Investments, tenth edition

 

 

interest rate parity relationship 

 

 

 or  

  covered  interest 

 arbitrage  relationship    ,  which we first encountered in Chapter 23. 

 Unfortunately, such perfect exchange rate hedging usually is not so easy. In our exam-

ple, we knew exactly how many pounds to sell in the forward or futures market because the 

pound-denominated return in the United Kingdom was riskless. If the U.K. investment had 

not been in bills, but instead had been in risky U.K. equity, we would have known neither 

the ultimate value in pounds of our U.K. investment nor how many pounds to sell forward. 

The hedging opportunity offered by foreign exchange forward contracts would thus be 

imperfect. 

 To summarize, the generalization of Equation 25.1 for unhedged investments is that   

 

1

1 r(US) 5 31 1 r(foreign)4E

1

/E

0

 

 (25.3)   

 where   r (foreign) is the possibly risky return earned in the 

currency of the foreign investment. You can set up a per-

fect hedge only in the special case that  r (foreign) is itself 

a known number. In that case, you know you must sell in 

the forward or futures market an amount of foreign cur-

rency equal to [1  1   r  (foreign)] for each unit of that cur-

rency you purchase today.