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COMM 220 (34)
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COMM 220
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Part 2INTEREST RATE PARITY and COVERED INTEREST ARBITRAGE Exchange rates are not only important for considering the trade of goods and servicesbut also when investors are moving their money from one country to another for thepurposes of financial investment In addition most major industrialized countries have floating exchange rates meaningthe relative values of currencies fluctuates continuously throughout the trading dayHeres an example of a typical problemYou want to decide whether to invest 1 million of your money in Canada or FranceSuppose the domestic interest rate in Canada isr3Dthe interest rate in France is r5FThe spot exchange rate p C 13021or 10767990p C0The future exchange rate pinCtermsunknown 1Investing in France requires converting our dollar toand then converting theinvestment return back to dollars at the end of the yearThis entails exchange rate risk because the spot price of the Euro a year from now is uncertainFirst you have to calculate the future exchange rate p that would make an investor 1indifferent between investing in France or CanadaAssuming investment of 1 millionReturn 1 year from now from Canadian deposit 1 million 103C1030000Return 1 year from now from French deposit 1million 76799105806390To be indifferent between either investment1030000 806390you need the future exchange rate p to be C 1030000127731 806390Thehas to depreciate from C13021 to C12773 to break evenThis represents a depreciation of the Euro of about 2 which makes sensebecause the interest rate is 2 higher in France than in CanadaIf you think the Euro will depreciate by more than 2 you would invest in Canada andborrow in France If you think the Euro will depreciate by less than 2 or even appreciate you wouldinvest in France and borrow in Canada 232
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