Question

Question 2

a. Explain the difference between UIP and CIP, and specifically how CIP leads to UIP.

b. When there is a forward discount, what condition must be true (in CIP or UIP)? Explain how that condition leads to a forward discount.

c. Suppose you have the following spot exchange rates: USD/AUD 0.5300 AUD/EUR 1.6428 USD/EUR 0.8782

1. Calculate the US dollar profit (per 1 USD), if any, on a three-point arbitrage.

2. Calculate AUD profit (per 1 AUD), if any, on a three-point arbitrage.

3. How can you explain the answers in (1) and (2)?

Answer 1

a. Uncovered interest parity (UIP) theory states that the difference in interest between two countries will equal to the relative changes in currency foreign exchange rates over the same period.

- if the UIP theory relationship doesnt hold good then there is an opportunity to make risk free profit by using currency arbitrage. This is calles Covered Interest Parity(CIP).

- According to UIP Theory,

   Fo= S0(1+ia)/ (1+ ib)

where Fo= Forward price, So= spot price

   ia= inst rate in country a

   ib = interest rate in country b

- CIP will ultimately lead to UIP.

-

For example , Spot rate = $1 = Rs.50 one yaer Forward rate = $1= 52 $ interest rate = 1% Rs. Interest rate =2$ according to UIP theory Forward rate should be $1= Rs.50(1.02)/$1.01 = Rs.50.50 as the Forward $ is selling in premium hence all the incestor will start buying $,which will ultimately leads to reduction in $ price to 50.50 in one year.

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b. only in CIP(Covered interest parity) theory there is concept of forward premium or discount. currency of the Country having highest interest will lead that current to trade in forward dicount.

-country having highest interets rate will attract more investors which initially leads that country currency to trade in premium for short time. But after time passage when the investors want to convert the returns of that country to their respective foreign exchange they will start selling that country curreny which will lead to forward discount for that currency.

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c. 1&3

Arbitrage profit in Per USD.

AUD 1 =USD 0.5300

EUR 1 =AUD 1.6428

EUR 1 = USD 0.8782

1. Give USD 0.8707 & buy AUD	USD 0.8707
2.AUD to be recived (USD 0.8707/0.5300)	AUD 1.6428
3.GIVE AUD 1.6428 and buy EUR	EUR 1
4.Give EUR 1 and receive USD	USD 0.8782
Arbitrage gain(4-1)	USD 0.0075

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C. 2 & 3

1. Give AUD 1.6428	AUD 1.6428
2.Give AUD 1.6428 & Receive EUR 1	EUR 1
3.Give EUR 1 & receive USD	USD 0.8782
4.Give USD nad receive AUD(USD0.8782/USD0.5300)	AUD 1.6570
Arbitrage gain(4-1)	AUD 0.0142