FINS3616 Lecture Notes - Lecture 4: Interest Rate Parity, Foreign Exchange Market, Arbitrage

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18 May 2018

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3 – Interest Rate Parity

Two ways to buy a currency forward:

1. Enter into a forward contract

2. Borrow the domestic currency, buy foreign currency on spot market and invest for

term

Why should interest rate parity hold?

• If not, arbitrage possibilities would exist (barring any government controls)

• Forces relationship between forward/spot rates and the interest rate differential

between two countries

Deriving covered interest rate parity

• Expressing that when the forward rate is priced correctly, an investor is indifferent

between investing at home or abroad

• General expression for interest rate parity:

• Interest rate parity and forward premium discounts:

 Forward premium if id > if

 Forward discount if id < if

External currency market

• Bank market for deposits and loans that are denominated in foreign currencies (from

the perspective of the bank)

 Market prospers because it is a way to get around reserve requirements, which

are generally lower in this market

• Interest rates lower due to avoided regulations and increased competition (i.e. supply

of said currency)

 Annualised rate * (1/100) * (number of days/360) = de-annualised rate

• Influence over other markets

 External currency market influences rates elsewhere

 Loans to investors/corporations are based on these interbank markets

 Most important is the LIBOR

Does covered interest rate parity hold?

• Prior to 2007, documented violations of interest rate parity were very rare

• Frequency, size and duration of apparent arbitrage opportunities do increase with

market volatility – especially around GFC

Why deviations from interest rate parity may seem to exist

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Document Summary

Two ways to buy a currency forward: enter into a forward contract, borrow the domestic currency, buy foreign currency on spot market and invest for term. Why should interest rate parity hold: forces relationship between forward/spot rates and the interest rate differential. If not, arbitrage possibilities would exist (barring any government controls) between two countries. Deriving covered interest rate parity: expressing that when the forward rate is priced correctly, an investor is indifferent between investing at home or abroad, general expression for interest rate parity: External currency market: bank market for deposits and loans that are denominated in foreign currencies (from the perspective of the bank) Market prospers because it is a way to get around reserve requirements, which are generally lower in this market. Interest rates lower due to avoided regulations and increased competition (i. e. supply of said currency) Annualised rate * (1/100) * (number of days/360) = de-annualised rate. Loans to investors/corporations are based on these interbank markets.

Related Questions

Consider the following model of the saving-investment balance. In this model, the following relationship must remain in balance: S + (M-X) = I + (G-T) where,

S is domestic saving by households and businesses

M is U.S. imports of goods and services

X is U.S. exports of goods and services

I is private domestic investment in capital goods

G is total federal, state and local government spending on goods and services, and

T is the net receipt of tax revenues by federal, state and local governments

The presentation: âLesson 1: The Savings and Investment Balanceâ in this weekâs lesson can help you understand this identity better.

Clearly, as with any high-level model, there are limitations but letâs try to understand how this model functions mechanically.Consider the model of the saving-investment balance only as an algebraic accounting identity (i.e., do not consider any economic repercussions or additional complications (those can come later)), What does the model predict will happen to gross private domestic investment (I) if:

a) Domestic saving by households was to decrease, everything else remaining the same?

b) U.S. net tax receipts were to increase, everything else remaining the same?

c) There was a sudden increase in exports from the U.S., everything else remaining the same?

d) Pre-tax business profits were to increase, everything else remaining the same?

e) Federal grants to state and local governments were to disappear, everything else remaining the same?

2. Examine the note and bond yields presented below for Treasury and Corporate AAA, AA and A-rate bonds. Why do the yields differ across the securities and within securities, across time? Which premiums or market expectations most appropriately explain those differences? In particular, what accounts for the differences in rates across securities types for the same maturities? And speculate on what factor or factors can best explain why the yields rise as maturities lengthen (within particular types of bonds). Finally, do any securities look out of place and, if so, which and why?

Treasuries

2 year 0.33%

5 year 1.39%

10 year 2.64%

20 year 3.42%

Corporate, AAA

2 year 0.40%

5 year 1.77%

10 year 3.52%

20 year 4.93%

(table continues on next page)

Corporate, AA

2 year 0.63%

5 year 1.91%

10 year 3.50%

20 year 4.43%

Corporate, A

2 year 0.84%

5 year 2.15%

10 year 3.67%

20 year 4.75%

3. Suppose that today the one-year Treasury note yields 0.12% (0.0012 in decimal form), the two-year note yields 0.40% (0.0040), the three-year note yields 0.78% (0.0078), the five-year note yields 1.60% (0.0160), the seven-year note yields 2.22% (0.0222) and the ten-year note yields 2.81% (0.0281). Under the pure expectations theory with no maturity risk:

a) What is the expected yield on a one-year note delivered one year from now?

b) What is the expected yield on a one-year note delivered two years from now?

c) What is the expected yield on a three-year note delivered two years from now?

d) What is the expected yield on a two-year note delivered five years from now?

e) What is the expected yield on a five-year note delivered five years from now?

f) What is the expected yield on a seven-year note delivered three years from now?

Note: This concept is discussed in Chapter 3 of the text and in âLesson 2: More On Yield Curves and Forward Rate Determinationâ in this weekâs online materials.

4. Assume that interest rate parity holds so that future or forward exchange rates adjust to eliminate investor arbitrage profits. If interest rates in Britain are higher than corresponding interest rates in Japan, would you expect an appreciating pound or a depreciating pound in the futures (forward) market relative to the current spot market rate? In terms of the supply and demand for pounds in the spot and forward currency markets, what is implicitly occurring in each as a result of interest rate parity? Is the pound selling forward at a premium or at a discount relative to the yen? (The presentation âLesson 3: On Exchange Ratesâ from this weekâs materials can help shed light on this subject. The portion on interest rate parity later in the presentation, so stick with it. Itâs also discussed in Chapter 16.)

