AEM_ECON_2300_Lecture_18___Spring_2009

AEM_ECON_2300_Lecture_18___Spring_2009 - AEMECON 2300...

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AEM-ECON 2300 International Trade and Finance Lecture 18  Spring, 2009 Prof. David Lee
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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 a  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. 4% 1%   In aggregate, purchase of pounds in spot market (rate rises) and 
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AEM_ECON_2300_Lecture_18___Spring_2009 - AEMECON 2300...

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