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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...
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This note was uploaded on 01/16/2010 for the course FBE 436 at USC.
 '09
 PROTOPAPADAKIS

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