TOPIC 4:
THE LINK BETWEEN FOREIGN EXCHANGE MARKET AND FINANCIAL
MARKETS
Although we have discussed the spot, forward and futures foreign exchange markets
individually, in practice exchange rates in the three markets are determined
simultaneously in conjunction with interest rates.
We observed in section that among the participants in the foreign exchange market are
the investors who want to acquire short-term investments abroad.
The demand for foreign exchange for purposes of investing in short-term assets,
denominated in foreign currency, will depend not only on the interest rates in the two
countries but also on the exchange rate that the investor expects at the end of the
investment period.
Two factors will influence the decisions of the investors in short term assets
denominated in foreign currency, namely:
The rate of interest earned on the short-term assets
The additional income earned due to the appreciation of the foreign currency
over the investment period.
The risks associated with the change in exchange rate can be hedged in the forward
market, if the investor is risk averse and does not wish to stay uncovered.
The covered investment position will then include interest earned on the foreign
investment plus the cost of hedging in the forward market.
If the financial markets are working normally, that is if they are in equilibrium, the risk
averse short-term investor should be indifferent between the domestic and the foreign
investment.
Similarly, in equilibrium the risk-averse importer should be indifferent between
hedging using the short-term foreign investment and by using the forward market.
Thus, the link between the spot, forward, and money markets that generates the
equality conditions is achieved through covered interest arbitrage.
Covered and Uncovered Interest Arbitrage
There are two types of interest arbitrage activities. These are:
Uncovered interest arbitrage
Covered interest arbitrage
1
, Both of them seek to take advantage of differences in short-term interest rates on similar
assets denominated in foreign currencies at a particular point in time.
One type of interest arbitrage activity is speculative, in that the investor does not use
the forward exchange market to hedge against foreign exchange risk. This type of
arbitrage is known as uncovered interest arbitrage.
That is, the investor is not “covered” against the risk of spot rate fluctuations.
The second type of arbitrage activity utilizes the forward market of foreign exchange to
hedge against the risk involved in the transactions.
This type of arbitrage is called covered interest arbitrage.
That is, the investor is covered against the risk of possible spot rate fluctuation.
1. Uncovered Interest Arbitrage
The theory of uncovered interest arbitrage states that the differences between the
current spot exchange rate and the expected future spot rate of two currencies reflects
differences in the interest rate on short-term assets denominated in the two currencies.
For example, suppose a Kenyan investor had Ksh 1.6 million to invest, and the
following business information was accessible to him:
a) The spot rate between the Kenya Shilling and the dollar is e = Ksh / $ = Ksh80;
b) The 90-days interest rate on CBK Treasury bill rates is 1.8 per cent;
c) The 90-days interest rate on US Treasury Bills is 2 per cent;
What would be the Kenyan investor’s options?
One, he could invest his Ksh 1.6million in CBK Treasury Bills at 1.8 per cent
interest rate and get a return of Ksh 28800/= at the end of the 90-days maturity
period.
Two, he could buy US dollars at Ksh 80/= per dollar and get US$ 20,000.
Then, through electronic transfer, he could invest in 90-day US Treasury Bills at 2%
and get a return of US$ 400 at the expiry of the 90 day period.
Finally, he would convert the $400 back into Kenya shillings.
If the investor chose the second option, his return on the investment in terms of Kenya
shillings will depend on the spot exchange rate at the maturity of the investment.
If the spot rate did not change, (e = Ksh/$ = 80/=) over the 90-day period, he could get
($400x80/=) Ksh 32000/=.
However, if after 90 days the spot rate dropped to Ksh70/= per dollar, the Kenyan
investor would be able to get back only ($400 x Ksh70/=) Ksh 28000/=.
2
THE LINK BETWEEN FOREIGN EXCHANGE MARKET AND FINANCIAL
MARKETS
Although we have discussed the spot, forward and futures foreign exchange markets
individually, in practice exchange rates in the three markets are determined
simultaneously in conjunction with interest rates.
We observed in section that among the participants in the foreign exchange market are
the investors who want to acquire short-term investments abroad.
The demand for foreign exchange for purposes of investing in short-term assets,
denominated in foreign currency, will depend not only on the interest rates in the two
countries but also on the exchange rate that the investor expects at the end of the
investment period.
Two factors will influence the decisions of the investors in short term assets
denominated in foreign currency, namely:
The rate of interest earned on the short-term assets
The additional income earned due to the appreciation of the foreign currency
over the investment period.
The risks associated with the change in exchange rate can be hedged in the forward
market, if the investor is risk averse and does not wish to stay uncovered.
The covered investment position will then include interest earned on the foreign
investment plus the cost of hedging in the forward market.
If the financial markets are working normally, that is if they are in equilibrium, the risk
averse short-term investor should be indifferent between the domestic and the foreign
investment.
Similarly, in equilibrium the risk-averse importer should be indifferent between
hedging using the short-term foreign investment and by using the forward market.
Thus, the link between the spot, forward, and money markets that generates the
equality conditions is achieved through covered interest arbitrage.
Covered and Uncovered Interest Arbitrage
There are two types of interest arbitrage activities. These are:
Uncovered interest arbitrage
Covered interest arbitrage
1
, Both of them seek to take advantage of differences in short-term interest rates on similar
assets denominated in foreign currencies at a particular point in time.
One type of interest arbitrage activity is speculative, in that the investor does not use
the forward exchange market to hedge against foreign exchange risk. This type of
arbitrage is known as uncovered interest arbitrage.
That is, the investor is not “covered” against the risk of spot rate fluctuations.
The second type of arbitrage activity utilizes the forward market of foreign exchange to
hedge against the risk involved in the transactions.
This type of arbitrage is called covered interest arbitrage.
That is, the investor is covered against the risk of possible spot rate fluctuation.
1. Uncovered Interest Arbitrage
The theory of uncovered interest arbitrage states that the differences between the
current spot exchange rate and the expected future spot rate of two currencies reflects
differences in the interest rate on short-term assets denominated in the two currencies.
For example, suppose a Kenyan investor had Ksh 1.6 million to invest, and the
following business information was accessible to him:
a) The spot rate between the Kenya Shilling and the dollar is e = Ksh / $ = Ksh80;
b) The 90-days interest rate on CBK Treasury bill rates is 1.8 per cent;
c) The 90-days interest rate on US Treasury Bills is 2 per cent;
What would be the Kenyan investor’s options?
One, he could invest his Ksh 1.6million in CBK Treasury Bills at 1.8 per cent
interest rate and get a return of Ksh 28800/= at the end of the 90-days maturity
period.
Two, he could buy US dollars at Ksh 80/= per dollar and get US$ 20,000.
Then, through electronic transfer, he could invest in 90-day US Treasury Bills at 2%
and get a return of US$ 400 at the expiry of the 90 day period.
Finally, he would convert the $400 back into Kenya shillings.
If the investor chose the second option, his return on the investment in terms of Kenya
shillings will depend on the spot exchange rate at the maturity of the investment.
If the spot rate did not change, (e = Ksh/$ = 80/=) over the 90-day period, he could get
($400x80/=) Ksh 32000/=.
However, if after 90 days the spot rate dropped to Ksh70/= per dollar, the Kenyan
investor would be able to get back only ($400 x Ksh70/=) Ksh 28000/=.
2
