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- Derivation of Purchasing Power Parity
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nations and their local interest rates, and the essential role that it plays in foreign exchange markets. According to this concept, the difference between the market interest rates in any two countries is about the same as the difference between the forward and the spot exchange rates of their respective currencies. Therefore no arbitrage opportunity in the mutual trading of their currencies can exist unless this parity breaks down. In practice however, due to the government interference via currency controls, the full realization of this parity might not occur. IRP can occur because of the international arbitrage. That is why to know about IRP at first we should know what international arbitrage is and how does it happen.

Arbitrage Arbitrage can be loosely defined as capitalizing on a discrepancy in quoted prices by making risk less profit. In many case, the strategy does not require an investment of funds to be tied up for a length of time and does not involve any risk. The act of arbitrage will cause prices to realign. For example if shop x increase its product price due to increase of demand and at the same time another shop y decrease its product prices due to fall of demand. It this case arbitrage can happen. There are three common form of arbitrage. These are:

Locational Arbitrage Locational arbitrage means which is the process of buying a currency at the location where it is priced cheap and immediately selling it at another location where it is priced higher. Location arbitrage is normally conducted by banks or other foreign exchange dealers whose computers can continuously monitor the quotes provided by other banks. If other banks noticed a discrepancy between two banks, they would quickly engage in locational arbitrage to earn an immediately risk free return. Gain fro location arbitrage is based on the amount of money that you use to capitalize on the exchange discrepancy, along with the size of the discrepancy. Gains from location arbitrage can happen if the ask price of currency is lower in one bank and the bid price of currency in higher in another bank.

Triangular Arbitrage Triangular arbitrage means in which currency transactions are conducted in the spot market to capitalize on a discrepancy in the cross exchange rate between two currencies. Cross exchange rate represent the relationship between two currencies that are different from ones base currency. In USA the cross exchange rate means the relationship between two non dollar currencies. For exampleStep-1: your initial investment $10000 will converted into that is 6250 based on price $1.60 per pound. Step-2: Then the 6250 are converted into MYR50625 when piece for pound of MYR8.1 Step-3: Finally MYR50625 are converted into $10125 when price of MYR in dollar.20. So profit is 10125-10000=$125. So in this situation arbitrage is possible. For clear concept a graph is given below-

$

Step3: Exchange MYR for $ at $.20 per MYR (MYR50625=$10125 Step1: Exchange $ for at $1.60 per ($10000=6250

MYR

Step2: Exchange for MYR8.1 at per (6250=MYR50625

Covered Interest Arbitrage Covered interest arbitrage is the process of capitalizing on the interest rate differential between two countries while covering exchange rate risk with a forward contract. The logic of the term covered interest arbitrage becomes clear when it is broken into two parts. Interest arbitrage refers to the process of capitalizing on the difference between interest rate between two countries and covered refers to hedging position against exchange rate risk. Covered interest arbitrage is sometimes interpreted to mean that the funds to be invested are borrowed locally. In this case, the investors are not tying up any of their own funds. In another interpretation, however, the investors use their own funds. In this case, the term arbitrage is loosely defined since there is a positive dollar amount invested over a period of time.

Interest Rate Parity Once market forces cause interest rates and exchange rates to adjust such that covered interest arbitrage is no longer feasible, there is an equilibrium state referred to as interest rate parity. In equilibrium, the forward rate differential between two currencies. Interest Rate parity means relationship between the currency exchange rates of two nations and their local interest rates, and the essential role that it plays in foreign exchange markets. According to this concept, the difference between the market interest rates in any two countries is about the same as the difference between the forward and the spot exchange rates of their respective currencies. According to interest rate parity the difference between the (risk free) interest rates paid on two currencies should be equal to the differences between the spot and forward rates. If interest rate parity is violated, then an arbitrage opportunity exists. The simplest example of this is what would happen if the forward rate was the same as the spot rate but the interest rates were different, and then investors would: 1. borrow in the currency with the lower rate 2. convert the cash at spot rates 3. enter into a forward contract to convert the cash plus the expected interest at the same rate 4. invest the money at the higher rate 5. convert back through the forward contract 6. repay the principal and the interest, knowing the latter will be less than the interest received.

Derivation of Interest Rate parity The relationship between a forward premium or discount of a foreign currency and the interest rate representing these currencies according to IRP can be determined as follows. Consider a US investor who attempts covered interest arbitrage. The investors return from using covered interest arbitrage can be determined given the following: The amount of home currency (U.S. dollars in our example) that is initially invested(Ah) The spot rate (S) in dollars when the foreign currency is purchased. The interest on foreign deposit (if) The forward rate (F) in dollars at which the foreign currency will be converted back to us dollars. Amount receive upon maturity(An)

The amount of the home currency received at the end of the deposit period due to such a strategy is:

A = ( A S )(1 + i ) F

n h f

Since F is simply S times one plus the forward premium (called p), we can rewrite this equation:

A = ( A S )(1 + i )[S (1 + p)

n h f

A (1 + i

h

)(1 + p)

Interest Rate Parity The rate of return from this investment (called R) is as follows:

R=

AA A

n h

[ Ah (1 + i f )(1 + p)]

A

h f

A [(1 + i )(1 + p) 1] A

h

= (1 + i f )(1 + p ) 1

If IRP exist, then the rate of return achieved from covered interest arbitrage (R) should be equal to the rate available in the home country. Set the rate that can be achieved from using covered interest arbitrage equal to the rate that can be achieved from an investment in the home country (the return on a home investment is simply the home interest rate called

):

R = ih

(1 + i f )(1 + p ) 1 = i h

By rearranging terms, we can determine what forward premium of the foreign currency should be under conditions of IRP:

(1 + i f )(1 + p) 1 = i h (1 + i f )(1 + p) = 1 + i h (1 + p) = 1 + ih

1+ i f 1

p=

1+ i f

1 + ih

Thus, given the two interest rates of concern, the forward rate under conditions of IRP can be derived. If the actual forward rate is different from this derived forward rate, there may be potential for covered interest arbitrage.

