Week 7 International Economics: Theory And Policy Questions

CIP
Name:
Instructor:
Institution:
Date:
QUESTION 1
What is covered interest parity? What are the two assumptions of covered interest parity? How do investors use covered interest arbitrage to maximize their investment returns?
Covered interest rate parity, commonly referred with its initials as CIP, is a condition that establishes some form of physical regulations when it comes to matters concerning international finance. In so doing, it stipulates that the differential when it comes to the nominal rates of two different nations should be equal to the resultant forward premium thereof. In other terms, the differentials in the currencies of two or more nations in the international markets should match up, or be the identical in results, to the forward as well as the spot exchange rates. The resultant effect of this is that there is no defined opportunity for interest rates between the two countries. There are two main assumptions done by CIP. First is that there is a perfect capital mobility.
First of all, capital mobility usually refers to the capability, ability and the ease of private cash to flow to circulate within and outside a nation’s boundary, in efforts to make more profits. Capital mobility is usually dictated to a great extent, by the restrictions and controls placed upon cash inflows and outflows by the government (Krugman, Obstfeld, & Melitz, 2013). For CIP, assumption of a perfect capital mobility means that there is no restrictions at all, and that such cash flows seamlessly across the respective economies.
The second assumption made in CIP is that there is an identical level of risk when it comes to the instruments of debt that are calibrated in terms of both domestic as well as foreign currencies. Interest rates usually vary per country, depending on the economic cycles and factors affecting it periodically. These variations however, also provide a window of opportunity for investors. The amount of profit realized from CIP arbitrage is typically minimal, especially in highly competitive economies, or in those that enjoy minimal levels of asymmetry in information. What now brings about substantial profits is the volume of the whole (Krugman, Obstfeld, & Melitz, 2013).
When a large volume, each making these minimal profits is treated as a bundle, hence resulting in greater profits. Such opportunities are usually not so common, since, many people often rush to take advantage of the openings, thereby quickly resulting in a market correction of the imbalance. The best way investors take advantage of the situation is that they engage in market transactions that are simultaneously spot and forward.
They engage in such an exercise, since they target that at the end of it all, they manage to make profits that are bereft of much risk, through taking or enjoying the benefits of the security provided by two different currencies. For example, given that at the current CIP rate, the dollar is cheaper than the Franc in the forward market, then a brilliant investor with the ability to borrow the dollars at the present rates can easily benefit. This is by engaging in a swap that would see him disposing off the dollars at the current rate, also referred to as the spot rate; and then buying ...