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Understanding Covered Interest Parity in Integrated Markets

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This document explores the concept of Covered Interest Parity (CIP) within the framework of integrated markets. It outlines four key conditions necessary for market integration and compares covered interest parity, uncovered interest parity, and real interest parity. Practical examples are provided, illustrating how to utilize forward and spot exchange rates to determine investment outcomes in different currencies. The relationships between U.S. and Japanese interest rates are analyzed, demonstrating the impact of different economic factors on investment decisions and currency exchange.

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Understanding Covered Interest Parity in Integrated Markets

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  1. Integrated MarketsPart I Covered Interest Parity

  2. Conditions for Integration • Four increasingly demanding conditions • Covered interest parity • Uncovered interest parity • Real interest parity • Feldstein/Horioka

  3. Covered Interest Parity • i$ = interest rate in USA • i¥ = interest rate in JPN (Both yearly) • F = forward exchange rate ($/¥) • E = spot exchange rate ($/¥)

  4. Covered Interest Parity • One dollar in USA will earn $1*(1 + i$) by next year • This money invested in Japan will earn $1*(1 + i¥)/E in yen by next year • Two different currencies • ER, one year from now, is unknown

  5. Covered Interest Parity • What can we now do? • SELL (1 + i¥)/E yen in the FORWARD market for F*(1 + i¥)/E dollars • Restated, this dollar amount is: • (1 + i¥)F/E, and is equal to the dollar earnings if invested in USA

  6. Covered Interest Parity • OK, now: • (1 + i$) = (1 + i¥)F/E, or • (1 + i$)/(1 + i¥) = F/E

  7. Covered Interest Parity • Now, subtract 1 from both sides: • (1+i$)/(1+i¥) - (1+i¥)/(1+i¥) = F/E – E/E, • (i$ - i¥)/(1 + i¥) = (F – E)/E

  8. Covered Interest Parity • Because 1 + i¥ is about equal to 1, (i$ - i¥) = (F – E)/E

  9. Out of a recent WSJ: E = .009482; F (6 month) = .009537 F – E = .000055; so, 55/9482 = .0058 for 6 months or .0116 for a year In % terms, that is 1.16% differential

  10. 1.16% of What? • (i$ - i¥) = 1.16% • Later we’ll see this is an underestimate, or my other estimates are over estimates

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