The covered interest parity diagram r $ -r &  A  B  C  E  E.

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Presentation transcript:

The covered interest parity diagram r $ -r &  A  B  C  E  E

International Financial and Exchange Rate Adjustments D&D& London money market & $ Forward market & E $/&,fwd D &,fwd S &,fwd Spot market & E $/& D&D& S&S& e0e0 Interest rate S&S& iLiL New York money market Interest rate D$D$ S$S$ i NY e 0, fwd

The interdependence of the parity conditions ( U n c o v e r e d ) i n t e r e s t p a r i t y (Expected) PPP F i s h e r - o p e n

Interest parity in the presence of transaction costs r $ -r & Unprofitable arbitrage Incentive to borrow in pounds and invest in dollars Incentive to borrow in dollars and invest in pounds

Round-trip covered interest arbitrage $ borrowing ----& investment $0$0 $n$n &0&0 &n&n &0&0 &n&n $0$0 $n$n

One-way covered interest arbitrage Spot dollars to future pounds $0$0 $n$n &0&0 &n&n Future pounds to spot dollars &0&0 &n&n $0$0 $n$n

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