L6_IRP1 - Review Real exchange rate relative price of the...

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1 1 Lecture 6: Interest Rate Parity Review Real exchange rate relative price of the same basket of goods Relax the PCM assumptions Empirical tests on PPP LOP and relative PPP The Balassa-Samuelson theory (*) 2 Lecture 6: Interest Rate Parity Outline: Interest Rate Parity Source: Chapter 5, Levich Interest rate parity theory under PCM Relax PCM assumptions Empirical tests
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2 3 Lecture 6: Interest Rate Parity Interest Rate Parity Source: Chapter 5, Levich Assume: Perfect Capital Market No transaction cost, no taxes, no uncertainty Link spot and forward markets simultaneously with domestic and foreign security markets through arbitrage on financial assets. Investors can costlessly arbitrage between alternative investment opportunities. 4 Lecture 6: Interest Rate Parity Investment 1: Place $1 in a USD-denom security offering interest rate i $ Investment 2: Place $1 in a euro-denom security offering interest rate i step 1: convert $ to euro at spot rate S $/€ step 2: deposit euros in bank, earn i e step 3: write forward contract to convert future euros to $ (F t, 1 year, $/€ )
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3 5 Lecture 6: Interest Rate Parity Investment 1: Place $1 in a USD-denom security offering interest rate i $ $1 (1 + i $ ) Investment 2: Place $1 in a euro-denom security offering interest rate i ($1 / S t ) * (1 + i ) * F t,1 convert $ to e earn interest on cover currency at spot rate ($/€) investment exposure in forward market ($/€) 6 Lecture 6: Interest Rate Parity The two investment are identical in all respects: maturity, credit risk and liquidity risk – except for currency denomination. Two investment should produce the same return: $1 (1 + i $ ) = ($1 / S t ) * (1 + i ) * F t,1 Rewriting: F t,1 = (1 + i $ ) S t (1 + i ) Subtract 1 from each side: F t,1 -S t = (i $ -i ) S t (1 + i ) Forward interest rate premium differential
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4 7 Lecture 6: Interest Rate Parity Covered Interest Parity F t,1 -S t = (i $ -i ) S t (1 + i ) F > S, $ price of € is higher in forward market, sold at a premium F < S, € is less expensive in forward market, sold at a discount Covered interest parity - investor’s FX risk is “covered” in the forward market 8 Lecture 6: Interest Rate Parity Approximation when i’s are low F t,1 -S t = (i $ -i ) S t If dollar provides a higher return than euro, the dollar must be expected to depreciate in the future. Dollar is sold at a discount, that is, the euro is sold at a premium, at the magnitude which exactly offsets the difference in returns. The reverse is also true.
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5 9 Lecture 6: Interest Rate Parity Notation: Interest rates quoted on an annualized basis, or per annum (p.a.) = interest earned on that security if it were held for one year. example:
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L6_IRP1 - Review Real exchange rate relative price of the...

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