Page 80 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

Unit 5: Currency Forecasting

£/$ is the forward sterling to dollar rate, Notes
f
£/$ is the spot sterling to dollar rate
s
Unless interest rates are very high or the period considered is long, this is a very good
approximation:
r = r + f
£ $
where f is the forward premium: (£/$ )/(£/$ ) – 1
f s
The above relationship is derived from assuming that covered interest arbitrage opportunities
should not last, and is therefore called covered interest rate parity.

Uncovered Interest Rate Parity

Assuming uncovered interest arbitrage leads us to a slightly different relationship:

r = r + E[∆S]
2
Where E[∆S] is the expected change is exchange rates.
This is called uncovered interest rate parity.

As the forward rate will be the market expectation of the change in rates, this is equivalent to
covered interest rate parity – unless one is speculating on market expectations being wrong. The
evidence on uncovered interest rate parity is mixed.

Self Assessment

Fill in the blanks:
7. Interest rate parity is a …………………… condition.
8. If interest rate parity is violated, then an …………………… opportunity exists.

9. According to interest rate parity the difference between the (risk free) interest rates paid
on two currencies should be equal to the differences between the …………………… rates.

10. The interest rate parity includes the …………………… and uncovered interest rate parity.
11. The evidence on uncovered interest rate parity is …………………….

Caselet Parity Conditions in International Finance

t the cornerstone of international finance relations, lie the PPP doctrine and the
three international interest parity conditions, viz. the Covered Interest Parity
A(CIP), the Uncovered Interest Parity (UIP) and the Fisher’s Real Interest Parity
(RIP). These parity conditions indicate the degree of market integration of the domestic
economy with the rest of the world.
Indian Evidence
Empirical estimates of parity conditions are plagued with theoretical and econometric
difficulties that make conclusions difficult even in the case of well developed markets.
Differences in estimates arise primarily from model specifications, choice techniques and
Contd...

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