interest rate parity

uncovered means that the equivalent return is

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

This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: 360 E S T S t ,T t T t 1 it*,T 360 it ,T i T E S t T S t 360 St 1 it*,T T 360 * t ,T 31 UIRP (cnt.) The idea is that If it > E(i\$eq,t) then “everyone” would want to deposit in \$s (dc), and borrow in fc. This will drive up i*t , depress it, and probably increase St (increased demand for fc) The process would continue until E(i\$eq,t) = it Opposite would happen if it < E(i\$eq,t) 32 8 UIRP (cnt.) If the market requires a risk premium, you wouldn’t expect it = E(i\$eq,t)! UIRP does not mean that you would find it,T = i\$eq,t,T every period They are only expected to be equal It means that over a long time they should be equal on average 34 UIRP (cnt.) The actual \$-equivalent return will be known at t +T, and it will be 1 i\$ eq,t ,T T 360 St T 1 it*,T T 360 St 35 UIRP Intuition LHS 1 it ,T T 360 RHS St T 1 it*,T T 360 St The LHS is the total (gross) return from a \$ deposit The RHS is the total (gross) \$-equivalent return from a fc deposit You can think of these as the costs of borrowing as well The higher the fc interest rate the higher the \$-equivalent return The more the \$ depreciates the higher the \$-equivalent return 37 9 UIRP Intuition LHS 1 it ,T T 360 RHS St T 1 it*,T T 360 St The basic intuition is: A currency with a high interest rate should depreciate high depreciate • The currency’s depreciation reduces its \$ return currency’ A currency with a low interest rate should appreciate low appreciate • The currency’s appreciation increases its \$ return currency’ High and low is by comparison with the \$ interest rate 38 UIRP Intuition 1 it ,T T 360 St T 1 it*,T T 360 St If the LHS is larger, it means the \$ depreciation doesn’t quite compensate for the low i* or The \$ appreciation more than offsets the high i* If the RHS is larger, it means the \$ depreciation more than compensates for the low i* or The \$ appreciation doesn’t quite offset the high i* 39 Does UIRP Hold? How well does UIRP work? You have already seen from the AbleTap case A lot at stake from the standpoint of financial management What are the overall conclusions? 42 10 Does UIRP Hold? (cnt.) i\$eq,t,T is very volatile, and almost all the volatility comes from the FX rate i\$eq,t,T seems to be a little higher than it wh...
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