Implication of Covered Interest Parity for Short-Term Financing For Russian and Kazakhstani Borrowers

Abstract

This study compared the effective financing rate of foreign currency and domestic currency interest rate using the indirect test of covered interest rate parity. The literature review expounded upon why firms might be interested in foreign financing, why individuals should consider the effective interest rate of foreign currency and exchange risk exposure when comparing the potential cost of financing in foreign currency with domestic interest rate, along with a discussion of the outlook exchange rate dynamics of the U. S. Dollar, EURO, Japanese yen, and Russian ruble from 2008 to 2013 with the relation to exchange risk, and why forward contracts are attractive for firms based on currencies dynamics analysis. In the methodology section, the theory behind covered interest parity condition and the statistical analysis were provided.

Implication of Covered Interest Parity for Short-Term Financing For Russian and Kazakhstani Borrowers

This study will compare the effective financing rate of foreign currency and domestic currency interest rate using the indirect test of covered interest rate parity. The purpose of this study is to compare two options for a Russian or Kazakhstani company and discover which option is cheaper in terms of cost: to borrow in domestic market in ruble or Tenge and repay the loan and interest in 3 months, or to borrow in a foreign market (for example in USD), convert the money in ruble or Tenge and buy USD forward in order to be able to repay the loan in USD. The introduction will present a definition of the covered interest rate parity. The literature review will explain the following: why firms might be interested in foreign financing, why individuals should consider the effective interest rate of foreign currency and exchange risk exposure when comparing the potential cost of financing in foreign currency with domestic interest rate, along with a discussion of the outlook exchange rate dynamics of the U. S. Dollar (USD), European EURO, Japanese yen (JPY), and Russian ruble (RUB) from 2008 to 2013 with the relation to exchange risk, and why forward contracts are attractive for firms based on currencies’ dynamics analysis. The relationship of Russia and Kazakhstan will be described to explain why Kazakhstan might borrow in the Russian ruble. In the methodology section, the theory behind covered interest parity condition and the statistical analysis will be provided. The results will show the data for the indirect test of covered interest parity using a paired t-test analysis to test if covered interest rate parity will hold. Following will be a discussion on which foreign financing options will be fruitful for Russian and Kazakhstani borrowers seeking short-term financing in foreign currency.

In general, according to Levich (2011), parity relationships play a central role in understanding the globalization dynamics between world economies and have a long history of research supporting their existence, and the interest rate parity is amongst the best of the statistical tools in the analysis of international financing. As Levich explained, the interest parity relationship exists when “covered yields are identical on assets that are similar in all important respects (e. g. maturity, default risk, exposure to capital controls, and liquidity) except for their currency of denomination” (p. 1).

According to Levich (2002), covered interest parity is a more accurate measure of variations from the ideal situation of “perfect capital mobility” (p. 14) for “real interest differentials” (p. 14). “Covered interest parity remains the benchmark for detecting departures from perfect capital mobility” (p. 14). Covered interest parity, according to Moosa (2002), maintains that in international financing situations, it is held that: no gain can be made (over domestic currency financing) by borrowing foreign currency funds, while covering the position in the forward market to avoid foreign exchange risk. This is because one of the implications of the validity of covered interest parity (CIP) is that the effective financing rate in a foreign currency, which is the interest rate on the foreign currency adjusted for changes in the exchange rate, will be equal to the cost of financing in the domestic currency, typically, taken to be the domestic interest rate. (p. 21)

In other words, covered interest parity, according to Moosa (2002), upholds the concept that all costs for foreign and domestic financing will be equal, and one will not have an advantage over the other. Moreover, the covered interest parity can be used to indicate the presence or absence of perfect fluidity between markets.

For this study, the indirect test of covered interest parity compares the effective financing rate of foreign currency and domestic currency interest rate. The discussion in the literature review will lay the foundation for the usefulness of the covered interest parity for international financing. 

Literature Review

The introduction explained the key concepts of covered interest parity. The literature review will examine why firms might be interested in foreign financing, followed by a discussion of why firms should consider the effective interest rate of foreign currency and exchange risk exposure when comparing the potential cost of financing in exchange rate dynamics with relation to exchange risk. An explanation of why forward contracts are attractive for firms based on currencies dynamics analysis will be analyzed. 

Why Firms Are Interested in Foreign Financing

Primarily, the reasons why a firm might be interested in foreign financing must be discussed in order to illuminate the role covered interest parity plays in the international marketplace. The factors are listed below:

• As Levich (2002) stated, if borrowing in one nation is overly restrictive, a firm might seek foreign financing. A nation might actively discourage foreign lending or foreign borrowing to help stabilize the national economy and their currency rates, conveyed Stiglitz, Ocampo, Spiegel, Ffrench-Davis, and Nayyar (2006). A firm can borrow funds from abroad in that currency as long as the unpredictable factors, such as currency rate fluctuations, are controlled, such as in “offsetting spot and forward currency contracts” (Levich, 2002, p. 4).

