FOREIGN TRADE UNIVERSITY HO CHI MINH CAMPUS

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INTERNATIONAL FINANCE COURSE

MIDTERM ASSIGNMENTS

TOPIC: Impact of market imperfections

(transaction cost, political risks, tax…)
on interest rate parity (IRP)

Group 7
Lecturer: Nguyen Kim Quoc Trung
Class: K55CLC1

Ho Chi Minh, November 2018

 Student’s name Student number

Trần Thị Mộng Tuyền 1601025179

Đoàn Quỳnh Hương 1601025066

Ngô Yến Ngân 1601025103

Huỳnh Thị Vân Thanh 1601055081

Lưu Hồng Thảo 1601025142

Nguyễn Lê Uyển Nhi 1601025114

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 SUPERVISOR’S REMARKS

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Ho Chi Minh City, November, 2018

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 TABLE OF CONTENT
ABSTRACT ............................................................................................................................ 1
CHAPTER 1. THEORETICAL FRAMEWORK .............................................................. 3
1.1. Covered interest rate parity (CIP).................................................................................3
1.1.1. Conditions ...................................................................................................................... 3
1.1.2. Formula .......................................................................................................................... 3
1.1.3. Meaning ......................................................................................................................... 4
1.2. Uncovered interest rate parity (UIP) ............................................................................ 4
1.2.1. Conditions ...................................................................................................................... 4
1.2.2. Meaning ......................................................................................................................... 5
1.3 Graphic analysis of IRP line…........................................................................................5
CHAPTER 2. HOW MARKET IMPERFECTIONS CAN AFFECT IRP LINE............8
2.1. Differential Tax Laws ..................................................................................................... 8
2.1.1. Withholding tax..............................................................................................................9
2.1.2. Difference between capital gains and income tax..........................................................9
2.2. Political Risks….............................................................................................................10
2.2.1. Crisis in foreign country...............................................................................................10
2.2.2. Default of foreign treasury bills....................................................................................10
2.2.3. Avoidance of domestic political risk............................................................................11
2.2.4. Third country’s perception toward foreign investment................................................11
2.3. Transaction Costs ......................................................................................................... 12
2.3.1. One-way arbitrage ........................................................................................................ 13
2.3.2. Round-trip arbitrage ..................................................................................................... 14
2.3.3. Results ......................................................................................................................... 15
2.4. Liquidity Preference......................................................................................................16
CHAPTER 3. EFFECT OF THE REASONS FOR INTEREST DISPARITY ON
INVESTMENT AND BORROWING.......................................................................................18
CONCLUSION ................................................................................................................. ...22
REFERRENCES .................................................................................................................. 23

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 LIST OF ABBREVIATIONS

NUMBER ABREVIATIONS MEANINGS

1 IRP The Interest Rate Parity

2 PPP Purchasing Power Parity

3 GDP Gross Domestic Product

4 CIA Covered Interest Arbitrage

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 LIST OF FIGURES
Figure 1.1.0: An illustration of arbitrage with IRP ................................................................ 3
Figure 1.3.1 .Illustration of IRP ............................................................................................. 6
Figure 1.3.2 Potential for Covered Interest Arbitrage With Transaction Costs.. ..................7
Figure 2.1.1 The share of taxes in GDP between different countries ....................................8
Figure 2.2.2: IRP deviations under influence of Japan government’s capital policy .......... 11
Figure 2.2.1 Interest parity in the presence of political risk ................................................. 12
Figure 2.3.1 The covered interest parity diagram ................................................................. 14
Figure 2.3.2 One-way covered interest arbitrage example .................................................. 14
Figure 2.3.3 Round-trip covered interest arbitrage example ................................................ 15
Figure 3.1: Covered parity for the Russian ruble was not realized between
October 2008 and January 2009 due to crisis ........................................................................ 20
Figure 3.2: borrowing dollars through the FX swap market became more
expensive than direct funding in the dollar cash market ...................................................... 21

