Scientific Essay, 2010
10 Pages, Grade: 1,0
1.1 Interest parity theory
1.2 Market efficiency regarding to CIRP
2. Covered interest rate parity
2.1 Differences between CIRP and UIRP
2.2 Composition of the CIRP
3.1 Transaction costs
3.2 Economical Situation
3.3 Development of the countries
3.5 Opportunity costs
3.6 Other reasons for deviation
3.7 Summary regarding to market efficiency
4. Development of the efficiency
The interest parity theory as started by John Maynard Keynes (1923) in his work “A Tract on Monetary reform” is a receding widespread economic model to explain investor behaviour and exchange rate movements. It concludes that investors invest where the best returns can be earned, with the original theory suggesting that investors only switch when the difference is 0.5 percent or higher. Peel, D. and Taylor, M.P.(2002) suggest that the interest rate parity can explain exchange rate movements solely by the return of interest from the investors. If the final value of the foreign investment is larger than that of domestic investment, the rational investor will invest his capital abroad. Because of these capital movements, the supply of capital decreases in the domestic capital market and increases in the foreign market. Furthermore, in the spot market increases the demand for foreign exchange and derivatives market on the exchange offer. These volume changes result in normal markets reacting to price adjustments that approximate the final value of the domestic investment of foreign investment (Felker 2003). Krugman (2006) explained the interest parity theory like, the exchange market is in equilibrium, when the deposits in all currencies offer the same expected return. Investors can simultaneously take out a forward contract on the foreign exchange market, which exists next to the “spot” foreign exchange market. Trade subjects at these futures markets are financial derivatives, the rates are different from the spot rate for immediately exchanging and they have included a forward premium and are named forward rates. With such a forward contract at the beginning, investors can fix the exchange rate at the beginning of an investment as of the date on which they want re-exchange it.
As a condition to the covered interest rate parity (CIRP) requires exchange market efficiency. According to the concept of market efficiency by Fama(1970), a market is efficient, if the price fully reflects all available market participant information. That implies that it is impossible to realise profits by evaluating accessible information in an efficient market. Because, if this would be possible, market participants would use this opportunity immediately to realise profits, resulting in the elimination of this opportunity, so that the resultant price reflects all the information again. In the term of currency exchange rates these assume, that in efficient exchange markets, it is impossible to achieve arbitrage, even over several currency exchanges, like triangle currency exchanges. Napolitano (2002) says that the CIRP is a necessary condition for exchange market efficiency, but it is not a sufficient one. The test of the CIRP is one of three steps to test market efficiency.
This essay examines the CIRP concerning the foreign market efficiency. It examines the results of scientific analyses and the impact of the new information technology. The aim is to explain reasons for different results, also when and how far the CIRP holds and what this means.
The difference between the covered interest rate parity and the uncovered interest rate parity (UIRP) is that the former is based on the assumption that the futures markets are used to cover themselves against exchange rate risks, whereas the latter states that the variables in the equation are all realized values. At the UIRP, there is no cover against exchange rate risks. In the CIRP, the forward rate is directly fixed as the exchange rate. The UIRP is expected to be only a corresponding exchange rate. However, in the UIRP, investors are not protected against changes in the exchange rate.
The CIRP theory states that the interest rate differential between two assets are identical in all aspects except currency of denomination, should be near zero once allowance is made the foreign exchange market. Profitable divergences from covered interest rate differential of zero represent risk-free arbitrage opportunities on the market and indicate inefficiency. Thus Wang (2010) stated that CIRP identifies the following relationship between
- F0,1 the forward exchange rate contracted now and to be delivered in the next period,
- S0 the currently prevailing spot exchange rate
- rh the interest rate in the home country
- rf the interest rate in the foreign country during the time period,
must be equal:
[illustration not visible in this excerpt] (Wang 2010)
The CIRP indicates that the forward premium must be equal to the two countries interest rate differential, if not there are useable profitable arbitrage opportunities and this would not arise or immediately be used in effectively exchange markets.
Requirements for the CIRP theory are the premise of fully capital mobility and substitutability of securities as well as perfect substitutability of assets. The investors are risk-neutral as well as there are no transaction costs and no trade barriers.
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