Covered and Uncovered Interest Rate Parity(国际金融-香港大学,WONG Ka Fu).ppt

Covered and Uncovered Interest Rate Parity WONG Ka Fu 26th January 2000 Comparing Local and Foreign Prices Prices within a country Prices across countries P (in home currency) P* (in foreign currency) 1 HD = x FD = 1/e FD, i.e., e HD = 1 FD P vs. eP* Return on a home asset Pt+1 - Pt dividends or any interest payments to the asset holder ? Dt+1 Pt+1 - Pt + Dt+1 Rate of Return on a home asset Return / cost of asset at time of purchase / year Home asset in home currency ( Pt+1 + Dt+1 - Pt )/ Pt = [ ( Pt+1 + Dt+1 ) / Pt ] - 1 Return on a foreign asset A foreign investor invests in a foreign asset Pt+1* - Pt* + Dt+1* = Pt+1* + Dt+1* - Pt* A home investor invests in a foreign asset et+1 (Pt+1* + Dt+1* ) - etPt* Rate of Return on a foreign asset Foreign asset in home currency [ et+1 ( Pt+1* + Dt+1* ) - etPt* ] / ( etPt* ) = [ et+1 ( Pt+1* + Dt+1* ) / ( etPt* ) ] - 1 = (et+1 / et ) [ ( Pt+1* + Dt+1* ) / Pt* ] - 1 Expectations Lottery 1 0.5 probability to win 1000 0.5 probability to win 0 Expect to win 0.5 × 1000 + 0.5 × 0 = 500 Expectations Lottery 2 0.2 probability to win 1000 0.3 probability to win 500 0.5 probability to win 0 Expect to win 0.2 × 1000 + 0.3 × 500 + 0.5 × 0 = 350 Expectations Lottery 3 Pi = f(yi) probability to win yi Expect to win Et(y) = ?i Pi yi = ?i f(yi) yi Expectations Lottery 4 f(y) probability to win y Expect to win Et(y) = E(y| information available at time t) = ?y?? f(y) y dy Replacing assets with deposits greatly simplifies the algebra: Some unknown quantities become known: Pt+1 = 1 Pt = 1 Dt+1 = Rt= home interest rate Pt+1*= 1 Pt* = 1 Dt+1*= Rt*= foreign interest rate The only unknown at time t is et+1 Expected return and expected rate of return Expected return on a home asset: Et (Pt+1 + Dt+1 - Pt ) = Et (Pt+1 + Dt+1) - Pt Expected rate of return on a home asset: Et [(Pt+1 + Dt+1) / Pt - 1 ] = Et (Pt+1 + Dt+1) / Pt - 1 Rate of return of home deposit Et (Pt+1 + Dt+1) / Pt - 1 Pt+1 = 1 Pt =