ChapterFour

ForwardExchangeandInternationalFinancialInvestmentForwardExchangeandInternationalFinancialInvestmentExchangeraterisk,hedgingandspeculatingThemarketbasicsofforwardforeignexchangeCoveredinternationalinvestmentanduncoveredinternationalinvestmentEXCHANGERATERISKSomeimportantfacts:Spotexchangerateschangefromminutetominuteinafloating-ratesystem.(appreciationordepreciation)Inafixed-ratesystem,spotexchangeratealsochangefromminutetominute,buttherangeoftherateislimitedtoasmallbandaroundtheparvalueaslongasthefixedrateisdefendedsuccessfullybythegovernmentauthorities.Whenthefixed-ratesystemcollapses,largechangesofexchangeratewilloccur.(devaluationorrevaluation)EXCHANGERATERISKEXCHANGERATERISKEXCHANGERATERISKWhatisexchangerisk?Currencyriskisaformofriskthatarisesfromthechangeinpriceofonecurrencyagainstanother.Wheneverinvestorsorcompanieshaveassetsorbusinessoperationsacrossnationalborders,theyfacecurrencyriskiftheirpositionsarenothedged.Aperson(oranorganization)holdinganetassetposition(alongposition)oranetliabilityposition(ashortposition)inaforeigncurrencyisexposedtoexchangeraterisk.Thevalueoftheperson’s(ortheorganization’s)incomeornetworthwillchangeiftheexchangeratechangesinawaythatthepersondoesnotexpect.Along(orlongposition)isthebuyingofasecuritysuchasastock,

commodity

orcurrencywiththeexpectationthe

asset

willriseinvalue.Inthecontextofoptions,itisthebuyingofanoptionscontract.Alongpositionistheoppositeofashort(orshortposition).Ashort,orshortposition,isadirectionaltradingorinvestmentstrategywheretheinvestorsellssharesofborrowedstockintheopenmarket.Theexpectationoftheinvestoristhatthepriceofthestockwilldecreaseovertime,atwhichpointthehewillpurchasethesharesintheopenmarketandreturnthesharestothe

brokerwhichheborrowedthemfrom.Essentially,whenspeakingofstocks,

longpositions

arethosethatareownedand

shortpositions

arethosethatareowed.

EXCHANGERATERISKCurrencyriskexistsregardlessofwhetheryouareinvestingdomesticallyorabroad.Ifyouinvestinyourhomecountry,andyourhomecurrencydevalues,youhavelostmoney.Anyandallstockmarketinvestmentsaresubjecttocurrencyrisk,regardlessofthenationalityoftheinvestorortheinvestment,andwhethertheyarethesameordifferent.Theonlywaytoavoidcurrencyriskistoinvestincommodities,whichholdvalueindependentofanymonetarysystem.EXCHANGERATERISKYoutakeavacationinJapanandbringRMBalongwithyoutoconvertintoyenasneededtopayforyourexpensedandpurchases.EconomicexposureEconomicexposure:theriskthatacompany’sprofitswillbeerodedbyexchangeratechangesbecauseofrisingoperatingcosts.Companiesareverylimitedintheactionstheycantaketoprotectthemselvesinthissituation.TranslationexposureTranslationexposure:theriskthatexchangeratechangeswilldiminishacompany’sincome,assets,equityorliabilities.Theirdenominationisthereforesignificant—althoughsomeanalystsbelievethatrealassets(thosethatarephysicalandidentifiableratherthanfinancial)arehardlyaffectedbycurrencymovementsatall.Inaccountingstatement,remainingbalanceis1milliondollars,$1=

￥8.7$1=

￥8,dollar,lost700,000RMB.TransactionexposureTransactionexposure:theriskthatexchangerateswillchangeafteracontractisagreed,butbeforeitiscompleted(orafterborrowing/lendingagreementsareestablishedbutbeforerepaymentshavebeenmade),andthatmajorlosseswilloccurasaresult.Thisisaproblemfrequentlyfacedbycompaniesworkingininternationalmarkets.￡1=SF3.2￡1=SF2.9hold1millionpounds$1=