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 ABSTRACT
In all economics courses and studies, it is a common occurrence for researchers to make
some assumptions in order to better analyse the changes and fluctuations happening in the market
and define the causes and impacts these events may have on the international and local economy.
One of such assumptions we usually use is that the economy operates on a “perfect” market
in which there is an unlimited number of buyers and sellers, all of whom are price takers and are
well-informed about the goods being sold and the prices charged by each seller; all firms sell
identical products and are free to enter or exit market without costs.
In real life, however, there is no product manufactured by different firms that is perfectly
identical, nor is all information readily available in the market. In addition, governments play an
important part in influencing the market through the usage of policies and laws, thus constraining
the free entry and exit of firms. Therefore, it is virtually impossible to find any market that
exhibits all these characteristics, thus making all real market, to some extent, “flawed” or
“imperfect”.
Similarly, in financial market, the assumption of a perfect market is utilized as a basis for
various theories such as the Law Of One Price, the Purchasing Power Parity and most
importantly, the Interest Rate Parity. However, the existence of imperfections in the market can
cause some effects on these theories.
In fact, empirical researches have shown that, in imperfect market, factors such as
transaction costs, political risk and differential tax laws can cause deviations from Interest Rate
Parity.
In a financial sense, transaction costs are fees charged by a financial intermediary, such as a
bank or broker to perform their services. In reality, it is inevitable that some countries will hold a
greater influence and power in the international market than others. Therefore, governments in the
more disadvantageous nations, in an order to keep the investment within their boundary, will
issue policies to raise transaction costs. With the new costs applied, local investors would not be
able to freely exchange for foreign currency to make an investment abroad, even though they can
see the opportunity for exploiting arbitrage. Transaction costs would offset the return investors
may gain from arbitrage activities and, in most cases, will cause a loss for an interest arbitrager.
Political risk is also another factor that cause deviations from Interest Rate Parity. In an
imperfect market, factors such as wars, international treaties or recessions can easily cause a
government to change its current policies, and the political risks that investors had to account for
in these cases would involve the uncertainty of the invested fund being frozen, becoming
inconvertible into other currencies or being confiscated.
Last but not least, the differential tax laws between two countries will also affect the
Interest Rate Parity. Each nation has different laws which may result in different tax rates, these
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rates are subject to change should a government decide to adjust the current laws and policies or
pass a new one altogether. Due to their own relative economic power in the market, some
countries may decide to enforce a rather high tax rate for on foreign investment activities or
unforeseeable changes in political relations may cause the government to change the current tax
rate applied. In which case, the resulting difference will surely cause a deviation from Interest
Rate Parity.
The focus of this paper is to find out how does each of these factors of an imperfect market
will affect the Interest Rate Parity in details.

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 CHAPTER 1. THEORETICAL FRAMEWORK
Interest Rate Parity (IRP) is a theory in which the differential between the interest rates of
two countries remains equal to the differential calculated by using the forward exchange rate and
the spot exchange rate techniques. Interest rate parity connects interest, spot exchange, and
foreign exchange rates. It plays a crucial role in Forex markets.
IRP theory comes handy in analysing the relationship between the spot rate and a relevant
forward (future) rate of currencies. According to this theory, there will be no arbitrage in interest
rate differentials between two different currencies and the differential will be reflected in the
discount or premium for the forward exchange rate on the foreign exchange.
The theory also stresses on the fact that the size of the forward premium or discount on a
foreign currency is equal to the difference between the spot and forward interest rates of the
countries in comparison.

Figure 1.1: An illustration of arbitrage with IRP

1.1. Covered interest parity (CIP):

1.1.1. Condition

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 Covered interest parity (CIP) is the closest thing to a physical law in international finance.
It holds that the interest rate differential between two currencies in the cash money markets
should equal the differential between the forward and spot exchange rates
1.1.2. Formula
CIP is a textbook no-arbitrage condition according to which interest rates on two otherwise
identical assets in two different currencies should be equal once the foreign currency risk is
hedged:

Where
S is the spot exchange rate in units of US dollar per foreign currency
F is the corresponding forward exchange rate
r is the US dollar interest rate
r* is the foreign currency interest rate,
Approximate: Interest rate in Euroland = Interest rate in UK + Forward premium
Assume Country X's currency is trading at par with Country Z's currency, but the annual
interest rate in Country X is 6% and the interest rate in country Z is 3%. All other things being
equal, it would make good sense to borrow in the currency of Z, convert it in the spot market to
currency X and invest the proceeds in Country X. However, to repay the loan in currency Z, one
must enter into a forward contract to exchange the currency back from X to Z. Covered interest
rate parity exists when the forward rate of converting X to Z eradicates all the profit from the
transaction.
Since the currencies are trading at par, one unit of Country X's currency is equivalent to one
unit of Country Z's currency. Assume that the domestic currency is Country Z's currency.
1+3%
Therefore, the forward price is equivalent to 0.97, or (1 × )
1+6%

1.1.3. Meaning
Using CIP, investors will be able to make decisions to invest in which financial market in
order to bring out the best benefits. Consequently, altering the degree of capital flows in the
international market.
1.2. Uncovered interest rate parity (UIP)
1.2.1. Condition.
Uncovered interest rate parity theory states the difference in interest rates between two
countries will equal the relative change in currency foreign exchange rates over the same period.

