According to IRP only one 1-year forward rateF(s/), can exist. It must be the case thatF($/) = $1.20/Why?If F($/) ± $1.20/, an astute trader could makemoney with the strategy of arbitrage portfolio(1) No net investment (2)No risk
11 According to IRP only one 1-year forward rate, F($/£), can exist. It must be the case that F($/£) = $1.20/£ Why? If F($/£) $1.20/£, an astute trader could make money with the strategy of arbitrage portfolio : (1) No net investment (2)No risk
ArbitrageStrategyIIf F($/) ≥ $1.20/ ( does not depreciate enough)i. Borrow $1,000 at t = 0 at is = 7.1%.ii.Exchange$1,000for800attheprevailingspotrate(note that 800 = $1,000-$1.25/)invest 800 at11.56% (i) for one year to achieve 892.48ili. Translate 892.48 back into dollars, ifF($/) > $1.20/, 892.48 will be more than enough torepay your dollar obligation of $1,071.Referto(1)Nonetinvestmentatthetimeofinvestment:(2)Norisk.thecashflow onthematuritydateiscertain
12 Arbitrage Strategy I If F($/£) > $1.20/£(£ does not depreciate enough) i. Borrow $1,000 at t = 0 at i$ = 7.1%. ii. Exchange $1,000 for £800 at the prevailing spot rate, (note that £800 = $1,000÷$1.25/£) invest £800 at 11.56% (i£) for one year to achieve £892.48 iii. Translate £892.48 back into dollars, if F($/£) > $1.20/£ , £892.48 will be more than enough to repay your dollar obligation of $1,071. Refer to (1) No net investment at the time of investment; (2)No risk: the cash flow on the maturity date is certain
Arbitrage StrategyIlIf F($/) < $1.20/ ( depreciates too much)i. Borrow 800 at t = 0 at ig= 11.56% .ii. Exchange 800 for $1,000 at the prevailing spotrate, invest $1,000 at 7.1% for one year to achieve$1,071.ili. Translate $1,071 back into pounds, ifF($/) < $1.20/ , $1,071 will be more than enough torepay your obligation of 892.48
13 Arbitrage Strategy II If F($/£) < $1.20/£ (£ depreciates too much ) i. Borrow £800 at t = 0 at i£= 11.56% . ii. Exchange £800 for $1,000 at the prevailing spot rate, invest $1,000 at 7.1% for one year to achieve $1,071. iii. Translate $1,071 back into pounds, if F($/£) < $1.20/£ , $1,071 will be more than enough to repay your £ obligation of £892.48
InterestRateParity(IRP)Defined*IRP is an arbitrage equilibrium condition thatshould hold in the absence of barriers tointernationalfinancial capital flows
14 Interest Rate Parity (IRP) Defined ❖IRP is an arbitrage equilibrium condition that should hold in the absence of barriers to international financial capital flows