￥5.8$1=

￥8borrow1milliondollarsforoneyearEXCHANGERATERISKTwotypesofresponsetoexchangerateriskHedging

istheactofreducingoreliminatinganetassetornetliabilitypositionintheforeigncurrencytoreduceexposuretoexchangeraterisk.(hedgers)Speculating

istheactoftakinganetassetposition(“long”)oranetliabilityposition(“short”)insomeforeigncurrencyasset,usuallytotrytoprofitfromthebeliefaboutwhatfutureexchangerateswillbe.(speculators)ThemarketbasicsofforwardforeignexchangeHowcanwehedgeorspeculate?Wecanhedgeorspeculatebyconductingsomeforeignexchangetransactions.Infact,wecanusespottransaction,forwardtransaction,futuretransactionandoptiontransactiontohedgeortospeculate.ThemarketbasicsofforwardforeignexchangeWhatisaforwardexchangecontract?Aforwardexchangecontractisanagreementtobuyorsellaforeigncurrencyforfuturedeliveryatapricesetnow.Banksactingasforeignexchangedealersgenerallyarewillingtomeettheneedsoftheircustomersforthespecificsizeoftheforwardexchangecontractandthespecific

dateinthefuturefortheexchange.Thepricesetnowiscalledtheforwardexchangerate.ForwardforeignexchangeForwarddatesaretypically30,90,180or360daysinthefuture.Forinstance,tobuy￡100,000of90-daysforwardsterlingat$1.4/￡,yousignanagreementtodaywithyourbankthat90daysfromnowyouwilldeliver$140,000indollarbankdepositsandreceive￡100,000inpoundbankdeposits.Theexchangeoftheseamountswilltakeplacetocarryouttheforwardcontracts,regardlessofwhattheactualspotexchangerateturnsouttobein90daysDonotconfusetheforwardratewiththefuturespotrate,thefuturespotratecouldbeabove,beloworequaltotheforwardrate.ForwardforeignexchangeAforwardrateisarateapplicabletoafinancialtransactionthatwilltakeplaceinthefuture.

Thespotrate,alsocalled“spotprice,”isbasedonthevalueofanassetatthemomentofthequote.Thisvalueisinturnbasedonhowmuchbuyersarewillingtopayandhowmuchsellersarewillingtoaccept,whichdependsonfactorssuchas

currentmarketvalue

andexpectedfuturemarketvalue.Asaresult,spotrateschangefrequentlyandsometimesdramatically.

ForwardforeignexchangeAtPremium,theforwardrate>thespotexchangerateAtDiscount,theforwardrate<thespotexchangerateAtParorFlat,theforwardrate=thespotexchangerateThespotexchangerate＄1=DM2（DM1=＄0.5）Theforwardrate＄1=DM2.5（DM1=＄0.4）USD

