Lecture3 - Lecture 3(Chapters 6 7 FINS3616 Jared Staneld...

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Lecture’3’(Chapters’6’&’7)’ FINS3616’ Jared’Stanfeld’
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INTEREST’RATE’PARITY’ Chapter’6’
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David’Villa’Example’ ’ Arsenal’is’a±empFng’to’buy’David’Villa’from’Barcelona’for’a’transfer’fee’ of’€13’million’in’6’months.’ Arsène’Wenger,’has’been’deep’in’thought’on’ how’to’ensure’that’Arsenal²s’transfer’budget’is’not’exposed’to’£/€’ transacFon’exchange’risk.’ ’ ’
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David’Villa’Example’ ’ Arsène’Wenger,’who’is’a’regular’reader’of’the’Financial’Times,’notes’that’the’ current’6’month’forward’rate’is’£0.86/€.’Wenger’calculates’that’if’Arsenal’ purchases’€13’million’6’months’forward,’it’will’cost’them’€13’million’x’ £0.86/€’=’£11.18’million’to’buy’Villa.’ ’ ’ ’ ’ Manuel’ Almunia’is’eager’to’impress’his’way’back’on’to’Arsenal’from’Wa\ord’ with’his’±nancial’acumen’(because’his’goalkeeping’sure’wasn²t’doing’the’ trick),’so’he’comes’to’Wenger’secretly’with’a’plan:’The’current’spot’rate’is’ £0.84/€’and’interest’rates’in’Spain’are’1.5%.’Why’doesn²t’Arsenal’just’ exchange’£10.84’million’now,’invest’it’for’6’months,’then’buy’Villa?’ ’ ’ ’ What’is’he’talking’about?’(£10.84÷£0.84/€)*(1.015) 0.5 =’€13’million’
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David’Villa’Example’ ’ Wenger’reminds’ Almunia’about’the’Fme’value’of’money.’Interest’rates’ are’6.37%’in’London,’if’Arsenal’instead’invests’£10.84’million’locally,’in’6’ months’they’will’have’£10.84*(1.0637) 0.5’ =’£11.18’million,’which’is’the’ amount’they’needed’to’purchase’€13’million.’“This’is’called’Covered’ Interest’Rate’Parity”’he’tells’ Almunia’while’conFnuing’to’work.’ Almunia’ walks’away’with’his’Fny’dog’a’bit’confused.’
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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$’at’ i A Exchange’A$’for’$’at’current’spot’rate’($1.07/A$)’ Invest’$’at’US’risk-free’rate’for’1’year’(1+i US )’ In’1’year’you’have’ » A$*(1+i A )’liability’ » A$*($1.07/A$)*(1+i US )’asset’
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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’
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