• Lower interest rates, according to Stiglitz et al. (2006), might attract firms away from domestic markets. If the country of origin does not place regulations on foreign borrowing to discourage the acquisition of foreign funds and encourage domestic borrowing, which Stiglitz et al. says helps stabilize economies, a firm could take advantage of the lower financing rates without many restricting factors or penalties. 

• For their global business strategy, a firm might be attracted to foreign financing because of currency values, stated Stiglitz et al. (2006). If domestic borrowers anticipate their currency to rise in value, they might seek a loan in foreign currency to offset their liabilities. In the end, they will not have to pay back quite as much money because their domestic currency is worth more than the foreign currency. They can get more foreign currency with every unit of their domestic currency, stated Stiglitz et al. However, in using forward contracts, currency fluctuations would be controlled, and the chance of arbitrage occurring is diminished. Covered interest rate parity is not a speculative situation, according to Mishkin (2006). Borrowers will not be able to earn arbitrage from currency or interest rate differences. 

• This is especially useful for multinational corporations with interests domestically and abroad. If trade is encouraged between two countries, foreign financing might be offered with forward contracts and parity rate situations if a firm must obtain funds within that country to cover the costs of doing business in that country, according to Contessi and Nicola (2012). As Contessi and Nicola stated:

Most firms rely on external capital (as opposed to their own capital, internal cash lows and reinvested earnings) to finance fixed costs—such as research and development, advertising, fixed capital equipment—and also to finance intermediate input purchases, inventories, payments to workers and other frequent costs before sales and payments of their output take place. (para. 1)

• Another reason a firm might seek foreign borrowing is to circumvent reporting requirements to the local government, Stiglitz et al. (2006) noted. Many foreign transactions are not reported to domestic governments because the transaction is not conducted within the confines of the domestic country’s soil. This is especially easy to do for multinational firms that have interests in foreign countries, stated Stiglitz et al. Especially with long-term earnings, concerns over financial reporting are cumbersome.

• A more practical reason to seek foreign financing, as Gamble (1996) conveyed, is because in foreign markets, particularly import/export, a firm’s competitors might offer transactions in the local foreign currency, which is more convenient than exchanging for US dollars for every transaction. In the end, buying and selling in foreign currency increases profits.

• As Husain (2006) explained, certain countries’ economies are heavily interrelated with one another, as Russia and Kazakhstan’s are. The practice of dealing in foreign currency could be the established trading practice, as Levitov (2010) explained.

Since covered interest rate parity is a situation where all predictable variables are controlled through a forward contract upon an agreed stabilized currency rate and interest rate, firms must consider what the cost of obtaining loans from abroad is versus obtaining financing domestically. The next section explains why firms should consider the effective interest rate of financing in foreign currency and exchange risk exposure when comparing the potential cost of financing in foreign currency with domestic interest rate.

Factors Affecting the Exchange of Currency 

Deviations from the interest rate parity are what results in arbitrage or losses. According to Levich (2011), divergences from parity occur more often than they did ten years ago because of the global economic downturn. These factors must be calculated in a cost analysis to discover which foreign financing situations are going to be financially worthwhile. There are two types of hindrances to free-flowing capital: unpredictable and predictable. Following is an explanation of why firms should take these factors into consideration when performing a cost analysis of domestic financing and foreign financing.

Unpredictable Deviations from Covered Interest Rate Parity. According to Levich (2011), research from the mid 1900s studied deviations from covered interest rate parity that are normally outside the covered interest parity arrangement: political climate, country regulations, imposed transaction fees, break of contract risks, restrictive government regulations, taxes, and inaccurate data. These factors, stated Levich, do not necessarily reflect inequality between markets, and have to do more with the macroeconomic policies and political environment of the country, which are factors that drive the supply and demand of currency. These are factors the lender and borrower cannot individually control. 

When these influences are prevalent, stated Levich (2011), they hinder capital markets, indicating there are obstacles for that foreign currency, such as a restrictive foreign policy, and the covered interest rate parity will not be sustained with too many of these influences. There will not be perfect capital fluidity between markets because of the added costs of currency exchange with that market. The following variations from parity, interest rate and currency fluctuations, are factors one can control within the transaction. These factors should be analyzed closely to ensure equity of transaction, and the covered interest parity is used to detect these deviations from unfettered capital fluidity (Levich, 2011). 

