interest rate parity

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

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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.

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