International Economics
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Dominick-Salvatore-International-Economics
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CIA Inflow CIA Outflow CIAP Forward Premium Forward Discount (–) A i – i *(%) B' A' FIGURE 14.4. Covered Interest Arbitrage. The vertical axis measures the difference in the interest rate in the home nation (i) and in the foreign nation ( i ∗ ) in percentages per annum. The horizontal axis measures the forward exchange rate, with the minus sign indicating a forward discount and positive values indicating a forward premium on the foreign currency in percent per annum. The solid diagonal line is the covered interest parity (CIAP) line. Below the CIAP line, either the negative interest differential exceeds the forward discount or the forward premium exceeds the positive interest differential. In either case, there will be a capital outflow under covered interest arbitrage. Above the CIAP line, the opposite is true and there will be an arbitrage inflow. investing abroad. The net gain would then be 1 percent per year or 1 / 4 of 1 percent for the three months or quarter of the investment. As the arbitrage outflow continues, the net gain diminishes and tends to disappear. Specif- ically, starting from point A, the transfer of funds abroad reduces the interest differential in favor of the foreign monetary center (say, from −2 to −1.5) and increases the forward discount on the foreign currency (say, from −1 to −1.5), as explained in the previous section, so as to reach the CIAP line (see the figure). Starting from point A , the transfer of funds abroad will increase the positive interest differential (say, from 1 to 1.5) and reduce the forward premium (say, from +2 to +1.5) so as to once again reach the CIAP line. Specifically, as funds move abroad, interest rates tend to rise at home and decline abroad. Since interest rates were already higher at home, the positive interest differential increases. On the other hand, as investors purchase the foreign currency to invest abroad, the spot rate rises. As they sell the foreign currency forward to cover their foreign exchange risk, the forward rate declines. Thus, the forward premium (i.e., the excess of the forward rate over Salvatore c14.tex V2 - 10/18/2012 1:15 P.M. Page 449 14.6 Interest Arbitrage and the Efficiency of Foreign Exchange Markets 449 the spot rate) diminishes. With the positive interest differential increasing and the forward premium decreasing, the net gain from arbitrage outflow diminishes until it becomes zero when the CIAP line is reached and the arbitrage outflow comes to an end. Above the interest parity line, either the positive interest differential exceeds the forward premium on the foreign currency (point B in the figure) or the negative interest differential is smaller than the forward discount on the foreign currency (point B ). In either case, it pays for foreigners to invest in our country, and there will be an arbitrage inflow . However, as the arbitrage inflow continues, the net gain diminishes and then disappears when the CIAP line is reached. In reality, interest arbitrage (inflow and outflow) will come to an end when the net gain reaches about 1 / 4 of 1 percent per year ( 1 / 16 of 1 percent for three months). This range is shown by the white area between the diagonal dashed lines in the figure. 14.6 D Covered Interest Arbitrage Margin We have seen that points on the CIAP line indicate either that the negative interest differential (in favor of the foreign monetary center) equals the forward discount (FD) on the foreign currency or that the positive interest differential (in favor of the home monetary center) equals the forward premium (FP) on the foreign currency. This can be expressed as: Download 7.1 Mb. Do'stlaringiz bilan baham: |
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