International Finance: Putting Theory Into Practice

136 CHAPTER 4. UNDERSTANDING FORWARD EXCHANGE RATES FOR CURRENCY

Figure 4.4: Appending Underlying Stories to the Variables inCIP

P. Sercu and R. Uppal The International Finance Workbook page 3. 23

5. 4 Causality in/around CIP? : one possible story

5. More on CIP

expected

spot rate

risks of

future spot

rate

expected

inflation,

abroad

business

conditions

(incl risk),

abroad

S r

expected

inflation,

home

business

conditions

(incl risk),

home

t t,T

r*t,T

Ft,T

AlthoughCIPitself does not say which term causes which, many economists and
practitioners do have theories about one or more terms that appear in the Covered
Interest Parity Theorem. One such theory is the Fisher equation, which says that
interest rates reflect expected inflation and the real return that investors require.
Another theory suggests that the forward rate reflects the market’s expectation
about the (unknown) future spot rate,S ̃T.^6 We shall argue in Section 4.4 that the
latter theory is true in a risk-adjusted sense. In short, while there is no causality in
CIPitself, one can append stories and theories to items in the formula. ThenCIP
becomes an ingredient in a richer economic model with causality relations galore—
butS,F,r andr∗ would all be endogenous, determined by outside forces and
circumstances. Figure 4.4 outlines a plausible causal story of how interest rates and
the forward rate are set and, together, imply the spot rate.

CIPand the Swap Rate

When the forward rate exceeds the spot rate, the foreign currency is said to beat a
premium. Otherwise, the currency isat a discount(Ft,T< St), orat par(Ft,T=St).
In this text, we often use the word premium irrespective of its sign; that is, we treat
the discount as a negative premium. From [4.7], the sign of the premium uniquely

(^6) We use a tilde ( ̃.) above a symbol to indicate that the variable is random or uncertain.