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Chapter 15

# Chapter 15 - Chapter 15 Exchange Rates Interest Rates and...

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Chapter 15: Exchange Rates, Interest Rates and Interest Parity Interest Parity This means equalization of interest rate measured in one common currency across nations. This happens because many savers move their loanable funds from one market where interest rate is low to another seeking higher interest rate. The adjustments in the market interest rate continue until in each market the quantity supplied and quantity demanded of loanable funds equal. Example 1: Suppose a U.S individual having dollars is willing to invest her funds in either the US treasury bills or the UK treasury bills. Those two instruments have the same characteristics. US investing: One US dollar ( \$1 ) R = interest rate on dollars (\$) \$1 *(1+R) = (1+R) = dollars accumulated after one year if one dollar is invested. UK investing R* = interest rate on pound (₤). E t = \$/₤ = spot exchange rate at current period or spot rate. \$1 /E t = 1 /E t = converting one dollar into pounds (at the \$/₤ rate) now or spot. 1/E t *(1+R*) = pounds accumulated after one year from investing one ( \$1 ) dollar today in a UK financial instrument after converting it into pounds. Now we have reached the time of maturity (one year after investing in the UK) and transferring the pounds into dollars \$ . Suppose E t+1 = \$/₤ is the (future) spot rate at the time of maturity or t +1 . Then [1/E t (1+R*)]*E t+1 (this is accumulated pounds after one year times the future spot rate E t+1 = \$/₤ in one year at t + 1 ) is amount of dollar at maturity from investing in the UK after converting the accumulated pounds (after one year) to dollars. If \$1*(1+R) > [ ( 1/E t ) (1+R*)]*E t+1 or (1+R)/ (1+R*) > E t+1 / E t then invest in the US and vice versa..

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Practice Example 2 : Investment in the US vs. the UK( where to invest? ) R = 5% (in \$) R*= 6% (in ₤) E t = \$/₤ = \$1.5/₤ ( spot rate at time t, now) Amount invested: \$100. Calculate: \$100*(1+R) = \$100*(1+0.05) = ? dollars accumulated after one year (maturity) of investing one dollar in the US (\$105). 100*1/E t *(1+R*) = ? pounds accumulated after one year (maturity) investment in the UK: [(\$100/\$1.5)*(\$1.06)= ₤70.67 )] Suppose after one year : E t+1 = 1.40 \$/₤ future spot rate at time t+1 Convert the pounds to dollars at maturity using S t+1 100*1/E t *(1+R*)* E t+1 = [[(\$100/\$1.5)*(\$1.06)*( \$ 1.400] = \$98.93? dollars at maturity. Which instrument should the US saver choose? Answer: The US. [You can also check the condition (1+R)/ (1+R*) > E t+1 / E t (1.05/1.06) > \$1.40/ \$1.50 or 0.990566 > 0.9333. End of practice example . Expectations Define expected exchange rate as E e t+ 1 = \$/ ₤. At the time of investing (say now), the US saver does not know the future spot exchange rate ( E t+1 ) at the time of maturity. This saver has expectations of this future spot rate. So decisions are made on the basis of expected spot exchange rate ( E e t+1 ). So the
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Chapter 15 - Chapter 15 Exchange Rates Interest Rates and...

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