International Finance FINA 5331 Lecture 11: Covered interest rate parity, Hedging currency risk in yuan, Uncovered interest rate parity Read: Chapter 5 ( ) Chapter 6 ( ) Aaron Smallwood Ph.D.

Interest Rate Adjustment The forward contract matures in M days. Interest rates are quoted in annualized terms. We need to adjust interest rates to facilitate a comparison:

Borrowing in the domestic currency; lending in the foreign If I borrow one unit of the domestic currency, in M days, I will repay: To lend in the foreign currency, I must convert domestic currency into foreign currency. For each unit of domestic currency I have, I receive, 1/S t units of the foreign currency.

Lending Now I lend the proceeds in the foreign country…I have 1/S t units of the foreign currency…I will receive: Problem…these proceeds are in foreign currency units…I want the proceeds in domestic currency. I could have acquired a forward contract, to sell forward foreign currency proceeds in M periods. The result:

The result: Suppose Then, to profit, I could borrow in the domestic currency, convert the proceeds into foreign currency, lend in the foreign market, and convert proceeds back into domestic currency using a forward contract. What if, I can still profit…Start by borrowing in the foreign currency.

No arbitrage Smart traders will eliminate profitable arbitrage opportunities quickly when they exist. Thus, as a rule: Implications: Suppose domestic interest rates fall as a result of, say, monetary policy. To ensure equilibrium: –1. Foreign interest rates must also fall… –2. and/or The forward rate must fall. –3. and/or…The spot rate must rise. An increase in the spot rate implies a DOMESTIC CURRENCY DEPRECIATION.

Covered Interest Rate Parity The no arbitrage condition is frequently re- arranged in a more convenient way:

Deviations from CIRP? Transactions Costs –The interest rate available to an arbitrageur for borrowing, i b,may exceed the rate he can lend at, i l. –There may be bid-ask spreads to overcome, F b /S a < F/S –Thus (F b /S a )(1 + i ¥ l )  (1 + i ¥ b )  0 Capital Controls –Governments sometimes restrict import and export of money through taxes or outright bans. Taxation differences on capital gains.

Hedging with Yuan Non-deliverable Forward Contract Hedging is possible: –Example: Nanyang Bank (among others) sell NDFs in yuan. –Contracts settle in dollars. Forward rate is the rate you “lock in at.” Settlement rate is the official closing RMB price of the dollar. –Settlement amount: [1-(Forward Rate/Settlement Rate)]*Size –If forward rate>settlement price: “Seller” of US dollars is paid by the buyer Example: Suppose you will receive $500,000 in one year. You may be concerned that the RMB could appreciate significantly. The current forward rate is RMB If you agree to sell dollars, and the future settlement price in one year is RMB 6, you will receive a dollar amount that exactly offset the costs of selling dollars at a rate below RMB

FRUH and UIP F t = E(S t+1 ) if investors are risk neutral. Since investors are assumed to be rational, E(S t+1 ) = S t+1 + ε t+1 where ε t+1 is a random (unforecastable) forecast error. Then F t = S t+1 + ε t+1 and the forward rate is an unbiased predictor of the future spot rate. From CIP = (1 + i * t ) (it – i*t)(it – i*t) StSt Ft – StFt – St

FRUH and UIP Then it must be the case that or approximately This is the Uncovered Interest Parity condition. It will only hold if investors are risk neutral or equivalently they do not care about the currency denomination of the assets they hold = (1 + i * t ) (it – i*t)(it – i*t) StSt E(S t+1 ) – S t E(s t+1 ) – s t =i t -i t *

FRUH and UIP If uncovered interest parity (UIP) holds then FRUH is true and investors are risk neutral. Risk neutrality implies that investors have no currency preference in which their investments are denominated. Assets with identical risk characteristics but denominated in different currencies will be viewed as perfect substitutes.