Lecture 9 Interest rate parity Flashcards
What is interest rate parity
Two assets with the same risk should have the same return. If this were not true, market participants could sell one asset and buy the other until their returns were equalized.
What is obtaining forward cover
The forward market allows market participants to hedge. By selling foreign exchange forward an investor can lock in a rate of return on a foreign investment today.
Corollary to the covered interest parity condition
the difference between foreign and domestic interest rates is approximately equal to the forward discount or premium on foreign exchange
What is Covered interest rate parity
refers to a condition in which the relationship between interest rates and the spot and forward exchange rates of two countries are in equilibrium and
equal to the percentage difference between the forward and spot exchange rates.
presence of a forward contract in CIRP which “covers” the investor against exchange rate fluctuations
Covered interest rate parity says…
says the difference between foreign and domestic interest rates is approximately equal to the forward discount or premium on foreign exchange
Uncovered interest rate parity says…
the difference between foreign and domestic interest rates is approximately equal to expected rate of foreign currency appreciation or depreciation
Covered interest rate parity considers the scenario where investors can hedge against exchange rate risk by using forward contracts.
Uncovered interest rate parity, on the other hand, does not involve hedging against exchange rate risk.
Rational expectations (R.E.) hypothesis maintains:
(1) The expected spot rate is an unbiased forecast of future spot rates.
2) The forward rate is the market’s forecast of future spot rates.
According to this theory, the forward discount (or premium) can be interpreted as the market’s forecast of where exchange rates are headed in the future. Period
