Chapter18: International aspects of financial management
18.4 Exchange rates and interest rates
As before, we will use S_{0} to stand for the spot exchange rate. You can take the Australian nominal riskfree rate as the shortdated government debt. COVERED INTEREST ARBITRAGE Suppose we observe the following information about Australian and Hong Kong currency in the market: where R_{HK} is the nominal riskfree rate in Hong Kong. The period is one year, so F_{1} is the 365day forward rate. Do you see an arbitrage opportunity here? There is one. Suppose you have $1 to invest, and you want a riskless investment. One option you have is to invest the $1 in a riskless Australian investment such as a oneyear government bond. We will call this Strategy 1. If you do this, then, in one period, your $1 will be worth: Alternatively, you can invest in the Hong Kong riskfree investment. To do this, you need to convert your $1 to HKD and simultaneously execute a forward trade to convert HKD back to dollars in one year. We will call this Strategy 2. The necessary steps would be as follows:
The return on this investment is apparently 12%. This is higher than the 10% we get from investing in Australia. Since both investments are riskfree, there is an arbitrage opportunity. To exploit the difference in interest rates, you need to borrow, say, $5 million at the Australian rate and invest it at the Hong Kong rate and enter into a forwardexchangerate agreement. To find out what the roundtrip profit is from investing $5 million in this strategy, we can work through the steps above:
The activity that we have illustrated here goes by the name of covered interest arbitrage. The term covered refers to the fact that we are covered in the event of a change in the exchange rate since we lock in the forward exchange rate today. INTEREST RATE PARITY If we assume that significant covered interest arbitrage opportunities do not exist, then there must be some relationship between spot exchange rates, forward exchange rates and relative interest rates. To see what this relationship is, note that, in general, Strategy 1 above—investing in a riskless Australian investment—gives us (1 + R_{AU}) for every dollar we invest. Strategy 2, investing in a foreign riskfree investment, gives us S_{0} × (1 + R_{FC})/F_{1} for every dollar we invest. Since these have to be equal to prevent arbitrage, it must be the case that: Rearranging this a bit gets us the famous interest rate parity (IRP) The condition stating that the interest rate differential between two countries is equal to the percentage difference between the forward exchange rate and the spot exchange rate. condition: There is a very useful approximation for IRP that illustrates very clearly what is going on and is not difficult to remember. If we define the percentage forward premium or discount as (F_{1} − S_{0})/S_{0}, then IRP says that this percentage premium or discount is approximately equal to the difference in interest rates: Very loosely, what IRP says is that any difference in interest rates between two countries for some period is just offset by the change in the relative value of the currencies, thereby eliminating any arbitrage possibilities. Notice that we could also write: In general, if we have t periods instead of just one, the IRP approximation will be written as:

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