Interest Rate Arbitrage and Parity

Theory takes for granted, that whenever enormous profits can be made in any particular trade, a sufficient number of capitalists will be induced to engage in it, who will, by their competition, reduce the profits to the general rate of mercantile gains. It assumes that in the trade of exchange does this principle more especially operate, it not being confined to English merchants alone; but being perfectly understood, and profitably followed, by the exchange and bullion merchants of Holland, France, and Hamburgh; and competition in this trade being well known to be carried to its greatest height.

David Ricardo's reply to Mr. Bosanquet

Akiko Isobe is the money market fund manager at Fuji Life—the life insurance company headquartered in Tokyo. Frustrated by the paltry 0.25 percent return per annum offered by short-term deposits in yen (¥), Akiko has been tempted by the significantly higher yields offered in Australian dollar (AUD) at 6.25 percent, South African rand at 12 percent, and Turkish lira at 17.5 percent. Would abandoning the almighty yen for a few months or even a year be a chance worth taking? Can these more exotic currencies be trusted? What are the risks involved? Can these risks be hedged?

This chapter explores the relationships known as interest rate arbitrage (IRA) and interest rate parity (IRP), which bind interest rates in two different currencies vis-à-vis their spot and forward exchange (FX or forex) rates. The theory ...

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