Tuesday, March 21, 2017

Covered interest parity cannot work

John Cochrane does the usual great job of explaining fianacial jargon:

Here's how covered interest parity works. Think of two ways to invest money, risklessly, for a year. Option 1: buy a one-year CD (conceptually. If you are a bank, or large corporation you do this by a repurchase agreement). Option 2: Buy euros, buy a one-year European CD, and enter a forward contract by which you get dollars back for your euros one year from now, at a predetermined rate. Both are entirely risk free. They should therefore give exactly the same rate of return, by arbitrage. If european interest rates are higher than US interest rates, then the forward price of the euro should be lower, enough to exactly offset the apparent higher return.  If not, then banks can (say), borrow in the US, go through the european option, pay back the US loan and receive an absolutely sure profit.
This is a bet over time, my promise of a synchronous time sequence of payments is better than  yours.  But is implies sufficient subdivision of the time line.  That is, the theory assumes probability with replacement, but the economy is asynchronous congestion management without replacement. My winning time sequence necessarily reduces the pace of your time sequences, spectrum is bound.

The time sequences are backed up by CD insurance, bu it is not going to help. The final back up is the courts, and that is not a priceable risk.   Pure cash cannot bet time,

The economy operats by generating surpluses with congestion

The idea is a short queue of trucks coming in than the queue of shopping bags going out.  That is the basis of economies of scale, it allows the internal transaction costs of unloading rucks to be precise, set pricing.  The uncertainty of arrival is the prime denomination of price, everything containerized from that.  But it is a probable uncertainty, not timed in any way.

Covered interest parity works when the US taxpayer has a growing debt flow and the guarantee of time sequences has momentum.

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