Preparing for A Summer Vacation (and what it says about arbitrage) Roberto Chang January 2013 Econ...
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![Page 1: Preparing for A Summer Vacation (and what it says about arbitrage) Roberto Chang January 2013 Econ 336.](https://reader035.fdocuments.us/reader035/viewer/2022072009/56649d8c5503460f94a731db/html5/thumbnails/1.jpg)
Preparing for A Summer Vacation(and what it says about arbitrage)
Roberto ChangJanuary 2013
Econ 336
![Page 2: Preparing for A Summer Vacation (and what it says about arbitrage) Roberto Chang January 2013 Econ 336.](https://reader035.fdocuments.us/reader035/viewer/2022072009/56649d8c5503460f94a731db/html5/thumbnails/2.jpg)
The “problem”
• My son and a friend of his are graduating from high school and saving for a big celebratory “Euro Trip”
![Page 3: Preparing for A Summer Vacation (and what it says about arbitrage) Roberto Chang January 2013 Econ 336.](https://reader035.fdocuments.us/reader035/viewer/2022072009/56649d8c5503460f94a731db/html5/thumbnails/3.jpg)
![Page 4: Preparing for A Summer Vacation (and what it says about arbitrage) Roberto Chang January 2013 Econ 336.](https://reader035.fdocuments.us/reader035/viewer/2022072009/56649d8c5503460f94a731db/html5/thumbnails/4.jpg)
The exchange rate question
• They say they will need, say, about 1000 Euros each, by July (six months from now).
• Since the dollar/Euro exchange rate can move a lot, they are wondering what is the best way to plan to have that amount for the July trip.
![Page 5: Preparing for A Summer Vacation (and what it says about arbitrage) Roberto Chang January 2013 Econ 336.](https://reader035.fdocuments.us/reader035/viewer/2022072009/56649d8c5503460f94a731db/html5/thumbnails/5.jpg)
Covering with a forward contract
• A forward contract is an agreement to exchange currencies at a given date in the future, at a given price (the forward rate)
• So, one way to have € 2000 in six months is to set aside some amount of dollars (say, x) in an interest bearing account and enter a forward contract to exchange x*(1 + i$) dollars for Euros in July
![Page 6: Preparing for A Summer Vacation (and what it says about arbitrage) Roberto Chang January 2013 Econ 336.](https://reader035.fdocuments.us/reader035/viewer/2022072009/56649d8c5503460f94a731db/html5/thumbnails/6.jpg)
• Let F€/$ be the forward exchange rate.
• Then for the plan to succeed,
x * (1 + i$) * F€/$ = € 2000
that is, x = € 2000 / [(1 + i$) * F€/$ ]
![Page 7: Preparing for A Summer Vacation (and what it says about arbitrage) Roberto Chang January 2013 Econ 336.](https://reader035.fdocuments.us/reader035/viewer/2022072009/56649d8c5503460f94a731db/html5/thumbnails/7.jpg)
Is there another way?
• There is an alternative: my son could take some amount of dollars today, say y dollars, exchange them for Euros today, and save the Euros in an interest bearing Euro account
• If the (spot) exchange rate today (Euros per dollar) is E€/$ and the interest rate on Euro deposits is i€, we need
z* E€/$ *(1+ i€) = € 2000
![Page 8: Preparing for A Summer Vacation (and what it says about arbitrage) Roberto Chang January 2013 Econ 336.](https://reader035.fdocuments.us/reader035/viewer/2022072009/56649d8c5503460f94a731db/html5/thumbnails/8.jpg)
z* E€/$ *(1+ i€) = € 2000
Or, equivalently, z = € 2000/[E€/$ *(1+ i€) ]
![Page 9: Preparing for A Summer Vacation (and what it says about arbitrage) Roberto Chang January 2013 Econ 336.](https://reader035.fdocuments.us/reader035/viewer/2022072009/56649d8c5503460f94a731db/html5/thumbnails/9.jpg)
There is no free lunch!
• Summarizing, there are two ways to plan to have two thousand Euros by July:
x = € 2000 / [(1 + i$) * F€/$ ]
z = € 2000/[E€/$ *(1+ i€) ]• But x and z must be equal!! • Why? Suppose x < z. Then by borrowing the €
2000, obtaining z dollars today, and investing x in dollars, one would make z – x.
![Page 10: Preparing for A Summer Vacation (and what it says about arbitrage) Roberto Chang January 2013 Econ 336.](https://reader035.fdocuments.us/reader035/viewer/2022072009/56649d8c5503460f94a731db/html5/thumbnails/10.jpg)
• It follows that no arbitrage requires:x = € 2000 / [(1 + i$) * F€/$ ]
= z = € 2000/[E€/$ *(1+ i€) ]
that is(1 + i$) * F€/$ = E€/$ *(1+ i€)
orF€/$ = E€/$ *(1+ i€)/ (1 + i$)
![Page 11: Preparing for A Summer Vacation (and what it says about arbitrage) Roberto Chang January 2013 Econ 336.](https://reader035.fdocuments.us/reader035/viewer/2022072009/56649d8c5503460f94a731db/html5/thumbnails/11.jpg)
Covered Interest Parity
• The condition F€/$ = E€/$ *(1+ i€)/ (1 + i$)
is known as covered interest parity. As seen, it is an implication of no arbitrage.• This can be used to infer the forward exchange
rate. Today, E€/$ = 0.75, i$ = 0.0015, i€ = 0.00105, so the forward rate should be:
F€/$ = 0.75* (1.00105)/(1.0015) = 0.7496