4.3. THE LAW OF ONE PRICE AND COVERED INTEREST PARITY 139
Table 4.2:HCand swappedFCinvestments with nondiscriminatory taxesInvestclp 100 Investnok1 and hedge
initial investment 100 1 ×100 = 100
final value 100 ×1.21 = 121 [1×1.10]×110 = 121
income 21 21
interest 21 [1×0.10]×110 = 11
capgain 0 110 – 100 = 10
taxable 21 21
tax (33.33 %) 7 7
after-tax income 14 14The first point you should be aware of is that, by going for a swappedfcdeposit
instead of ahc one, the total return is in principle unaffected but the relative
weight of the interest and capital-gain components is changed. Consider our Chilean
investor who compares an investment innokto one inclp. Given the spot rate of
100, we consider investments of 100clpor 1nok. In Table 4.2 you see that the
clpinvestment yields interest income only, while thenokdeposit earns interest (10
pence, exchanged at the forward rate 110) and a capital gain (you buy the principal
at 100, and sell later at 110). But in both cases, total income is 21. (This, indeed,
is the origin of the nameCIP: the return, covered, is the same.)
DoItYourself problem 4.5
Verify that the expression below follows almost immediately from CIP, Equation
[4.7]:
Ft,Trt,T∗ + (Ft,T−St) =Strt,T. (4.14)
Then trace each symbol in the formula to the numbers we used in the numerical
example. Identify the interest on the Peso and Crown deposits, and the capital gain
or loss.
So we know that total pre-tax income is the same in both cases. If all income is
equally taxable, the tax is the same too, and so must be the aftertax income. It also
follows that if, because ofe.g.spreads, there is a small advantage to, say, the Peso
investment, then taxes will reduce the gain but not eliminate it. That is, if Pesos
would yield more before taxes, then they would also yield more after taxes.
In most countries, corporate taxes are neutral between interest income and capital
gains, especially short-term capital gains. But there are exceptions. Theukused to
treat capital gains onfcloans differently from capital losses and interest received.
Under personal taxation, taxation of capital gains is far from universal, and/or long-
term capital gains often receive beneficial treatment. In cases like this, the ranking