# 1 the theory of covered interest rate parity the

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Unformatted text preview: work. Almunia walks away with his Fny dog a bit confused. 6.1 The Theory of Covered Interest Rate Parity •  The intuiFon behind interest rate parity •  Two ways to buy a currency forward •  Enter into a forward contract •  Borrow domesFc currency, buy foreign currency on spot market and invest for term •  How would that work (say for a year)? –  –  –  –  Borrow A\$ at iA Exchange A\$ for \$ at current spot rate (\$1.07/A\$) Invest \$ at US risk- free rate for 1 year (1+iUS) In 1 year you have »  A\$*(1+iA) liability »  A\$*(\$1.07/A\$)*(1+iUS) asset 6.1 The Theory of Covered Interest Rate Parity •  The intuiFon behind interest rate parity •  Why there must be interest rate parity •  If not, arbitrage possibiliFes would exist (barring any government controls) •  Forces relaFonship between forward/spot rates and the interest rate diﬀerenFal between two countries •  Fh/f / Sh/f = (1 + ih) / (1 + if). 6.1 The Theory of Covered Interest Rate Parity \$10M to invest; iU.S.=8%; iU.K.= 12%; S=\$1.60/£; F1- yr = \$1.53/£ \$10M * 1.08 1.  2.  3.  4.  Convert into forex using spot rate: \$10M/(\$1.60/£) = £6.25M Invest at foreign interest rate: £6.25M * 1.12 = £7M Convert back at forward rate: £7M * \$1.53/£) = \$10.71M Compare to what you could have earned by just invesFng in your home naFon: \$10M * 1.08 = \$10.8M Inves&ng in the U.S. is more proﬁtable for Kevin. But what if he could borrow/lend? Is the answer sFll the same? 6.1 The Theory of Covered Interest Rate Parity \$10M to invest; iU.S.=8%; iU.K.= 12%; S=\$1.60/£; F1- yr = \$1.53/£ \$10M * 1.08 1.  Borrow pounds: £1M * 1.12 = £1.12M (what Kevin owes at end of investment term) 2.  Convert pounds to dollars: £1.12M * (\$1.60/£) = \$1.6M 3.  Invest a...
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## This note was uploaded on 07/17/2013 for the course FINS 3616 at University of New South Wales.

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