atPremium,DMatDiscountThemarketbasicsofforwardforeignexchangeHowareforwardforeignexchangetransactionsconducted?Forlargecustomers,theydonotneedtocommitanythingotherthanthewrittenagreementuntiltheexchangeactuallyoccursinthefuture.Forothers,theymustpledgeamarginthatthebankcanseizeifthecustomerfailstofulfillthecontractinthefuture.(forwardexchangemarketisanoverthecountermarket)HedgingHowcanweuseforwardtransactiontohedge?Openpositionmeansalongpositionorashortposition.Longposition----------sellinaforwardcontractShortposition----------buyinaforwardcontractHedgingHedginginvolvesacquiringanassetinaforeigncurrencytooffsetanetliabilitypositionalreadyheldintheforeigncurrency,oracquiringaliabilityinaforeigncurrencytooffsetanetassetpositionalreadyheld.Hedgersininternationaldealingsarepersonswhohaveahomecurrencyandseekabalancebetweentheirliabilitiesandassetsinforeigncurrencies.Infinancialjargon,hedgingmeansavoidingbothkindsof“open”positioninaforeigncurrency---both“long”positions(holdingnetassetsintheforeigncurrency)and“short”positions(owingmoreoftheforeigncurrencythanoneholds).BuyingHedgingConsideraU.S.companythathasboughtsomemerchandiseandwillhavetopay￡100,000threemonthsfromnow.Assumingthatthisrepresentsanoverallnetliabilitypositioninpounds(perhapsbecausethecompanyhasnootherassetsorliabilitiesinpounds),thecompanyisexposedtoexchangeraterisk.Itdoesnotknowthedollarvalueofitsliabilitybecauseitdoesnotknowthespotexchangeratethatwillexist90daysfromnow.BuyingHedgingOnewaytohedgeitsriskexposureistoenterintoaforwardcontracttoacquire(orbuy)￡100,000in90days.Ifthecurrentforwardrateis$1.4/￡,thenthecompanymustdeliver(orsell)$140,000in90days.Thecompanyhasanassetpositioninpoundsthroughmatchesitspoundliabilitytopayforthemerchandise,creatinga“perfecthedge”.Thecompanynowisassuredthatthemerchandisewillcost$140,000regardlessofwhathappenstothespotexchangerateinthenext90days.SellingHedgingConsideraU.S.companythatwillreceiveapaymentof￡1millionin60daysisunsureofthedollarvalueofthisreceivable,becausethespotexchangeratein60daysisuncertain.Itcanhedgebysellingpounds(andbuyingdollars)ina60-dayforwardexchangecontract,

usingtheforwardexchangeratetolockinthenumberofdollarsitwillreceive.SpeculateHowcanweuseforwardtransactiontospeculate?(whoisaspeculator?)Ifyouexpectacurrencytoappreciate----buyitinaforwardcontractIfyouexpectacurrencytodepreciate----sellitinaforwardcontractForwardcontractisveryrisky.SpeculateSpeculatingmeanscommittingoneselftoanuncertainfuturevalueofone’snetworthintermsofhomecurrency.

Aspeculatorisanybodywhoiswillingtotakeanetpositioninaforeigncurrency,whateverhismotivesorexpectationsaboutthefutureoftheexchangerate.Ifaspeculatorthinksshehasafairlygoodideaofwhatwillhappentothespotexchangerateinthefuture,itiseasytobetonthebasisofthatideausingtheforwardmarket.Itissoeasy,infact,thatthespeculatorcanevenbetwithmoneyshedoesnothaveinhand.SpeculateSupposethatinAprilyouareconvincedthatthepoundsterlingwilltakeadivefromitscurrentspotexchangeratevalueofabout$1.45andbeworthonly$1.20inJuly.PerhapsyouseeacomingpoliticalandeconomiccrisisinBritainthatothersdonotsee.Youcanmakeanenormousgainbyusingtheforwardmarket.Contractaforeignexchangetraderatyourbankandagreetosell￡10millionatthecurrent90-dayforwardrateof$1.4.

IfthebankbelievesinyourabilitytohonoryourforwardcommitmentinJuly,youdonotevenneedtoputupanymoneynowinApril.Justsigntheforwardcontract.SpeculateOnthecontractdateinJuly,instructyourbanktosettletheforwardcontractagainsttheactualspotrate,whichhassunkasyouexpectedto$1.20.Effectively,inJulyyouarebuying￡10millioninthespotmarketat$1.20(totalcostof$12million)andsellingthepoundsat$1.4intotheforwardcontract(totalreceiptof$14million).Younetaprofitof$2millionforafewminutes’effort,alotofforesight,andanunderstandingof“buylow,sellhigh”.

