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Class Notes
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Canada
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Ryerson University
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Finance
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FIN 621
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Sergiy Rakhmayil
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Lecture

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Finance

FIN 621

Sergiy Rakhmayil

Winter

Description

• International Finance-lecture3
IBS 621
• Lecture 3
• Foundations of International Financial Management
• Globalization and the Multinational Firm
• International Monetary System
• Balance of Payments
• The Market for Foreign Exchange
• International Parity Relationships
• International Parity Relations
• Interest rate parity
• Purchasing power parity
• Fisher effect
• Using the parity relations in forecasting exchange rates
• Interest Rate Parity
• F – forward rate, FC/DC
• S – spot rate, FC/DC
• rFC interest rate of foreign currency (FC)
• rDC – interest rate of domestic currency (DC)
• Interest Rate Parity
• You observe that spot EUR/USD=1.05, one-year interest rates are: r USD=1.76%,
r =3.39%, what is the 1-year forward EUR/USD rate?
EUR
• IRP and Covered Interest Arbitrage
• If IRP failed to hold, an arbitrage would exist. It’s easiest to see this in the form of
an example.
• Consider the following set of foreign and domestic interest rates and spot and
forward exchange rates.
• IRP and Covered InterestArbitrage
• Alternative 1. Invest $1,000 in Canada @ ___%, in one year investment will be
worth $1,071 = $1,000(1+ i ) = $1,000(1.071)
• Alternative 2.
– Exchange $1,000 for £800 at the going spot rate, (note that £800 =
$1,000÷$______/£),
– invest £800 in the UK at i = £1.56% for one year, receive £892.48.
– Translate £892.48 back into dollars at F ($/£)360$1.20/£, the £892.48 will
be exactly $1,071.
• Note that payoffs for alternatives 1 and 2 are ________
• IRP and Covered InterestArbitrage
• According to IRP only one 360-day forward rate, F ($/£), 360 exist. It must be
the case that
F 360£) = ____________
• If F360/£) $1.20/£, riskless arbitrage is possible
– As usual, buy low-sell high
• Arbitrage Strategy I
• If F360/£) > $1.20/£, let’s say _______. Forward GBP overpriced (CAD is
underpriced). Sell forward GBP and buy spot GBP to make it riskless. – Borrow $__________ at t = 0 at i = 7.1%.$
– Exchange $1,000 for £_______ at the prevailing spot rate, (note that £800
= $1,000÷$1.25/£) invest £800 at 11.56% (i ) for o£e year to achieve
£892.48
– Translate £__________ back into dollars, if
F 360£) > $1.20/£ , £892.48 will be more than enough to repay your dollar
obligation of $1,071. £892.48 * $1.3 = $1160.22, profit = $_________
• Arbitrage Strategy II
• If F 360£) < $1.20/£, let’s say $______. Forward GBP underpriced (CAD
overpriced). Buy forward GBP (sell forward CAD), sell spot GBP, get CAD to
make it riskless.
i. Borrow £_______ at t = 0 at i = 11£56% .
ii. Exchange £800 for $______ at the prevailing spot rate, invest $1,000 at
7.1% for one year to achieve $________.
iii. Translate $1,071 back into pounds, if
F 360£) < $1.20/£ , $1,071 will be more than enough to repay your £ obligation
of £892.48. $1,071/$1.10= £973.64, profit = £___________
• IRP and Forward Bid-Ask Spread
• F bid* bidr bid,FC(1+r ask,DC
• F ask ask* (1+r ask,FC/(1+rbid,DC
– F – forward exchange rate, FC/DC
– S – spot exchange rate, FC/DC
– r bid,FCrask,FCnterest rates on lending (i.e. on your savings account) and
borrowing (i.e. if you want to get a loan) in the foreign country
– r bid,DC ask,DCending and borrowing interest rates in the home country
(country of the currency that is in the denominator in the FC/DC exchange
rate)
• IRP and Bid-Ask Spread
• You see the following rates. Spot USD/EUR=1.1865-70, JPY/USD=108.10-20.
The interest rates are: r $5-5.25, r EUR=3.25-3.5, r =JPY5-1.5. What should be the
spot JPY/EUR rate and 3-month forward JPY/EUR rates?
• IRP and Bid-Ask Spread
• Purchasing Power Parity
• The exchange rate between two currencies should equal the ratio of the countries’
price levels:
• For example, if an ounce of gold costs $300 in the U.S. and £150 in the U.K., then
the price of one pound in terms of dollars should be:
• Purchasing Power Parity
• If the law of one price were true for all goods and services, the purchasing power
parity exchange rate can be found from any set of prices.
• This is absolute purchasing power parity.
• Hamburger standard compares Big Mac prices with the exchange rates to
determine whether or not overvaluation or undervaluation exist.
• Index introduced by The Economist, shortly after the Bog Mac they introduced
the Tall Latte index. Subscription required. They offer free online subscription, try
and see the articles. • Purchasing Power Parity
• S 0 spot

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