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The strategy is the same as before, except the euro investment will not be sold at the end of the
year using the forward exchange rate Ft agreed upon earlier, but at the prevailing spot exchange
rate (St + 1)
When the no-arbitrage condition is satisfied without the use of a forward contract to hedge
against exposure to exchange rate risk, interest rate parity is said to be uncovered. Risk-neutral
investors will be indifferent among the available interest rates in two countries because the
exchange rate between those countries is expected to adjust such that the dollar return on dollar
deposits is equal to the dollar return on euro deposits, thereby eliminating the potential
for uncovered interest arbitrage profits. Uncovered interest rate parity helps explain
the determination of the spot exchange rate. The following equation represents uncovered interest
rate parity.
𝑆𝑡
(1 + 𝑖 ∗) ( ) = (1 + 𝑖)
𝑆𝑡 + 1

Where
(St + 1) the expected future spot exchange rate at time (t + 1)
St is the current spot exchange rate at time t
i is the interest rate in one country (for example, the United States)
i* is the interest rate in another country or currency area (for example, the Eurozone)
Approximate: The domestic interest rate = Foreign interest rate minus expected appreciation of
the domestic currency
Say the spot (current) exchange rate was £1=$1.62. The markets expect that in a year’s
time, the exchange rate will be £1=$1.64. US bonds pay a rate of 3.2%. The UIP condition will
1.62
imply that (1 + 𝑖) = (1.032) = 1.01941 so UK bonds would pay a rate of 1.94%.
1.64

Say you had £100. You could buy £100 of UK bonds and after a year they would be worth
£100 x 1.01941 = £101.94. Alternatively, £100 could buy you £100 x 1.62 = $162 of US bonds
now. In a year’s time they would be worth $162 x 1.032 = $167.184. When you converted that
back into pounds (assuming the exchange rate was the same as had been expected) you would
have 167.184/1.64 = £101.94.
If the expected exchange rate next year was £1=$1.64 and UK bonds paid an interest rate
higher than 1.94% then nobody would hold US bonds, they may as well hold UK bonds instead.
If UK bonds paid an interest rate lower than 1.94% then nobody would hold UK bonds, they may
as well hold US bonds. The fact that both are selling on the markets implies that arbitrage has
equalised their expected return – although individual buyers may choose UK or US bonds

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because they expect that the exchange rate will be higher or lower than the general market
expectation.
1.2.2. Meaning
The UIP relation plays a central role in the real world workings of currency fluctuations. It
says that the nominal exchange rate will rise if the domestic interest rate rises, or if the future
expected exchange rate rises. It will fall if the foreign interest rate rises.
1.3. Graphic analysis of IRP line
The interest rate differential can be compared to the forward premium, which means the
expected future price for a currency is greater than the spot price (or discount, which means the
expected future price for a currency is less than the spot price) with the use of a graph. The
vertical axis shows the difference in interest rates in favour of the foreign currency (ih – if), and
the horizontal axis shows the forward premium or discount on that currency.
The interest rate parity (IRP) line is the diagonal line cutting the intersection of the axes,
including points that represent IRP. Therefore, point A,B,C and D, which lying on IRP line, is
where covered interest arbitrage is impossible.

Figure 1.3.1. Illustration of IRP

For any points that do not on the IRP line, it can be expected that covered interest arbitrage
will be beneficial for investors. However, when investors and firms take advantage of such
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opportunities, the point will tend to move toward the IRP line and covered interest arbitrage is no
longer feasible.
Point below the IRP line: If the current interest rate and forward rate situation is represented
by point X or Y, home country investors can engage in covered interest arbitrage. By investing in
a foreign currency, they will earn a higher return (after considering the foreign interest rate and
forward premium or discount) than the home interest rate.
Point below the IRP line: Take point Z for example. It represents a foreign interest rate that
exceeds the home interest rate by 1 percent, while the forward rate exhibits a 3 percent discount.
This point, like all points to the left of the IRP line, represents a situation in which investors
would achieve a lower return on a foreign investment than on a domestic one.
The interest rate parity line shows the equilibrium state, but transaction costs cause the line to
be a band rather than a thin line. Transaction costs arise from foreign exchange and investment
brokerage costs on buying and selling securities. As for individual, the transaction costs is
actually the cost of supporting trade activities to banks instead of typical transaction cost.

Figure 1.3.2 Potential for Covered Interest Arbitrage When Considering Transaction Costs

The following sections will elaborate more on the specific effects caused by each of above
mentioned elements of imperfect market.
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 CHAPTER 2. HOW MARKET IMPERFECTIONS CAN AFFECT IRP LINE
Any transactions would involve costs when the assets are exchanged from one currency into
another or when market participants change their holdings of financial assets. Such costs can be
identified as pure transaction costs arising from the commissions that the financial institutions
charge their customers. In addition, market participants are most likely to incur additional costs,
reflecting taxes, search time, political risks, or exchange risks due to changes in tax policy, capital
controls or exchange market pressures. Such costs in aggregate can be identified as risk-
associated transaction costs.
Effects of these two types of costs can be understood visually by understanding the concept
of IRP band.
2.1. Differential Tax Laws
Tax is a an economic tool that most governments in the world apply to their own nations. It
is used as a source of income of governments, utilized to build facilities and make investment
with a goal to further develop their own countries’ economies. Despite this, not all governments
issued the same tax policies as each other, as developed countries generally have a higher tax rate
than their developing counterparts.

