Reference no: EM132550576
1. After a major disruption in global politics such as 9/11, the Greek crisis, or Brexit, governments aim prevent any further slowdowns in the economy. To accomplish this goal, governments will often lower interest rates. These rates are lowered as a way of encouraging citizens to borrow capital and stimulate the economy.
Covered interest arbitrage is a process involving capitalization on the difference in interest rates between two countries while covering exchange rate risk with a forward contract. Interest rate parity, or IRP, occurs when "market forces cause interest and exchange rates to adjust such that covered interest arbitrage is no longer feasible" resulting in a state of equilibrium. If a country were to undergo a major political disruption that effects its financial markets, an investor may capitalize on the economic downturn by utilizing covered interest arbitrage. The investor can do so since the recent disruption has created a larger gap in exchange rates between that nation and the others.
2. When consumer and investor economic expectations are grim during events like 9/11, Brexit and the Greek Crisis, a decline in that country's interest rates typically occurs followed by relatively high inflation. Forward rates are effected as a result. In situations where foreign interest rates are higher than the home country, forward rates experience a discount. The level of this discount should be proportional to the degree of differential in interest rates between the two countries in question according to the interest rate parity. This can also cause short-run combined interest arbitrage benefits until IRP occurs through forward rate adjustments. However, investor concerns about repayment feasibility due to political risk may prevent some from participating in the volatile financial market which further drives interest rates downward. A reduction in interest rates causes pressure in forward discounts downward to the same degree. Lower interest rates and inflation cause a decrease in imports and increase in exports as demand for the currency rises. This eventually leads to an appreciation in the currency value relative to level of inflation differential with trading countries according to the IFE.
3. After such large events that cause not only political and emotional unrest, the economy also takes a hit as well. This also affects the business expectations and lowers them to below what people would normally require from businesses. This causes people to be more independent and also leads to a fall in the interest of rate expectations. While that also occurs, the IRP between countries has a larger gap, and the rate increases. Since a larger gap is achieved with parity, it also causes countries to spend less money on foreign investments and focus on keeping the money in the country in order to aid their own economy. Currently, the main powers like the US and China are also wagering in a trade war and it will be quite interesting how much the IRP may increase if it continues or if there will be a second wave.