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6. Parity Relationships

6. Parity Relationships. “Parity” is a relationship that must hold to prevent arbitrage profits from appearing. Arbitrage.

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6. Parity Relationships

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  1. 6. Parity Relationships “Parity” is a relationship that must hold to prevent arbitrage profits from appearing.

  2. Arbitrage The text defines arbitrage as “…the act of simultaneously buying and selling the same or equivalent assets or commodities for the purpose of making certain, guaranteed profits.” Put simply, if there are two ways to take a financial position, those two ways must have the same price. Parity (of some kind) will be said to exist when arbitrage opportunities are absent.

  3. Interest Rate Parity In either case you end of with $ at the end of the time period…riskless and certain.

  4. Interest Rate Parity S(£/$)x(1 + i£)xF($/£) S(£/$)x(1 + i£)/F(£/$) Future $1x(1 + i$) S(£/$)x(1 + i£) = $1 S(£/$) Today UK USA

  5. Approximating the IRP Relationship The IRP relationship can be re-written as Or approximated as This states that the forward premium is approximately equal to the interest rate differential. For example, if a foreign country’s currency is expected to depreciate by 2%, its interest rate should be 2% higher than the domestic rate.

  6. Covered Interest Arbitrage (when IRP doesn’t hold)

  7. Interest Rate Parity: Discussion Question The interest rate parity relationship is between the spot and forward rates of two currencies, and the interest rates in each domestic economy. So, which if any of these is “causing” the other rates to adjust?

  8. IRP: Strong but Inexact Parity The IRP relationship won’t hold exactly due to…. The net result is that currencies usually trade within bands near the parity relationship.

  9. Acceptable Trading Bands Within IRP

  10. IRP Deviations with Capital Controls: The Case of Japan Capital Controls

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