Question 4 (Interest Rate Parity) a) Extract and plot using a line graph the JA and US Nominal Interest Rate

from 2000 to 2011. b) Does interest parity hold between JA and US over the same period? Use the uncovered interest parity formula to support your answer. c) Use the interest parity relationship discussed to predict the movement in the JA and US interest rate. Justify your predictions. d) Identify factors that can account for deviations from interest rate parity. Explain how each identified factor causes a deviation.

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I. Introduction Interest Rate Parity Interest rate parity, also known as the asset approach to exchange rate determination, results from investors seeking to make a profit by obtaining higher interest rates in foreign markets thus covering their risk. It refers to a condition of equality between the rates of return on comparable assets between two countries. The interest rate parity theory states that the forward rate (F) differs from the spot rate (E) at equilibrium by an amount equal to the interest differential (id - if) between two countries. For interest parity to hold, both sided of the equation must be equal. The interest rate differential is given by the interest rate of the domestic country minus the interest rate of the foreign country ie (id - if). This must be equal to the forward or discount premium given by the forward rate minus the spot rate divided by the spot rate ie ((F - E)/E). Covered return refers to the domestic currency value of a foreign investment when the foreigncurrency proceeds are sold in the forward market (Husted and Melvin 2010). Covered interest rate parity states that the interest rate differential is equal to the forward discount (or premium). This is achieved when there is no more opportunities for profit. The forward rate relates to the spot and domestic and foreign interest rates. If the domestic interest rate is higher than the foreign interest rate then the currency will be at a forward premium. Whereas if the domestic interest rate is lower than that of the foreign interest rate then then the currency will be at a discount.

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Part C Uncovered interest rate parity (UIRP) predicts that high yield currencies should be expected to depreciate. It also predicts that, ceteris paribus, a real interest rate increase should appreciate the currency (Bekaert et al 2007). The fisher equation states that nominal interest rates are equal to the real interest rates plus expected inflation. Interest rates are equalized across countries when the fisher equation, interest parity and relative purchasing power parity all hold. According to the fisher effect, countries with higher inflation rates have higher interest rates. The interest rates in Jamaica from the years 2000 to 2011 are significantly higher than that of the USA over the same period. From 2000 to 2003 the interest rates of the two countries diverged, moving even farther apart in 2003. With this divergence over the four year period, the interest rate currency of Jamaica is expected to depreciate at an increasing rate over time. Since the interest rate differential (Jamaica interest rate minus US interest rate) is not equal to the expected change in the Exchange rate then there will be movements in the interest rate and exchange rate markets. In this case because the Jamaican interest rate is higher than the US interest rate by an amount greater than the exchange rate change, then the return to investments in Jamaica will be greater for investors. Because of this, investors will move the assets to Jamaica to take advantage of this higher return. When investors begin to move their assets to Jamaica they will demand more Jamaican dollars. This will result in an increase the expected exchange rate change. Simultaneously, with the influx of investments, the interest rate offered in Jamaica will start to diminish. This is because there will be a increasing supply of investments at the particular interest rates. The result is a steady decline in the Jamaican interest rate. This series of events

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will carry on until the expected change in the exchange rate is equal to the interest rate differential. The periods 2004 to 2007 reflected a convergence in the term structure as the two term structures moved closer together, the high interest rate currency is expected to depreciate at a declining rate relative to the low-interest rate currency. Part D Transaction costs is a factor which causes interest rate parity to deviate. Transaction costs are the costs which are incurred while buying or selling different securities. These usually include commission of the forex broker, costs associated with information gathering and processing, brokerage fees, and the spreads the difference between the price the dealer paid for a security and the price at which it can be sold. The cost of buying and selling of securities and foreign exchange may be less than or equal to those costs of the deviations from interest parity that exists from making the required transactions. Speculators therefore are unable to make a profit due to these deviations due to these costs. The costs of the transaction covers any possible profit. An important determinant of whether this is the case is the trade price disclosure regime}in markets with little post-trade transparency, dealers can more easily rebate transaction costs for informed traders to subsequently benet from such purchased information in follow-on trading or pricesetting (Ramadorai 2008). Interest rate parity may not hold due to differential taxation. The differences in the rate of taxation across countries may cause the same investment to yield different returns. The income on interest is often times taxed differently than that from capital gains. Where a situation like this

