The document discusses interest rate parity (IRP), which states that expected returns on investments should be equalized across countries once currency risk is accounted for. It provides examples of how covered and uncovered interest rate parity work using forward currency contracts. Covered interest rate parity holds better empirically, while uncovered interest rate parity violations exist but are smaller than previously believed. If IRP holds, arbitrage opportunities are eliminated as domestic and foreign returns will be equal after accounting for exchange rates. The document also discusses limitations of IRP as it has not always held in recent years.
The document discusses interest rate parity (IRP), which states that expected returns on investments should be equalized across countries once currency risk is accounted for. It provides examples of how covered and uncovered interest rate parity work using forward currency contracts. Covered interest rate parity holds better empirically, while uncovered interest rate parity violations exist but are smaller than previously believed. If IRP holds, arbitrage opportunities are eliminated as domestic and foreign returns will be equal after accounting for exchange rates. The document also discusses limitations of IRP as it has not always held in recent years.
The document discusses interest rate parity (IRP), which states that expected returns on investments should be equalized across countries once currency risk is accounted for. It provides examples of how covered and uncovered interest rate parity work using forward currency contracts. Covered interest rate parity holds better empirically, while uncovered interest rate parity violations exist but are smaller than previously believed. If IRP holds, arbitrage opportunities are eliminated as domestic and foreign returns will be equal after accounting for exchange rates. The document also discusses limitations of IRP as it has not always held in recent years.
The document discusses interest rate parity (IRP), which states that expected returns on investments should be equalized across countries once currency risk is accounted for. It provides examples of how covered and uncovered interest rate parity work using forward currency contracts. Covered interest rate parity holds better empirically, while uncovered interest rate parity violations exist but are smaller than previously believed. If IRP holds, arbitrage opportunities are eliminated as domestic and foreign returns will be equal after accounting for exchange rates. The document also discusses limitations of IRP as it has not always held in recent years.
Download as DOCX, PDF, TXT or read online from Scribd
Download as docx, pdf, or txt
You are on page 1/ 7
SYNOPSIS
TITLE INTREST PARITY INTRODUCTION The IRPT is a fundamental law of international finance. Open the pages of the Wall Street Journal and you will see that Argentine bonds yield 10% and Japanese bonds yield 1%. Why wouldn't capital flow to Argentina from Japan until this differential disappeared? Assuming that there are no government restrictions to the international flow of capital or transaction costs, the barrier that prevents Japanese capital to fly to Argentina is currency risk. Once yens are exchanged for pesos, there is no guarantee that the peso will not depreciate against the yen. There is, however, one way to guarantee a conversion rate between the peso and the yen: a trader can use a forward foreign currency contract. Forward foreign currency contracts eliminate currency risk. A forward foreign currency contract allows a trader to compare domestic returns with foreign returns translated into the domestic currency, without facing currency risk. Arbitrage will ensure that both known returns, expressed in the same currency, are equal. That is, world interest rates are linked together through the currency markets. The IRPT embodies this relation: If the interest rate on a foreign currency is different from that of the domestic currency, the forward exchange rate will have to trade away from the spot exchange rate by a sufficient amount to make profitable arbitrage impossible.
OBJECTIVE OF THE STUDY
To explain the conditions that will result in various forms of currency arbitrage, along with the currency realignments that will occur in response; and To explain the concept of interest rate parity, and how it prevents foreign exchange arbitrage opportunities.
METHODOLOGY.
The word method indicates the mode or the way of accomplishing an objective. For this purpose research is done by using secondary data collected through various online and offline database. Research is done using analytical tools like eviews and Microsoft excel.
SECONDARY DATA Secondary data means data that are already available that is the data which have already been collected and analysed by someone else. When the researcher utilizes the secondary data, then he has to look into various sources from where he can obtain them. In this case data is collected using various online and offline database available,like prowess,ace equity,yahoo finance and nseindia which provides historical data for various companies
COVERED INTEREST RATE PARITY (CIRP)
Covered Interest Rate theory states that exchange rate forward premiums (discounts) offset interest rate differentials between two sovereigns. In another words, covered interest rate theory holds that interest rate differentials between two countries are offset by the spot/forward currency premiums as otherwise investors could earn a pure arbitrage profit. Covered Interest Rate Examples Assume Google Inc., the U.S. based multi-national company, needs to pay it's European employees in Euro in a month's time. Google Inc. can achieve this in several ways viz:
Buy Euro forward 30 days to lock in the exchange rate. Then Google can invest in dollars for 30 days until it must convert dollars to Euro in a month. This is called covering because now Google Inc. has no exchange rate fluctuation risk.
