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PART VI. INTEREST RATE PARITY THEORY

PART VI. INTEREST RATE PARITY THEORY

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INTEREST RATE PARITY

THEORY

2.



The forward premium or

discount equals the interest

rate differential.

(F - S)/S = (rh - rf)

where



rh = the home rate

rf = the foreign rate

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INTEREST RATE PARITY

THEORY

3. In equilibrium, returns on

currencies will be the same

i. e. No profit will be realized

and interest parity exists

which can be written

(1 + rh) = F

(1 + rf)

S

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INTEREST RATE PARITY

THEORY

B. Covered Interest Arbitrage

1. Conditions required:

interest rate differential does

not equal the forward premium or

discount.

2. Funds will move to a country

with a more attractive rate.

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INTEREST RATE PARITY

THEORY

3.

Market pressures develop:

a. As one currency is more demanded spot

and sold forward.

b.

rates.



Inflow of fund depresses interest



c. Parity eventually



reached.

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INTEREST RATE PARITY

THEORY

C. Summary:

Interest Rate Parity states:

1. Higher interest rates on a

currency offset by

discounts.



forward



2. Lower interest rates are

offset by forward premiums.

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PART VI. THE RELATIONSHIP BETWEEN THE

FORWARD AND THE FUTURE SPOT RATE



I. THE UNBIASED FORWARD RATE

A. States that if the forward rate

is unbiased, then it should

reflect the expected future

spot rate.

B. Stated as

ft = e t



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PART VI. CURRENCYFORECASTING

I. FORECASTING MODELS

A. Created to forecast exchange

rates in addition to parity

conditions.

B. Two types of forecast:

1. Market-based

2. Model-based



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PART VI. INTEREST RATE PARITY THEORY

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