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The economic theories that link exchange rates, price levels, and interest rates together are called international parity conditions.
These international parity conditions form the core of the financial theory that is unique to international finance.
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the theory holds better for countries with relatively high rates of inflation and underdeveloped capital markets.
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Exhibit 7.3 IMFs Real Effective Exchange Rate Indexes for the United States, Japan, and the Euro Area (2000 = 100)
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Where i = nominal interest rate, r = real interest rate and = expected inflation.
Empirical tests (using ex-post) national inflation rates have shown the Fisher effect usually exists for short-maturity government securities (treasury bills and notes).
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S2
= i$ - i
Where i$ and i are the respective national interest rates and S is the spot exchange rate using indirect quotes (/$). Justification for the international Fisher effect is that investors must be rewarded or penalized to offset the expected change in exchange rates.
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[1 + (i$ x 90/360)]
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SF
= Spot Forward
Forward
This is the case when the foreign currency price of the home currency is used (SF/$).
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Exhibit 7.8 Uncovered Interest Arbitrage (UIA): The Yen Carry Trade
In the yen carry trade, the investor borrows Japanese yen at relatively low interest rates, converts the proceeds to another currency such as the U.S. dollar where the funds are invested at a higher interest rate for a term. At the end of the period, the investor exchanges the dollars back to yen to repay the loan, pocketing the difference as arbitrage profit. If the spot rate at the end of the period is roughly the same as at the start, or the yen has fallen in value against the dollar, the investor profits. If, however, the yen were to appreciate versus the dollar over the period, the investment may result in significant loss.
Copyright 2010 Pearson Prentice Hall. All rights reserved.
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Exhibit 7.10 Forward Rate as an Unbiased Predictor for Future Spot Rate
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Chapter 7
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