about the fluctuations among major
currencies.
Suppose you are a manufacturer of a certain product and also
engaged in foreign trade. As you conduct your daily transactions of
buying foreign parts or exporting finished products to foreign
markets, the exchange position naturally fluctuates and does not
remain "square." This means that you may incur gain or loss
depending on the exchange rate movement at any moment, which
is often hard to predict. Suppose also that your main business is
manufacturing and you are not interested in foreign currency
speculation. Particularly, you want to avoid exchange losses.
If your country has sufficiently developed and externally open
financial markets, there are two alternative ways to "cover" or
"hedge"--i.e., make your exchange position square and avoid
exchange risk (see handout no.4). More concretely, assume that
you are a Japanese exporter of an industrial product expecting a
receipt of $100 after 3 months. You want to fix this receipt in
terms of yen (domestic currency) now. Suppose also that:
S (spot exchange rate) is currently $1=100 yen
F (3-month forward exchange rate) is--initially--$1=102
yen
i (Japanese interest rate) is 4%/year
i* (US interest rate) is 6%/year
The first method is forward cover. You go to a bank and make a
forward contract today. That is to say, you agree to sell $100 to
the bank after 3 months and receive a specified amount of yen
16. (10,200 yen = $100 x 102) at that time. Then you wait for 3
months before executing this transaction. The exchange rate for
selling USD in the future (forward rate, 102), offered by the bank,
is different from the exchange rate for today (spot rate, 100).
The second method is borrow dollar and sell spot now. That is to
say, you go to a bank and borrow $98.52 today, immediately
convert it to yen (9,852yen) in the spot market and deposit it at
the bank. After 3 months, you withdraw 9,951 yen (principal plus
accrued interest) and simultaneously repay $100 (principal plus
accrued interest) to the bank with the export receipt.
Either way, you fix the yen receipt as of today so there is no
exchange risk. But with the assumptions illustrated above, forward
cover yields 10,200 yen and the borrowing method yields only
9,951 yen. Clearly, everyone prefers the first method. That means
that the situation is not in equilibrium.
If everyone tries to sell USD forward while no one buys USD
forward, there will be an oversupply of forward dollar and its price
will fall. It will fall until forward USD becomes precisely $1=99.51
yen; because at this rate, the first and second method will be
equivalent. This is an example of financial arbitrage and LOOP. The
same "commodity" (export receipt after three months' wait)
obtained through the forward exchange market and the bank loan
market now bears the same price. Needless to say, actual interest
arbitrage occurs instantaneously, not sequentially and slowly.
The CIP condition can be written as follows:
(F-S)/S = (i-i*)/(1+i*)
or approximately,
(F-S)/S = i - i*
if i* is sufficiently small. This means that
F>S if and only if i > i*
F<S if and only if i < i*
In words, if the domestic interest rate is higher than the foreign
interest rate, the forward exchange rate (future dollar) must be
higher than the spot exchange rate (today's dollar), and vice
versa. This relationship should always hold among high-quality,
low-risk financial instruments under capital mobility.
Testing capital mobility
CIP can be used as a test for capital mobility. Sometimes the
government says capital movement is liberalized but actual
transactions are secretly controlled. If CIP holds, we can say that
the country truly has an open capital market. The UK liberalized its
capital market externally in 1979. Thereafter, CIP began to hold
(see p.122 of Batiz-Batiz). Japan revised its foreign exchange law
in December 1980, and CIP began to hold after that. Since then,
CIP has always held between Japan and the US (handout no.4).
17. Since virtually all developed countries in North America, EU and
Japan have open capital markets, CIP holds trivially and as a
matter of course among key currencies of dollar, euro and yen--it
would be surprising if the situation is otherwise (but not between
Russia and China). You can check this with financial news reports
on any day. The following is the data for April 18, 2002 as
published in Nihon Keizai Shimbun (Japan Economic Journal,
or Nikkei for short), the most influential Japanese economic
newspaper:
CIP between Japan and the US (April 18, 2002)
Source: Nikkei, the next day
Bilateral interest rate differential, (i
- i*)
-1.7375%
Japanese interest rate, i (CD 3-
month)
i =
0.0825%
American interest rate, i* (CD 3-
month)
i* = 1.82%
Forward premium/discount on the
dollar, (F-S)/S
-1.86%
Gap between (i - i*) and (F-S)/S 0.1225%
While there is a small gap between the interest rate differential
and the forward discount, the magnitude is fairly small. Even if CIP
is holding, statistical discrepancy can arise from various reasons:
(i) time difference between Tokyo and NY markets (data are not
taken exactly at the same moment); (ii) Japanese and US
certificate of deposits (CDs) are not perfectly substitutable due to
different liquidity, tax rules, regulations, etc; and (iii) transaction
costs.
There are a few additional remarks on CIP:
(1) Don't try to perform CIP yourself. Arbitrage for CIP is
automatic and instantaneous. Leave it to banks and financial
companies.
(2) While causality is often mutual in economics, we can say that,
for CIP, main causality runs from the interest rate gap to the
forward exchange rate. In other words, F is determined by the
difference between i and i*.
(3) Some exchange risks cannot be hedged (or covered).
Unhedgeable exchange risks include the following:
(i) Protection against a high or low exchange rate level, in contrast
to protection against change from now to future. No banks will
help you even if you complain about the current exchange rate
level.
18. (ii) Long-term exchange risks. Usually, forward markets beyond 1
year are either nonexistent or extremely thin.
(iii) Business risks which are inseparable from exchange risk. If
you are a manufacturing firm, your business carries many risks
other than the exchange risk. You don't know whether your
factories will operate smoothly without technical or labor troubles,
whether the market will grow, and whether you can beat other
competitors. Because these business uncertainties always exist,
you don't know what exchange positions you will have next month,
next year, or beyond. But if you don't know them, you can't go to
the bank and hedge them! While fancy financial instruments like
futures, options and swaps are available, exchange risk cannot be
eliminated but must be added to the existing business risks.
Technically speaking, this problem arises from the incompleteness
of forward commodity contracts. Ronald McKinnon calls this
the Arrow-Debreu dilemma.
How can we explain deviations from
CIP?
Academically, the empirical deviations from CIP are always
explained as violations to the assumption of free capital flow and
the substitutability of assets from different countries. The possible
explanations include:
1. There may be transaction costs, which introduces a
"transaction band" into the CIP equation. Recently, Cody (1990),
Moosa (1996) and Balke and Wohar (1998) studied about the
relation between CIP and the transaction costs.
2. There may be possible capital controls, which actually adds
costs to the investment in other countries and creates similar
effects of the transaction costs to the CIP equation.
3. There may be difference in tax rates on interest income and
foreign exchange losses/gains in different countries. This
difference contributes to the non-substitutability of investments in
different countries and makes investment in a country more
preferable than the other.
5)UNCOVERED INTEREST RATE PARITY
{UIP}
19. What is UIP?
UIP states that if funds flow freely across country boarders and
investors are risk neutral, after the adjustment of expected
depreciation, the expected rates of return to substitutable assets
denominated in different currencies should be equal. In equation,
it is expressed as the equality between the expected changes in
spot exchange rate and the interest differentials of two countries.
Like that of CIP, the underlying mechanism of UIP is interest
arbitrage activities. For example, if domestic interest rate is lower
than the expected rate of return on an identical foreign asset,
investors