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FOREIGN

EXCHANGE
MARKETS
PARVESH AGHI
Exchange Rate
Determination

Monday, September 07, 2020 2


Theories of Exchange Rate Determination

The Purchasing Power Parity Theory


The Mint Parity Theory If price of computer is 500 US $ in NY &
Gold price Britain £ 20 per ounce & in the it costs 2500 HK $ in HK
US $ 80 per ounce : £ 1 = $ 4. $1 = 5HK$
Inflation rate differential.

The Interest Rate Parity Theory (IRP)


Strong relationship between interest
International Fisher Effect (IFE) rate and movement in of currency
Theory values.
is based on the present and the future risk US interest 2% p.a
free nominal interest rates.. India 6% p.a
Spot rate Rs 70/$ – one year Fwd. rate
should be Rs 70 ( 1.04) =Rs 72.8/$

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What Is Interest Rate Parity (IRP)?
If the 1-year interest rate in
Interest rate parity is a theory the US is 2 percent & that
should be equal to the interest
which states that ‘the size of in India is 6 percent, the
rate differential between the
the forward premium (or USD would trade at a 4
two countries of concern
discount) percent premium against the
Rupee

Thus, the act of covered


When interest rate parity
because any interest rate interest arbitrage would
exists, covered interest
advantage in the foreign generate a return that is no
arbitrage (means foreign
country will be offset by the higher than what would be
exchange risk is covered) is
discount on the forward rate generated by a domestic
not feasible
investment
Covered interest rate arbitrage is the practice of using favorable interest rate
differentials to invest in a higher-yielding currency, and hedging the exchange
risk through a forward currency contract.

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Question
According to the interest parity condition, if the domestic interest rate is 12 percent
and the foreign interest rate is 10 percent, then
A. the expected appreciation of the foreign currency must be 4 percent.
B. the expected appreciation of the foreign currency must be 2 percent.
C. the expected depreciation of the foreign currency must be 2 percent.
D. the expected depreciation of the foreign currency must be 4 percent

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Answer
According to the interest parity condition, if the domestic interest rate is 12 percent and the foreign
interest rate is 10 percent, then

A. the expected appreciation of the foreign currency must be 4 percent.

B. the expected appreciation of the foreign currency must be 2 percent.

C. the expected depreciation of the foreign currency must be 2 percent.

D. the expected depreciation of the foreign currency must be 4 percent

Answer: B

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Covered Interest Arbitrage

If the discount on the forward


Covered Interest Arbitrage has market of the currency with
an advantage as there is an the higher interest rate
incentive to invest in the becomes larger than the
higher-interest currency to the interest differential, then it
point where the discount of pays to invest in the lower-
that currency in the forward interest currency and take
market is less than the interest advantage of the excessive
differentials. forward premium on this
currency.

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Example
If the 1-year interest rate
in the US is 2 percent & If USD/INR spot rate is
that in India is 6 percent, 70, the 1-year forward
the USD would trade at a rate would be 72.80
4 percent premium (1.04x 70)
against the Rupee

If the 1-year forward


72.80 is referred to as the trades at any rate other
no-arbitrage forward than 72.80, it would
price present an arbitrage
opportunity.

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Example
by borrowing in USD at 2
percent, converting USD into INR
If it trades lower than 72.80, let’s say at
at 70 today, entering into a
72.50, then, one can exploit the
forward contract to Buy USD 1-
arbitrage opportunity
year forward and lending the
INR at 6 percent. )

The transaction would result in


an arbitrage profit of 0.43
percent.).

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Example
Arbitrage Profit (0.43 percent) =
-2 percent (cost of borrowing USD)
-3.57 percent (cost of Selling USD
today and buying USD 1-year
forward*)
+ 6 percent (rate earned by
lending/investing in INR).
( 72.50-70.00) 70 x100 = 3.57%
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Example
By borrowing in INR at
6 percent, converting
If it trades higher than
Rupee into USD at 70,
72.80, let’s say 73.00,
entering into a forward
then, one can exploit the
contract to sell USD
arbitrage opportunity
after 1-year at 73 and
by borrowing in INR at
lending the USD
6 percent
(investing USD at 2
percent).
73-70 /70 = 4.28%
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Example
73-70 /70 = 4.28%

Arbitrage Profit (0.28


The transaction would percent) = -6 percent (cost
result in an arbitrage of borrowing in INR) +
profit of 0.28 percent 4.28 percent (implied rate
(Since the interest of Rs 3 in the Buy USD today, Sell
on Rs 70 for 1-year is USD forward
equivalent to 4.28 transaction*) + 2 percent
percent). (rate earned by
investing/lending in USD).

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The Formula For Interest Rate Parity (IRP) Is

According to the interest parity theory ,


forward rate are dependent on the prevailing
interest rate in the two currencies .

The forward rate can be calculated by the


following formula :
F = 1+ Rh
S 1+ Rf
Where F and S are future and spot currency
rates . Rh and Rf are Simple interest rate in the
home and foreign currency
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PRACTICE
QUESTIONS

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Exercise 1

On April 1, 3 months interest rate in the UK £ and US $ are


7.5% and 3.5% per annum respectively.
The UK £/US $ spot rate is 0.7570

What would be the forward rate for US $ for delivery on


30th June?

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Answer
 

1$ = £ .7570
=

=
F = £.7570 x =
F= £.7570 x 1.009913
1$ ( 3 month fwd rate) = £.7645

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Exercise 2
The rate of inflation in India is 8%
per annum and in the U.S.A. it is
4%. The current spot rate for
USD in India is Rs 46. What will
be the expected rate after 1 year
and after 4 years applying the
Purchasing Power Parity Theory.

