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ChapterFour
ForwardExchangeandInternationalFinancialInvestmentForwardExchangeandInternationalFinancialInvestmentExchangeraterisk,hedgingandspeculatingThemarketbasicsofforwardforeignexchangeCoveredinternationalinvestmentanduncoveredinternationalinvestmentEXCHANGERATERISKSomeimportantfacts:Spotexchangerateschangefromminutetominuteinafloating-ratesystem.(appreciationordepreciation)Inafixed-ratesystem,spotexchangeratealsochangefromminutetominute,buttherangeoftherateislimitedtoasmallbandaroundtheparvalueaslongasthefixedrateisdefendedsuccessfullybythegovernmentauthorities.Whenthefixed-ratesystemcollapses,largechangesofexchangeratewilloccur.(devaluationorrevaluation)EXCHANGERATERISKEXCHANGERATERISKEXCHANGERATERISKWhatisexchangerisk?Currencyriskisaformofriskthatarisesfromthechangeinpriceofonecurrencyagainstanother.Wheneverinvestorsorcompanieshaveassetsorbusinessoperationsacrossnationalborders,theyfacecurrencyriskiftheirpositionsarenothedged.Aperson(oranorganization)holdinganetassetposition(alongposition)oranetliabilityposition(ashortposition)inaforeigncurrencyisexposedtoexchangeraterisk.Thevalueoftheperson’s(ortheorganization’s)incomeornetworthwillchangeiftheexchangeratechangesinawaythatthepersondoesnotexpect.Along(orlongposition)isthebuyingofasecuritysuchasastock,
commodity
orcurrencywiththeexpectationthe
asset
willriseinvalue.Inthecontextofoptions,itisthebuyingofanoptionscontract.Alongpositionistheoppositeofashort(orshortposition).Ashort,orshortposition,isadirectionaltradingorinvestmentstrategywheretheinvestorsellssharesofborrowedstockintheopenmarket.Theexpectationoftheinvestoristhatthepriceofthestockwilldecreaseovertime,atwhichpointthehewillpurchasethesharesintheopenmarketandreturnthesharestothe
brokerwhichheborrowedthemfrom.Essentially,whenspeakingofstocks,
longpositions
arethosethatareownedand
shortpositions
arethosethatareowed.
EXCHANGERATERISKCurrencyriskexistsregardlessofwhetheryouareinvestingdomesticallyorabroad.Ifyouinvestinyourhomecountry,andyourhomecurrencydevalues,youhavelostmoney.Anyandallstockmarketinvestmentsaresubjecttocurrencyrisk,regardlessofthenationalityoftheinvestorortheinvestment,andwhethertheyarethesameordifferent.Theonlywaytoavoidcurrencyriskistoinvestincommodities,whichholdvalueindependentofanymonetarysystem.EXCHANGERATERISKYoutakeavacationinJapanandbringRMBalongwithyoutoconvertintoyenasneededtopayforyourexpensedandpurchases.EconomicexposureEconomicexposure:theriskthatacompany’sprofitswillbeerodedbyexchangeratechangesbecauseofrisingoperatingcosts.Companiesareverylimitedintheactionstheycantaketoprotectthemselvesinthissituation.TranslationexposureTranslationexposure:theriskthatexchangeratechangeswilldiminishacompany’sincome,assets,equityorliabilities.Theirdenominationisthereforesignificant—althoughsomeanalystsbelievethatrealassets(thosethatarephysicalandidentifiableratherthanfinancial)arehardlyaffectedbycurrencymovementsatall.Inaccountingstatement,remainingbalanceis1milliondollars,$1=
¥8.7$1=
