International Financing World - Assignment Example

Finance and Accounting: International Finance 26356

Introduction

In the international money markets, the difference between the values of the currencies of two countries is equal to the variation between the currencies’ forward and spot rates thus creating a no-arbitrage condition. The yields from the interest-bearing domestic and foreign investments should be equal when the currency markets is used to determine the payoff of the domestic currency from the foreign investment. On the other hand, the uncovered interest rate parity condition states that the difference in interest rates between two nations is equal to the expected change in foreign exchange rates between the currencies of those countries. The expected return of a domestic investment is equal to the expected return of a foreign investment after the adjustment of the exchange rates. It is realized when the no-arbitrage condition is satisfied without the need for forward contracts for the purpose of hedging against foreign risk. The main difference between the two conditions is that the covered parity locks the future rate while the uncovered parity projects on the future rate (Du et al., 2016). This article examines both the covered and the uncovered interest rate parity in international finance.

Questions

Covered Interest Rate Parity (CIRP) is the relationship that exists between the forward currency and the interest rates of two countries at equilibrium. This creates a no-arbitrage condition which is created by the utilization of forward contracts. In covered interest rate parity, there is no incentive to borrow money due to the lack of difference between the interest rates of the two countries. Compound interest is the interest earned on interest. In this case, the interest was earned on interest for a period of three months. Based on the analysis of the graph, the three months compound interest had a decreasing trend for the six months. This means that the foreign exchange rates also had a decreasing trend to attain parity with the compound interest rates. There has to be equity between the interest rates the exchange rates for covered Interest Rate Parity (CIRP) to occur.

This graph highlights the differences of the interest rates between US and UK. US had a higher interest rate compared to UK. However, the differences between of the interest rates between the two countries was very minimal. The differences in interest rates also affects the Covered Interest Rate Parity (CIRP). The differences in the interest rates should also be matched in the exchange rate differences. This will be crucial in establishing the parity between the two countries. This will assist in correcting the discrepancies in pricing to control arbitrage.

The above graph indicates the percentage change in the exchange rate for a total of three months. The change of the exchange rates also affects the Covered interest rates parity. Both countries need to have a similar percentage change in their respective exchange rates to ensure that the Covered interest rates parity is held. US needs to have a similar percentage change to UK to fulfill the requirements of having the Covered interest rates parity. Based on the case study, there is a reducing trend in percentage change up to a certain point where the reducing trend becomes constant. This shows that the two countries need to have such a trend for the parity to occur.

The foreign exchange rate is an important measure of a country’s economic health in comparison with other countries. It is analyzed constantly to determine the economic stability of a country. The exchange rate during my birthday was 1.11435 while three months later the exchange rate was 1.13995. This was an increase in exchange rate of 2.29%. The increase in the exchange rate might be due to several factors. The first factor is change in the inflation rates between the two countries. There was reduction inflation rates which increased the value of the currency. Another factor that might have led to the increase in exchange rates is the interest rates. There was an increase in interest rates which led to the appreciation of the currency hence an increase in exchange rates. The terms of trade between the two countries also affects the exchange rates. There might have been an improvement in the trade agreements between the two countries causing an increase in export prices that lead to improvement of the exchange rates.

Forward contract is an engagement between two people, the buyer and the seller to deliver a commodity at a future specified date at a specified price. They are mainly used in foreign exchange transactions to reduce the risk of losses due to the variations in the exchange rates. The value of the commodity at the future data is determined using various assumptions about the exchange rates. In this case, investing 1000 units of my home currency on my birthday will amount to $1117. The forward exchange rate at the future date will have a value of $1448. This means that the forward contract will have a gain of $331 since there is no transaction costs.

The value of the 1000 units of my local currency at my birthday is $1117. However, the forward rate is 1.4487 meaning that the value of the currency is $1448. This means that the total profit for entering the forward contract is $331. This shows that forward contracts are important in hedging against t=foreign exchange risk. Exchange rates vary greatly as they are affected by various factors. By entering into a forward contract, the investor is able to lock out the variations in the exchange rates. The contract protects the investor from the adversity of depreciation in the value of the currency below the contract agreement. However, the investor also gives up all the benefits that might result with the appreciation in the value of the currency.

The Uncovered Interest Rate parity (UIRP) is a congruence condition which states that the variation in the interest rates between two countries is similar to the expected change in exchange rates between these countries’ currency. In uncovered IRP, the investor is unable to hedge against currency risk by engaging in a forward contract. The expected spot rate in the future is not considered. The future rate is obtained by multiplying the current rate with the inflation rate differential. This means that if I enter into a forward contract to lock against currency risk, the spot rate in the future will be constant meaning that it will be similar to the rate the investor intends to lock in. Based on the analysis of the difference in the interest rates between the two countries in this case, USA and UK shows that they bare a certain resemblance to the exchange rates variations. The Uncovered Interest Rate Parity (UIRP) was held during this period.

The Uncovered Interest Rate Parity (UIRP) is not concerned with the forward rates. It is concerned with forecasting the expected future spot rates. The expected future spot rate needs to be in parity with the interest rates of each currency. Theoretically, for Uncovered Interest Rate Parity (UIRP) to occur, both countries need to have a similar interest rate meaning that the country with a higher interest rate is expected to depreciate its interest rate to equate it with the low currency nation. However, this is a different story in reality because since the implementation of the floating exchange rates nations having high interest rates appreciate in value. Based on the case study analysis of the information provided, Uncovered Interest Rate Parity (UIRP) was held in the period under consideration. The differences obtained in the interest rates between US and UK is equivalent to the expected change in the exchange rates between those nations. This gets rid of the arbitrage opportunity in those counties.

Arbitrage is the purchase of securities from one market and selling it in another market at a higher price to gain some profit from the temporal differences in prices in the two markets. The exploitation of the price discrepancies in the two markets generates the profits in arbitrage. This is important in enhancing the efficiency of the markets. Based on the analysis of the above findings, it is clear that arbitrage is possible in foreign exchange markets. The differences in the price of the currencies in various currency markets will result to exchange-rate differentials which if capitalized will lead to arbitrage. The lower interest currency will trade at a premium with respect to the currency having a higher interest rate. In the foreign exchange markets, inefficiencies in the market creates the opportunities for arbitrage. In the case study, the price differential is obtained as the trade net payoff which is enough to cover the expenses incurred in the trade. There records provided in the case study indicates the differences in foreign exchange rates in the different markets. As such, transferring foreign exchange from the market having a low exchange rate to a market with higher exchange rates will result to arbitrage due to the discrepancies in the prices (Ma, 2008).