International macroe.. - Free

1.1. INTERNATIONAL FINANCIAL MARKETS 5on a 1-period Eurodollar deposit, i ∗ t betheinterestrateonanEuroeurodeposit rate at the same bank, S t , the spot exchange rate (dollars pereuro), and F t , the 1-period forward exchange rate. Because both Eurodollarand Euroeuro deposits are issued by the same bank, the twodeposits have identical default and political risk. They differ only by thecurrency of their denomination. 1 Covered interest parity is the conditionthat the nominally risk-free dollar return from the Eurodollar andthe Euroeuro deposits are equal. That is1+i t =(1+i ∗ t )F t. (1.2)S tWhen (1.2) is violated a riskless arbitrage proÞt opportunity is availableand the market is not in equilibrium. For example, suppose there areno transactions costs, and you get the following 12-month eurocurrency,forward exchange rate and spot exchange rate quotationsi t =0.0678, i ∗ t =0.0422, F t =0.9961, S t =1.0200.You can easily verify that these quotes do not satisfy (1.2). Thesequotes allow you to borrow 0.9804 euros today, convert them to 1/S t =1 dollar, invest in the eurodollar deposit with future payoff 1.0678 butyou will need only (1 + i ∗ t )F t /S t =1.0178 dollars to repay the euroloan. Note that this arbitrage is a zero-net investment strategy since itis Þnanced with borrowed funds. Arbitrage proÞts that arise from suchquotations come at the expense of other agents dealing in the internationalÞnancial markets, such as the bank that quotes the rates. Sincebanks typically don’t like losing money, swap or forward rates quoted bybank traders are routinely set according to quoted eurocurrency ratesand (1.2).Using the logarithmic approximation, (1.2) can be expressed aswhere f t ≡ ln(F t ), and s t ≡ ln(S t ).i t ' i ∗ t + f t − s t (1.3)1 Political risk refers to the possibility that a government may impose restrictionsthat make it difficult for foreign investors to repatriate their investments. Coveredinterest arbitrage will not in general hold for other interest rates such as T-bills orcommercial bank prime lending rates.