Interest rate parity defines the relationship among

Start studying Chapter 7: International Arbitrage and Interest Rate Parity. Define the relationship between exchange rates (current spot, future spot, and. Interest rate parity defines the relationships among which of the following? A. Spot exchange rates, future exchange rates, interest rates, and inflation rates B. Answer: Arbitrage can be defined as the act of simultaneously buying and selling Discuss the implications of the interest rate parity for the exchange rate determination. .. Among other things, Mr. Mobaus would like you to do the following.


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. Arbitrage is the activity of purchasing shares or currency in one financial market and selling it at a premium profit in another.

Example Assume Yahoo Inc. Then it can invest this money in dollars for 30 days after which it must convert the dollars to Euro.

interest rate parity defines the relationship among

This is known as covering, as now Yahoo Inc. Yahoo can also convert the dollars to Euro now at the spot exchange rate. Then it can invest the Euro money it has obtained in a European bond in Euro for 1 month which will have an equivalently loan of Euro for 30 days.

Interest rate parity - Wikipedia

Then Yahoo can pay the obligation in Euro after one month. Under this model, if Yahoo Inc.

interest rate parity defines the relationship among

It is also known as covering because by converting the dollars to Euro at the spot rate, Yahoo is eliminating the risk of exchange rate fluctuation. Uncovered Interest Rate Parity UIP Uncovered Interest Rate theory says that the expected appreciation or depreciation of a particular currency is nullified by lower or higher interest.

The Interest Rate Parity Model

Example In the given example of covered interest rate, the other method that Yahoo Inc. This method is known as uncovered, as the risk of exchange rate fluctuation is imminent in such transactions. Covered Interest Rate and Uncovered Interest Rate Contemporary empirical analysts confirm that the uncovered interest rate parity theory is not prevalent.

However, the violations are not as huge as previously contemplated. The violations are in the currency domain rather than being time horizon dependent.

The Interest Rate Parity Model

Forward Rates and Expected Future Spot Rates Our current understanding of the workings of the foreign exchange market suggests that under a system of freely floating rates, both the spot rate and the forward rate are influenced heavily by current expectations of future events, and both rates move in tandem, with the link between them based on interest differentials.

New information, such as a change in interest rate differentials, is reflected almost immediately in both the spot and forward rates. Suppose a depreciation of pounds sterling is anticipated. Recipients of sterling will begin selling sterling forward whereas sterling-area dollar earners will slow their sales of dollars in the forward market.

These actions will tend to depress the price of forward sterling. At the same time, banks will probably try to even out their long net purchaser positions in forward sterling by selling sterling spot.

interest rate parity defines the relationship among

In addition, sterling-area recipients of dollars will tend to delay converting dollars into sterling, and earners of sterling will speed up their collection and conversion of sterling. In this way, pressure from the forward market is transmitted to the spot market, and vice versa. Equilibrium is achieved only when the forward differential equals the expected change in the exchange rate. At this point, there is no longer any incentive to buy or sell the currency forward. A formal statement of the unbiased nature of the forward rate is that the forward rate should reflect the expected future spot rate on the date of settlement of the forward contract: The general conclusion from early studies was that forward rates are unbiased predictors of future spot rates.

But more recent studies, using more powerful econometric techniques, argue that the forward rate is a biased predictor, probably because of a risk premium.