Class 4

August 17 of 2022

Chapter 4 : International parity condition’s part 2

1. FISHER EFFECT AND FISHER OPEN

Fisher effect
I: nominal interest rate are equal to real rate of return `r` plus compensation for eexpectes
inflation
(Approximation form)
I=r + expected inflation
R= i-expected inflation
Expected inflation =i-r

Fisher open
Expected percentage change in the exchange rate should be equal in magnitude but opposite in
sign to the difference in nominal interest rates between 2 countries (foreign-home)
(Approximation form)
(S1-S2)/S2=-(I foreign currency-I home currency)
S1: beginning period
S2: en of period
Indirect quotation
Dollar is home currency
JPY Foreign

Derivation of the fisher open equation starting from relative PPP equation

(S1-S2)/S2= expected inflation dollar- expected inflation foreign currency

Since i=r+expected inflation then expected inflation =i-r substituting for each currency
(S1-s2)/s2= (idollar-rdollar)-(iforeign-rforeign)
Equilibrium rdollar=rforeign

2. FORWARD RATE
Is an exchange rate quoted today for settlement at some future date. Forward contracts allow
to fix price at which you can buy or sell a currency in the future (30,60,90,180 or 360 days)
NOMINAL INTEREST RATE IS A PERCENTAGE PER YEAR
 Nominal interest rate is not what you made in one year

Effective rate is what you make

Nominal :4% year

Maturity:90 days

Effective:

365 days/90 days= 4

Nominal 4%/ 4= 1% for 90 days

3. FORWARD PREMIUM
Is the percentage difference btw the spot and forward exchange rate, stated in annual % items.

Swiss frank is more expensive with the forward rate for the American ,Is selling forward at premium
Nominal 2.5% per year

Maturity 30 days

365days/30 days= 12

Effective 2.5%/12=0.002 for 30 days

Nominal 5% per year

Maturity 30 days.

365days/30 days=12

Effective 5%/12=0.004 for 30 days

Nominal 8% per year

Maturity 90 days

365 days /90 days= 4

Effective 8%/4= 0.02 for 90 days

fsf=-(isf-idollar)

Fsf30= -(2.5%-5%)

Fsf30=2.5%
4. INTEREST RATE PARITY THEORY (IRP)´

Difference in national interest rates for securities of similar risk and maturiry should be equal to, bot
opposite in sign to, the forward premium or discount for the foreign currency, except for transaction
costs.

5. COVERED INTEREST ARBITRAGE (CIA)

An arbitrager exploits a disequilibrium by investing in whichever currency offers the higher return on
a covered basis.

6. UNCOVERED INTEREST ARBITRAGE (UIA)

Investors borrow in currencies with lower interest rate and convert the proceeds into currencies
that offer much higher interest rates.

Transaction is uncovered because the investor does not sell the higher yield currency proceeds
forward, choosing to remain uncovered and accept the currency risk

7. EQUILIBRIUM BTW INTEREST RATES AND EXCHANGE RATES

8. THE FORWARD RATE AS AN UNBIASED PREDICTOR OF THE FUTURE SPOT RATE