¥8,dollar,lost700,000RMB.TransactionexposureTransactionexposure:theriskthatexchangerateswillchangeafteracontractisagreed,butbeforeitiscompleted(orafterborrowing/lendingagreementsareestablishedbutbeforerepaymentshavebeenmade),andthatmajorlosseswilloccurasaresult.Thisisaproblemfrequentlyfacedbycompaniesworkingininternationalmarkets.£1=SF3.2£1=SF2.9hold1millionpounds$1=
¥5.8$1=
¥8borrow1milliondollarsforoneyearEXCHANGERATERISKTwotypesofresponsetoexchangerateriskHedging
istheactofreducingoreliminatinganetassetornetliabilitypositionintheforeigncurrencytoreduceexposuretoexchangeraterisk.(hedgers)Speculating
istheactoftakinganetassetposition(“l(fā)ong”)oranetliabilityposition(“short”)insomeforeigncurrencyasset,usuallytotrytoprofitfromthebeliefaboutwhatfutureexchangerateswillbe.(speculators)ThemarketbasicsofforwardforeignexchangeHowcanwehedgeorspeculate?Wecanhedgeorspeculatebyconductingsomeforeignexchangetransactions.Infact,wecanusespottransaction,forwardtransaction,futuretransactionandoptiontransactiontohedgeortospeculate.ThemarketbasicsofforwardforeignexchangeWhatisaforwardexchangecontract?Aforwardexchangecontractisanagreementtobuyorsellaforeigncurrencyforfuturedeliveryatapricesetnow.Banksactingasforeignexchangedealersgenerallyarewillingtomeettheneedsoftheircustomersforthespecificsizeoftheforwardexchangecontractandthespecific
dateinthefuturefortheexchange.Thepricesetnowiscalledtheforwardexchangerate.ForwardforeignexchangeForwarddatesaretypically30,90,180or360daysinthefuture.Forinstance,tobuy£100,000of90-daysforwardsterlingat$1.4/£,yousignanagreementtodaywithyourbankthat90daysfromnowyouwilldeliver$140,000indollarbankdepositsandreceive£100,000inpoundbankdeposits.Theexchangeoftheseamountswilltakeplacetocarryouttheforwardcontracts,regardlessofwhattheactualspotexchangerateturnsouttobein90daysDonotconfusetheforwardratewiththefuturespotrate,thefuturespotratecouldbeabove,beloworequaltotheforwardrate.ForwardforeignexchangeAforwardrateisarateapplicabletoafinancialtransactionthatwilltakeplaceinthefuture.
Thespotrate,alsocalled“spotprice,”isbasedonthevalueofanassetatthemomentofthequote.Thisvalueisinturnbasedonhowmuchbuyersarewillingtopayandhowmuchsellersarewillingtoaccept,whichdependsonfactorssuchas
currentmarketvalue
andexpectedfuturemarketvalue.Asaresult,spotrateschangefrequentlyandsometimesdramatically.
ForwardforeignexchangeAtPremium,theforwardrate>thespotexchangerateAtDiscount,theforwardrate<thespotexchangerateAtParorFlat,theforwardrate=thespotexchangerateThespotexchangerate$1=DM2(DM1=$0.5)Theforwardrate$1=DM2.5(DM1=$0.4)USD
atPremium,DMatDiscountThemarketbasicsofforwardforeignexchangeHowareforwardforeignexchangetransactionsconducted?Forlargecustomers,theydonotneedtocommitanythingotherthanthewrittenagreementuntiltheexchangeactuallyoccursinthefuture.Forothers,theymustpledgeamarginthatthebankcanseizeifthecustomerfailstofulfillthecontractinthefuture.