2016/11/2 Interest Rates and Exchange Rates Covered Interest Parity If Janet Yellen hints the fed will raise s interest rate, how will Investor has USD 10 S/E Spot RMB respond in the foreign exchange market? million to put on deposit S/E 360 day forward In the capital market, investors arbitrage on interest rates G0-day Libor rying to finance with currencies of low interest and invest in pot, put proceeds d ∈360- day libor 4.3% emember this may be prohibited by the capital control. sell balance forward for Even if not, investors may also encounter exchange rate changes, which may eat all the arbitrage profit. They need to cover(hedge) the profit in the forward market. Covered Interest Parity Covered Interest Arbitrage(CIA) Eurodollar rate 400% per anau will have $10*(1+4)=510, 4 million in 360 days Invest on毛 exchange s to e at the spot rate get 66 4516 million will have E6 7290 million in 360 days(=6.4516x1043). emro meT maker s104165 million(=67290×1.548) The better choice is investing in E an also borrow in s and investing in interest rat arbitrage Covered Interest Parity Forward rate and and Forward rate Interest Rate Parity risk free arbitrage terest Rate Parity(IRP) he difference in the national interest rates for securities of Spot and forward rates and yields will adjust very quickly so that similar risk and maturity should be equal to, but opposite in the return is the same for the two transactions sign to, the forward rate discount or premium for the In fact, The forward rate is determined by the following formula foreign currency, except for transaction costs. It holds well for those free-floating currencies. F-51+ 1≈4%-4.3%=-0.3%; disappears in less than one second expect for the transaction cost.2016/11/2 7 4-37 Interest Rates and Exchange Rates • If Janet Yellen hints the Fed will raise $ interest rate, how will RMB respond in the foreign exchange market? • In the capital market, investors arbitrage on interest rates, trying to finance with currencies of low interest and invest in high. (Remember : this may be prohibited by the capital control. ) • Even if not, investors may also encounter exchange rate changes, which may eat all the arbitrage profit. • They need to cover(hedge) the profit in the forward market. Covered Interest Parity • Investor has USD 10 million to put on deposit for 360 days. • Could also buy euro spot, put proceeds on deposit at € Libor and sell balance forward for USD. $/€ Spot $1.550 $/€ 360 day forward $1.548 $ 360-day Libor 4.0% € 360-day Libor 4.3% Which is the better investment? 4-38 Covered Interest Parity • Invest on $ – will have $10*(1+4)=$10.4 million in 360 days • Invest on € – exchange $ to € at the spot rate, get €6.4516 million (=10÷1.55) – will have €6.7290 million in 360 days (=6.4516×1.043). – sell this amount forward at the forward rate and get $10.4165 million (=6.7290×1.548) • The better choice is investing in € – Can also borrow in $ and investing in €  interest rate arbitrage! 4-39 4-40 Eurodollar rate = 4.00 % per annum 360 days Dollar money market euro money market $10,000,000 $10,400,000 $10,416,542 S=$1.55//€ €=10M/1.5 =6.4516M €6.7290M F360 ==$1.548/€ x 1.043 x 1.04 Start End Euroeuro rate = 4.30 % per annum Arbitrage Potential Covered Interest Arbitrage (CIA) 4-41 Covered Interest Parity and Forward Rate • This cannot persist as it represents a risk free arbitrage opportunity. • Spot and forward rates and yields will adjust very quickly so that the return is the same for the two transactions. • In fact, The forward rate is determined by the following formula: ଴଺ଷܨ ୣ୳୰୭/$ = ܵଷ଺଴ ୣ୳୰୭/$ 1 + ݅$ 1 + ݅௘௨௥௢ = 1.55 ∗ 1 + 4% 1 + 4.3% = 1.5455 < 1.548 ிିௌ ௌ = ଵାସ% ଵାସ.ଷ% − 1 ≈ 4% − 4.3% = −0.3% ; ܨ ≈ 1.55 ∗ 1 − 0.3% = 1.5454 *In this example, € in the forward market is more expensive than predicted by the formula, so we buy € in the spot market and sell in the forward to make a profit. In real life, the spread disappears in less than one second expect for the transaction cost. Forward Rate and Interest Rate Parity • Interest Rate Parity (IRP) – The difference in the national interest rates for securities of similar risk and maturity should be equal to, but opposite in sign to, the forward rate discount or premium for the foreign currency, except for transaction costs. – It holds well for those free-floating currencies. 4-42