Figure 2.1.1. The share of taxes in GDP between different countries (Source: Besley, Timothy
and Persson, Torsten, 2014)

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 There are many reasons for this differentials such as different economic structures, political
factors (developing countries tend to have weaker institutions, fragmented policies, etc.), or
sociological and cultural ones (generally weaker sense of national identity and poorer norm
compliance among developing nations), all of which constitute to make the differences in tax
laws between nations.
It is undeniable that tax rate plays an important role in helping investors determine whether
to make the investment decision. If taxes are the same on domestic and on foreign investment and
borrowing, then the existence of taxes will make no difference in our investment and borrowing
criteria or the interest-parity line. On the other hand, if tax rates differ then the interest parity
condition will be affected. Therefore, it is advisable that investors and firms that set up deposits in
other countries should be aware of the existing tax laws.
There are two ways in which taxes could conceivably affect the parity condition. One way
involves withholding taxes, and the other involves differences between the tax rate on income and
that on capital gains.
2.1.1. Withholding tax
A withholding tax is a tax applied to foreigners at the source of their earnings. For example,
when a Canadian resident earns $100 in the United States, the payer of that $100 is required to
withhold and remit 15 percent of the earnings to the US Internal Revenue Service. Similarly, the
earnings of US residents in Canada are subject to a withholding tax.
However, due to the existence of the withholding tax credits, the interest parity condition is
generally not affected by the withholding tax. For example, suppose that a resident of the United
States pays the equivalent of $15 on $100 of interest or dividends earned in Canada, and the total
tax payable on the $100 when declared in the United States is $25. The Internal Revenue Service
will grant the US resident a $15 credit on taxes paid to the taxing authority in Canada. Only an
additional $10 will be payable in the United States. The investor ends up paying a total of $25,
which is the same as she would have paid on $100 earned at home.
Therefore, as long as withholding tax is less than or equal to the domestic tax rates, there is
no incentive to choose domestic securities rather than foreign securities. Only if the amounts
withheld are greater than the withholding tax credits will there be a reason to keep money at
home.
2.1.2. Differences between Capital Gains and Income Tax
Researches have shown that should tax rate on capital gains is lower than that on ordinary
income, the slope of the interest parity line will be affected.
When there is a difference in tax rates between incomes and capital gains/losses, it has been
deducted that the number will deviate from the interest rate parity by an amount equal to

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 𝟏 − 𝑻𝒌
𝒙=
𝟏 − 𝑻𝒚

Where
Tk is the tax rate on capital gains
Ty is the tax rate on income.
When the capital gains tax rate is lower than the income tax rate, x will be greater than 1. For
example, if Tk = 0.10 and Ty = 0.25 then x = 1.20. This means that the interest parity line in this
case will be flatter than 45 degree.
Due to this reason, in some cases, covered interest arbitrage might be feasible when considering
before-tax returns but not necessarily when considering after-tax returns.
2.2. Political Risks

Political risk involves the uncertainty that while funds are invested in a foreign country,
they may be frozen, become inconvertible into other currencies, or be confiscated. Even if such
extremes do not occur, investors might face new or increased taxes in the foreign country.
Usually, the investment that involves the least political risk is at home because when funds are
invested abroad, the risk of tax or other changes at home is added to the risk of changes in another
political boundary.

2.2.1. Crisis in foreign country

After taking into account of the transaction costs, even when the covered interest arbitrage
seems to be possible the foreign investors still have to cope with the political risks which is the
economic status of the foreign country. There is no guarantee that the foreign government will
allow the funds to be reconverted, especially in a crisis of the foreign country, its government to
limit any exchange of the local currency for other currencies so that their economic status shall
get better off. In this case, the investor would be unable to utilize these investment until the
foreign government disable the restriction.

Freely convertible currencies have immediate value on the foreign exchange market, and
few restrictions on the manner and amount that can be traded for another currency. Free
convertibility is a major feature of a hard currency. Some countries pass laws restricting the legal
exchange rates of their currencies or requiring permits to exchange more than a certain amount.
Some currencies, such as the North Korean won, the Transnistrian ruble, and the Cuban national
peso, are officially nonconvertible and can only be exchanged on the black market. If an official
exchange rate is set, its value on the black market is often lower. Convertibility controls may be
introduced as part of an overall monetary policy. For example, restrictions on the Argentine peso
were introduced during an economic crisis in the 1990s and scrapped in 2002 during a subsequent
crisis.

