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Chapter 6 International Parity Conditions

FIN3034 Tutorial 4 week 5


13. Interest Rate Parity. Define interest rate parity. What would it say about interest rates if spot rates and forward rates
were the same?
The theory of interest rate parity (IRP) provides the linkage between the foreign exchange markets and the
international money markets. The theory states: The difference in the national interest rates for securities of similar
risk and maturity should be equal to, but opposite in sign to, the forward rate discount or premium for the foreign
currency, except for transaction costs.
If the spot rate and forward rate are the same, IRP says that nominal interest rates are equal.
14. Covered Interest Arbitrage. Ignoring transaction costs, under what conditions will covered interest arbitrage be
plausible?
Covered interest arbitrage (CIA) involves an investment in a currency that is covered by a forward contract to sell that
currency when the investment matures. CIA is plausible when the difference in interest rates is different from the
forward premium.
15. Uncovered Interest Arbitrage. Define uncovered interest arbitrage and explain what expectations an investor or
speculator would need to undertake an uncovered interest arbitrage investment?
A deviation from covered interest arbitrage is uncovered interest arbitrage (UIA), wherein investors borrow in
countries and currencies exhibiting relatively low interest rates and convert the proceeds into currencies that offer
much higher interest rates. The transaction is uncovered because the investor does not sell the higher yielding
currency proceeds forward, choosing to remain uncovered and accept the currency risk of exchanging the higher yield
currency into the lower yielding currency at the end of the period.
Exhibit 6.8 demonstrates the steps an uncovered interest arbitrager takes when undertaking what is termed the yen
carry trade. Borrowing in the Japanese yen market has always been desirable as yen interest rates are frequently very
low, Japanese banks which are largeare frequently interested in lending to multinational companies, and the yen
itself may hold its value for long periods of time.

Arbitrage is making profit. This profit can be because of different interest rate in different markets and different
exchange rates. In order to find if there is an arbitrage opportunity you must first compare if there is a difference in
interest rates. If the answer is yes, then you calculate the forward premium.

After that you compare the difference in the interest rates with the forward premium you can apply the ARBITRAGE
RULE OF THUMB. Arbitrage rule of thumb indicates the final step whether you sell forward the higher interest
proceeds into lower or sell forward the lower interest proceeds in to higher to maximise outcome.

Chapter 6 International Parity Conditions

P6.7

Starts with when you COMPARE TWO Investment choices. One by investing the funds at hand in the US dollar market.
Then selling the dollar proceeds forward. Or two by exchanging the USD dollar funds at hand at spot rate and investing
in the Yen market.
Covered interest arbitrage (CIA) involves an investment in a currency that is covered by a forward contract to sell that
currency when the investment matures. CIA is plausible when the difference in interest rates is different from the
forward premium.
1.4 is greater than 1.358, i.e. Interest rate diff is higher than FORWARD PREMIUM (ARBITRAGE RULE OF THUMB)
FORWARD PREMIUM = Spot Forward * 360 * 100
Forward
n

You invest the 500,000 dollars in the higher interest rate market and then sell the dollar proceeds forward to get final
outcome in Yen to MAXIMISE OUTCOME. This is also indicated in the rule of thumb.
Checklist 1 Sell the invested dollar proceeds FORWARD into yen to maximise the arbitrage profit.
Checklist 2 In other words, he is able to maximise by having outcomes in the opposite currency the lower currency
(Yen) and leverage on the difference in interest rates.

Takeshi Kamada, a foreign exchange trader at Credit Suisse (Tokyo), is exploring covered interest arbitrage
possibilities. He wants to invest $5,000,000 or its yen equivalent, in a covered interest arbitrage between U.S.
dollars and Japanese yen. He faced the following exchange rate and interest rate quotes.
Assumptions
Arbitrage funds available
Spot rate (/$)
180-day forward rate (/$)
180-day U.S. dollar interest rate
180-day Japanese yen interest rate

Value
$5,000,000
118.60
117.80
4.800%
3.400%

Yen Equivalent
593,000,000

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount,
investing in the higher interest market and then selling the proceeds forward will maximise return. If the
difference in interest rates is less than the forward premium, investing in the lower interest mark et and then
selling the proceeds forward will maximise return.
Difference in interest rates ( i$ - i )
Forward premium on the yen
CIA profit potential

1.400%
1.358%
0.042%

In order to lock-in a covered interest arbitrage (CIA) profit, Takeshi Kamada should invest in the higher
yielding interest rate (USD) and simultaneously sell the proceeds forward to Yen.

Chapter 6 International Parity Conditions

START
5,000,000

Spot (/$)
118.60

593,000,000
Japanese yen

U.S. dollar interest rate (180 days)


4.800%

1.0240

---------------> 180 days ---------------->

1.0170

3.400%
Japanese yen interest rate (180 days)

5,120,000

Forward-180 (/$)
117.80

603,136,000
603,081,000
55,000
END

Takeshi Kamada generates a CIA profit by investing the higher interest rate currency, the dollar, and
simultaneously selling the dollar proceeds forward into yen at a forward premium.

