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Interest Rate Parity

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Interest Rate Parity. The relationship between EXCHANGE RATE AND PRICES is called PURCHASING POWER ... 1-- you need to exchange your $ into ... – PowerPoint PPT presentation

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Title: Interest Rate Parity


1
Interest Rate Parity
  • The relationship between EXCHANGE RATE AND
    PRICES is called PURCHASING POWER PARITY.

2
Interest Rate Parity
  • The relationship between the EXCHANGE RATES AND
    INTEREST RATES, is called Interest rate parity or
    covered interest arbitrage.

3
Interest Rate Parity
  • The relationship between the EXCHANGE RATES AND
    INTEREST RATES, is called Interest rate parity or
    covered interest arbitrage.
  • let
  • i interest rate in the US
  • i? interest rate in the UK

4
Interest Rate Parity
  • The relationship between the EXCHANGE RATES AND
    INTEREST RATES, is called Interest rate parity or
    covered interest arbitrage.
  • let
  • i interest rate in the US
  • i? interest rate in the UK
  • If you invest 1 in the US by the end of the
    first period you will have
  • (1 i)

5
Interest Rate Parity
  • If you wanted to invest in the UK, you will have
    to go through several steps
  • 1-- you need to exchange your into
  • 1/Rs number of s that one could receive for
    one dollar in the spot market.

6
Interest Rate Parity
  • If you wanted to invest in the UK, you will have
    to go through several steps
  • 1-- you need to exchange your into
  • 1/Rs number of s that one could receive for
    one dollar in the spot market.
  • 2-- you need to lend the money in the UK
  • 1/Rts (1 i?) number of s that you will
    have at the end of one period.

7
Interest Rate Parity
  • If you wanted to invest in the UK, you will have
    to go through several steps
  • 3-- you need to sell your s when you want to
    bring back your money to the US.
  • Rt1s1/ Rts (1 i?) number of s that you
    will have at the end of one period.

8
Interest Rate Parity
  • Now you can compare your yields and decide
    whether or not to invest here or in the UK.
  • (1 i) Rt1s1/ Rts (1 i?)

9
Covered Interest Parity
  • 4-- When you lend your money, you know exactly
    how much s you have to sell. You could sell
    them right away in the forward market and cover
    yourself.
  • (1 i) Rtf 1/ Rts (1 i?)
  • or
  • (1 i) Rtf / Rts (1 i?)

10
Covered Interest Parity
  • (1 i) Rtf / Rts (1 i?)
  • (1 i) / (1 i?) Rtf / Rts
  • (1 i) / (1 i?) - 1 Rtf / Rts - 1
  • (i - i?) / (1 i?) (Rtf - Rts )/ Rts

11
Interest Rate Parity
  • Example
  • i 10 which means at the end of the period
    you would have 1.1
  • i 10
  • Rtf 1.55
  • Rts 1.65

12
Interest Rate Parity
  • which means at the end of the period you would
    have
  • 1.55/1.65(1.1) 1.033
  • Therefore, you could invest in the US and earn a
    higher yield.
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