(forwardexchangemarketisanoverthecountermarket)HedgingHowcanweuseforwardtransactiontohedge?Openpositionmeansalongpositionorashortposition.Longposition----------sellinaforwardcontractShortposition----------buyinaforwardcontractHedgingHedginginvolvesacquiringanassetinaforeigncurrencytooffsetanetliabilitypositionalreadyheldintheforeigncurrency,oracquiringaliabilityinaforeigncurrencytooffsetanetassetpositionalreadyheld.Hedgersininternationaldealingsarepersonswhohaveahomecurrencyandseekabalancebetweentheirliabilitiesandassetsinforeigncurrencies.Infinancialjargon,hedgingmeansavoidingbothkindsof“open”positioninaforeigncurrency---both“l(fā)ong”positions(holdingnetassetsintheforeigncurrency)and“short”positions(owingmoreoftheforeigncurrencythanoneholds).BuyingHedgingConsideraU.S.companythathasboughtsomemerchandiseandwillhavetopay£100,000threemonthsfromnow.Assumingthatthisrepresentsanoverallnetliabilitypositioninpounds(perhapsbecausethecompanyhasnootherassetsorliabilitiesinpounds),thecompanyisexposedtoexchangeraterisk.Itdoesnotknowthedollarvalueofitsliabilitybecauseitdoesnotknowthespotexchangeratethatwillexist90daysfromnow.BuyingHedgingOnewaytohedgeitsriskexposureistoenterintoaforwardcontracttoacquire(orbuy)£100,000in90days.Ifthecurrentforwardrateis$1.4/£,thenthecompanymustdeliver(orsell)$140,000in90days.Thecompanyhasanassetpositioninpoundsthroughmatchesitspoundliabilitytopayforthemerchandise,creatinga“perfecthedge”.Thecompanynowisassuredthatthemerchandisewillcost$140,000regardlessofwhathappenstothespotexchangerateinthenext90days.SellingHedgingConsideraU.S.companythatwillreceiveapaymentof£1millionin60daysisunsureofthedollarvalueofthisreceivable,becausethespotexchangeratein60daysisuncertain.Itcanhedgebysellingpounds(andbuyingdollars)ina60-dayforwardexchangecontract,
usingtheforwardexchangeratetolockinthenumberofdollarsitwillreceive.SpeculateHowcanweuseforwardtransactiontospeculate?(whoisaspeculator?)Ifyouexpectacurrencytoappreciate----buyitinaforwardcontractIfyouexpectacurrencytodepreciate----sellitinaforwardcontractForwardcontractisveryrisky.SpeculateSpeculatingmeanscommittingoneselftoanuncertainfuturevalueofone’snetworthintermsofhomecurrency.
Aspeculatorisanybodywhoiswillingtotakeanetpositioninaforeigncurrency,whateverhismotivesorexpectationsaboutthefutureoftheexchangerate.Ifaspeculatorthinksshehasafairlygoodideaofwhatwillhappentothespotexchangerateinthefuture,itiseasytobetonthebasisofthatideausingtheforwardmarket.Itissoeasy,infact,thatthespeculatorcanevenbetwithmoneyshedoesnothaveinhand.SpeculateSupposethatinAprilyouareconvincedthatthepoundsterlingwilltakeadivefromitscurrentspotexchangeratevalueofabout$1.45andbeworthonly$1.20inJuly.PerhapsyouseeacomingpoliticalandeconomiccrisisinBritainthatothersdonotsee.Youcanmakeanenormousgainbyusingtheforwardmarket.Contractaforeignexchangetraderatyourbankandagreetosell£10millionatthecurrent90-dayforwardrateof$1.4.
IfthebankbelievesinyourabilitytohonoryourforwardcommitmentinJuly,youdonotevenneedtoputupanymoneynowinApril.Justsigntheforwardcontract.SpeculateOnthecontractdateinJuly,instructyourbanktosettletheforwardcontractagainsttheactualspotrate,whichhassunkasyouexpectedto$1.20.Effectively,inJulyyouarebuying£10millioninthespotmarketat$1.20(totalcostof$12million)andsellingthepoundsat$1.4intotheforwardcontract(totalreceiptof$14million).Younetaprofitof$2millionforafewminutes’effort,alotofforesight,andanunderstandingof“buylow,sellhigh”.
