Post on 19-Jan-2016
Chapter 10
Covered Interest Parity
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 2
Objectives
• To outline reasons for interest in covered interest parity (CIP).
• To describe the CIP condition.• To describe the mechanics of covered
arbitrage.• To explain deviations from CIP.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 3
Definition
• The CIP hypothesis describes the relationship between the spot rate, the forward rate and interest rates.
• It is an application of LOP to financial markets.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 4
Reasons for interest in CIP
• It can be used as a measure of capital mobility.
• It links the term structure of interest rates with the term structure of forward spreads.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 5
Reasons for interest in CIP (cont.)
• It implies optimal resource allocation in a market economy.
• It has implications for financing and investment decisions.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 6
The CIP Equilibrium Condition
fii
iSF
i
)1()1(
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 7
Return on Investments
Converting at spot rate
Investing in foreign assets
Reconverting at forward rate
Domesticinvestment
Foreigninvestment
SK
)1( iSK
Investor(K)
)1( iS
KF )1( iK
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 8
Covered Interest Arbitrage
Covered margin
Investing at domestic rate
Domestic foreign
Borrowing domestic currency
Converting at spot rate
Investing at foreign rate
Foreign domestic
Borrowing foreign currency
Converting at spot rate
S
1 unit
Reconverting at forward rate
Loan repayment
Loan repayment
Covered margin
1 unit 1 unit
Reconverting at forward rate
S1
)1(1 iS
)1( iSF
)1( iFS
)1( iS
S
i1 i1
)1()1( iiSF )1()1( ii
FS
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 9
Profit from Covered Arbitrage (Domestic→Foreign)
fii
iiSF
π
)1()1(π
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 10
The Interest Parity Forward Rate
i
iSF
1
1
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 11
Covered Arbitrage with Bid-Offer Spreads (Domestic→Foreign)
mfii
iiSF
ab
aba
b
π
)1()1(π
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 12
Covered Arbitrage with Bid-Offer Spreads (Foreign→Domestic)
mfii
iiFS
ab
aba
b
π
)1()1(π
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 13
Arbitrage with Bid-Offer Spreads
Covered margin
Investing at domestic bid rate
Domestic foreign
Borrowing domestic currency
Converting at spot offer rate
Investing at foreign bid rate
Foreign domestic
Borrowing foreign currency
Converting at spot bid rate
S
1 unit
Reconverting at forward bid rate
Loan repayment
Loan repayment
Covered margin
1 unit 1 unit
Reconverting at forward offer rate
aS1
)1(1 ba
iS
)1( bb iS
bS
)1( ba
b iSF
)1( ba
b iFS
ai1 ai1
)1()1( aba
b iiSF )1()1( ab
a
b iiFS
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 14
Covered Arbitrage and Consistency of Cross Forward Rates
• Covered arbitrage and three-point arbitrage in the spot market can maintain the consistency of cross forward rates.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 15
Deviations from CIP
• Deviations from CIP are indicated by a non-zero covered margin.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 16
Covered Margins in Percentage Points (Short Australian Dollar)
(a) AUD/USD
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
Dec-88 Dec-93 Dec-98 Dec-03
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 17
Covered Margins in Percentage Points (Short Australian Dollar) (cont.) (b) AUD/JPY
-2.0
-1.0
0.0
1.0
2.0
3.0
Dec-88 Dec-93 Dec-98 Dec-03
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 18
(c) AUD/GBP
-3.0
-2.0
-1.0
0.0
1.0
2.0
3.0
Dec-88 Dec-93 Dec-98 Dec-03
Covered Margins in Percentage Points (Short Australian Dollar) (cont.)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 19
Covered Margins in Percentage Points (Short Australian Dollar) (cont.) (d) AUD/CAD
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
Dec-88 Dec-93 Dec-98 Dec-03
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 20
The Effect of Transaction Costs
tfiitiiFS
tfiitiiSF
)1()1(π
)1()1(π
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 21
Political Risk
• This refers to the uncertainty that while funds are invested abroad they may be frozen, become inconvertible or be confiscated.
• A minimum covered margin is required before indulging in covered arbitrage.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 22
Tax Differentials
• The covered margin is reduced in the presence of taxes.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 23
Liquidity Differences
• The more uncertainty there is concerning future needs and alternative sources of financing, the higher the premium to be received before indulging in covered arbitrage.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 24
Other Factors
• Other factors cause deviations from CIP because they hinder the movement of arbitrage funds.
• These include inelastic supply, capital market imperfections and capital controls.