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Answer
End of Year

1 Rs 46 x 1.08/1.04 Rs 47.77

2 Rs 47.77x 1.08/1.04 Rs 49.61

3 Rs 49.61 x 1.08/1.04 Rs 51.52

4 Rs 51.52 x 1.08/1.04 Rs 53.50

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EXERCISE 3
If the present interest rate for 6 months borrowings in India is 9% per
annum and the corresponding rate in USA is 2% per annum, and the US$ is
selling in India at Rs 64.50/$.
Then :
(i) Will US $ be at a premium or at a discount in the Indian forward market?
(ii) Find out the expected 6 month forward rate for US$ in India.

(iii) Find out the rate of forward premium/discount.

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Solution
 
Under the given circumstances, the USD is expected to quote at a premium in India as the interest rate
is higher in India.

=
Where: Rh is home currency interest rate, R f is foreign currency interest rate, F is end of the period forward rate,
and S is the spot rate.

Therefore

Fwd rate = 64.5 x = Rs 66.74

Rate of premium = x x 100 = 6.94%

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Exercise 4
Followings are the spot exchange rates quoted at three different
forex markets:
USD/INR 48.30 in Mumbai
GBP/INR 77.52 in London
GBP/USD 1.6231 in New York
The arbitrageur has USD1,00,00,000. Assuming that there are no
transaction costs, explain whether there is any arbitrage gain
possible from the quoted spot exchange rates

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solution
USD/INR 48.30 in Mumbai
GBP/INR 77.52 in London
GBP/USD 1.6231 in New York

GBP 1= Rs 77.52
GBP1 = USD 1.6231
USD 1.6231= Rs 77.52
USD 1 = Rs 47.76
So dollar is expensive in India , buy dollar in India and sell abroad

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Solution
The
  arbitrageur can proceed as stated below to realize arbitrage gains.
USD/INR : 48.30 in Mumbai
(i) Buy Rs from USD 1,00,00,000 At Mumbai 48.30 × 10,000,000 = Rs 48,30,00,000

GBP/INR 77.52 in London


GBP 1 = Rs 77.52

(ii) Convert these Rs to GBP at London = GBP 62,30,650.155

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solution
GBP/USD 1.6231 in New York
GBP 1= USD 1.6231
(III) Convert GBP to USD at New York GBP 62,30,650.155 × 1.6231 USD = USD
1,01,12,968.26

There is net gain of USD 1,01,12,968.26 less USD 1,00,00,000 = USD 1,12,968.26
Exercise 5

Spot rate 1 US $ = Rs 48.0123

180 days Forward rate for 1 US $ = Rs 48.8190

Annualized interest rate for 6 months – Rupee = 12%


Annualized interest rate for 6 months – US $ = 8%

Is there any arbitrage possibility? If yes how an arbitrageur can take


advantage
of the situation, if he is willing to borrow Rs 40,00,000 or US $83,312.

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Solution
Spot Rate = Rs 40,00,000 / US$83,312 = 48.0123
Forward Premium on US$ =
[(48.8190 – 48.0123)/48.0123] x 12/6 x 100 == 3.36%
Interest rate differential = 12% - 8%= 4%
Since the negative Interest rate differential is greater than forward
premium there is a possibility of arbitrage inflow into India
The advantage of this situation can be taken in the following manner:

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solution
Particulars workings Amount
Borrow US$ 83,312 for 6 months
Amount to be repaid after 6 months US $ 83,312 (1+0.08 x 6/12) US$86,644.48
Convert US$ 83,312 into Rupee and get the US$ 83,312 x Rs 48.0123 Rs 40,00,000
principal i.e.

Interest on Investments for 6 months Rs 40,00,000/- x 0.06 Rs 2,40,000


Total amount at the end of 6 months 40,00,000 + 2,40,000 Rs 42,40,000
Converting the same at the forward rate Rs 42,40,000/ Rs 48.8190 US$ 86,851.43
Hence the gain is US $ (86,851.43 – 86,644.48) US$ 206.95
($206.95 x Rs 48.8190) Rs 10,103

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Exercise 6
Spot rate 1 US $ = Rs 74.8325
180 days Forward rate for 1 US $ = Rs 75.9200
Annualized interest rate for 6 months – Rupee = 6%
Annualized interest rate for 6 months – US $ = 2%
Is there any arbitrage possibility? If yes how an arbitrageur can take advantage
of the situation, if he is willing to borrow Rs 50,00,000 or US $66,816.

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Forward premium =(76.5200-74.8325) / 74.8325 x 12/6 x 100

.0091871 x2x100 = 1.8374%

Interest rate differential 6% - 2%= 4%


Since the negative Interest rate differential is greater than forward premium there is a
possibility of arbitrage inflow into India
The advantage of this situation can be taken in the following manner:

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solution
Particulars workings Amount
Borrow US $66,816 for 6 months
Amount to be repaid after 6 months US $ 66816 (1+0.02 x 6/12) US$67,484
Convert US$ 66816 into Rupee and get the US$ 66816 x Rs 74.8325 Rs 50,00,000
principal i.e.

Interest on Investments for 6 months Rs 50,00,000/- x 0.03 Rs 1,50,000


Total amount at the end of 6 months 50,00,000 + 1,50,000 Rs 51,50,000
Converting the same at the forward rate Rs 52,50,000/ Rs 75.92 US$69,151.74
Hence the gain is US $ (86,851.43 – 86,644.48) US$ 1667
($1667 x Rs 75.8325) Rs 1,26412

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“Spread love everywhere you go.
Let no one ever come to you
without leaving happier."

Mother Teresa