Note on Covered Interest Arbitrate

Note on Covered Interest Arbitrate - the foreign country...

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Steps for the covered interest arbitrage(CIA). First, make sure you know how to write down the covered interest rate parity (CIRP) for any pair of currencies. There are many forms the CIRP, but for CIA the useful form is that F ($ =FC ) S ($ =FC ) (1 + i FC ) = 1 + i $ when the FX rates are direct or S ( FC= $) F ( FC= $) (1 + i FC ) = 1 + i $ when the FX rates are indirect here FC stands for foreign currency. Second, calculate both sides of the CIRP with given rates. The rule for arbitrage are: 1) if the righ-hand-side (RHS) of the CIRP is less than the left-hand-side (LHS) of the CIRP, i.e. RHS < LHS, meaning the U.S. provides less return than the foreign country, then the strategy of ar- bitrage requires borrowing dollars in U.S. and investing (depositing) in
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Unformatted text preview: the foreign country through three steps. 2) if RHS < LHS, then the strat-egy of arbitrage requires borrowing FC in foreign country and investing (depositing) in the U.S. through three steps. The three steps are typically like the following: 1)convert the bor-rowed currency into the other currency at the spot rate. 2) invest (de-posit) the proceeds from conversion at the other currency&s interest rate. 3) Buy the borrowed currency forward, which will give you the amount of ±nal proceeds. Finally, the pro±t is calculated by the following formula profit = final proceeds & repay 1...
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This note was uploaded on 12/06/2011 for the course FIN 536 taught by Professor Staff during the Fall '11 term at S.F. State.

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