Interest rate parity is the situation that exists when the expected rate of return on riskless securities is the same in all countries. If the expected rate was higher in one country than another, money would flow to the country with the higher rate. The process would increase the rates in the low-rate country and lower rates in the high-rate country. The process (arbitrage) would continue until rates were equal (parity existed).
For example, say $856.90 is converted to Canadian dollars at an exchange rate of 1.1670 CDW to $1 to buy a CDW1,000 6-month bond that pays an annual rate of 4%. At the end of 6 months, the investor would receive CDW1,020. If the exchange rate remains the same, the Canadian dollars can be converted into $874.03 (1,020/1.1670), which translates into a 4% annual rate of return. But suppose the Canadian dollar is expected to appreciate against the U.S. dollar, and so the forward rate is 1.1614 CDW per U.S. dollar. Then, the CDW1,020 will buy $878.22 (1,o20/1.614). This gives an annual rate of return of 4.98%. Thus, the investor earns 4% on the Canadian investment and then gains 0.98% on the appreciation of the CDW that leaves the net return of 4.98%. Therefore, given the prior assumptions, a 4% Canadian rate implies that the U.S. riskless rate on a 6-month bond should be 4.98%. If the U.S. and Canadian rates were the same 4%, then U.S. money would flow to Canada, driving down Canadian rates and driving up U.S. rates, until equilibrium has been reached (interest rate parity).
For Tuesday, May 1, read pages 944-966 of Chapter 27 "Multinational Financial Management." Focus your attention on the section entitled, "Trading in Foreign Exchange -- Interest Rate Parity." Do the following problems for Chapter 27: 2, 3, 9, 10, and 11.
In addition, refer back to the post of April 23 entitled, "Interest Rate Parity" and answer the question on the Indian INR arbitrage. Also, complete the arbitrage question from the handout on the Dollar and SF.
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