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 Figure 2.2.1: IRP deviations under influence of Japan government’s capital policy

2.2.2. Default of foreign Treasury bills

Investors may also aware of a slight default risk on foreign investments such as foreign
Treasury bills, since they may not be assured that the foreign government will guarantee full
repayment of interest and principal upon date. Therefore, because of concern that the payment of
foreign Treasury bills may be delayed, they may accept a lower interest rate on their domestic
Treasury bills rather than engage in covered interest arbitrage in an effort to obtain a slightly
higher expected return.

2.2.3. Avoidance of domestic political risk

For investors in some countries, it is politically less risky to send funds abroad. This will be
true if investors thereby avoid politically risky possibilities at home. For example, people in some
volatile countries have invested in Switzerland and the United States for political safety. In these
circumstances, a foreign investment might be made even at a covered interest disadvantage. In
general, however, we expect investors to require a premium from a foreign investment versus a
domestic investment.

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Figure 2.2.3. Interest parity in the presence of transaction costs, political risk, or liquidity premiums

2.2.4. Third country’s perception toward foreign investment

In diagrammatic terms, political risk creates a band like above, only in the area beyond
some covered differential is there an incentive to invest abroad. The political risk band does not
have to be of equal width on the two sides of the interest-parity line if one country is viewed as
riskier than the other. For example, Canadian yields are generally a little higher than US yields,
even after allowance for forward hedging. This can be attributed to US investors viewing Canada
as being politically riskier than Canadians view the US, thereby causing a larger political-risk
premium on Canadian securities than on US securities.

Even when covered yields are on instruments which trade in different countries, third-
country investors might force interest rates and exchange rates onto the interest-parity line. For
example, if Japanese investors view the United States and Britain as equally risky politically from
their perspective, then they will drive the interest rates and exchange rates for the United States
and Britain onto the interest-parity line. This is true even if investors in the United States and
Britain perceive foreign investment as riskier than investment at home. Of course, if conditions
are driven onto the interest-parity line, this will encourage US and British investors to keep funds

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at home, because neither is receiving compensation for the perceived risk of investing in the other
country.

2.3. Transaction Costs

The cost of transacting in foreign exchange is reflected in the bid-ask spread in exchange
rates. The bid-ask spread represents the cost of two foreign exchange transactions, a purchase and
a sale of foreign currency. That is, if a person buys and then immediately sells a foreign currency,
the cost of these two transactions is the difference between the buying and selling prices of the
currency, which is the bid-ask spread. Covered investment or borrowing involve two foreign
exchange transaction costs – one on the spot market and the other on the forward market. These
two transaction costs discourage foreign-currency denominated investment and borrowing.
Interest arbitrage also involves two foreign exchange transaction costs, since the borrowed
currency is sold spot and then bought forward. However, there are additional transaction costs of
interest arbitrage due to interest-rate spreads. This is because interest rate is likely to exceed the
investment interest rate.
It might seem that there could be deviations from interest parity by up to the extra
transaction costs of investing or borrowing in foreign currency before the benefits of the foreign
alternative are sufficient to compensate for the added costs.
In terms of Figure 2.3.1, it would appear that transaction costs could allow the situation to
be slightly off the interest-parity line; the apparent advantages to foreign-currency
investments/borrowing at points just off the line do not trigger foreign borrowing investing
because the benefits are insufficient to compensate for the costs. Indeed, because the cost of
covered interest arbitrage includes the borrowing investing interest rate spread as well as foreign
exchange transaction costs, it might appear that deviations from interest parity could be relatively
large before being sufficient to compensate for the transaction costs of covered interest arbitrage.

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 Figure 2.3.1. The covered interest parity diagram

Despite the preceding, which would suggest that deviations from interest parity could result
from transaction costs, it has generally become recognized that transaction costs do not contribute
to deviations from interest parity. A major reason for this recognition is the realization that one-
way interest arbitrage circumvents transaction costs in foreign exchange and securities markets.
We can explain the nature of one-way interest arbitrage and how it influences the interest-parity
condition by contrasting one-way and round-trip arbitrage.
2.3.1. One-way arbitrage

