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EXCHANGE
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Part 3
PARVESH AGHI
Exchange Rate
Determination
3
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
4
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
Answer: B
7
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
15
Answer
1$ = £ .7570
=
=
F = £.7570 x =
F= £.7570 x 1.009913
1$ ( 3 month fwd rate) = £.7645
16
Exercise 2
17
Answer
End of Year
1 Rs 46 x 1.08/1.04 Rs 47.77
18
Exercise 2A
Citi Bank quotes JPY/ USD 105-106.5, and Honk Kong Bank quotes
USD/JPY 0.0090-0.0093.
(a) Are these quotes identical?
(b) If not, is there a possibility of arbitrage?
(c) If there is an arbitrage opportunity, how would you profit from it?
Buy JPY from Hong Kong Bank at USD/JPY 0.00930 and sell them to Citi Bank at USD /JPY 0.00939
107.52
Solution
Buy USD
from Citi
BID ASK Bank
CITI BANK JPY/ USD 105-106.5 $1 = JPY
Sell
105 JPY 106.5
HONG USD/JPY 0.0090-0.0093 JPY1 = $ them
0.00900
to $ 0.00930
HK bank
KONG
$1 =JPY JPY 111.11
107.52
buy USD from Citi Bank at 106.5 and sell them to Honk Kong at
107.5269
Gain of Yen 1.02 per $
Exercise 2B
State Bank of India quotes USD /INR 73.15 – 73.25 , and New York Bank
quotes INR/USD 0.01359 - 0.01362.
(a) Are these quotes identical?
(b) If not, is there a possibility of arbitrage?
(c) If there is an arbitrage opportunity, how would you profit from it?
=
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
The US dollar is selling in India at Rs 74.86 . If the interest rate for a 6 months borrowing in India is 8% per
annum and the corresponding rate in USA is 2%.
(i) Do you expect that US dollar will be at a premium or at discount in the Indian Forex Market?
(ii) What will be the expected 6-months forward rate for US dollar in India? and
(iii) What will be the rate of forward premium or discount?
Solution 3A
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
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 , sell dollar in India and buy abroad
18 Lots
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