interest rate parity

uncovered means that the equivalent return is

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

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