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..
This preview has intentionally blurred sections. Sign up to view the full version.
View Full Document
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
This is the end of the preview.
Sign up
to
access the rest of the document.
 Fall '06
 Gang
 International Economics, Exchange Rate, Interest Rates, Spot rate, Foreign exchange market, Interest rate parity

Click to edit the document details