Chapter_05_a - Chapter Outline Interest Rate Parity...

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Chapter Outline Interest Rate Parity Purchasing Power Parity The Fisher Effects Forecasting Exchange Rates
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Chapter Outline Interest Rate Parity Covered Interest Arbitrage IRP and Exchange Rate Determination Reasons for Deviations from IRP Purchasing Power Parity The Fisher Effects Forecasting Exchange Rates
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Chapter Outline Interest Rate Parity Purchasing Power Parity PPP Deviations and the Real Exchange Rate Evidence on Purchasing Power Parity The Fisher Effects Forecasting Exchange Rates
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Chapter Outline Interest Rate Parity Purchasing Power Parity The Fisher Effects Forecasting Exchange Rates
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Chapter Outline Interest Rate Parity Purchasing Power Parity The Fisher Effects Forecasting Exchange Rates Efficient Market Approach Fundamental Approach Technical Approach Performance of the Forecasters
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Interest Rate Parity Interest Rate Parity Defined Covered Interest Arbitrage Interest Rate Parity & Exchange Rate Determination Reasons for Deviations from Interest Rate Parity
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Interest Rate Parity Defined IRP is an arbitrage condition. If IRP did not hold, then it would be possible for an astute trader to make unlimited amounts of money exploiting the arbitrage opportunity. Since we don’t typically observe persistent arbitrage conditions, we can safely assume that IRP holds.
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Interest Rate Parity Defined Suppose you have $100,000 to invest for one year. You can either 1. invest in the U.S. at i $ . Future value = $100,000(1 + i $ ) or 1. trade your dollars for pounds at the spot rate, invest in England at i £ and hedge your exchange rate risk by selling the future value of the British investment forward. The future value = $100,000( F / S )(1 + i £ ) Since both of these investments have the same risk, they must have the same future value—otherwise an arbitrage would exist, therefore ( F / S )(1 + i £ ) = (1 + i $ )
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Interest Rate Parity $100,000 $100,000(1 + i $ ) $100,000( F / S )(1 + i £ ) 1. Trade $100,000 for £ at S 1. Invest £100,000 at i £ S 1. One year later, trade £ for $ at F
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Interest Rate Parity Defined Formally, ( F / S )(1 + i £ ) = (1 + i $ ) or if you prefer, IRP is sometimes approximated as 1 + i £ 1 + i $ = S F i $ i £ = S F – S
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Interest Rate Parity Carefully Defined Depending upon how you quote the exchange rate ($ per £ or £ per $) we have: 1 + i $ 1 + i £ S £/$ F £/$ = 1 + i $ 1 + i £ S $/£ F $/£ = or
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Arbitrage If IRP failed to hold, an arbitrage would exist. It’s easiest to see this in the form of an example. Consider the following set of foreign and domestic interest rates and spot and forward exchange rates. Spot exchange rate
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Chapter_05_a - Chapter Outline Interest Rate Parity...

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