Ifyouaresmarterthantheothersinthemarketplace,youcangetrichusingtheconvenientforwardexchangemarket.SpeculateYourspeculationmayturnoutdifferently,however.Supposeyouarewrong.SupposethatBritain’sprospectsbrightengreatlybetweenAprilandJuly.SupposethatwhenJulycomesaround,thespotvalueofthepoundhasrisento$1.80.NowinJulyyoumustcomeupwith$18milliontogetthe￡10millionyoucommittedtosellintheforwardcontractforonly$14million.CaseSupposeanAmericanwhoimportsradiosfromJapanknowsthatin30dayshemustpayyentoaJapanesesupplierforashipmentarrivingthen.Theimportercanselleachradiofor$100andmustpayhissupplier￥9,000perradio;sohisprofitdependsonthedollar/yenexchangerate.Atthecurrent,spotexchangerateof$0.0105/yenIfoverthenext30daysthedollarunexpectedlydepreciatesto$0.0115/yenCase:howwouldtheU.S.companydo?(hedgingusingforwardforeignexchangeAU.S.companyhasboughtsomemerchandiseandwillhavetopay￡100,000threemonthsfromnow.Assumingthatthisrepresentsanoverallnetliabilitypositioninpounds(perhapsbecausethecompanyhasnootherassetsorliabilitiesinpounds),thecompanyisexposedtoexchangeraterisk.Case:howwouldyouspeculateusingaforwardcontract?InAprilyouareconvincedthatthepoundsterlingwilltakeadivefromitscurrentspotexchangeratevalueofabout$1.45andbeworthonly$1.20inJuly.PerhapsyouseeacomingpoliticalandeconomiccrisisinBritainthatothersdonotsee.CurrencyfuturesIn

finance,a

futurescontract

(morecolloquially,

futures)isastandardized

forwardcontract

whichcanbeeasilytradedbetweenpartiesotherthanthetwoinitialpartiestothecontract.Thepartiesinitiallyagreetobuyandsellan

asset

forapriceagreedupontoday(the

forwardprice)withdeliveryandpaymentoccurringatafuturepoint,thedeliverydate.Acurrencyfuture,alsoFXfutureorforeignexchangefuture,isafuturescontracttoexchangeonecurrencyforanotherataspecifieddateinthefutureataprice(exchangerate)thatisfixedonthepurchasedate.Typically,oneofthecurrenciesistheUSdollar.ThepriceofafutureisthenintermsofUSdollarsperunitofothercurrency.CurrencyfuturesHistoryCurrencyfutureswerefirstcreatedattheChicagoMercantileExchange(CME)in1972,lessthanoneyearafterthesystemoffixedexchangerateswasabandonedalongwiththegoldstandard.SomecommoditytradersattheCMEdidnothaveaccesstotheinter-bankexchangemarketsintheearly1970s,whentheybelievedthatsignificantchangeswereabouttotakeplaceinthecurrencymarket.TheyestablishedtheInternationalMonetaryMarket(IMM)andlaunchedtradinginsevencurrencyfuturesonMay16,1972.Today,theIMMisadivisionofCME.Inthesecondquarterof2005,anaverageof332,000contractswithanotionalvalueof$43billionweretradedeveryday.Currentlymostofthesearetradedelectronically.CurrencyfuturesFeaturesStandardizedtermsClearinghouseMarginsystemClosingoffuturesCurrencyfuturesStandardizedtermsContractsizeisstandardizedExample:62,500Sterling;125,000Euro;100,000Dollar–ChicagoMercantileexchangeDateofdeliveryispredeterminedThirdWednesdayofJan,March,April,June,July,Sept.,Oct.,Dec.CurrencyfuturesClearinghouseEachexchangehasaclearinghouseClearinghousearrangesfordeliveryofassetandpaymentofmoneyClearinghousebecomesthecounterpartytotheoriginalpartiesOriginalparties:buyerandsellerClearinghousebecomescounterpartytobuyer(todelivertheasset)Clearinghousebecomesthecounterpartytotheseller(tomakepayment)CurrencyfuturesIn

