interest rate parity

How well does uirp work you have already seen from

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Unformatted text preview: en the fc interest rates are above the $ rates, and i$eq,t,T might be a little lower than it when the fc interest rates are below the $ rates It is difficult to get statistical significance 43 CIRPT It is clear that with UIRP we are comparing apples and oranges! The $ return is riskless The $-Equivalent return is very volatile and maybe risky St T 1 it*, T St 1 it , T • Aside: what is the difference between volatility and riskiness? 50 CIRPT (cnt.) 1 i t ,T E S t T St 1 i * t ,T What if we were to hedge the FX risk? Then we would have 1 i t ,T Ft ,T St 1 i 1 i * t ,T $ eq ,t ,T And both returns would have the same risk! 52 11 CIRPT 1 it ,T Ft ,T St (cnt.) 1 i 1 i * t ,T $ eq ,t ,T In this case, if the 2 returns are not equal at any time we can expect arbitrage to take place Buy the currency in the cheap market and simultaneously deliver it to the expensive market 53 CIRPT (cnt.) We say that a currency is at a discount if it is cheaper forward than spot We say that a currency is at a premium if it is more expensive forward than spot 54 CIRPT (cnt) CIRP says that if you eliminate the FX risk by hedging (covering) with a forward contract, the domestic and foreign returns better be the same: better 1 i t ,T T 360 FS 1 i t ,T t * t ,T T 360 55 12 CIRPT Ft ,T S t St i (cnt.) t ,T i t*,T T 1 i t*,T T 360 360 Intuition: the PV of the interest differential is completely offset by the forward discount or premium Higher $ i means that the $ is at a discount Higher fc i means that the fc is at a discount or the $ it at a premium 56 CIRPT (cnt.) Approximate CIRP relations They are nice for short-hand but not sufficiently accurate F t ,T S t St i t ,T i t*,T It works OK when the fc interest rate is small • Note the the T/360 adjustment is dropped for simplicity for both F ln t ,T ln Ft ,T ln St it ,T it*,T S t This is the continuously compounded version of CIRP It works OK when the time interval is small 61 Examples F0 ,T 1 i0 ,T T 360 * St 1 i0 ,T T 360 or * i0 ,T i0 ,T T F0 ,T S 0 360 * S0 1 i0 ,T T...
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