interest rate parity

we can fix this by borrowing in s for t days now it

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Unformatted text preview: Day T: Receive 1 fc from the fc deposit * 1 i0,T * 1 i0,T Pay off the $ loan including interest: S0 1 i0 ,T * 1 i0 , T This is the cost of 1 fc at date T 78 Synthetic Forward (cnt.) Day T: Receive 1 fc from the fc deposit * 1 i0,T * 1 i0,T Pay off the $ loan including interest: S0 1 i0 ,T * 1 i0 , T This is the cost of 1 fc at date T Therefore, it is the synthetic forward rate: Fsynth S 0 1 i0,T * 1 i0,T 79 17 Synthetic Forward (cnt.) Lessons: You don’t need to have a forward market in order to hedge or speculate You’ll use the cheaper of the two methods If Fmarket ≠ Fsynthetic you can earn arbitrage profits If you “own” a Forward contract are you long or short fc? 80 Synthetic Forward (cnt.) A Graphic Representation: i* FC S Space F Time U.S. Now i At T 81 Synthetic Forward (concl.) Arbitrage will insure that, within the limits of transactions costs and small risk differences, Fmarket = Fsynthetic and therefore 82 18 Synthetic Forward (concl.) Arbitrage will insure that, within the limits of transactions costs and small risk differences, Fmarket = Fsynthetic and therefore Fsynth Fmarket S 0 1 i0,T * 1 i0,T F0,T S0 1 i0,T * 1 i0,T 83 Does CIRP Hold? Answer: Very much so! It holds very closely for Eurocurrencies It holds less well for national rates • The reason is sovereign risk (see text) • Ger-ft-t.xls & Jap-ft-t-.xls 85 Is CIRP Relevant In Practice? Answer: YES! Shopping for covered rates is not very rewarding! In fact, banks use CIRP to calculate their forward quotes Of course there is a bid/ask spread! When you shop around you’ll get the inside quote The banks earn the bid/ask spread for the service they provide 86 19 What About Arbitrage? If fc Forward rate is more expensive than the Synthetic Forward Go with the synthetic forward even better Short the market forward and cover with the synthetic Forward If fc Ft,T < FSynthetic Go with the market F Go long on Ft,T and cover with FSynthetic 87 Does F Predict S? The RHS of CIRP and UIRP are the same Therefore, iff UIRP holds, 93 Does F Predict S? The RHS o...
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