The purpose of this assignment is to analyse whether the Covered Interest Rate Parity (CIRP) holds in the relationship between two actual currencies. I decided to focus on the euro and the dollar because it is the financial instrument the most active and the most used in the world. Since the euro has been introduce in 1999 its value has fluctuated vis a vis the dollar. At the beginning it has lost some of its value, then it appreciated and now its value is widely above the one in 1999. €uro has reached its peak vis a vis the dollar in November 2007 at USD $1.45/1€. Ups and downs of the exchange rate have coincided with variations of the interest rates between investments in the Euro zone and in the US. CIRP links these two variables and when it holds, investments made in two different countries should have the same value at the end of the period.
[...] At the contrary the forward exchange rate is the rate fixed at the present time for a delivery of the purchased currency at a future date (one month, three months, six months, one year). Since the collapse of the Bretton Woods system (established after the Second World War) in August 1971 (end of the convertibility of US dollar into gold) the floating exchange rates system came into effect (Jamaica agreement). It means that the value of one currency vis a vis another currency can depreciate or apprise. [...]
[...] Conclusion We have seen in the first part of this assignment that CIRP does not hold. In other words, arbitrage opportunities exist but they are not significant deviations from CIRP (Taylor, 2002). But we did not take in account the transaction costs, which can be higher than the arbitrage profits. Indeed, the fact that we take middle rates instead of exact rates can distort the result. Covered interest arbitrage is profitable only if its guaranteed return exceeds the attendant transaction costs. [...]
[...] ‘Exchange rates and interest rate differentials: recent developments since the introduction of the euro', Monthly report of the Deutsche Bundesbank, July 2005, Vol 57 (iss p27 42. Seshan, A (2006), ‘Covered Interest Rate Parity', BusinessLine Taylor, M (2002), ‘Covered Interest Rate arbitrage in the interwar period and the Keynes-Einzig conjecture', Journal of money, credit and banking, February 2002. [...]
[...] Collect foreign exchange spot and forward rate data and interest rate data for two currencies: examine whether CIRP holds: analyze and discuss the results Introduction The purpose of this assignment is to analyse whether the Covered Interest Rate Parity (CIRP) holds in the relationship between two actual currencies. I decided to focus on the euro and the dollar because it is the financial instrument the most active and the most used in the world. Since the euro has been introduce in 1999 its value has fluctuated vis a vis the dollar. [...]
[...] There is the possibility to exploit the interest rate differential for a free-risk investment and profit by investing dollar in Eurozone. But as we proved, differential profit is very small, about (See figure 1). Figure 1 But the question is not whether observed deviations from covered interest parity are statistically significant but instead whether they represent the opportunity of a risk-free profit. We need to take in account the transaction costs which can reduce arbitrage opportunities or even prevent arbitrage opportunities from existing. [...]
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