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Author Topic: Interest Rate Partiy Example Philipp S.  (Read 1498 times)

Offline Philipp

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Interest Rate Partiy Example Philipp S.
« on: February 24, 2010, 10:50:15 pm »
Interest Rate Parity Example

1-year Japanese bonds pay 4% interest       => Rf =0.04
1-year US Treasury notes pay 9 % interest     => Rd=0.09
Japanese Yen / dollar spot rate is              => S = 90 Yen / $
1-year Japanese Yen / dollar Forward rate is   => F = 85 Yen / $

Is dollar at a forward premium or a discount?

90 Yen (S)  >  85 Yen (F)  -> forward discount

Does the IRP hold?
   F / S = (1+ Rf) / (1+ Rd)
   85 / 90 = 1.04 / 1.09
   0.94≠0.95 -> Parity does not hold!

4% interest is too high and 9% interest for Rd is too low.
If Rf declines to 2.46 % IRP will be hold. Or Rd will raise to 10.64% IRP will be hold.

1. ) Borrow money in the US for a cheap interest rate.
(10,000,000)*(1.09) = 10,900,000 $ -> next year

2. ) Exchange the borrowing to JPY
$ 10,000,000 *  90 Yen/$  =  900,000,000 Yen

3.) Loan this money at 4 %
900,000,000 Yen * 1.04 = 936,000,000 Yen -> next year

4.) Buy US-$ one-year forward
10,900,000 $  x  85 Yen/$ = 926,500,000 Yen

5) Arbitage Profit: 936,000,000 Yen  -  926,500,000 Yen = 9,500,000 Yen