Ifyouaresmarterthantheothersinthemarketplace,youcangetrichusingtheconvenientforwardexchangemarket.SpeculateYourspeculationmayturnoutdifferently,however.Supposeyouarewrong.SupposethatBritain’sprospectsbrightengreatlybetweenAprilandJuly.SupposethatwhenJulycomesaround,thespotvalueofthepoundhasrisento$1.80.NowinJulyyoumustcomeupwith$18milliontogetthe£10millionyoucommittedtosellintheforwardcontractforonly$14million.CaseSupposeanAmericanwhoimportsradiosfromJapanknowsthatin30dayshemustpayyentoaJapanesesupplierforashipmentarrivingthen.Theimportercanselleachradiofor$100andmustpayhissupplier¥9,000perradio;sohisprofitdependsonthedollar/yenexchangerate.Atthecurrent,spotexchangerateof$0.0105/yenIfoverthenext30daysthedollarunexpectedlydepreciatesto$0.0115/yenCase:howwouldtheU.S.companydo?(hedgingusingforwardforeignexchangeAU.S.companyhasboughtsomemerchandiseandwillhavetopay£100,000threemonthsfromnow.Assumingthatthisrepresentsanoverallnetliabilitypositioninpounds(perhapsbecausethecompanyhasnootherassetsorliabilitiesinpounds),thecompanyisexposedtoexchangeraterisk.Case:howwouldyouspeculateusingaforwardcontract?InAprilyouareconvincedthatthepoundsterlingwilltakeadivefromitscurrentspotexchangeratevalueofabout$1.45andbeworthonly$1.20inJuly.PerhapsyouseeacomingpoliticalandeconomiccrisisinBritainthatothersdonotsee.CurrencyfuturesIn
finance,a
futurescontract
(morecolloquially,
futures)isastandardized
forwardcontract
whichcanbeeasilytradedbetweenpartiesotherthanthetwoinitialpartiestothecontract.Thepartiesinitiallyagreetobuyandsellan
asset
forapriceagreedupontoday(the
forwardprice)withdeliveryandpaymentoccurringatafuturepoint,thedeliverydate.Acurrencyfuture,alsoFXfutureorforeignexchangefuture,isafuturescontracttoexchangeonecurrencyforanotherataspecifieddateinthefutureataprice(exchangerate)thatisfixedonthepurchasedate.Typically,oneofthecurrenciesistheUSdollar.ThepriceofafutureisthenintermsofUSdollarsperunitofothercurrency.CurrencyfuturesHistoryCurrencyfutureswerefirstcreatedattheChicagoMercantileExchange(CME)in1972,lessthanoneyearafterthesystemoffixedexchangerateswasabandonedalongwiththegoldstandard.SomecommoditytradersattheCMEdidnothaveaccesstotheinter-bankexchangemarketsintheearly1970s,whentheybelievedthatsignificantchangeswereabouttotakeplaceinthecurrencymarket.TheyestablishedtheInternationalMonetaryMarket(IMM)andlaunchedtradinginsevencurrencyfuturesonMay16,1972.Today,theIMMisadivisionofCME.Inthesecondquarterof2005,anaverageof332,000contractswithanotionalvalueof$43billionweretradedeveryday.Currentlymostofthesearetradedelectronically.CurrencyfuturesFeaturesStandardizedtermsClearinghouseMarginsystemClosingoffuturesCurrencyfuturesStandardizedtermsContractsizeisstandardizedExample:62,500Sterling;125,000Euro;100,000Dollar–ChicagoMercantileexchangeDateofdeliveryispredeterminedThirdWednesdayofJan,March,April,June,July,Sept.,Oct.,Dec.CurrencyfuturesClearinghouseEachexchangehasaclearinghouseClearinghousearrangesfordeliveryofassetandpaymentofmoneyClearinghousebecomesthecounterpartytotheoriginalpartiesOriginalparties:buyerandsellerClearinghousebecomescounterpartytobuyer(todelivertheasset)Clearinghousebecomesthecounterpartytotheseller(tomakepayment)CurrencyfuturesIn
finance,
margin
is
collateral
thattheholderofa
financialinstrument
hastodepositwitha
counterparty
(mostoftentheir
broker
oran
exchange)tocoversomeorallofthe
creditrisk