finance,

margin

is

collateral

thattheholderofa

financialinstrument

hastodepositwitha

counterparty

(mostoftentheir

broker

oran

exchange)tocoversomeorallofthe

creditrisk

theholderposesforthecounterparty.Thereare3typesofmarginsInitialmargintobepaidupfrontMaintenancemargintobemaintainedthroughoutthedurationofthecontractVariationmargin(shortfallinmargin)toberemittedpromptly.CurrencyfuturesExampleformarginsystemCanDollarfutures:size=100,000CADDealerbuysonecontractatUSD0.75/CADValueofcontract:USD75,000Initialmargin:10percent=USD7,500Maintenancemargin:7.5percent=USD5,625PricemovesuptoUSD0.755/CAD:dealergainsUSD500(100,000*USD0.005)PricemovesdowntoUSD0.740:dealerlosesUSD1000(100,000*USD0.010)CurrencyfuturesClosingoffuturesFuturescanbeclosed:ExchangeofassetandcashondeliverydateCashsettlementthroughareversetradeonanydayHedgerspreferexchangeofasset;speculatorsprefercashsettlementCurrencyfuturesHedgingwithcurrencyfuturesImporterbuystherequiredcurrencyfuturescontractThus“locksin”apriceforthepurchaseofforeigncurrencyExportersellstheexpectedcurrencyfuturescontract“locksin”apriceforthesaleCurrencyfuturesSpeculationwithcurrencyfuturesFluctuationsinexchangeratesusedtoreapspeculativeprofitsSpotrate:USD1=Rs.46.401monthfuturerate:USD1=Rs.46.60Expectedspotrateonmaturity:USD1=Rs.46.75Dealerbuysonecurrencyfuturescontractofsize100,000USDValueofcontract:Rs.46,60,000;Margindeposit:Rs.4,66,000IfexchangeratemoveuptoRs.46.75asanticipated,dealergainsprofitofRs.15,000(100,000*0.15)InternationalfinancialinvestmentInternationalfinancialinvestmentismorecomplicatedthandomesticinvestmentbecauseoftheneedforcurrencyexchanges,bothtoacquireforeigncurrencynowandtotranslatetheforeigncurrencybackinthefuture.(thedifferencebetweeninvestingindomesticassetsandinvestinginforeignassets)Decisionsaboutinternationalinvestmentarebasedonthereturnsandrisksoftheavailableinvestmentalternatives.InternationalfinancialinvestmentSupposethataU.S.investorinvestsinaforeign-currency-denominatedfinancialasset,likeaBritishgovernmentsecurityorapoundtimedeposit.First,shemustconvertherdollarsintopoundsattheinitialspotexchangerate.Then,sheusesthepoundstobuythepound-denominatedfinancialasset.Sheholdsthisasset,earningpoundreturnsandhavingwealthinpoundsayearfromnow.Thiscanbeconvertedbackintodollars(eitheractuallyorsimplytodeterminethedollarvalueofwealth)atsomedollar-poundexchangeratethatappliestoforeignexchangetransactionsayearfromnow.InternationalfinancialinvestmentWhatexchangeratecanbeusedtoconvertpoundsbackintodollarsayearfromnow?Therearetwomajoralternatives,andthesecorrespondtoourconceptsofhedgingandspeculation.First,shecancontractnowfortheexchangeofpoundsbackintodollarsattheone-yearforwardexchangerateusingaforwardexchangecontract.Herpoundliabilityintheforwardcontractmatchesherpoundassetposition,soshehashedgedherexposuretoexchangeraterisk.Shehasahedgedorcoveredinternationalinvestment.InternationalfinancialinvestmentSecond,shecanwaitandconvertbackintodollarsatthefuturespotexchangerate,theonethatwillexistayearfromnow.Shedoesnotknowforsurewhatthisfuturespotexchangeratewillbesoherinvestmentisexposedtoexchangeraterisk.Thisunhedgedinvestmenthasaspeculativeelementtoit,anditiscalledanuncoveredinternationalinvestment.InternationalfinancialinvestmentTwokindsofinternationalfinancialinvestmentCoveredinternationalinvestmentIftherateatwhichthefuturesaleofforeigncurrencywilloccurislockedinnowthroughaforwardexchangecontract,therewillbeacoveredinternationalinvestment.UncoveredinternationalinvestmentIfthefuturesaleofforeigncurrencywilloccuratthefuturespotrate,wehaveauncoveredinternationalinvestment.InternationalinvestmentwithcoverSpotrate(directquotation):eForwardrate(directquotation):fDomesticinterestrate:idForeigninterestrate:ifInternationalinvestmentwithcoverTwowaystoinvestforadomesticinvestorwithaprincipalof1.Investindomesticassetsforayear,theinvestorcanget(1+id)inayear.Investinforeignassetsforayear,theinvestorcanget1/e·(1+if)·fInternationalinvestmentwithcoverInternationalinvestmentwithcoverSupposewewanttoconvertpresentdollarsintofuturedollars.WecouldrouteourmoneythroughBritain,buyingpoundinthespotmarket,obtaining1/epoundsforeachdollar.Wewouldtheninvestthesepoundsatinterestandhave(1+iUK)/epoundsatmaturityforeachinitialdollar.Atthetimeoftheinvestmentwealsoselltheupcomingpoundsintheforwardmarket(attherateoff)togetanassurednumberofdollarsinthefuture.Overall,thisyields(1+iUK)×f/efuturedollarsforeverydollarinvestednow.OrwecouldsimplyinvestourmoneyatinterestinAmerica,getting(1+iUS)futuredollarsforeverypresentdollar.InternationalinvestmentwithcoverWhichroadweshouldtakedependsonthesignofthedifferencebetweenthetworeturns.Thisdifferenceissometimescalledthecoveredinterestdifferential(CD):CD=(1+iUK)×f/e-(1+iUS)CD>0:investinginBritainCD<0:investinginAmericaCD=0:investinginBritainandAmericaarethesameInternationalinvestmentwithcoverDefinitionofforwardpremiumForwardpremiumistheproportionatedifferencebetweenthecurrentforwardexchangerateandcurrentspotrate.ThatisF=(f-e)/eF>0:atpremiumF<0:atdiscountF=0:atparorflatInternationalinvestmentwithcoverThecoveredinterestdifferentialisapproximatelyequaltotheforwardpremiumonthepoundplustheinterestratedifferential:CD=F+(iUK-iUS)

