5. Given the following information and international parity conditions, estimate

Question

5. Given the following information and international parity conditions, estimate the investment return and future exchange rate movement Currency 1-Yr LIBOR Currency Pair Spot JPY 0.10% JPY/CAD 96.3719 CAD 1.00% CAD/GBP 1.588 0.65% JPY/GBP 153.0408 GBP 1) Calculate the one year investment return to a Canadian investor whose cur- rency exposure to GBP is fully hedged if covered interest parity holds. 2) Forecast JPY/GBP exchange rate one year from now if uncovered interest parity holds. 3) What is the expected movement of JPY/CAD one year from now if uncovered interest rate parity holds.

Explanation / Answer

1)

We have CAD/GBP Spot = 1.588

Therefore, GBP/CAD spot = 1/1.588 = 0.6297

We have the following equation for Covered interest parity.

Ff/d=Sf/d(1+if[Actual/360] / 1+id[Actual/360])

Here, duration is 1 year so actual = 360 days

Thus, we have Ff/d=Sf/d(1+if / 1+id)

Here, if and id are foreign(UK) and domestic(Canada) risk free rates.

Sf/d is spot rate (GBP/CAD) and Ff/d is the forward rate.

Ff/d = 0.6297*(1.0065/1.01) = 0.6275

After one year, the Canadian investor will be able to convert 0.6275 units of GBP per unit of CAD

His initial 0.6297 units of GBP will grow to 1.0065*0.6297 = 0.6338 GBP units

Thus, the Canadian investor will get 0.6338*(1/0.6275) units of CAD = 1.01 units of currency for the initial investment of 1 CAD. Return = 1.004%

2)

We have Spot JPY/GBP = 153.0408

Uncovered interest rate parity states that the expected forward rate movement in the foreign currency (JPY) is equal to the interest rate differentials between domestic and foreign currencies, if – id

Here, if – id = 0.1- 0.65 = -0.55%

Which means that in 1 year, expected %age change in the value of JPY/GBP = -0.55%

That is, one year hence JPY/GBP = 153.0408*(1-0.0055) = 152.1990

3)

Following the same approach as for question 2 above we get,

if – id = 0.1-1 = -0.9%

One year hence JPY/CAD = 96.3719*(1-0.009) = 95.504553

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