Predictable Deviations from Covered Interest Rate Parity. In order to prevent deviations from covered interest rate parity, firms need to examine the exposure to foreign exchange fluctuations and the national interest rate of the country (Stiglitz et al., 2006). Firms can utilize the covered interest rate parity to see if there are any obstacles in the flow of capital between the countries as well as ensure equity in the borrowing-lending scenario (Levich, 2011). The covered interest parity is used to calculate the best interest rate and currency rate forecast, as well as to detect the presence of any other unpredictable factors present that would impinge upon the free flow of currency exchange between countries.

Why Firms Would Want a Forward Contract. A forward contract controls predictable deviation from covered interest parity, according to Levich (2011). As Levich stated, firms can agree upon a forward rate to control for the factors that could result in a loss. Forward contracts assure that the covered interest parity will hold, and the exchange of currency at a future date will be equal and not result in loss or in arbitrage.  

Why Firms Should Consider Foreign Exchange and Interest Rates in Comparing Domestic Funding with International Funding. If the interest rate and foreign exchange rates are not considered, it could result in a loss for the corporation, according to Cengage (n. d.). As Cengage stated, multinational corporations must constantly engage in how foreign exchange rates affect their assets. 

Firms and central banks might be interested in foreign financing if the interest rates are lower in another country abroad versus loans offered domestically. When the foreign currency fluctuations are controlled in a forward contract, this could translate to significant savings for the entity borrowing the money financing their efforts (Contessi & Nicola, 2012). 

Some corporations choose not to hedge for these factors because they feel they are diversified enough within the foreign country to dissipate risks of deviations from parity, according to Georgia University (n. d.). Firms may choose to control for interest rates and foreign exchange rates because, as Georgia University stated, the ideal market doesn’t usually exist, and hedging controls for capital market imperfections. Hedging not only reduces market uncertainties, Georgia University (n. d.) noted, but also can reduce a corporation’s tax liability.  Cengage (n. d.) stated a multinational firm would probably want to conduct forecasting analyses for unstable currencies. 

Cengage (n. d.) conveyed multinational firms assess currency fluctuations through using “forecasting techniques” (p. 27), which are also used by banks to calculate and offer forward prices. The forward price, according to Delcoure, Barkoulas, Baum, and Chakraborty (2003) and Ho (2003), when the conditions of both uncovered interest parity and covered interest parity are met, is an impartial forecaster of future outright rates.

Yet, as Delcoure et al. (2003) stated, covered interest parity has its limits. While it is good at uncovering when the parity situation exists, the free flow of capital between two nations, and when it doesn’t exist, factors blocking the free flow of capital between two nations, it falls short of explaining all the real world factors that can deviate from parity, stated Delcoure et al. One must consider other types of analyses to fully understand exchange rates and why they deviate, and the factors that affect the law of supply and demand governing them, stated Delcoure et al. Examining the factors that affect the supply and demand of currency helps firms in their decision making process of whether or not to finance in a foreign currency. 

In the following section, the outlook of exchange rate dynamics between the USD to EURO, JPY, and RUB from 2008-2013 will be examined in relation to each country’s historical economic events. One can consider all the needed currencies against USD because Russia and Kazakhstan use cross-rating for EUR and JPY based on USD. These currencies will be used to test the hypothesis.

The Exchange Rate Dynamics between the U. S. Dollar and EURO, JPY, and RUB from 2008-2013

One of the goals of this study is to understand currency fluctuations between the USD and EURO, JPY, and RUB. According to Lyons (2001), to understand how and why exchange rates fluctuate depend on the economic model of supply and demand. To understand the factors affecting the supply and demand of national currencies, Lyons stated, one must take into consideration three dynamics characteristically known to affect the supply and demand of currencies: macroeconomic influences, such as inflation rates set by governments and GDP; political climate and whether or not the country is relatively stable (United States) or volatile (Egypt); and psychological, such as investor reactions to a central bank increasing and decreasing interest rates, and investors’ impression on the value of a currency based upon its national deficit. The histories of USD to EURO, JPY, and RUB will be explained in terms of these three supply and demand factors. Also, the exchange rates will be expressed in the foreign currency against the USD and values will be reflected in USD per foreign currency. For the purposes of this study, currency dynamics will be explained in how many foreign currencies can one buy per USD.

However, before the history of the conversions between these currencies and the USD is explored, it is helpful to explain the relationship between Russia and Kazakhstan, describing the financial interests Kazakhstan and Russia share, and why Kazakhstan borrowers would consider the ruble as a currency for borrowing. 

Russian – Kazakhstan Relations and the Pegging of the Kazakhstan Tenge

History of Russian – Kazakhstan relations. According to the Russian Voice (2012, Russia, Kazakhstan to focus…), Kazakhstan and Russia established their relations 20 years ago after the dissolution of the USSR. Since then, they have established a common nuclear energy program, a common energy transportation system, reestablished their borders, collaborated their national defense systems (2012, Russian Voice, Russia, Kazakhstan to merge…), and combined their air forces (2012, Russian Voice, Russia, Kazakhstan to join…) and continue collaborating in their space programs (Kroth, 2012). 

