Covered interest rate arbitrage with transaction costs (advanced). Assume that U.S.-based potential arbitrageurs do not hold cash, but hold dollar-denominated securities. Covered investment in sterling-denominated securities then requires the execution of four transactions: (1) sale of domestic securities with transaction costs of τ_d percent, (2) spot purchase of pounds sterling with costs of τ_s

percent, (3) purchase of sterling-denominated securities with transaction costs of τ_f, and (4) forward sale of pounds sterling with transaction costs of τ_F.

a. Reformulate the interest rate parity theorem taking into account these transaction costs.

b. What are the upper and lower limits on the implicit interest rate?

c. What do your conclusions in parts a and b imply in terms of the interest parity line as drawn in Exhibit 6. 3?

Data from Exhibit 6. 3

Transcribed Image Text:

Interest rate differential (360) > AUD (360) Interest parity line (96-100)/100=-4% 45 AUD at a premium AUD at a discount Implicit interest rate 0.25% -6.25% = -6% EXHIBIT 6.3 Interest Rate Parity Theory (360)