Thisformulashowsthatthenetincentivetoinvestindomesticassetsorforeignassetsdependsonhowtheforwardpremiumontheforeigncurrencycompareswiththedifferencebetweentheinterestrates.CoveredInterestArbitrageWhatisacoveredinterestarbitrage?Coveredinterestarbitrageisbuyingacountry’scurrencyspotandsellingthatcountry’scurrencyforward,tomakeanetprofitfromthecombinationofthedifferenceininterestratesbetweencountriesandtheforwardpremiumonthatcountry’scurrency.Coveredinterestarbitrageissuchasurethingthatitisanendangeredspecies.Aprofitablecoveredinterestarbitrageopportunityisusuallygonewithinaminuteortwo.CoveredInterestParityWhatiscoveredinterestparity?CoveredInterestparitymeansCD=0Acurrencyisataforwardpremium(discount)byasmuchasitsinterestrateislower(higher)thantheinterestrateintheothercountry(thatisF≈id-if)Theoverallcoveredreturnonaforeign–currencyinvestmentequalsthereturnonacomparabledomestic-currencyinvestment(F+if≈id)Coveredinterestparityisano-arbitrageconditioninfinancialmarket.CoveredInterestParityCoveredinterestparityprovidesanexplanationfordifferencesbetweencurrentspotandcurrentforwardexchangerates.Thecountrywithlowerinterestratewillhaveaforwardpremiumonitscurrency,withthepercentagepointdifferenceintheinterestratesequaltothepercentforwardpremium.Thecountrywithhigherinterestratewillhaveaforwarddiscountonitscurrency,withthepercentagepointdifferenceintheinterestratesequaltothepercentforwarddiscount.CoveredInterestParityCoveredinterestparitylinkstogetherfourrates:e,f,idandif.Ifoneoftheserateschanges,thenatleastoneoftheotherratesalsomustchangetomaintaincoveredinterestparity.FromCD=1/e·(1+if)·f-(1+id),andletCD=0wecangetf/e=(1+id)/(1+if)Thecurrentspotandcurrentforwardratesarehighlypositivelycorrelatedovertime.InternationalinvestmentwithoutcoverUncoveredinternationalfinancialinvestmentinvolvesinvestinginafinancialassetdenominatedinaforeigncurrencywithouthedgingorcoveringthefutureproceedsoftheinvestmentbackintoone’sowncurrency.Inthesimplestcase,theforeigncurrencyproceedswillbetranslatedbackintodomesticcurrencyusingwhateverspotexchangerateexistsatthefuturedate(eitheractually,ortocalculatewealthandoverallreturnsinone’sowncurrency).Thefuturespotrateisnotknownforsureatthetimeoftheinitialinvestment,sotheinvestmentisexposedtoexchangeraterisk(assumingthattheinvestorhasnootheroffsettingliabilityinthiscurrency).

