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Lesson 58
1
Interest Parity
When U.S. assets become more attractive
relative to foreign assets, the demand for
dollars increases causing the dollar to
appreciate
This lesson formalizes the way to think
about this type of change
Lesson 58
2
There are many assets in the world:
stocks,
bonds, bank accounts, gold, etc.
Simplify by thinking of only two assets
A U.S. bond, and a foreign bond
Both carry the same risk of default
Purchaser of a bond earns interest (seller
has to pay interest)
Lesson 58
3
Notation:
U.S. interest rate
i
=
*
foreign interest rate
i
=
spot exchange rate ($/FC)
E
=
forward exchange rate ($/FC)
F
=
Time periods all match (interest rates,
forward rate)
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Lesson 58
4
Start with
D
dollars
( )
1
Di
+
Want to earn interest on them to have as
many dollars in future as possible
Buy U.S. bond or buy foreign bond?
Amount of dollars in future from buying
U.S. bond is simple:
Lesson 58
5
Calculation for buying foreign bond more
complicated
D
E
First have to convert
D
dollars into foreign
currency
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 Summer '08
 leidholm
 Economics

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