Lesson_58_Interest Parity

# Lesson_58_Interest Parity - Interest Parity When U.S assets...

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1 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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2 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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## This note was uploaded on 09/14/2009 for the course ECON 340 taught by Professor Leidholm during the Summer '08 term at Michigan State University.

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Lesson_58_Interest Parity - Interest Parity When U.S assets...

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