1. Chapter 10 Covered Interest Parity

2. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 2 Objectives To outline reasons for interest in covered interest parity (CIP). To describe the CIP condition. To describe the mechanics of covered arbitrage. To explain deviations from CIP.

3. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 3 Definition The CIP hypothesis describes the relationship between the spot rate, the forward rate and interest rates. It is an application of LOP to financial markets.

4. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 4 Reasons for interest in CIP It can be used as a measure of capital mobility. It links the term structure of interest rates with the term structure of forward spreads.

5. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 5 Reasons for interest in CIP (cont.) It implies optimal resource allocation in a market economy. It has implications for financing and investment decisions.

6. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 6 The CIP Equilibrium Condition

7. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 7 Return on Investments Converting at spot rate Investing in foreign assets Reconverting at forward rate Domestic investment Foreign investment Investor (K)

8. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 8 Covered Interest Arbitrage Covered margin Investing at domestic rate Domestic  foreign Borrowing domestic currency Converting at spot rate Investing at foreign rate Foreign  domestic Borrowing foreign currency Converting at spot rate S 1 unit Reconverting at forward rate Loan repayment Covered margin 1 unit Reconverting at forward rate S

9. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 9 Profit from Covered Arbitrage (Domestic → Foreign)

10. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 10 The Interest Parity Forward Rate

11. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 11 Covered Arbitrage with Bid-Offer Spreads (Domestic → Foreign)

12. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 12 Covered Arbitrage with Bid-Offer Spreads (Foreign → Domestic)

13. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 13 Arbitrage with Bid-Offer Spreads Covered margin Investing at domestic bid rate Domestic  foreign Borrowing domestic currency Converting at spot offer rate Investing at foreign bid rate Foreign  domestic Borrowing foreign currency Converting at spot bid rate S 1 unit Reconverting at forward bid rate Loan repayment Covered margin 1 unit Reconverting at forward offer rate

14. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 14 Covered Arbitrage and Consistency of Cross Forward Rates Covered arbitrage and three-point arbitrage in the spot market can maintain the consistency of cross forward rates.

15. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 15 Deviations from CIP Deviations from CIP are indicated by a non- zero covered margin.

16. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 16 Covered Margins in Percentage Points (Short Australian Dollar)

17. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 17 Covered Margins in Percentage Points (Short Australian Dollar) (cont.)

18. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 18 Covered Margins in Percentage Points (Short Australian Dollar) (cont.)

19. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 19 Covered Margins in Percentage Points (Short Australian Dollar) (cont.)

20. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 20 The Effect of Transaction Costs

21. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 21 Political Risk This refers to the uncertainty that while funds are invested abroad they may be frozen, become inconvertible or be confiscated. A minimum covered margin is required before indulging in covered arbitrage.

22. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 22 Tax Differentials The covered margin is reduced in the presence of taxes.

23. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 23 Liquidity Differences The more uncertainty there is concerning future needs and alternative sources of financing, the higher the premium to be received before indulging in covered arbitrage.

24. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 24 Other Factors Other factors cause deviations from CIP because they hinder the movement of arbitrage funds. These include inelastic supply, capital market imperfections and capital controls.