Figure 2.3.2. One-way covered interest arbitrage example

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 While a precise definition of one - way arbitrage must await our more formal presentation
below, the general idea can be described here. Consider any market participant who has a need to
exchange one currency for another of some maturity . He can accomplish that exchange either
directly , in the exchange market of the maturity he desires , or he can use a market of a different
maturity and simultaneously shift commitments through time via the two securities markets . If he
chooses the second, more roundabout method, we will say that he is engaging in one - way
arbitrage.
The choice between direct transactions and one-way arbitrage will be made by comparing
the costs of the two alternatives, taking into account transactions costs as well as the exchange
and interest rates. By examining these costs, we will derive bounds on the permissible departures
from interest parity that are consistent with equilibrium in the spot and forward exchange
markets.
One-way arbitrage can come in various forms. However, we need to consider only the form
which involves the lowest transaction cost, because it is this arbitrage that will determine the
maximum deviation from interest parity; just as the arbitrager with the lowest cost of interest
arbitrage drives interest rates and exchange rates to levels closest to the interest-parity line, so it is
that the form of one-way arbitrage that faces the lowest transaction cost drives us closest to the
parity line.
2.3.2. Round-trip arbitrage

Figure 2.3.3. Round-trip covered interest arbitrage example

Similarity, round- trip arbitrage model is hard to define. So we will explain it in an example.
In Figure 3, we can see that as before, the four corners of the diagram show current dollars
($0), current pounds, (£0), future dollars ($n), and future pounds (£n). The arrows drawn between
the corners of the figure show the interest rates or exchange rates when going between the corners
in the directions of the arrows.
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 For example, when going from $0 to £0 as shown by the downward-pointing arrow in the
left-hand panel of Figure 2.3.3a, the transaction occurs at the spot exchange rate, S($/ask£):
pounds are being purchased. The left downward-pointing arrow shows the spot exchange rate at
which the borrowed dollars are exchanged into pounds; the pounds must be purchased, so the spot
rate is the ask rate for pounds, S($/ask£). The bottom rightward-pointing arrow shows the interest
rate earned on the pound-denominated investment which converts today’s pounds, £0, into future
pounds £n. Finally, the right upward-pointing arrow shows the forward exchange rate at which the
dollars needed for repaying the dollar loan are purchased with pounds, Fn($/bid£). The top
leftward-pointing arrow from $n to $0 shows the interest rate on dollar borrowing which gives
immediate dollars - $0, in return for paying dollars back in the future - $n.
We see that the borrowing- investment arbitrage involves a transaction cost spread in the
foreign exchange market – spot bid versus forward ask – and in the securities market – borrowing
rate versus the investment rate. If the maximum possible sizes of deviations from covered interest
parity due to transaction costs were determined only by round-trip covered interest arbitrage, the
deviations could be quite large. This is because for round-trip interest arbitrage to be profitable it
is necessary to overcome the transaction costs in the foreign exchange markets and the borrowing
– lending spread on interest rates.
2.3.3. Results
One-way interest arbitrage, illustrated in Figure 2.3.2, involves comparing two alternative
ways of going from one corner to another corner that is diagonally opposite. Either route involves
two transaction costs, but since these are for the same types of transactions, they do not cause
deviations from interest parity. In other words, because the choices involve the same transaction
costs whichever route is taken, one-way arbitrage should drive markets very close to covered
interest parity.
Round-trip interest arbitrage, illustrated in Figure 2.3.3 involves going along all four sides
of the diagram at the interest rates and exchange rates that are shown. The presence of four
transaction costs allows for large deviations from interest parity.
To conclude, the one-way arbitrage we have described produces the interest-parity line.
An alternative way of concluding the deviations from interest parity as a result of
transaction costs are small is to consider the choice faced by third-country borrowers and
investors. For example, if Japanese or German investors and borrowers are looking for the best
currency to invest or borrow, they will drive the situation between dollars and pounds to the
interest-parity line. This is because the Japanese or Germans pay foreign exchange costs whatever
the currency of their investment or borrowing, and compare investment rates in the two
currencies, or borrowing rates in the two currencies. For this reason, or because of the presence of
one-way arbitrage, we can expect deviations from interest parity to be too small for round-trip
arbitrage to ever occur. We conclude that transaction costs are probably not a cause of deviations
from interest parity.
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2.4. Liquidity Preference
An asset’s liquidity indicates the quickness with which it can be converted into cash or cash
equivalents, at the least possible cost. If the time taken to liquidate a foreign investment and/or a
domestic investment is same, then the costs involved in liquidating the same are different on
account of differences in laws and regulations of both the countries. The cost of liquidating an
investment is the cost which is to be incurred to make an investment liquid before maturity.

For example if a person who have made an fixed deposit in a bank, and withdraws it before
maturity, then the loss of interest and charges charged by bank are altogether termed as cost of
liquidity preference.

If cash managers want to avoid the foreign exchange risk that would be faced by leaving the
original forward contract in effect. There is also uncertainty at the time of the original investment
concerning what the spot rate will be if redemption is early and what the rate will be for offsetting
the original forward contract with a reverse contract. Liquidity preference is hence another reason
for a band around the covered interest-parity line.