Determining the forward premium Using the information just presented, the forward premium can be measured based on the interest rate differential under conditions of IRP. Assume that the US dollar exhibits a year interest rate of 4 percent, while Bangladeshi TK. Exhibits a year interest rate of 3 percent. From a Bangladeshi investors perspective, the BDT is the home currency. According to IRP, the forward rate premium of the dollar with respect to the BDT should be:

1 +.03 1 1 +.04

p=

= 0096 . = 96 % .

Thus the US dollar should exhibit a forward discount of about .96 percent. This implies that Bangladeshi investors would receive .94 percent less when selling US dollar 1 year from now (based on forward sale) than the price they pay for US dollar today at the spot rate. If US dollar spot rate is TK .20 then:

F = S (1 + p ) =tk .2 (1 .0 9 ) 0 06 =tk .1 8 8 90

Graphic Analysis of Interest Rate Parity (Discount and Premium) The interest rate differential can be compared to the forward premium (or discount) with the use of graph. All the possible points that represent interest rate parity are plotted on following graph by using the approximation expressed earlier and plugging in numbers.

ih if (%)

-5

-1

Point representing a Discount For all situations in which the foreign interest rate exceeds the home interest rate, the forward rate should exhibit a discount approximately equal to that differential. When the foreign exchange rate exceeds the home interest rate by 1 percent (

i i

h

should exhibit a discount of 1 percent. This is represented by point A on the graph. If the foreign interest rate exceeds the home rate of 2 percent, then the forward rate should exhibit a discount 2 percent, as represented by point B on the graph, and so on. Point Representing a premium For all situations in which the foreign interest rate is less then the home interest rate, the forward rate should exhibit a premium approximately equal to that differential. For example, if the home interest exceeds the foreign interest rate by 1 percent

should be 1 percent, as point C. If the home interest rate exceeds the foreign rate by 2 percent then the forward premium should be 2 percent, as represented by point D, and so on. How to test whether Interest rate Parity Exists An investor or firm can plot all realistic points for various currencies on a graph such as that in previous graph to determine whether gains from covered interest arbitrage can be achieved. The location of the points provides an indication of whether covered interest arbitrage is worthwhile. For points to the right of the IRP line, investors in the home country should consider using

10

Interest Rate Parity covered interest arbitrage, since a return higher than the home interest rate is achievable. Of course, as investor and firms take advantage of such opportunities, the point will tend to move toward IRP line. Covered interest arbitrage should continue until the interest rate parity relationship holds. Interest rate parity does not imply that investors from different countries will earn the same returns. It is focused on the comparison of a foreign investment and domestic investment in risk free interest bearing securities by a particular investor.

Does Interest Rate Parity Holds? To determine conclusively whether interest rate parity holds, it is necessary to compare the forward rate with interest rate quotations occurring at the same time. If the forward rate quotations do not reflect the same time of day, then results could be somewhat distorted. Due to limitations in access to obtain quotations that reflect the same point in time. A comparison of annualize forward rate premiums and annualize interest rate differentials for five widely traded currencies as of April 13, 2007, is provided in following graph from U.S. perspective. At that time the U.S. interest rates was higher than Japan and German interest rates and lower then the interest rate in other countries. In the graph it is shown that the yen and euro (Germanys currency) placed a forward premium, while all other currencies placed a discount. The Australian dollar placed in the most forward discount, which is attributed to its relatively high interest rate. The forward premium or discount of each currency is in line with the interest rate differential and therefore reflects IRP. At different points in time, the position of a country may change. For example, if Brazils interest rate increased while other countrys interest rates remain same, then Brazils position would move down. Basically in real life IRP does not exist absolutely. Because investment in foreign currency is not easy and there are many other costs to invest in foreign currency. But some time relatively IRP exist in some situation. In time some investor invest in foreign currency with huge amount for this reason in some situation some countrys interest rate move down and some move up. But in generally they do not held in one line.

11

iu.s if

(%) 6 J

1G -6 -5 -4 -1

-6

Conclusion Finally we can say that IRP means relationship between the currency exchange rates of two nations and their local interest rates, and the essential role that it plays in foreign exchange markets. According to this concept, the difference between the market interest rates in any two countries is about the same as the difference between the forward and the spot exchange rates of

12

Interest Rate Parity their respective currencies. Basically in real life IRP does not exist absolutely. Because investment in foreign currency is not easy and there are many other costs to invest in foreign currency. But some time relatively IRP exist in some situation. In some time some investor invest in foreign currency with huge amount for this reason in some situation some countrys interest rate move down and some move up. But in generally they do not held in same line.

13

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