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exist, arbitrage will not equate the forward premium to the interest differential causing interest parity not to hold. Also, capital controls causes deviation from interest parity. Capital control are measures taken by a governing body, the central bank or any regulatory body that limits the flow of foreign capital in and out of the domestic economy. This includes taxes, tariffs, outright legislation and volume restrictions, as well as market-based forces. If there are government barriers on the movement of capital, such as of the buying and selling of foreign exchange and international securities this interferes with interest rate parity. The government may prohibit domestic residents from buying a certain amount of securities in foreign investments. This would cause the arbitrage opportunities to become obsolete. With the absence of arbitrage there will be inequality between interest rate differentials and exchange rate as there will be no market to resolve the difference. In addition, time lags between observing opportunity for profit and making the trade to take advantage of it will distort interest rate parity. Political risks arising from uncertainty of potential political decisions causes interest parity to deviate. Even with the absence of capital controls, government plays a role in interest rate activities. Investors may be reluctant to shift their investments across countries because of fear that overseas government may freeze their assets and interfere with their return due to political instability and other factors. This will result in a persistent gap between interest rates that is independent of the exchange rate between countries. Thus interest parity would not hold.

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Appendix Part A Nominal Interest Rates for Jamaica and the United States of America. 2000-2011 Years Jamaica (%) USA (%) 2000 18.32 5.83 2001 15.7 1.72 2002 15.68 1.20 2003 19.86 0.89 2004 13.9 2.20 2005 12.69 3.89 2006 11.60 4.84 2007 12.51 3.08 2008 21.79 0.04 2009 15.50 0.07 2010 7.21 0.15 2011 6.26 0.02

NOMINAL INTEREST RATES FOR JAMAICA AND THE UNITED STATES 2000-2011
Jamaica 25 21.79 20 18.32 15 10 5 0 2000 2001 5.83 3.89 1.72 1.20 2002 0.89 2003 2.20 2004 2005 2006 15.7 15.68 13.9 12.69 11.60 12.51 7.21 4.84 3.08 2007 0.04 2008 0.07 2009 0.15 2010 0.02 2011 19.86 15.50 USA

6.26

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Part B. Calculation of Uncovered Interest Parity

[ iJ $ iUS $

Et 1 Et ] Et Et 1 Et iJ $ iUS $ Et 0.0696379 12.49 0.0533854 13.98 0.1934487 14.48 0.0588641 18.97 0.018911 11.70 0.05408 8.80 0.0482696 6.76 0.0558934 9.43 0.2135217 21.75 -0.0125438 15.43 -0.0148775 7.06 6.24

Year Jamaica 2000 18.32 2001 15.7 2002 15.68 2003 19.86 2004 13.9 2005 12.69 2006 11.6 2007 12.51 2008 21.79 2009 15.5 2010 7.21 2011 6.26

USA 5.83 1.72 1.20 0.89 2.20 3.89 4.84 3.08 0.04 0.07 0.15 0.02

E t 1
46.08 48.54 57.93 61.34 62.5 65.88 69.06 72.92 88.49 87.38 86.08

Et
43.08 46.08 48.54 57.93 61.34 62.5 65.88 69.06 72.92 88.49 87.38 86.08

Interest rate parity does not hold for any of the periods 2000-2011 as the interest rate differential E Et [ iJ $ iUS $ ] and the forward premium (or discount) [ t 1 ] are not equal at any year. Et

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Exchange Rate between Jamaica and the United States 2000-2011. Year 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 USD$ 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 JMD$ 43.08 46.08 48.54 57.93 61.34 62.50 65.88 69.06 72.92 88.49 87.38 86.08

$ $ $ $ $ $ $ $ $ $ $ $

$ $ $ $ $ $ $ $ $ $ $ $

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Reference Melvin, M & Hustead, S, (2010). International Economics, Eighth Edition.

Ramadorai,T. (2008). What determines transaction costs in foreign exchange markets? International Journal of Finance and Economics. Int. J. Fin. Econ. 13: 14 25.

Websites:
http://www.boj.org.jm/foreign_exchange/fx_rates_annual.php http://www.boj.org.jm/statistics/econdata/stats_list.php?type=5 Comparative Bank Rates and Treasury Bill Rates.

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