Buys the foreign currency used to acquire the foreign

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buys the foreign currency used to acquire the foreign-currency bond in the spot FX market andsells the foreign currency he/she will receive on the foreign bond in the forward FX market.Recall from chapter 2 that a purchase of currency in the spot market and simultaneous sale ofthis currency in the forward market is called a spot-forward (or FX) swap and is the largest singlekind of transaction in the FX market.So CIP is really just a purchase of a foreign bond7 See Appendix 6.A for this derivation. We assume N=1 for convenience.17
combined with a spot-forward swap. CIP differs fundamentally from UIP because with CIP theinvestor uses the forward market to lock in a known USD total return on the foreign bond fromthe very start.Instead of guessing about the future value of the exchange rate the investor knowswith certainty what it will be since he/she has sold the foreign currency forward for an agreed-onexchange rateat the time the initial investment is made.With CIP the IIRP condition is writtenwith the forward exchange rate, Ft+N(domestic currency/foreign currency) replacing the expectedfuture spot rate, Et[St+N] in the UIP equation as shown belowThe term ‘covered’ in CIP has a similar connotation as in the home or automobileinsurance markets we are more familiar with.For example, if you have fire insurance on yourhouse, you say you are ‘covered’ for that peril.With CIP, covered means you have insuredagainst possible loss due to depreciation in the foreign currency.Using our USD-JPY example,CIP would involve buying 10,000 JPYs with USDs in the spot FX market and simultaneouslyselling 10,500 JPYs for USDs in the one-year-ahead forward FX market.If the forwardexchange rate were Ft+1(USD/JPY) = $.01/¥then this investment strategy would lock in a fivepercent return to holding the JPY bond.Equation (6.9a) shows the CIP equation for the USD-JPY bond investment strategy.Exhibit 6.9 diagrams the two bond purchase choices under CIP in terms of the stepsundertaken to carry them out.Exhibit 6.9CIP Bond Investment ChoicesBuy Foreign JPY Bond181.Buy USD bond for $1002. Receive $1051 YearBuy Domestic USD BondToday
The logarithmic approximation version of CIP isi(dom, currency)= i(for. currency)+%∆Ft,t+1(dom. currency/for. currency)](6.10)where %∆Ft,t+1= (Ft+1St)/St.The term %∆Ft,t+1is the percent difference between the spotexchange rate Stand the forward rateFt+1.%∆Ft,t+1> 0 implies that Ft+1> Stmeaning that theforeign currency is more expensive in the forward market than the spot market. That is theforeign currency is selling at a forward premium.An%∆Ft,t+1< 0 implies that Ft+1< Stmeaningthat the foreign currency is cheaper in the forward market than the spot market. That is theforeign currency is selling at a forward discount.The relationship between the forward premiumor discount and the domestic and foreign interest rates is summarized in Exhibit 6.10Exhibit 6.10Forward Premiums, Discounts and Interest RatesInterest RatesForward Premium or Discounti(dom, currency)

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Term
Spring
Professor
FrancieCate-Arries
Tags
Exchange Rate, Inflation, International Finance, The Land, Foreign exchange market, USDs

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