Exchange Rate Economics: Theories and Evidence

14 Introduction
or
F (1 + i)
=
S (1 + i ∗ ) ,(1.10)
which is the condition of covered interest parity. Hence if (1.10) holds there will
be no incentive for funds to move from the home to the foreign country since
the interest differential in favour of the foreign country is offset by the forward
premium. Expression (1.10) may be simplified by taking natural logarithms of the
terms on the left and right hand sides,that is,
i − i ∗ = f − s,(1.11)
and i and i ∗ are approximately equal to ln(1 + i) and ln(1 + i ∗ ),respectively,and
f − s is the forward premium. Thus,if i ∗ > i it is clear from (1.11) that must be less
than s; the forward value of the home currency is at a premium and the forward
value of the foreign currency is at a discount. It is expected that arbitrage will ensure
that equation (1.10/1.11) holds continuously. Thus any slight interest differential
in favour of the foreign country will lead to a large quantity of arbitrage funds
moving to the foreign country and in doing so will force the forward rate to give a
premium on the pound which just offsets the interest differential.
The covered interest parity condition may alternatively be written:
CD = i − i ∗ − f − s = 0,(1.12)
where CD is the covered interest differential which indicates that covered arbitrage
will only be profitable if the CD is non-zero. In such a case,of course,there would
be a riskless profit to be made from covered interest arbitrage.
Consider now the use made by commercial traders of the forward exchange market.
In our discussion of the balance of payments model it was implicitly assumed
that importers and exporters pay for goods and services immediately. But usually
there are lags between the delivery of goods and their actual payment,and
under a flexible exchange rate system exporters and importers may wish to guard
against the risk of exchange rate changes during this period by hedging in the
foreign exchange market. For example,an importer may take delivery today of
goods which require payment in 3 months. To avoid the exchange risk inherent
in such a transaction,the importer will use the forward exchange market to sell
domestic currency for foreign currency in 3 months at a price agreed now. Since
the importer holds a foreign currency asset (the foreign currency due in 3 months)
and an equal offsetting foreign currency liability,his position is,as in the case of
arbitrage,classified as being closed.
In contrast to arbitrageurs and hedgers,speculators deliberately accept a net
open position in foreign exchange. Speculation may occur in both the spot and
the forward markets,although ‘pure’ speculation is regarded as being confined
to the forward market because little or no funds are required. 9 For the moment
we concentrate on pure speculation. If the speculator expects that the future spot