theholderposesforthecounterparty.Thereare3typesofmarginsInitialmargintobepaidupfrontMaintenancemargintobemaintainedthroughoutthedurationofthecontractVariationmargin(shortfallinmargin)toberemittedpromptly.CurrencyfuturesExampleformarginsystemCanDollarfutures:size=100,000CADDealerbuysonecontractatUSD0.75/CADValueofcontract:USD75,000Initialmargin:10percent=USD7,500Maintenancemargin:7.5percent=USD5,625PricemovesuptoUSD0.755/CAD:dealergainsUSD500(100,000*USD0.005)PricemovesdowntoUSD0.740:dealerlosesUSD1000(100,000*USD0.010)CurrencyfuturesClosingoffuturesFuturescanbeclosed:ExchangeofassetandcashondeliverydateCashsettlementthroughareversetradeonanydayHedgerspreferexchangeofasset;speculatorsprefercashsettlementCurrencyfuturesHedgingwithcurrencyfuturesImporterbuystherequiredcurrencyfuturescontractThus“l(fā)ocksin”apriceforthepurchaseofforeigncurrencyExportersellstheexpectedcurrencyfuturescontract“l(fā)ocksin”apriceforthesaleCurrencyfuturesSpeculationwithcurrencyfuturesFluctuationsinexchangeratesusedtoreapspeculativeprofitsSpotrate:USD1=Rs.46.401monthfuturerate:USD1=Rs.46.60Expectedspotrateonmaturity:USD1=Rs.46.75Dealerbuysonecurrencyfuturescontractofsize100,000USDValueofcontract:Rs.46,60,000;Margindeposit:Rs.4,66,000IfexchangeratemoveuptoRs.46.75asanticipated,dealergainsprofitofRs.15,000(100,000*0.15)InternationalfinancialinvestmentInternationalfinancialinvestmentismorecomplicatedthandomesticinvestmentbecauseoftheneedforcurrencyexchanges,bothtoacquireforeigncurrencynowandtotranslatetheforeigncurrencybackinthefuture.(thedifferencebetweeninvestingindomesticassetsandinvestinginforeignassets)Decisionsaboutinternationalinvestmentarebasedonthereturnsandrisksoftheavailableinvestmentalternatives.InternationalfinancialinvestmentSupposethataU.S.investorinvestsinaforeign-currency-denominatedfinancialasset,likeaBritishgovernmentsecurityorapoundtimedeposit.First,shemustconvertherdollarsintopoundsattheinitialspotexchangerate.Then,sheusesthepoundstobuythepound-denominatedfinancialasset.Sheholdsthisasset,earningpoundreturnsandhavingwealthinpoundsayearfromnow.Thiscanbeconvertedbackintodollars(eitheractuallyorsimplytodeterminethedollarvalueofwealth)atsomedollar-poundexchangeratethatappliestoforeignexchangetransactionsayearfromnow.InternationalfinancialinvestmentWhatexchangeratecanbeusedtoconvertpoundsbackintodollarsayearfromnow?Therearetwomajoralternatives,andthesecorrespondtoourconceptsofhedgingandspeculation.First,shecancontractnowfortheexchangeofpoundsbackintodollarsattheone-yearforwardexchangerateusingaforwardexchangecontract.Herpoundliabilityintheforwardcontractmatchesherpoundassetposition,soshehashedgedherexposuretoexchangeraterisk.Shehasahedgedorcoveredinternationalinvestment.InternationalfinancialinvestmentSecond,shecanwaitandconvertbackintodollarsatthefuturespotexchangerate,theonethatwillexistayearfromnow.Shedoesnotknowforsurewhatthisfuturespotexchangeratewillbesoherinvestmentisexposedtoexchangeraterisk.Thisunhedgedinvestmenthasaspeculativeelementtoit,anditiscalledanuncoveredinternationalinvestment.InternationalfinancialinvestmentTwokindsofinternationalfinancialinvestmentCoveredinternationalinvestmentIftherateatwhichthefuturesaleofforeigncurrencywilloccurislockedinnowthroughaforwardexchangecontract,therewillbeacoveredinternationalinvestment.UncoveredinternationalinvestmentIfthefuturesaleofforeigncurrencywilloccuratthefuturespotrate,wehaveauncoveredinternationalinvestment.InternationalinvestmentwithcoverSpotrate(directquotation):eForwardrate(directquotation):fDomesticinterestrate:idForeigninterestrate:ifInternationalinvestmentwithcoverTwowaystoinvestforadomesticinvestorwithaprincipalof1.Investindomesticassetsforayear,theinvestorcanget(1+id)inayear.Investinforeignassetsforayear,theinvestorcanget1/e·(1+if)·fInternationalinvestmentwithcoverInternationalinvestmentwithcoverSupposewewanttoconvertpresentdollarsintofuturedollars.WecouldrouteourmoneythroughBritain,buyingpoundinthespotmarket,obtaining1/epoundsforeachdollar.Wewouldtheninvestthesepoundsatinterestandhave(1+iUK)/epoundsatmaturityforeachinitialdollar.Atthetimeoftheinvestmentwealsoselltheupcomingpoundsintheforwardmarket(attherateoff)togetanassurednumberofdollarsinthefuture.Overall,thisyields(1+iUK)×f/efuturedollarsforeverydollarinvestednow.OrwecouldsimplyinvestourmoneyatinterestinAmerica,getting(1+iUS)futuredollarsforeverypresentdollar.InternationalinvestmentwithcoverWhichroadweshouldtakedependsonthesignofthedifferencebetweenthetworeturns.Thisdifferenceissometimescalledthecoveredinterestdifferential(CD):CD=(1+iUK)×f/e-(1+iUS)CD>0:investinginBritainCD<0:investinginAmericaCD=0:investinginBritainandAmericaarethesameInternationalinvestmentwithcoverDefinitionofforwardpremiumForwardpremiumistheproportionatedifferencebetweenthecurrentforwardexchangerateandcurrentspotrate.ThatisF=(f-e)/eF>0:atpremiumF<0:atdiscountF=0:atparorflatInternationalinvestmentwithcoverThecoveredinterestdifferentialisapproximatelyequaltotheforwardpremiumonthepoundplustheinterestratedifferential:CD=F+(iUK-iUS)
Thisformulashowsthatthenetincentivetoinvestindomesticassetsorforeignassetsdependsonhowtheforwardpremiumontheforeigncurrencycompareswiththedifferencebetweentheinterestrates.CoveredInterestArbitrageWhatisacoveredinterestarbitrage?Coveredinterestarbitrageisbuyingacountry’scurrencyspotandsellingthatcountry’scurrencyforward,tomakeanetprofitfromthecombinationofthedifferenceininterestratesbetweencountriesandtheforwardpremiumonthatcountry’scurrency.Coveredinterestarbitrageissuchasurethingthatitisanendangeredspecies.Aprofitablecoveredinterestarbitrageopportunityisusuallygonewithinaminuteortwo.CoveredInterestParityWhatiscoveredinterestparity?CoveredInterestparitymeansCD=0Acurrencyisataforwardpremium(discount)byasmuchasitsinterestrateislower(higher)thantheinterestrateintheothercountry(thatisF≈id-if)Theoverallcoveredreturnonaforeign–currencyinvestmentequalsthereturnonacomparabledomestic-currencyinvestment(F+if≈id)Coveredinterestparityisano-arbitrageconditioninfinancialmarket.CoveredInterestParityCoveredinterestparityprovidesanexplanationfordifferencesbetweencurrentspotandcurrentforwardexchangerates.Thecountrywithlowerinterestratewillhaveaforwardpremiumonitscurrency,withthepercentagepointdifferenceintheinterestratesequaltothepercentforwardpremium.Thecountrywithhigherinterestratewillhaveaforwarddiscountonitscurrency,withthepercentagepointdifferenceintheinterestratesequaltothepercentforwarddiscount.CoveredInterestParityCoveredinterestparitylinkstogetherfourrates:e,f,idandif.Ifoneoftheserateschanges,thenatleastoneoftheotherratesalsomustchangetomaintaincoveredinterestparity.FromCD=1/e·(1+if)·f-(1+id),andletCD=0wecangetf/e=(1+id)/(1+if)Thecurrentspotandcurrentforwardratesarehighlypositivelycorrelatedovertime.InternationalinvestmentwithoutcoverUncoveredinternationalfinancialinvestmentinvolvesinvestinginafinancialassetdenominatedinaforeigncurrencywithouthedgingorcoveringthefutureproceedsoftheinvestmentbackintoone’sowncurrency.Inthesimplestcase,theforeigncurrencyproceedswillbetranslatedbackintodomesticcurrencyusingwhateverspotexchangerateexistsatthefuturedate(eitheractually,ortocalculatewealthandoverallreturnsinone’sowncurrency).Thefuturespotrateisnotknownforsureatthetimeoftheinitialinvestment,sotheinvestmentisexposedtoexchangeraterisk(assumingthattheinvestorhasnootheroffsettingliabilityinthiscurrency).
