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Sem 5 Prep
← Open Economy MacroHedging, speculation and interest arbitrage

Formulas for this chapter

Covered interest arbitrage margin

Margin = interest differential - forward discount on the foreign currency A forward premium is a negative discount, so it adds.

Deciding whether moving short-term funds abroad with the exchange risk covered is worth doing. Positive means yes; zero means covered interest parity holds.

Interest differential
Foreign rate less domestic rate, both per year
Forward discount
Annualised, from ((FR - SR) / SR) x (12 / n) x 100; work out the sign from the quotes
Holding-period gain
Annual margin x n / 12, applied to the sum placed

Speculative profit on a forward position

Short (sold forward): profit = amount x (contract rate - spot at maturity) Long (bought forward): profit = amount x (spot at maturity - contract rate)

Any question giving a forward contract rate, an amount and the spot rate that actually occurred. Decide the direction of the position first; the sign follows.

Contract rate
The forward rate agreed when the position was opened
Spot at maturity
The rate at which the position is closed out
Short and long
Short is selling or borrowing, expecting a fall; long is buying or holding, expecting a rise

Covered interest parity

Interest differential = forward discount on the foreign currency so that the margin is zero

Checking whether a set of quotes is internally consistent, or explaining why an arbitrage opportunity disappears. It does not imply equal interest rates or equal spot and forward rates.

Enforcement
Spot purchases and forward sales by arbitrageurs raise the spot rate and depress the forward rate until the gap matches the differential
Residual decision
With the margin at zero, going abroad unhedged is a speculative view on the spot rate, not an arbitrage
Step 2 of 25
The real wordsTheory

Foreign exchange risk

The slide states it in one sentence: whenever a future payment must be made or received in foreign currency, a foreign exchange risk is involved, because spot rates vary over time.

The student's note adds why rates vary: shifts in the demand for and supply of foreign exchange, caused by changes in tastes, inflation, interest rates, growth and expectations in different nations.

The risk is not created by the contract. It is created by the gap in time between agreeing a price and settling it.

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