# 2 interest rates in the external currency market

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Unformatted text preview: t U.S. interest rate: £1.6M * 1.08 = \$1.728M 4.  Convert back at forward rate: \$1.728M * \$1.53/£) = £1,129,411.76 Kevin would make £9,411.76 (Step 4 – Step 1) proﬁt for every £1M that is borrowed! 6.1 The Theory of Covered Interest Rate Parity •  Deriving interest rate parity –  Expressing that when the forward rate is priced correctly, an investor is indiﬀerent between invesFng at home or abroad –  General expression for interest rate parity [1+i] = [1/S] * [1+i*] * F –  Interest rate parity and forward premiums and discounts (1+i)/(1+i*) = F/S SubtracFng 1 from each side and simplifying we obtain (F- S)/S = (i- i*)/(1+i*) If the result of this equaFon is (+), the forward is selling at a premium, if it is (- ), the forward is selling at a discount Exhibit 6.1 Diagram of Covered Interest Arbitrage 6.2 Covered Interest Rate Parity in PracFce •  The External currency market •  Bank market for deposits and loans that are denominated in foreign currencies (from the perspecFve of the bank) •  Example: pound- denominated deposits and loans made by banks in Frankfurt •  Market prospers because it is a way to get around reserve requirements, which are usually lower in this market Exhibit 6.2 Interest Rates in the External Currency Market Lower than they would be due to the skirted regulations and increased Competition, i.e., supply of said currency Annualized rate * (1/100) * (number of days/360) = de-annualized rate 6.2 Covered Interest Rate Parity in PracFce •  Inﬂuence over other markets –  External currency market inﬂuences rates elsewhere –  Loans to investors/corporaFons are based on these interbank rates –  Most important of rates is LIBOR •  Covered interest arbitrage with transacFon costs Exhibit 6.3 Covered Interest Rate Parity with Bid- Ask Rates An Example with TransacFon Costs Conv...
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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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