InternationalinvestmentwithoutcoverTheinvestor’sexpectedfuturespotrate(eex)canbeusedtodetermineanexpectedoverallreturnontheuncoveredinternationalinvestment.Wefirstbuypoundsinthespotmarket,obtaining1/epoundsforeachdollar.Wetheninvestthesepounds,andwewillhave(1+iUK)/epoundsatmaturityforeachinitialdollar.Wehaveanexpectationthatwecanconvertthesepoundsbackintodollarstherateofeextoobtain(1+iUK)×eex/efuturedollarsexpectedforeachdollarinvestednow.Thiscanbecomparedtothefuturedollars(1+iUS)thatwecouldobtainsimplybyinvestingeachpresentdollarinadollar-denominatedasset.InternationalinvestmentwithoutcoverTwowaystoinvestforadomesticinvestorwithaprincipalof1.Investindomesticassetsforayear,theinvestorcanget(1+id)inayear.Investinforeignassetsforayear,theinvestorexpectstoget1/e·(1+if)·EfinayearInternationalinvestmentwithoutcoverThedefinitionanduseofexpecteduncoveredinterestdifferential(EUD)EUD=1/e·(1+if)·Ef-(1+id)EUD>0:investingabroadEUD<0:investingathomeInternationalinvestmentwithoutcoverDefinitionofexpectedrateofappreciationExpectedrateofappreciationistheproportionatedifferencebetweentheexpectedexchangerateandcurrentspotrate.ThatisEF=(Ef-e)/eThenEUD≈EF+(if-id)Thisformulashowsthatthenetincentivetoinvestindomesticassetsorforeignassetsdependsonhowtheexpectedrateofappreciationontheforeigncurrencycompareswiththedifferencebetweentheinterestrates.IfyourearrangetheformulaasEUD≈(EF+if)-id,thenyoucangetanotherinterpretationoftheformula.InternationalinvestmentwithoutcoverIfanuncoveredforeignfinancialinvestmentisexposedtoexchangeraterisk,whywouldanyonewanttoinvestuncovered?Theexpectedoverallreturnontheuncoveredinvestmentmaybehigherthanthereturnthatcanbeobtainedathome(EUDispositive)Thecontributionofuncoveredinvestmentcanlowertheriskinessoftheinvestor’sfullinvestmentportfoliobecauseofthebenefitsofdiversificationofinvestments.InternationalinvestmentwithoutcoverUncoveredinterestparityTheassumptionofriskneutralUncoveredinterestparitymeansEUD=0Acurrencyisexpectedtoappreciate(depreciate)byasmuchasitsinterestrateislower(higher)thantheinterestrateintheothercountry.WhichmeansEF≈id-ifTheexpectedoveralluncoveredreturnontheforeign-currencyinvestmentequalsthereturnonthedomesticcurrencyinvestment.WhichmeansEF+if≈id.InternationalinvestmentwithoutcoverUncoveredinterestparitylinkstogetherfourrates:e,Ef,idandif.Ifoneoftheserateschanges,thenatleastoneoftheotherratesalsomustchangetomaintaincoveredinterestparity.1/e·(1+if)·Ef=1+idExercise1.Thecurrentspotexchangerateis$0.010/yen.
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