International-Financial-Management---Bekaert-2e---

©2012PearsonEducation,Inc.Chapter6InterestRateParityQUESTIONS1.Explaintheconceptsofpresentvalueandfuturevalue.Answer:Theseconceptsrelatetothetimevalueofmoney.Becauseinterestratesarepositive,agivenamountofmoneyinthefutureisnotworthasmuchtoday.Ifyouwanttoknowhowmuchafutureamountofmoneyisworth,youtakethepresentvalue.Thisistheamountthatyoucouldborrowagainstthefutureamountwhileusingthefutureamounttopaytheinterestplusprincipalontheloan.Analogously,thefuturevalueofanamountofmoneyavailabletodayisthevaluethatwouldbeavailableinthefutureifyouinvestedtodayandreceivedtheprincipalplusinterestontheinvestmentinthefuture.2.Ifthedollarinterestrateispositive,explainwhythevalueof$1,000,000receivedeveryyearfor10yearsisnot$10,000,000today.Answer:Ifyouweretoborrowagainsteachoftheannual$1,000,000payments,thebankwouldlendyouprogressivelysmalleramounts.Thepresentvalueofthe10paymentscouldbefoundbyusingthespotinterestrates,i(t,k),attimetforyeart+kinthefuture.Thepresentvaluewouldbe10kk=1$1,000,000PV=1+i(t,k)3.Describehowyouwouldcalculatea5-yearforwardexchangerateofyenperdollarifyouknewthecurrentspotexchangerateandthepricesof5-yearpurediscountbondsdenominatedinyenanddollars.Explainwhythishastobethemarketprice.Answer:The5-yearforwardratewouldbeequaltothespotrateofyenperdollartimestheratioofthefuturevaluein5yearsofoneyentothefuturevaluein5yearsofonedollar.Thelogicisthefollowing.Ifyoucaninvestdirectlyinyenfor5years,youcanconvertoneyenintothefuturevalueofoneyenin5years.Alternatively,youcanconverttheoneyenintodollarsinthespotforeignexchangemarket,investthatdollarprincipalfor5yearstogetthefuturevalueofdollars,andcontracttodaytosellthosedollarsintheforwardmarkettogetbacktofutureyenin5years.Ifthetwoamountsoffutureyendiffer,therewouldbeanChapter6:InterestRateParity©2012PearsonEducation,Inc.2arbitrageavailableinwhichyouwouldborrowfutureyenwheretheyarecheapandinvestinfutureyenwheretheyareexpensive.Hence,the5yearforwardrateshouldsatisfy551+i(t,5,?F(t,5,?$)=S(t,?$)?1+i(t,5,$)4.Ifinterestrateparityissatisfied,therearenoopportunitiesforcoveredinterestarbitrage.Whatdoesthisimplyabouttherelationshipbetweenspotandforwardexchangerateswhentheforeigncurrencymoneymarketinvestmentoffersahigherreturnthanthedomesticmoneymarketinvestment?Answer:Iftheforeigncurrencymoneymarketinvestmentoffersahigherreturn(intheforeigncurrency)thanthedomesticmoneymarketinvestment,theforeigncurrencymustbeatadiscountintermsofthedomesticcurrencyintheforwardmarket.Theforwarddiscountlocksinacapitallosswhenthetransactionexchangeriskisoffset,whichreducesthehigherreturnoftheforeigncurrencybacktothelowerreturnofferedinthedomesticmoneymarket.5.Itisoftensaidthatinterestrateparityissatisfiedwhenthedifferentialbetweentheinterestratesdenominatedintwocurrenciesequalstheforwardpremiumordiscountbetweenthetwocurrencies.Explainwhythisisanimprecisestatementwhentheinterestratesarenotcontinuouslycompounded.Answer:Interestrateparityrequirestheequalityofreturnsfrominvestingdirectlyinthedomesticmoneymarketversusconvertingdomesticcurrencyintoforeigncurrency,investingtheforeigncurrency,andsellingtheforeigncurrencyforward.Symbolically,wehave11+i(t,DC)=?1+i(t,FC)?F(t,DC/FC)S(t,DC/FC)Ifwedivideby1+i(t,FC)onbothsidesandsubtractonefrombothsides,wegeti(t,DC)-i(t,FC)F(t,DC/FC)-S(t,DC/FC)=1+i(t,FC)S(t,DC/FC)Theleft-handsideistheinterestdifferentialbetweenthedomesticandforeignratesadjustedforthedenominatortermandtheright-handsideistheforwardpremiumordiscountontheforeigncurrencyintermsofthedomesticcurrency.6.Whatdoeconomistsmeanbytheexternalcurrencymarket?Answer:Theexternalcurrencymarketisaninterbankmarketfordepositsandloansthataredenominatedincurrenciesthatarenotthecurrencyofthecountryinwhichthebankisoperating.Itssettlementproceduresareidenticaltothoseoftheforeignexchangemarket.Thefirstcurrencyforwhichthesedepositsandloansbegantotradewasthedollar,andtheChapter6:InterestRateParity©2012PearsonEducation,Inc.3depositswerecalledEurodollarsbecausetheyweredollar-denominateddepositsatEuropeanbanks.ThemarketforothercurrenciescametobecalledtheEurocurrencymarket,eventhoughthetradingmightbedoneinAsiaortheAmericas.Withtheadventoftheeuroasacurrency,thetermexternalcurrencymarketseemslessconfusing.7.Whatdeterminesthebid–askspreadintheexternalcurrencymarket?Whyisitusuallysosmall?Answer:Thebid-askspreadintheexternalcurrencymarketisthedifferencebetweenthebidrate,whichistheinterestratethatthebankpaysonitsdepositsandtheaskrate,whichistheinterestratethatthebankchargesonitsloans.Themarketisverycompetitive,andthebid-askspreadsaresmall.Thereasonisbecausethebanksacceptingthedepositsandmakingtheloansaresubjectonlytotheregulationsofthegovernmentofthecountryinwhichthebankisoperating,notthegovernmentofthecountrythatissuesthemoneyinwhichthedepositsandloansaredenominated.Theseregulationsincludehowmuchbanksmustkeeponreservewiththeirnation’scentralbank.Becausereserverequirementsareoftenlowerforforeigncurrencydepositsthanfordomesticcurrencydeposits,bankscanlendoutalargerpartofthesedeposits.Thus,theforeigncurrencydepositsarepotentiallym