Lecture_19___Fall_2007 - Interest Arbitrage Uncovered...

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Interest Arbitrage Uncovered interest arbitrage : making foreign financial investments without obtaining “cover” for exchange rate risk Example: Annual 3-months U.K. 3-month Treasury bill interest rate 10% 2.5% U.S. 3-month Treasury bill interest rate 6% 1.5% Uncovered interest differential favoring U.K. 4% 1.0% ± If pound depreciates (from $2.00 to $1.98, or 1.0%), then investor makes less (zero) ± If pound appreciates (from $2.00 to $2.02, or 1.0%), then investor makes more (2%)
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Interest Arbitrage Uncovered interest arbitrage : making foreign financial investments without obtaining “cover” for exchange rate risk Example: Annual 3-months U.K. 3-month Treasury bill interest rate 10% 2.5% U.S. 3-month Treasury bill interest rate 6% 1.5% Uncovered interest differential favoring U.K. 4% 1.0% ± If pound depreciates (from $2.00 to $1.98, or 1.0%), then investor makes less (zero) ± If pound appreciates (from $2.00 to $2.02, or 1.0%), then investor makes more (2%) ± Potential for earning return, but investor exposed to exchange rate
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Interest Arbitrage Covered interest arbitrage : making foreign financial investments with simultaneous transaction in forward foreign exchange market to offset exchange rate risk Example: Annual 3-months U.K. 3-month Treasury bill interest rate 12% 3% U.S. 3-month Treasury bill interest rate 8% 2% Uncovered interest differential favoring U.K. 4% 1% ± Purchasing 3-month Treasury bills in London (with pounds purchased in spot market) earns 1% more than in New York ± To avoid exchange rate risk, investor sells pounds on 3-month forward market at a cost equal to discount on forward pound
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Interest Arbitrage Covered interest arbitrage : making foreign financial investments with simultaneous transaction in forward foreign exchange market to offset exchange rate risk Example: Annual 3-months U.K. 3-month Treasury bill interest rate 12% 3% U.S. 3-month Treasury bill interest rate 8% 2% Uncovered interest differential favoring U.K. 4% 1% ± If current value of pound = $2.00, and 3-month forward pound = $1.99, then forward discount = 0.5%.
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Interest Arbitrage Covered interest arbitrage : making foreign financial investments with simultaneous transaction in forward foreign exchange market to offset exchange rate risk Example: Annual 3-months U.K. 3-month Treasury bill interest rate 12% 3% U.S. 3-month Treasury bill interest rate 8% 2% Uncovered interest differential favoring U.K. 4% 1% ± If current value of pound = $2.00, and 3-month forward pound = $1.99, then forward discount = 0.5%. ± Covered interest-rate differential ” = uncovered differential – forward discount = 1% - 0.5% = 0.5%
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Interest Arbitrage Covered interest arbitrage : making foreign financial investments with simultaneous transaction in forward foreign exchange market to offset exchange rate risk Example: Annual 3-months U.K. 3-month Treasury bill interest rate 12% 3% U.S. 3-month Treasury bill interest rate 8% 2% Uncovered interest differential favoring U.K.
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This note was uploaded on 02/19/2008 for the course AEM 2300 taught by Professor Lee,d.r. during the Fall '06 term at Cornell University (Engineering School).

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Lecture_19___Fall_2007 - Interest Arbitrage Uncovered...

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