What to do if 1 rf 1 construct position portfolio

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Unformatted text preview: on (portfolio) today: 1 2 3 4 2 Ff /d (1 + rd ) = Ff /d (1 + rd ) Sd/f Sf /d Borrow from domestic bank. (short a deposit) Covert loan to foreign currency at the spot rate. Lend to foreign bank. (long a deposit) Enter into foreign-to-domestic forward fx position. Close out position (portfolio) in the future: 1 2 3 Take proceeds from foreign deposit. Covert to domestic currency at prearranged rate. Repay loan from domesic bank. R. J. Hawkins: Covered Interest Parity Econ 136: Financial Economics 19/ 22 The Differential: The f /d version Recall our basic equality: Sf /d (1 + rf ) = (1 + rd ) Ff /d . Collecting currency rates and interest rates: Sf /d (1 + rd ) = . Ff /d (1 + rf ) Recalling that: 1 = 1 − rf + higher-order terms (1 + rf ) We can write: Sf /d ≈ 1 + rd − rf Ff /d or Sf /d − Ff /d ≈ rd − rf Ff /d R. J. Hawkins: Covered Interest Parity Econ 136: Financial Economics 20/ 22 The Synthetic Call 50 OPTION PRICE (arbitrary) IN THE MONEY Synthetic Portfolio OUT OF THE MONEY 40 1 BREAKEVEN 10 Long the underlying. 3 20 Long European put. 2 30 Short (borrow) K...
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