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Lecture 18 - Spring 2010

Lecture 18 - Spring 2010 - AEM-ECON 2300 International...

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AEM-ECON 2300 International Trade and Finance Lecture 18 Spring, 2010 Prof. David Lee
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Interest Arbitrage Uncovered interest arbitrage : making foreign financial investments without obtaining “cover” for exchange rate risk Example: Annual 3-months U.K. 3-month Treasury bill interest rate 10% 2.5% U.S. 3-month Treasury bill interest rate 6% 1.5% Uncovered interest differential favoring U.K. 4% 1.0% If pound depreciates (from $2.00 to $1.98, or 1.0%), then investor makes less (zero) If pound appreciates (from $2.00 to $2.02, or 1.0%), then investor makes more (2%) Potential for earning return, but investor exposed to exchange rate risk.
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Interest Arbitrage Covered interest arbitrage : making foreign financial investments with a simultaneous transaction in forward foreign exchange market to offset exchange rate risk Example: Annual 3-months U.K. 3-month Treasury bill interest rate 12% 3% U.S. 3-month Treasury bill interest rate 8% 2% Uncovered interest differential favoring U.K. 4% 1% Purchasing 3-month Treasury bills in London (with pounds purchased in spot market) earns 1% more than in New York To avoid exchange rate risk, investor sells pounds on 3-month forward market at a cost equal to discount on forward pound
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Interest Arbitrage Covered interest arbitrage : making foreign financial investments with simultaneous transaction in forward foreign exchange market to offset exchange rate risk Example: Annual 3-months U.K. 3-month Treasury bill interest rate 12% 3% U.S. 3-month Treasury bill interest rate 8% 2% Uncovered interest differential favoring U.K. 4% 1% If current value of pound = $2.00, and 3-month forward pound = $1.99, then forward discount = 0.5%. Covered interest-rate differential = uncovered differential – forward discount = 1% - 0.5% = 0.5%
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Interest Arbitrage Covered interest arbitrage : making foreign financial investments with simultaneous transaction in forward foreign exchange market to offset exchange rate risk Example: Annual 3-months U.K. 3-month Treasury bill interest rate 12% 3% U.S. 3-month Treasury bill interest rate 8% 2% Uncovered interest differential favoring U.K. 4% 1% In aggregate, purchase of pounds in spot market (rate rises) and sale of pounds in forward market (rate falls) drives “forward discount” to equal the interest differential. This illustrates… Interest rate parity : forward premium or discount is equal to the interest rate differential (between countries)
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Interest Arbitrage Covered interest arbitrage : making foreign financial investments with simultaneous transaction in forward foreign exchange market to offset exchange rate risk Example: Annual 3-months U.K. 3-month Treasury bill interest rate 12% 3% U.S. 3-month Treasury bill interest rate 8% 2% Uncovered interest differential favoring U.K. 4% 1%
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