InternationalinvestmentwithoutcoverTheinvestor’sexpectedfuturespotrate(eex)canbeusedtodetermineanexpectedoverallreturnontheuncoveredinternationalinvestment.Wefirstbuypoundsinthespotmarket,obtaining1/epoundsforeachdollar.Wetheninvestthesepounds,andwewillhave(1+iUK)/epoundsatmaturityforeachinitialdollar.Wehaveanexpectationthatwecanconvertthesepoundsbackintodollarstherateofeextoobtain(1+iUK)×eex/efuturedollarsexpectedforeachdollarinvestednow.Thiscanbecomparedtothefuturedollars(1+iUS)thatwecouldobtainsimplybyinvestingeachpresentdollarinadollar-denominatedasset.InternationalinvestmentwithoutcoverTwowaystoinvestforadomesticinvestorwithaprincipalof1.Investindomesticassetsforayear,theinvestorcanget(1+id)inayear.Investinforeignassetsforayear,theinvestorexpectstoget1/e·(1+if)·EfinayearInternationalinvestmentwithoutcoverThedefinitionanduseofexpecteduncoveredinterestdifferential(EUD)EUD=1/e·(1+if)·Ef-(1+id)EUD>0:investingabroadEUD<0:investingathomeInternationalinvestmentwithoutcoverDefinitionofexpectedrateofappreciationExpectedrateofappreciationistheproportionatedifferencebetweentheexpectedexchangerateandcurrentspotrate.ThatisEF=(Ef-e)/eThenEUD≈EF+(if-id)Thisformulashowsthatthenetincentivetoinvestindomesticassetsorforeignassetsdependsonhowtheexpectedrateofappreciationontheforeigncurrencycompareswiththedifferencebetweentheinterestrates.IfyourearrangetheformulaasEUD≈(EF+if)-id,thenyoucangetanotherinterpretationoftheformula.InternationalinvestmentwithoutcoverIfanuncoveredforeignfinancialinvestmentisexposedtoexchangeraterisk,whywouldanyonewanttoinvestuncovered?Theexpectedoverallreturnontheuncoveredinvestmentmaybehigherthanthereturnthatcanbeobtainedathome(EUDispositive)Thecontributionofuncoveredinvestmentcanlowertheriskinessoftheinvestor’sfullinvestmentportfoliobecauseofthebenefitsofdiversificationofinvestments.InternationalinvestmentwithoutcoverUncoveredinterestparityTheassumptionofriskneutralUncoveredinterestparitymeansEUD=0Acurrencyisexpectedtoappreciate(depreciate)byasmuchasitsinterestrateislower(higher)thantheinterestrateintheothercountry.WhichmeansEF≈id-ifTheexpectedoveralluncoveredreturnontheforeign-currencyinvestmentequalsthereturnonthedomesticcurrencyinvestment.WhichmeansEF+if≈id.InternationalinvestmentwithoutcoverUncoveredinterestparitylinkstogetherfourrates:e,Ef,idandif.Ifoneoftheserateschanges,thenatleastoneoftheotherratesalsomustchangetomaintaincoveredinterestparity.1/e·(1+if)·Ef=1+idExercise1.Thecurrentspotexchangerateis$0.010/yen.