Chapter 9 - Collective Investment Schemes Flashcards
Explain interest rate parity theory and illustrate it with a short example. Include the relevant formula in your answer.
The interest-rate parity (IRP) theory shows the link between exchange rates and interest rates.
In essence, IRP theory shows how forward-exchange rates may be determined using interestrate
differentials (IRDs) between two countries and their current spot rates.
The formula is
Forward rate = 1 + r$ X spot rate
——–
1 + r£
Where:
r$ = dollar (variable currency) interest rate for the relevant period.
r£ = sterling (fixed currency) interest rate for the relevant period.
It is worth noting the specific way in which r$ and r£ are calculated. They should be based on the
number of days in the period.
For example, if dollar interest rates for a three-month (91- day) period are 8%, the relevant value for
r$ is (8% × 91/360), i.e. 2.02%. If sterling interest rates for a three-month (91-day) period are 10%,
then the relevant value for r£ is (10% × 91/365), i.e. 2.49%.
The use of a 360-day year for dollar interest rates and a 365-day year for sterling is market
convention. When banks work out the yield they wish to pay or receive, they take this into account in
their quote.
Thus, if the current spot rate is £1 = $1.4275
The three-month forward rate (using the formula) is
r$ = 1 + ( 8% x 91/360) = 1.02022 r£ = 1 + (10% x 91/365) = 1.02493
Therefore
Forward three-month forward rate would equal
- 02022 x 1.4275 = 1.4209.
- ———– - 02493
Outline the characteristics of a certificate of deposit (CD).
A certificate of deposit (CD) is in effect a securitised bank deposit.
Ideally, banks would like to be able to take deposits from customers on the understanding that these
deposits would not be repayable within the short term.
However, investors are either unwilling to commit their funds for specified time periods (time
deposits) or demand too high a premium.
The resolution to this dilemma came in the 1960s with the creation of certificates of a bank deposit
that was committed for a period.
Such certificates normally carry a fixed coupon rate and have a maturity of up to five years, more
normally one year or less.
Like any other security, the certificate can be traded, enabling the deposit holder to realise the
deposit through the sales proceeds and not by withdrawal.
Conventionally, CDs are issued by highly-rated banks and other financial organisations and,
therefore, carry a limited credit risk (or at least were thought until recently to carry little risk).
Unlike other money market instruments, they do carry a coupon, which is only paid on maturity.
Once issued, CDs trade on a yield basis. That is to say, the amount that is to be paid for the CD
means that, given the fixed coupon, the new purchaser will generate the yield at which it is trading.
The minimum denomination for a CD is usually £100,000. Then in increments of £10,000 above this.
Peter has joined your organisation’s dealing area. He is aware of the terms ‘spot rate’ and
‘forward rate’ but does not really understand them and is particularly unsure how each of
these is quoted. He has also heard mention of ‘purchasing power parity’ and wonders what
this is.
Peter asks for your assistance. Explain each of the three terms to Peter.
The spot market:
This is the market for immediate currency trades. Delivery will take place two business days
(T + 2) after the deal is made. The market has no formal market place and trading takes place via
telephones with prices being quoted on screen services.
The spot market quotes bid-offer prices in the form of a spread, normally based against the dollar (ie
the $ is the fixed currency). The main exception to this is £/$ (known as cable), where the $ is
quoted against the £ (ie the £ is the fixed currency).
Where the dollar is quoted against a foreign currency, this can be referred to as an American terms
quote. If a foreign currency is quoted against the $, this is referred to as European terms. Therefore,
the cable rate is quoted in American terms.
To assist in remembering which rate to use, remember that the bank always gives you the worst
rate.
The forward market:
This is a market in currencies for delivery at an agreed date in the future. The exchange at which
delivery takes place is agreed now. Forward rates are quoted as premiums (pm) or discounts (dis) to
the spot rate. It is possible for rates to be quoted at par where the spot and forward are the same.
It is important to remember that these rates are quoted in cents, whereas the spot rate is quoted in
dollars. A premium implies that the currency is becoming more expensive (strengthening against
sterling).
Hence, to obtain the forward rate the premium is subtracted from the spot rate. Similarly, the
discount is added. This will be the rule regardless of the nature of the quote, direct or indirect,
premiums are subtracted and discounts are added.
One important factor to remember about this market is that it does not reflect an expectation of what
the spot rate will be in three, six or nine months’ time. It is simply a mathematical result of the
difference in interest rates in the two countries.
Purchasing Power Parity:
In the shorter term, the exchange rate is determined by supply and demand factors and, to a greater
or lesser extent, market sentiment. Longer-term exchange rates are determined by purchasing
power parity, which is a relationship between economies and the levels of inflation they suffer.
Purchasing power parity is best explained by way of a small example.
If a basket of goods costs £100 in London and the same basket of goods costs €200 in Paris, this
predicts the exchange rate between the two countries will be £1 = €2. However, if the two economies
suffer differing rates of inflation then, over time, the exchange rate will alter.
If, after a number of years, the basket of goods costs £115 in London, due to the impact of inflation
on UK prices, and yet remains at €200 in Paris, this would suggest that the exchange rate between
the two currencies is now £1 = €1.74 – a decline in the value of sterling.
This theory of exchange rate behaviour can also be referred to as The Law of One Price.
Short-term supply and demand features may well mask this overall trend, but purchasing power
parity gives an underlying theme to the foreign exchange markets.
If one economy consistently has an inflation rate in excess of its competitors, then its currency will
deteriorate against its trading partners.
Name six short-term factors that may influence exchange rates
Candidates may have named any SIX of the following seven short term factors:
- Interest rates (yield differential)
- Balance of payments.
- Economic growth.
- Fiscal and monetary policies.
- Natural resources.
- Currency bloc membership.
- Political events.
