Chapter 6 - Interest Rate Parity (and part of chapter 7 - speculation and risk in foreign exchange market)

Synthetic Forward

Borrowing or lending the foreign currency coupled with making a transaction in the spot market

Interest Rate Parity (relationship is called covered interest rate parity)

Describes a no-arbitrage relationship between spot and forward exchange rates and the two nominal interest rates associated with these currencies

Spot interest rate

When there are no intervening cash flows between the time a deposit is made and the maturity of the deposit, the interest rates are said to be ______________________________.

Premium

From our expression of interest rate parity, [ (i - istar) / (1 + istar) ] = [ (F - S) / S ] , we learn that if the domestic currency interest rate is greater than the foreign currency interest rate, the foreign currency must be at a _______________________.

Discount

From our expression of interest rate parity, [ (i - istar) / (1 + istar) ] = [ (F - S) / S ] , we learn that if the domestic currency interest rate is less than the foreign currency interest rate, the foreign currency must be at a _______________________.

Covered Interest Rate Arbitrage

If the interest rate parity does not hold, traders can make an extraordinary profit via ___________________________________.

Asset

If the underlying transaction gives you a liability (accounts payable) denominated in foreign currency, you need an equivalent ______________ in the money market to provide a hedge.

Liability

If the underlying transaction gives you an asset (accounts receivable) denominated in foreign currency, you need an equivalent ______________ in the money market to provide a hedge.

Percentage spread between the currencies forward and spot rates

In international money markets, the interest rate differential between two currencies approximately equals what?

interest differentials

Interest rate parity implies that forward premiums and discounts in the foreign exchange market offset ___________________________ to eliminate possible arbitrage that would arise from borrowing the low-interest-currency, lending at the high-interest-currency and covering the foreign exchange risk

Term structure of interest rates

The ________________________________ for a particular currency is a description of the different spot interest rates for various maturities into the future

External currency market

The _________________________________ is a bank market for deposits and loans that are denominated in currencies that are not the currency of the country in which the bank is operating.

Political risk

The possibility of an event such as the government imposing exchange controls or the government declaring a "bank holiday", closing the banks for a period of time, is called ___________________________.

1. Some currency markets may not have forward contracts 2. Individual companies are not able to borrow and lend at the interest rates available in the interbank market, which means the two strategies may not be equivalent 3. When time horizons are long, forward contract can be expensive as the bid-ask spread widens substantially.

What are the 3 reasons why someone would use a synthetic forward as opposed to entering a forward contract?

Exchange controls

When governments of countries interfere with the buying and selling of foreign exchange by imposing taxes, limits, or prohibit buying/selling altogether. These are referred to as ___________________________________.

1. Forward market 2. synthetic forward

When interest rate parity holds, there are 2 equivalent ways to hedge your risk:

Default risk, exchange controls, and political risk

What are the 3 reasons that apparent arbitrage opportunities might not result in riskless profitable trades?