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International Finance-lecture3.docx

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FIN 621
Sergiy Rakhmayil

• 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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