5. The spot market rate for the euro is 1.4059 Canadian dollars per euro. The 3-month futures (forward) rate on the euro is 1.4147 Canadian dollars per euro. The yield on a 3-month Canadian government security is 1.16 percent (0.0116 decimal), annual percentage rate (APR). The yield on a 3-month euro area security is 0.24 percent (0.0024 decimal), annual percentage rate (APR). Show that interest rate parity (IRP) does not hold by solving for the forward rate that ensures IRP. How would you take advantage of the arbitrage opportunity arising from the actual data (i.e., borrow 1,000,000 euros, convert to Canadian dollars, invest in Canada, sell the proceeds forward and then repay your loan or borrow 1,000,000 Canadian dollars, convert to euros, invest in Europe, sell the proceeds forward and then repay your loan)?

plumduck388

a. What is a multinational corporation? Why do firms expand into other countries?

b. What are the five major factors that distinguish multinational financial management from financial management as practiced by a purely domestic firm?

c. Consider the following illustrative exchange rates:

U.S. Dollars Required to Buy One Unit of Foreign Currency

Japanese yen 0.009

Australian dollar 0.650

1. Are these currency prices direct quotations or indirect quotations?

2. Calculate the indirect quotations for yen and Australian dollars.

3. What is a cross rate? Calculate the two cross rates between yen and Australian dollars.

4. Assume that Citrus Products can produce a liter of orange juice and ship it to Japan for $1 75. If the firm wants a 50% markup on the product, what should the orange juice sell for in Japan?

5. Now assume that Citrus Products begins producing the same liter of orange juice in Japan. The product costs 250 yen to produce and ship to Australia, where it can be sold for 6 Australian dollars. What is the U.S. dollar profit on the sale?

6. What is exchange rate risk?

d. Briefly describe the current international monetary system. What are the different types of exchange rate systems?

e. What is the difference between spot rates and forward rates? When is the forward rate at a premium to the spot rate? When is it at a discount?

f. What is interest rate parity? Currently, you can exchange 1 yen for 0 0095 U.S. dollar in the 30-dayforward market, and the risk-free rate on 30-day securities is 4% in both Japan and the United States. Does interest rate parity hold? If not, which securities offer the highest expected return?

g. What is purchasing power parity (PPP)? If grapefruit juice costs $2 a liter in the United States and purchasing power parity holds, what should be the price of grapefruit juice in Australia?

h. What effect does relative inflation have on interest rates and exchange rates?

i. 1. Briefly explain the three major types of international credit markets.

2. Briefly explain how ADRs work.

j. What is the effect of multinational operations on capital budgeting decisions?

k. To what extent do average capital structures vary across different countries?

carmineweasel488

Citrus Products Inc. is a medium-sized producer of citrus juice drinks with groves in Indian River County, Florida. Until now, the company has confined its operations and sales to the United States; but its CEO, George Gaynor, wants to expand into the Pacific Rim. The first step is to set up sales subsidiaries in Japan and Australia, then to set up a production plant in Japan, and finally to distribute the product throughout the Pacific Rim. The firmâs financial manager, Ruth Schmidt, is enthusiastic about the plan, but she worries about the implications of the foreign expansion on the firmâs financial management process. She has asked you, the firms most recently hired financial analyst, to develop a 1-hour tut0rial package that explains the basics of multinational financial management. The tut0rial will be presented at the next board of directors meeting. To get you started, Schmidt has given you the following list of questions. a. What is a multinational corporation? Why do firms expand into other countries? b. What are the five major factors that distinguish multinational financial management from financial management as practiced by a purely domestic firm? c. Consider the following illustrative exchange rates: U.S. Dollars Required to Buy One Unit of Foreign Currency Japanese yen 0.009 Australian dollar 0.650 1. Are these currency prices direct quotations or indirect quotations? 2. Calculate the indirect quotations for yen and Australian dollars. 3. What is a cross rate? Calculate the two cross rates between yen and Australian dollars. 4. Assume that Citrus Products can produce a liter of orange juice and ship it to Japan for $1 75. If the firm wants a 50% markup on the product, what should the orange juice sell for in Japan? 5. Now assume that Citrus Products begins producing the same liter of orange juice in Japan. The product costs 250 yen to produce and ship to Australia, where it can be sold for 6 Australian dollars. What is the U.S. dollar profit on the sale? 6. What is exchange rate risk? d. Briefly describe the current international monetary system. What are the different types of exchange rate systems? e. What is the difference between spot rates and forward rates? When is the forward rate at a premium to the spot rate? When is it at a discount? f. What is interest rate parity? Currently, you can exchange 1 yen for 0 0095 U.S. dollar in the 30-dayforward market, and the risk-free rate on 30-day securities is 4% in both Japan and the United States. Does interest rate parity hold? If not, which securities offer the highest expected return? g. What is purchasing power parity (PPP)? If grapefruit juice costs $2 a liter in the United States and purchasing power parity holds, what should be the price of grapefruit juice in Australia? h. What effect does relative inflation have on interest rates and exchange rates? i. 1. Briefly explain the three major types of international credit markets. 2. Briefly explain how ADRs work. j. What is the effect of multinational operations on capital budgeting decisions? k. To what extent do average capital structures vary across different countries?

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FINS3616 Lecture Notes - Lecture 4: Interest Rate Parity, Foreign Exchange Market, Arbitrage

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