interest rate parity

# Interest rates in different currencies related can

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Unformatted text preview: d? For example: Should we borrow in Japan and lend in Turkey? Borrow in Pesos and deposit in Bolivars? 13 Interest Rate Basics The market rate (or nominal rate), i, is the sum of 3 components: The real rate, r, determined by the demand for investment and the supply of savings • Domestic and international factor The inflation rate, , that is determined by the country’s demand & supply of money (monetary policy) An inflation risk premium, rp • Possibly other risk premia (ignore) 14 3 Interest Rate Basics (cnt.) it Ert E t rp ,t So we have: The real return and inflation are both expected; only it is observed! Inflation and the related risk premium are mainly related to national economic policies The savings-investment market may be national or international ex Depending on the openness of the economy But interest rates across currencies must be related in some way, because international investors have most of them available for investment and arbitrage 15 Definitions St: Spot exchange rate at time t (\$/fc) Domestic currency per unit of foreign currency Ft,T: Forward rate at time t. Zt,T is Futures Contract matures at time t +T it,T: T-day domestic interest rate/year Interest rate for deposit/loan made at time t maturing at time t +T i*t,T: Corresponding foreign interest rate 16 \$-Equivalent Returns The 1st step in understanding the relation is to derive the \$-equivalent return It means: what would your return be in \$s in when you invest in a foreign currency account? (Think of AbleTap) The calculation applies to any return • Stocks, bonds, real estate, etc. 17 4 \$-Equivalent Returns (cnt.) Consider investing \$1 in a fc account 1st you have to convert the \$1 to fc Then you earn the fc interest Then you have to convert the whole thing back to \$s Only then you can compare it to what you would have earned if you stayed in \$s 18 \$-Equivalent Returns (cnt.) In algebraic terms this is: 1 i\$ eq ,t ,T 1 St St is the spot rate (\$/fc) T is the time interval (say 3 months) 19...
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