Cirp

Essay on whether covered interest rate parity holds based on the foreign exchange rate and interest rate for two currencies

Introduction:

As we know, Covered Interest Rate Parity (CIRP) is important for foreign currency investment. Therefore, this report has been compiled to indicate how the CIRP holds according to the forward premium and interest rate differential. This report can be divided into two parts. The first part is explaining how CIRP operate basic on non-transaction. The second part is analyzing the CIPR holds which considered the transaction cost.

Main body:

Non-transaction cost

In this part, I will indicate how the CIRP holds with non-transaction cost.

◆ Exchange rate and interest rate information in the UK and US are given as follow: (31/08/2010)

|The spot rate: $/￡ |S0=$1.5369/￡ |

|One month forward rate: |F0,30=$1.5366/￡ |

|Three months forward rate: |F0,90=$1.5360/￡ |

|One year forward rate: |F0,360=$1.5344/￡ |

|US interest rate: |0.25% |

|UK interest rate: |0.5% |

Source: adapted from FT website and fxstreet website, (2010)

We should calculate the forward premium and interest rate differential to decide whether CIRP holds.

The one month forward premium: [(F0,30- S0)/ S0] ×12 = [(1.5366-1.5369)/1.5369] ×12=-0.002342377

The three months forward premium: [(F0,90- S0)/ S0] ×4 = [(1.5360-1.5369)/1.5369] ×4=-0.002342375

The one year forward premium: (F0,360- S0)/ S0 = (1.5344-1.5369)/1.5369=-0.00163...