Since the required extra return depends on the likelihood that the funds will be needed, it is
clear that this liquidity consideration is different from the transaction costs consideration
discussed earlier, which involved known amounts of transaction costs.

In the case of transaction costs and political risks, the choice by third-country investors of
which currency-denominated securities to invest in should be symmetrical as far as liquidity
preference is concerned. That is, if there is the same probability of needing to liquidate
investments from either currency and the same transaction costs if liquidation occurs, liquidity
preference in the presence of third-country investors should not cause deviations from interest
parity.

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 CHAPTER 3. EFFECT OF THE REASONS FOR INTEREST DISPARITY ON INVESTMENT
AND BORROWING

The concept of interest rate parity is important in international finance for following
critical reason: It explains covered interest arbitrage, and it specifies conditions for speculation in
currency markets. Generally, IRP plays a key role in global macroeconomic models because it
can be taken as a benchmark for perfect capital mobility between markets.
Overall, the idea of interest rate parity is simple in perfect market conditions, but the world
market is never perfect. Critical imperfect elements such as transaction cost, political risks, tax
differentials and liquidity have been reported as factors causing IRP holding in reality. Still, there
may be more causes (like asynchronous data, non-comparability in asset risks) but above
elements can be seen as the most outstanding ones.
When interest rate parity does not hold, covered interest arbitrage deserves consideration.
Covered interest arbitrage may not be worthwhile due to various characteristics of foreign
investments, including transaction costs, political risk, and differential tax laws… as mentioned.
At the margin, arbitrage purchases tend to raise prices (of currency and money market
instruments), sales tend to lower prices (of currency and money market instruments), and thus
tend reduce any measured deviations from parity. However, arbitrage transactions entail both
costs (in currency markets and money markets) and risks (of default on investment positions or
forward contracts, or possible controls on capital movements). What have been analysed suggests
that:
Transaction costs are likely to work towards keeping investing and borrowing in the home
currency. The theory of Taylor analysed above confirmed that the foreign exchange market was
highly efficient in the sense that there were virtually no opportunities for round-trip arbitrage, and
only few and scattered possibilities for one-way arbitrage.
Withholding taxes are likely to matter only if withholding rates are higher than domestic tax
rates, but differential taxes on interest income versus capital gains could induce investors with
favourable capital gains treatment to place funds in currencies at a forward premium. In addition,
Levi noted that it was possible for residents of one country to face the tax rates just described
while residents of another country could face no taxes or equal taxes on capital gains and interest
charges. It that case, covered interest arbitrage could entail a measure of tax arbitrage as well. In
this case, while the traditional IRP line would still reflect market equilibrium, any agents subject
to differential capital gains and ordinary income tax rates could see these points as a profit
opportunity.
Political risk will create yield and cost differences that are not exploitable for those facing
the political risk, although the differences may be exploitable by others. In financial markets
where mobility is impeded, deviations from IRP can be large and volatile. Common examples
include countries that restrict currency convertibility. A more vivid example is the recent global
financial crisis that commencing in the summer of 2007 allowed substantial deviations from IRP
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among the world’s major convertible currencies. Political risk therefore associated deeply with
certain money markets, for countries with open and non-impeded transactions system, the
probability of arbitrage opportunity would be higher.
For example, countries with open capital market like Hong Kong is considered a leading tax
haven due to its laws that limit taxation of the island’s wealthy foreign residents and corporations.
Wealthy foreigners have every reason to bank their money in Hong Kong. For one, the island
does not tax income earned beyond its borders. Those who earn salaries in the region pay
approximately 15% in taxes, which is significantly lower than taxes levied on salaries in the
West. Additionally, corporations pay approximately 17% in taxes on profits generated in Hong
Kong. However, the autonomous region does not charge tax on capital gains, interest and
dividends. Foreigners who keep their money in Hong Kong pay no net-worth taxes and no public
benefits taxes, which are similar to Social Security taxes in the United States.
Liquidity preference refers that interest parity does not hold because foreign investments
are less liquid, those investors for whom liquidity is not relevant can enjoy higher yields.

