Lecture 2 interestparityconditionI.pptVIP

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Lecture 2 interestparityconditionI.ppt

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Lecture 2 interestparityconditionI

* * * * * * * ## * * ## * * * * * Not foreign exchange risk; other type of risk e.g political risk, sovereign risk. Risk averse investors would require payment of risk premium to hold foreign assets even though these assets offer same (covered) return on domestic assets. * * * * * * * * * * * * * * * ## * * * * * * * * * * * * ## * * Covered Interest Arbitrage * Covered margin Investing at domestic rate Domestic ? foreign Borrowing domestic currency Converting at spot rate Investing at foreign rate Foreign ? domestic Borrowing foreign currency Converting at spot rate S 1 unit Reconverting at forward rate Loan repayment Loan repayment Covered margin 1 unit 1 unit Reconverting at forward rate S S, F(D/F), i* foreign i domestic Outward Interest Arbitrage (Australian perspective) Borrow at domestic interest rate ? ? i Aus Convert borrowed funds in spot FX market at spot exchange rate S ie sell domestic currency/buy foreign currency, obtaining S units of foreign currency per unit of domestic currency? ? S(USD/AUD) Invest in (buy) foreign currency denominated asset ? ? iUS Sell foreign (buy domestic) currency forward? ?F(USD/AUD) Inward Interest Arbitrage (Australian perspective) Borrow at foreign interest rate ? ? i US Convert borrowed funds in spot FX market at spot exchange rate S ie sell foreign currency/buy domestic currency, obtaining 1/S units of domestic currency per unit of foreign currency? ?S(USD/AUD) Invest in (buy) domestic currency denominated asset ? ? iAUS Sell domestic (buy foreign) currency forward? ?F(USD/AUD) Covered Interest Parity (CIP) Example: Suppose you are given the following information: annual interest rate on 3-month UK-pound asset, iUK= 6% paannual interest rate on 3-month US-dollar asset, iUS= 5% paspot exchange rate S(USD/pound) = USD1.50 3-month forward exchange rate F(1/4)(USD/pound) =USD1.4985 Are there any interest arbitrage opportunities? If so d