International macroe.. - Free

1.1. INTERNATIONAL FINANCIAL MARKETS 9British devaluation. Looking at an eleven-day window spanning theevent an arbitrage that shorted 1 million pounds at a 1-month maturitycould potentially have earned a 4521-pound proÞt on WednesdayNovember 24 at 7:30 a.m. but by 4:30 p.m. Thursday November 24, theproÞt opportunity had vanished. A second event that he looks at is the1987 UK general election. Examining a window that spans from June1 to June 19, proÞt opportunities were generally unavailable. Amongthe few opportunities to emerge was a quote at 7:30 a.m. WednesdayJune 17 where a 1 million pound short position predicted 712 poundsof proÞt at a 1 month maturity. But by noon of the same day, thepredicted proÞt fell to 133 pounds and by 4:00 p.m. the opportunitieshad vanished.To summarize, the empirical evidence suggests that covered interestparity works pretty well. Occasional violations occur after accountingfor transactions costs but they are short-lived and present themselvesonly during rare periods of high market volatility.Uncovered Interest ParityLet E t (X t+1 )=E(X t+1 |I t ) denote the mathematical expectation of therandom variable X t+1 conditioned on the date-t publicly available informationset I t . If foreign exchange participants are risk neutral, theycare only about the mean value of asset returns and do not care at allabout the variance of returns. Risk-neutral individuals are also willingto take unboundedly large positions on bets that have a positiveexpected value. Since F t − S t+1 is the proÞt from taking a position inforward foreign exchange, under risk-neutrality expected forward speculationproÞts are driven to zero and the forward exchange rate must,in equilibrium, be market participant’s expected future spot exchangerateF t =E t (S t+1 ). (1.6)Substituting (1.6) into (1.2) gives the uncovered interest parity condition1+i t =(1+i ∗ t )E t[S t+1 ]. (1.7)S tIf (1.7) is violated, a zero-net investment strategy of borrowing in onecurrency and simultaneously lending uncovered in the other currency