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Wk14_15Nov_Ch18_IRParity

# Wk14_15Nov_Ch18_IRParity - Wk14 Tuesday Nov 14 2011 Tuesday...

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Tuesday: Ch. 18 – Interest Rate Parity Thursday: Ch. 19 – Purchasing Power Parity Overall theme: Details of the forces that influence exchange rates - in the short run (interest rate parity) - in the long run (purchasing power parity) Wk14: Tuesday, Nov. 14, 2011

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Today Covered Interest Rate Parity Uncovered Interest Rate Parity Empirical Evidence on both Parity Conditions
Covered Interest Parity Due to pressure from arbitrage: The return on a domestic deposit will equal the overall return on a foreign deposit which has been hedged with a forward contract.

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Covered Interest Parity U.S. CFO has \$20 million in cash which she will need in three months. Online data: Return on 3-month domestic deposit: i US = .03 Return on 3-month foreign deposit: i UK = . 04 Your recommendation?
More Data Return on 3-month domestic deposit: i US = .03 Return on 3-month foreign deposit: i UK = . 04 Spot exchange rate: e \$/£ = \$2.00/£ 3-month forward exchange rate: f \$/£ = \$1.96/£ Return on U.S. deposit: \$20M (1 + i US ) = \$20M (1+.03) Return on U.K. deposit: Convert \$’s to £’s \$20M/e \$/£ = \$20/(\$2/£) = £10M

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Compute Returns Return on U.S. deposit: \$1 (1 + i US ) \$20M (1+.03) = \$20.600 Return on U.K. deposit: Convert \$’s to £’s \$1 (1/e \$/£ ) \$20M/(\$2/£) = £10M Compute earnings \$1 (1/e \$/£ ) (1 + i UK ) £10M (1+.04) = £10.4M Sell pounds forward \$1 (1/e \$/£ ) (1 + i UK ) f \$/£ £10.4M x \$1.96/£ =
More Generally Return on Return on. U.S. Deposit U.K. Deposit (1 + i US ) vs. (1 + i UK ) (f \$/£ /e \$/£ ) Forward Premium F = (f- e)/e (1.96 \$/£ -2.00 \$/£ )/2.00 \$/£ = -.02 AN Approximation i US vs. i UK + F .03 .04 - .02

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U.S. Deposit U.K. Deposit (1 + i US ) = (1 + i UK ) (f \$/£ /e \$/£ ) Suppose < Then invest in U.K. Impact: e \$/£ rises, f \$/£ falls, i UK falls, i US rises Suppose > Then invest in U.S. Impact:
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Wk14_15Nov_Ch18_IRParity - Wk14 Tuesday Nov 14 2011 Tuesday...

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