 Other critical risks:

Empirical evidence suggests that deviations can be linked to greater credit and counterparty
risk among bank dealers, and a reduction in risk capital. Financial investment products such as
stocks, options, bonds, and derivatives carry counterparty risk. When the counterparty risk is
miscalculated and a party defaults, the impending damage can be severe. Counterparty risk is a
type (or subclass) of credit risk and is the risk of default by the counterparty in many forms of
derivative contracts. Let's contrast counterparty risk to loan default risk. If Bank A loans $10
million to Customer C, Bank A charges a yield that includes compensation for default risk. But
the exposure is easy to ascertain; it's roughly the invested (funded) $10 million.
Counterparty risk gained visibility in the wake of the global financial crisis. Counterparty
risk includes a range of scenarios, such as the risk that the failure of a bank could result in the loss
of a company’s deposits, or that changes to a bank’s lending policy could affect the company’s
access to financing. Likewise, the company could suffer financial loss if the counterparty in a
derivatives transaction failed to meet its obligations. Where supply chain exposures are
concerned, disruptions in the supply chain could result in essential deliveries being delayed,
incomplete or even failing to arrive at all – or customers could default on their payments,
potentially resulting in liquidity problems. On the secondary level, they also need to consider
operational risk, strategic risk, liquidity risk and market risk.
During the crisis, covered parity did not hold for a great number of currencies as a result of
the sharp rise in the counterparty risk premium (this premium is usually considered to be
effectively zero for short-term inter-bank loans; see Baba and Packer, 2009). As a result of
sudden and dramatic capital flight during the 2008–2009 crisis, covered parity for the Russian
ruble was not realized between October 2008 and January 2009.
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 Figure 3.1: Covered parity for the Russian ruble was not realized between October 2008
and January 2009 due to crisis

With so many possible scenarios, it should be no surprise that counterparty risk is also
connected to many other types of risk exposure. Measuring the ability and willingness of an entity
- which could be a person, corporation, security or country - to keep its financial commitments,
debts or credit ratings are essential tools to help you make investment decisions. Certain
researches have suggested that CIP deviations were smaller for Hong Kong, Japan and Singapore
(versus the USD) consistent with lower implied bank default risks in those countries.

In Global Financial Crisis (GFC), CIP has failed to hold. This is visible in the persistence of
a cross-currency basis since 2007. The cross-currency basis indicates the amount by which the
interest paid to borrow one currency by swapping it against another differs from the cost of
directly borrowing this currency in the cash market. Thus, a non-zero cross-currency basis
indicates a violation of CIP. Since 2007, the basis for lending US dollars against most currencies,
notably the euro and yen, has been negative: borrowing dollars through the FX swap market
became more expensive than direct funding in the dollar cash market. For some currencies, such
as the Australian dollar, it has been positive (following graph, left-hand and centre panels).

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 Figure 3.2: borrowing dollars through the FX swap market became more expensive than direct
funding in the dollar cash market

Initially, the violations of CIP were seen as a reflection of strains in global interbank
markets. Specifically, heightened concerns about counterparty risk and constrained bank access to
wholesale dollar funding inhibited arbitrage during the GFC, and again during the subsequent
euro area sovereign debt crisis.

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 CONCLUSION
There are advantages to investing in foreign markets, but the risks associated with sending
money abroad are considerably higher than those associated with investing in your own domestic
market. It is important to gain insight into different investment environments and to understand
the risks and advantages these environments pose.
If the exchange market is not efficient, it would be sensible for a firm to spend resources on
forecasting exchange rates. The Interest Rate Parity (IRP) relationship is one of the most relied
upon indicators of financial globalization. When the parity relationship holds, covered yields are
identical on assets that are similar in all important respects (e.g. maturity, default risk, exposure to
capital controls, and liquidity) except for their currency of denomination.
However, those respects are never the same. Measuring those costs, and recalibrating the
efficiency and mobility of international capital markets is a supreme challenge for financial
economists and all the approaches to analyse risks of imperfect market should all be considered
carefully and flexibly and this will base on the experience and analytical skills of the
investors/traders.

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 REFERRENCES
1. Timothy Besley and Torsten Persson, 2014, Why do developing countries tax so little
(http://eprints.lse.ac.uk/66002/1/Besley_Developing%20countries%20tax_2016.pdf)
2. Jeff Madura, 2010, International Financial Management Abridged 10th Edition
3. Maurice D. Levi , 2005, International Finance Fourth Edition
4. Ichiro Otani, Tomoyuki Fukumoto, 2011, China’s Capital Controls and Interest Rate Parity:
Experience during 1999 – 2010 and Future Agenda for Reforms
(https://www.boj.or.jp/en/research/wps_rev/wps_2011/data/wp11e08.pdf)
5. Richard M. Levich, 2011, Evidence on Financial Globalization and Crises: Interest Rate Parity
(https://core.ac.uk/download/pdf/18179111.pdf)
6. Hafsa H., 9 Main Reasons for Departure from Interest Rate Parity
(http://www.yourarticlelibrary.com/economics/foreign-exchange/9-main-reasons-for-departure-
from-interest-rate-parity-foreign-exchange/98502)
7. Wolfgang Schultze, 1994, Covered Interest Parity and Transaction Costs: A Synthesis of
Theory and Practice
(https://www.researchgate.net/publication/318827415_Covered_Interest_Parity_and_Transactio
n_Costs_A_synthesis_of_theory_and_practice)