Ch. 13 Exchange Rates, Interest Rates, and Interest Parity | EC 340 - Survey of Interntl Economics, Quizzes of International Economic Relations

Download Ch. 13 Exchange Rates, Interest Rates, and Interest Parity | EC 340 - Survey of Interntl Economics and more Quizzes International Economic Relations in PDF only on Docsity! TERM 1 Riskless arbitrage DEFINITION 1 -implies that in equilibrium both strategies will yield the same rate of return in dollars TERM 2 Covered Interest Parity (CIP) DEFINITION 2 -Under CIP, returns to holding dollar deposits accruing interest going along the path dollar today to dollars in one year must equal the returns from investing in euros going along the path with risk removed by use of a forward contract.-Riskless payoff must be the same on both paths ; riskless returns must be equal when expressed in a common currency-all exchange rate risk on the euro side has been "covered" by use of the forward contract TERM 3 CIP Equation DEFINITION 3 (1 + i $) = 1+i EUR)x F/E dollar return on dollar deposits = dollar return on euro deposits whenever the both sides of the equation are not equal, we should expect interest arbitrage used to exactly price forward contracts (If we know interest rates and E then we can solve for F TERM 4 Uncovered Interest Parity DEFINITION 4 -The investor does not use a forward contract to cover against exchange rate risk-The investor makes a forecast of the expected exchange rate and makes decisions based on this forecast TERM 5 UIP DEFINITION 5 -no arbitrage condition in the case of the risky interest arbitrage states that the expected returns must be equal when expressed in a common currency-assume risk neutrality ; a risk neutral investor does not care that the left hand side is certain, while the right hand side is risky.