P6.8

A deviation from covered interest arbitrage is uncovered interest arbitrage (UIA), wherein investors borrow in countries
and currencies exhibiting relatively low interest rates and convert the proceeds into currencies that offer much higher
interest rates.
The transaction is uncovered because the investor does not sell the higher yielding currency proceeds forward,
choosing to remain uncovered and accept the currency risk of exchanging the higher yield currency into the lower
yielding currency at the end of the period.
1.4 is greater than 1.017, i.e. Interest rate diff is higher than EXPECTED SPOT PREMIUM (ARBITRAGE RULE OF THUMB)
EXPECTED SPOT PREMIUM = Spot Expected Spot * 360 * 100
Expected Spot
n

Checklist 1 Exchange the invested dollar proceeds into yen at the expected spot rate to maximise the arbitrage
profit.
Checklist 2 In other words, he is only able to maximise by having outcomes in the opposite currency the lower
currency (Yen) and leverage on the difference in interest rates.

Chapter 6 International Parity Conditions


Takeshi Kamada, Credit Suisse (Tokyo), observes that the /$ spot rate has been holding steady, and both
dollar and yen interest rates have remained relatively fixed over the past week. Takeshi wonders if he should try
an uncovered interest arbitrage (UIA) and thereby save the cost of forward cover. Many of Takeshi's research
ass ociates -- and their computer models -- are predicting the s pot rate to remain close to 118.00/$ for the
coming 180 days. Us ing the s ame data as in the previous problem, analyze the UIA potential.
As sumptions
Arbitrage funds available
Spot rate (/$)
180-day forward rate (/$)
Expected s pot rate in 180 days (/$)
180-day U.S. dollar interest rate
180-day Japanese yen interest rate

Value
$5,000,000
118.60
117.80
118.00
4.800%
3.400%

Yen Equivalent
593,000,000

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the expected change in spot rate
investing in the higher interest mark et and then selling the proceeds forward will maximise return. If the
difference in interest rates is less than the expected change in spot rate, investing in the lower interest mark et
and then selling the proceeds forward will maximise return.
Difference in interest rates ( i$ - i )
Expected gain (loss) on the spot rate
UIA profit potential

1.400%
1.017%
0.383%

This tells Takeshi Kamada that he s hould start by borrowing in the lower yeilding currency first. Then in order
to lock-in an uncovered interest arbitrage (UIA) profit, Takeshi Kamada should convert the money into USD.
Then invest in the higher yielding interest rate (USD) and simultaneous ly s ell the proceeds forward to Yen.

P6.9 (PRACTISE SELF)


Heidi Hi Jensen, a foreign exchange trader at J.P. Morgan Chase, can invest $5 million, or the foreign currency
equivalent of the bank's short term funds, in a covered interest arbitrage with Denmark. Using the following
quotes can Heidi make covered interest arbitrage (CIA) profit?
Assumptions
Arbitrage funds available
Spot exchange rate (kr/$)
3-month forward rate (kr/$)
US dollar 3-month interest rate
Danish kroner 3-month interest rate

Value
$5,000,000
6.1720
6.1980
3.000%
5.000%

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount,
investing in the higher interest market and then selling the proceeds forward will maximise return. If the
difference in interest rates is less than the forward premium, investing in the lower interest mark et and then
selling the proceeds forward will maximise return.
Difference in interest rates ( i$ - i )
Forward discount on the krone
CIA profit potential

2.000%
-1.678%
0.322%

In order to lock-in a covered interest arbitrage (CIA) profit, Heidi Hi Jensen should invest in the higher
yielding interest rate (DKr) and simultaneously sell the proceeds forward to USD.

Thus, 2 is greater than 1.678, i.e. Interest rate diff is higher than FORWARD PREMIUM (ARBITRAGE RULE OF THUMB)

Chapter 6 International Parity Conditions

Step 1. Use the dollar funds at hand (CIA profit uses fund at hand) to invest in the US market.
2. Exchange the USD funds at spot rate to get Danish Krone proceeds
3. Invest the Danish Krone in the Local market to get Krone proceeds which you sell forward as per the ABRITRAGE
RULE OF THUMB (if interest rate is higher than forward premium invest in the higher interest market and then sell
that proceeds forward).
In this problem, the higher interest market is Danish Krone and sell Krone proceeds forward to get USD.
4. Compare the two to outcomes in USD to calculate the profit.

P6.10

Assumptions
Arbitrage funds available
Spot exchange rate (kr/$)
3-month forward rate (kr/$)
US dollar 3-month interest rate
Danish kroner 3-month interest rate

Value
$5,000,000
6.1720
6.1980
4.000%
5.000%

kr Equivalent
kr 30,860,000

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or
expected change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in
interest rates is less than the forward premium (or expected change in the spot rate), invest in the lower
yielding currency.
Difference in interest rates ( i$ - i )
Forward discount on the krone
CIA profit potential

1.000%
-1.678%
-0.678%

In order to lock-in a covered interest arbitrage (CIA) profit, Heidi Hi Jensen should invest in the lower yielding
interest rate (USD) and simultaneously sell the proceeds forward to DKr.

Here, 1.678 is greater than 1, i.e. Interest rate diff is lower than FORWARD PREMIUM (ARBITRAGE RULE OF THUMB)

Step 1. Use the dollar funds at hand (CIA profit uses fund at hand) to invest in the US market.
2. Exchange the USD funds at spot rate to get Danish Krone proceeds. Which you invest in the in the Local Krone market.
3. Then sell the invested dollar forward to get Danish krone proceeds. (if interest rate is lower than forward premium
invest in the lower interest market and then sell that proceeds forward).
In this problem, the lower interest market is Dollar and sell the dollar proceeds forward to get Danish Krone.
4. Compare the two to outcomes in Danish Krone to calculate the profit.