interest rate parity

in algebraic terms this is 1 i eq t t 1 st st is the

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: $-Equivalent Returns (cnt.) In algebraic terms this is: 1 i$eq,t ,T 1 1 it*,T St St is the spot rate ($/fc) T is the time interval (say 3 months) 20 5 $-Equivalent Returns (cnt.) In algebraic terms this is: 1 i$eq,t ,T 1 1 it*,T S t T St St is the spot rate ($/fc) T is the time interval (say 3 months) 21 $-Equivalent Returns (concl.) 1 i$eq,t ,T 1 1 it*,T S t T St The $-Eq return is a function both of the fc interest rate and the relation of St to St+T! Also note that the $-Eq return is uncertain It is the involvement of FX that links the interest rates of the various currencies 22 Examples 1 i$eq ,t ,T S t T 1 it*,T St i¥ = 0.75%, ¥/$ Spot = 107.0, Exp in 3 months 106.0 1 i$ eq 1 106 . 0 3 1 0.0075 * 1.01133 1 107 .0 12 Or 4.53% annualized If the FX rate was expected to remain the same, the $-eq return would be? If the ¥ was expected to depreciate (say 109.0), the $-eq return would be? 23 6 Examples (cnt.) 1 i$eq ,t ,T S t T 1 it*,T St iTL = 20.00%, TL/$ Spot = 1.25; E(S) in 1 year 1.48 t 26 Some Conclusions Interest rate differentials may be Completely offset Partially offset More than offset by FX movements There is always risk in “open” positions FX movements dominate $-equivalent returns, because they are very large 28 UIRP How do $ and $-equivalent returns of fc interest rates compare? UIRP(T) says that If investors are risk neutral or there is no systematic risk, then i$ = E(i$eq) for all currencies UIRP stand for Uncovered Interest Rate Parity 29 7 UIRP How do $ and $-equivalent returns of fc interest rates compare? UIRP(T) says that If investors are risk neutral or there is no systematic risk, then i$ = E(i$eq) for all currencies UIRP stand for Uncovered Interest Rate Parity E S t T 1 it ,T 1 E i$ eq ,t ,T 1 it*,T St 30 UIRP (cnt.) Uncovered means that the $-equivalent return is subject to FX risk • This is because we don’t know what the future spot rate, St+T , will be The UIRP expression can be rewritten as 1 i t ,T E S t T St 1 i * t ,T 1 i T...
View Full Document

This note was uploaded on 01/16/2010 for the course FBE 436 at USC.

Ask a homework question - tutors are online