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Econ 350- TA Handout #1 Puspa D.

Amri

Covered Interest Parity: What does the condition specify and what purpose does it serve?

Whenever there is a difference in rates of return between country A and country B (sometimes referred to as IRD for Interest Rate Differential), there will be an incentive for investors to move their funds into assets/investments that generate the higher rate of return. They are effectively exploiting these interest rate differentials in order to make a profit.
-Example. Suppose lending rates in Japan=2% and in the US=5%. Assume that the lending rate applies to two identical assets (i.e. loans of a similar maturity structure). -Banks in the US see a profit opportunity. They could borrow money from a Japanese bank and get Japanese Yen at the cost of 2% , and then make a profit by converting those Japanese Yens (JPY) into US$ and then lending the money to US borrowers, earning them a net 3% (5%-2%) returns.

However, the US banks investment, as with any other regular cross-border investors, is subject to an exchange rate risk. This means that the value of their investment could be jeopardized by changes in the exchange rates. Going back to our example, the US bank is required to repay in JPY when maturity is due. Suppose the US bank borrows at time t (this year), and the loan is due in 3 years (t+3). What if in the time that elapsed in between t and t+3, the JPY had considerably strengthened/appreciated? If the JPY appreciated by more than 3% , the expected profit from exploiting the IRD between Japan and the US would be eliminated. Worse yet, if the Yen appreciated by more than 3%, the US bank would suffer losses. If we were to get technical, we would say that the US bank failed to cover the cost of their investment.

Numerical Example: interest rate in Japan =2% interest rate in the US=5% Spot Exchange Rate=84 JPY/USD. At time t -US bank borrows 100,000 JPY -Then converts 100,000 JPY into USD at 84JPY/US$ $1190.5 -Then lends the money to US borrowers and earn 5% returns 105%*$1190.5= $ 1250 Time t+3 -Must repay 100,000 +2% interest= JPY102,000 -At the spot rates of 84 JPY/USD, the banks needs to repay $1214.4 bank made profit of $35.36 or roughly 3% profit. -But spot ex rates hardly remain the same. What if from t to t+3, the JPY had actually appreciated significantly at the spot rate, e.g to 80 JPY/US $?

Econ 350- TA Handout #1 Puspa D. Amri

It turns out the 3% interest rate differential (IRD) between the US and Japan was not enough to cover the cost of the banks investment, if the JPY appreciated from 84 JPY/USD to 80JPY/USD (more or less 5% appreciation). Therefore the bank experienced a loss of approximately -2% (3%-5%). One way to protect against risks of exchange rate fluctuations (exchange rate risk) is for the US bank to engage in arbitrage. Arbitrageurs are risk-averse investors who exploit interest rate differentials between two countries, but protect their investment against exchange rate risk. On the other hand, an uncovered investment or an open position would be undertaken by what are called speculators. Speculators are risk-takers, who exploit interest rate differentials and accept the exchange rate risk. How does covering work? The US bank would engage in a forward contract to purchase JPY at some time in the future, at a fixed pre-determined rate. Lets suppose that the US bank, before borrowing money from the Japanese bank, wanted to secure the initial exchange rate of 84 JPY/USD. According to our example, if the exchange rate remained at 84 JPY/USD, the bank would earn a 3% profit. To lock in this profit rate, all the US bank needs to do is purchase a forward contract, involving the right to acquire 100,000JPY at the rate of 84JPY/USD at some time in the future, which is in t+3.

There is one drawback to this scenario. The forward exchange rate is determined in the forward market, where speculators, hedgers and arbitrageurs interact to determine the price for forward rates. Therefore, the US bank cannot just choose 84 JPY/USD as the forward rate it wishes (unless they can easily find a speculator willing to sell them JPY at the exact specified rate and future date). Instead, they must check what the JPY/USD market rate for forward contracts is, and then decide whether or not it is profitable to cover the cost of their investment. Given the above, the covered interest parity (CIP) condition conveniently provides a guidelines on what the market rate for forward exchange rates should be. In other words, one of the uses of CIP is to determine the equilibrium level of forward exchange rates in the market of speculators and arbitrageurs. There are two versions of the formula (simple version, Bird Handout #2 ),

1.Forward Discount/Premium=Interest Rate Differential

2.

= i*- i

(approximate version, Pilbeam p. 23). i* =foreign interest rate

where S=Spot exchange rates( Foreign/Domestic)


2

Econ 350- TA Handout #1 Puspa D. Amri

F=Forward exchange rates(Foreign/Domestic)

i=domestic interest rate

The above formula suggests that the CIP specifies the conditions for a risk-averse investor to cover their investment. If the cost of covering the investment at least equal to the profit that he/she will make from exploiting interest rate differentials, then there an incentive to cover/to purchase forward contracts. (Simple cost and benefit comparison right?)

Final Points to consider 1. Note that the divergence between a currencys spot exchange rate and forward exchange rates give rise to the notion of a forward premium or a discount. If the Forward Rate>Spot rate, where the rate is expressed Foreign/Domestic, the domestic currency is sold at a discount. Vice for a premium. 2. A domestic currency that is sold at a discount means that in the future investors expect that the domestic currency will have a lower value. In other words, it is expected to depreciate. 3. Look closely at the formal version of formula #2. Whether or not the domestic currency will be sold at a discount or premium is determined by the interest rate differentials. In other words, the market rate for the forward exchange rate will be determined by CIP condition. 4. Any deviation from the CIP condition will influence the incentive to arbitrage/speculate. The act of arbitraging and speculating itself influences the equilibrium price of the forward rate: as arbitrageurs increase the demand for forward contracts , its price will increase up to the point where the forward rate will meet the CIP condition. .

Exercise: interest rate US (domestic) =5%, in Japan (foreign)= 2%. Current spot rate is 84 JPY/US$. 1.What is the equilibrium forward rate for the $? 2. Is the US$ sold at a premium or a discount? 3. What will likely happen to the US$ in the future? Appreciate or depreciate?