Hedging Assignment Harvard Case Solution & Analysis

2. Uncovered Interest Rate Parity (UIP)

Uncovered Interest Rate theory explains that predicted appreciation (depreciation) of a currency is balanced by lower (higher) interest. According to several empirical studies short run relationship between exchange rate and interest rate is negative because of the inflationary impact, whereas the long run relationship between exchange rate and interval rate is positive with the assumption of free capital mobility.

Uncovered Interest Rate Example

In this method if Google Inc. used uncovered interest rate it can be implemented as,

  • Google Inc. can also buy USD at the current spot rate to invest the money in dollars and convert it to Euro at the end of the month. As in this transaction risk of exchange rate fluctuation continuously exist, so this is called uncovered interest rate parity.

Covered Interest Rate vs. Uncovered Interest Rate

Latest empirical studies have investigated that uncovered interest rate parity does not hold, while valuations are not as large as previously supposed and looks to be currency rather than the time limit dependent. In comparing, covered interest rate parity is well proven in recent decades amongst the OECD economies for short-term tools. Any obvious deviations credit for transaction costs.

Implications of Interest Rate Parity Theory

In the presence of IRP theory arbitrage is not possible in other words, if IRP holds, then investors can not earn profit through arbitrage. In the absence of arbitrage the investors will earn at the same rate of return on investment, whether investors select a home country or overseas country for investment purpose. It does not matter whether an investor invests in domestic country or a foreign country.

To prevent arbitrage in case of domestic interest rates is lower than overseas interest rates, overseas currency must be traded at a forward discount to adjust any benefit of higher interest rates in foreign countries.

Contrary arbitrage opportunity exists for domestic investors, it will be beneficial for domestic investors to invest in the foreign market, if foreign currency is not traded at a forward discount or forward discount is not large sufficient to adjust the interest rate benefit of foreign countries.

Foreign currency must be traded at a premium, to adjust any benefit of higher interest rates in domestic country, to prevent the arbitrage opportunity in case if the domestic interest rate is higher than the foreign interest rate.

The arbitrage opportunity exists for foreign investors, so foreign investors can get benefit from investing in the domestic market if overseas currency is not exchanged at a forward premium or if the forward premium is not sufficient enough to adjust the higher interest rate advantage of domestic country.

Limitations of Interest Rate Parity Model

In latest years the interest rate parity model has presented little evidence of working. In several cases, countries with higher interest rates regularly experience its currency to appreciate because of higher demands and higher yields with the assumption of free capital mobility and has nothing to do with risk-less arbitrage.

Q3. Consider the following information:

rUS = 4%                     rUK = 7%

E0 = 1.60 dollars per pound

F0= 1.58 (one-year delivery)

Where the interest rates are annual yields on U.S. or U.K. T-bills. Given this information

a)      Where would you lend?

b)     Where would you borrow?

c)      How could you arbitrage?

ANSWER:

 a)

An interest rate is considered as a finance cost of borrowing the funds. The lender of the funds takes a risk while lending the money that the borrower might not pay back his funds at the time of maturity. It is a form of income for the lender of the funds.  The borrower of the funds needs to pay this cost as a servicing cost because he is able to use the funds for his sole purposes. A suitable example here is when a person takes out a mortgage loan to buy a house. He becomes the owner of the house now rather than becoming the owner of the house in his future. Some people borrow to invest in equipment to earn revenues and profits. Banks borrow and lend to earn spread and expand their operations..............................

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