LEC IV - INTEREST ARBITRAGE

LEC IV - INTEREST ARBITRAGE - Economics of Global Business...

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Click to edit Master subtitle style Economics of Global Business C30.0011 Guest Lecture Interest Parity, Covered and Uncovered Arbitrage Copyright ©: Joseph Foudy 2009 (charts and illustrations copyrighted by original sources)
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22 Interest Arbitrage n With ability to exchange currencies, interest rates in different states matter n Investors can seek out highest interest rate. n Traditional risk is that foreign currency will lose value and advantage of seeking out higher currency will disappear. n With hedging options, exchange rate risk disappears. Good question: Why anyone would invest in an asset that gets lower interest rate assuming identical risks? n Hedging leads to arbitrage opportunities, which in turn leads to changes in interest rates. n Consequently, we find that exchange rates and interest rates are linked. Let’s look at why this is the case.
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33 Interest Arbitrage n Interest Arbitrage refers to international flow of short-term funds to earn higher returns abroad. n When the foreign currency is hedged in the forward markets, by buying/selling the foreign currency forward, it is called a covered investment . n If it is not hedged it is called an uncovered investment.
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44 Covered Interest Arbitrage n Covered Interest Differential n CD = (1+ iU K) * f/e - (1+ iUS ) where n iU K = UK Interest Rate iUS = US Interest Rate n f = forward rate (for pound) e = spot rate (for the pound) e = ($/ £ ) n Simplified to CD = F + ( iU K - iUS ) CD = f-e + ( iU K - iUS ) e where F = (f-e)/e = forward premium or percentage change in rate and where we reduce this formula based on some simplifying assumptions (inaccurate at higher rates of interest) n The covered interest differential (or total return differential)
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55 Covered Interest Arbitrage n Simplified to CD = F + ( iU K - iUS ) n If UK has a higher interest rate ( iU K - iUS ) and the forward premium (F) is zero or positive, why not invest in the UK if financial produces are identical and there is no exchange
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LEC IV - INTEREST ARBITRAGE - Economics of Global Business...

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