Page 8 - FINAL CFA II SLIDES JUNE 2019 DAY 4

LOS 11.e: Explain international parity conditions (covered
and uncovered interest rate parity, forward rate parity, READING 11: CURRENCY EXCHANGE RATES: UNDERSTANDING EQUILIBRIUM VALUE
purchasing power parity, and the international Fisher effect).
MODULE 11.2: MARK-TO-MARKET VALUE, AND PARITY CONDITIONS

‘Covered’ Interest Rate Parity (bound by arbitrage)
When forward premium or discount exactly offsets differences in interest rates, so that an investor would earn the same return
investing in either currency (currency of country with higher interest rate will depreciate, exactly offsetting the higher interest rate).

Always follow the
numerator-denominator
rule. If given A/B, A
interest rate should be in
the numerator and the B
interest rate in the
denominator of the parity
equation.
EXAMPLE: Covered F = $1.30(1.08 / 1.06) = $1.3245
interest arbitrage:
The U.S. dollar Euro (base currency) has
interest rate is 8%, depreciated (at a more serious
and the euro interest discount) than implied by parity:
rate is 6%. The spot
exchange rate is FR (market) > FR (parity)
$1.30 per euro $1.35/EUR > $1.3245 EUR
(USD/EUR), and the
1-year forward rate is So what? Buy or sell EUR to
$1.35 per euro. start arbitrage?
Determine whether a
profitable arbitrage Sell euros in the forward market
opportunity exists, and do the opposite (i.e., buy
and illustrate such euros) in the spot market.
an arbitrage if it
does. Key steps…