International finance - Essay Example

International Finance Running head: International Finance International Finance 2 The objective of this paper is to show how covered interest arbitrage protects banks and individuals when making international financial investments. Further, the theory of purchasing power parity would be used to explain the impact of inflation on exchange rates. A hypothetical situation on winning the lottery would be utilized to explain the abovementioned concepts in detail. International Finance 3Answers to Questions:1.

If the exchange rate is US$= Eur1.25, you won 800,000 in US$.(1,000,000/1.25 = 800,000) 2. Interest rate in Irish bank = 5% p.a. Interest rate in US bank = 2% p.a. 1,000,000 X 0.05 = 50,000 + 1,000,000 = Eur1, 050,000 in one year in Ireland If money is taken to the US, 800,000 X 0.02 = 16,000 + 800,000 = US$ 816,000 in one year in USA 3. If Euro 1,050,000 exchanged in US at Eur1.30, Irish bank account would amount to 807,6924. Therefore, you would have earned more if you brought your winnings home to the USA.

COVERED INTEREST ARBITRAGEExplain how banks and individuals can use “covered interest arbitrage” to protect themselves when they make international financial investments. Covered interest arbitrage is defined in Wikipedia as “the investment strategy where an investor buys a financial instrument denominated in a foreign currency, and hedges his foreign exchange risk by selling a forward contract in the amount of the proceeds of the investment back into his base currency”. By actually knowing the exchange rate of the other currency (one year from the base year), banks and individuals earn an effective interest rate rather than the simple interest rate that would have been earned if the funds are left deposited in the bank.

International Finance 4Using the theory of purchasing power parity, explain how inflation impacts exchange rates. Based on the theory of purchasing power parity, what can we infer about the difference in inflation between Ireland and the USA during the year your lottery winnings were invested? First, in order to explain how inflation impact exchange rates, it is necessary to define purchasing power parity. The Dictionary of Economics defines purchasing power parity as “a theory which states that the exchange rate between one currency and another is in equilibrium when their domestic purchasing powers at that rate of exchange are equivalent”.

During the year that the lottery winnings were invested, the exchange rates were US$1 = Euro 1.25, meaning that it costs 1.25 Euros to purchase 1 Dollar on foreign exchange markets. Since after one year, the rate of exchange became US$1 = Euro 1.30, there was a 4 per cent inflation in Ireland which caused a devaluation in their exchange rate. The inflation rate was computed as follows: (1.30 – 1.20)/1.20. While there was no mention of any change in exchange rate in the US, it can be inferred that there was no inflation increase.

Therefore, the value of its currency remained the same. Following this flow of thought, it was indeed better off to bring the lottery winnings to US since it would have earned 8,308 more (816,000 – 807,692) than if it was left in the bank in Ireland.International Finance 5ReferencesCovered Interest Arbitrage. (n.d.) In Wikipedia, the free encyclopedia. Retrieved on December 13, 2008, from http://en.wikipedia.org/wiki/Covered_interest_arbitrageMoffatt, M. (2002). A Beginners Guide to Purchasing Power Parity Theory (PPP Theory).

Retrieved on December 13, 2008 from About.com http://economics.about.com/cs/money/a/purchasingpower.htm.