Convert dollars to Euro today at spot exchange rate. Invest Euro in a European bond (in Euro) for 30 days (equivalently loan out Euro for 30 days) then pay it's obligation in Euro at the end of the month.
Under this model Google Inc. is sure of the interest rate that it will earn, so it may convert fewer dollars to Euro today as it's Euro will grow via interest earned. This is also called covering because by converting dollars to Euro at the spot, the risk of exchange rate fluctuation is eliminated.
UNCOVERED INTEREST RATE PARITY (UIP)
Uncovered Interest Rate theory states that expected appreciation (depreciation) of a currency is offset by lower (higher) interest. Uncovered Interest Rate Example In the above example of covered interest rate, the other method that Google Inc. can implement is:
Google Inc. can also invest the money in dollars today and change it for Euro at the end of the month.
This method is uncovered because the exchange rate risks persist in this transaction.
COVERED INTEREST RATE VS. UNCOVERED INTEREST RATE
Recent empirical research has identified that uncovered interest rate parity does not hold, although violations are not as large as previously thought and seems to be currency rather than time horizon dependent. In contrast, covered interest rate parity is well established in recent decades amongst the OECD economies for short-term instruments. Any apparent deviations are credited to transaction costs.
IMPLICATIONS OF INTEREST RATE PARITY
If IRP theory holds then arbitrage in not possible. No matter whether an investor invests in domestic country or foreign country, the rate of return will be the same as if an investor invested in the home country when measured in domestic currency. If domestic interest rates are less than foreign interest rates, foreign currency must trade at a forward discount to offset any benefit of higher interest rates in foreign country to prevent arbitrage. If foreign currency does not trade at a forward discount or if the forward discount is not large enough to offset the interest rate advantage of foreign country, arbitrage opportunity exists for domestic investors. So domestic investors can benefit by investing in the foreign market. If domestic interest rates are more than foreign interest rates, foreign currency must trade at a forward premium to offset any benefit of higher interest rates in domestic country to prevent arbitrage. If foreign currency does not trade at a forward premium or if the forward premium is not large enough to offset the interest rate advantage of domestic country, arbitrage opportunity exists for foreign investors. So foreign investors can benefit by investing in the domestic market.
REAL INTEREST PARITY MEASURED
If uncovered interest parity does not seem to hold at short horizons, it seems unlikely that real interest parity, described as exact equalization of real interest rates, would hold. However, one could still test the weaker condition that movements in real rates in one country would be met by one for one real movements in other countries. The key difficulty with testing this condition, like that of uncovered interest parity, is that market expectations are not directly observable. Hence, one can conduct only joint tests for real interest parity. In Eiji Fujii and Menzie Chinn (2001), real interest rates are calculated using a variety of proxy measures of expected inflation: ex post inflation, and inflation predicted using lagged values of inflation models. Both approaches are consistent with rational expectations. They find that there real interest parity holds with different strength at different horizons. As in numerous previous studies (Cumby and Obstfeld, 1984; Mark, 1985), the real interest parity (RIP) hypothesis is decisively rejected with short horizon data. At five to ten-year horizons, however, the empirical evidence becomes far more supportive and in some cases the RIP hypothesis is not rejected. In general, RIP, up to a constant, holds better at long horizons than at short horizons. These results are robust to alternative ways of modeling expected inflation rates. In recent years, several countries, including the U.K., the U.S., France and Canada, have begun issuing inflation-indexed debt securities. These are marketable securities whose principal is adjusted by changes in the price level (usually the CPI). The principal increases with the inflation rate so that the real return can be directly observed. A cursory investigation reveals that there is no evidence of equalization. Moreover, while there is some covariation, it is not anywhere near one for one. However, the thinness of the markets and the differences in the maturities of the relevant debt instruments makes strong conclusions in either direction difficult.
LIMITATIONS OF INTEREST RATE PARITY
In recent years the interest rate parity model has shown little proof of working. In many cases, countries with higher interest rates often experience it's currency appreciate due to higher demands and higher yields and has nothing to do with risk-less arbitrage.
