Lecture 3 - International Parity Conditions

Question 1

What is the spot exchange rate?

Answer 1

Deals in the FOREX involving an immediate exchange of money - “on the spot”. Defined as units of the domestic currency (UK) per unit of foreign currency.

Question 2

Explain the forward exchange market.

Answer 2

Buyers and sellers agree to exchange currencies at a specified future date, at a specified forward rate (F).

Question 3

What is UIP?

Answer 3

Uncovered interest parity.

Question 4

What are the theoretical assumptions about UIP?

Answer 4

That foreign and domestic deposits are perfect substitutes. This will have important consequences as an investor will be indifferent between placing money in a domestic deposit (UK bank) or placing money in a foreign deposit (US bank).
The usual assumptions made with respect to arbitrage still apply, in particular, we need perfect capital ability, information and the absence of transaction costs.

Question 5

What is the difference between Uncovered Interest Parity (UIP) and Covered Interest Parity (CIP)?

Answer 5

The difference between uncovered interest parity (UIP) and covered interest parity (CIP) is that with the latter, the parties instead of relying on the expected spot exchange rate have the opportunity of entering into a forward agreement, so that they lock the exchange rate between pound and dollar, for example.

Question 6

What is the carry trade strategy?

Answer 6

Investors borrow money in a low interest rate currency and place it in a high interest rate currency.
They do it, in a sense, in order to define the uncovered interest rate predictions.
This is because they expect the high interest rate currency not to depreciate (or to depreciate less than the interest rate differential).

Question 7

UIP involves some risk associated with the…

Answer 7

Expected spot exchange rate. It is not arbitrage. Such risk can be eliminated by resorting to the forward market.

Question 8

Unlike UIP, CIP is an…

Answer 8

Arbitrage condition.

Question 9

Why CIP may not hold exactly?

Answer 9

• Transaction costs.
• Tax treatment of investment (capital gains tax on foreign earnings, but income tax on interest earnings).
• Political risk (default risk of foreign government and risk of capital controls).