Russia and Kazakhstan enjoy a robust trade. Their economies are heavily dependent on each other (Husain, 2006). Kazakhstan and Russia have similar economies, based upon the export of crude oil, and when crude oil prices drop, both economies suffer the same challenges (Husain, 2006). Kazakhstan and Russia often trade in the Russian ruble (Levitov, 2010).

Levitov (2010) conveyed, most recently, Russia opened the sale of its bonds in Russian currency to Belarus and Kazakhstan. Levitov (2010) elaborated upon Russian and Kazakhstan relations. Kazakhstan borrowers secure loans in ruble denomination to support trade efforts between the two countries.  

Kazakhstan and foreign borrowing. As Husain (2006) stated, Kazakhstan has increased their foreign borrowing in the last decade: “External borrowing by Kazakhstan’s private sector, especially banks, has surged in recent years. Indeed, overseas debt placements by private entities in Kazakhstan in 2004-2005 has exceeded that from many of the economies included in the major emerging market indices” (p. 15). Yet, borrowing in foreign currency, mainly in USD, has decreased in recent years, stated Husain, although it does remain substantial enough to remain vulnerable to international monetary fluctuations. Except for the most recent developments in 2010, Russia selling bonds in the ruble to Kazakhstan, “dollarization” (p. 15), borrowing in USD, is expected to remain high in the private sector in Kazakhstan. 

The pegging of the tenge. Husain (2006) provided the following explanation for why a country might want to peg their currency to a foreign currency. In order to bring stability to its own currency and to remain competitive in the international trading arena, a country might want to peg its currency to a foreign currency. If a country’s currency is pegged to the USD, as many countries are, such as the Chinese yuan, it becomes economic policy to allow them to keep their exchange rates low so their exports to the United States are competitively prices. Such is the case with Kazakhstan, whose tenge is pegged to the USD. However, the tenge is pegged to the USD because its main export, oil, is sold in dollars, which is in part the reason why the tenge has so many overseas holdings.  

As Husain (2006) stated: For Kazakhstan, macroeconomic instability during the transition process in the 1990s likely precluded the maintenance of a peg, even if it had been desirable for economic and financial reasons. As stability was restored, a de facto peg against both the dollar and the ruble emerged, consistent with the need to build monetary policy credibility and, for the most part, an absence of factors that would imply sizeable economic costs of maintaining a peg. (p. 16)

Since the tenge is pegged to the Russian ruble and the USD, the analysis of currency exchange and the effects of the law of supply and demand governing the exchange rates include that of the USD, RUB, EURO, and JPY.

History of EURO to USD Conversion

(Formula omited for preview. Available via download) 

EURO to USD 2008. According to Amadeo (2013), at the beginning of 2008, the EURO was $1.4738, believing that the crisis caused by defaults on subprime loans was going to be confined to the U. S. However, Amadeo stated, the recession started spreading the globe, and people began to stockpile USD, and the EURO fell to $1.3919.

EURO to USD 2009. Amadeo (2013) explained the events of 2009 in the following way. At the beginning of 2009, the EURO was strong at $1.3946. When the EBC increased its rate to 1.5%, the EURO bottomed out at $1.2545, reflecting investors’ concerns that the EBC was raising its rates too early, squelching any chance of economic resurgence. Fears of the impending recession decreased the value of bonds and investments in EURO. When the EBC realized the failure of its tactic, it lowered its base commercial interest rate. This strategy was effective, and the EURO increased 20% between March 3 and December 1. Moreover, concerns over the 13 trillion U. S. deficit resulted in investors’ loss of confidence in the dollar, and they dumped their U. S. holdings. The EURO closed the year out at $1.4332.

EURO to USD 2010. Amadeo (2013) described the factors involving currency fluctuations in 2010. The EURO opened at $1.4419 in January. In the first half of the year, it decreased 17% against the USD in the first half of June to its lowest value of $1.20 due to investors’ concerns over weak European economic conditions. When the European economy demonstrated signals of economic recovery, the EURO increased to $1.42 in November. However, confidence fell again and so did the EURO, to $1.3269 at the end of December.

EURO to USD 2011. According to Amadeo (2013) and the description of the events of 2011, the year began with the EURO opening at $1.3371. In July, it hit an annual ceiling of $1.4675 because of the subprime loan default crisis in the U. S. which caused investors to sell off their USD holdings, and the ECB increased its interest rates to 1.5%, which increased bank rates for the loan industry, increasing the currency rates of the EURO. 

Amadeo (2013) further elaborated, just when the U. S. subprime loan crisis was beginning to settle, investors sold off their EUROs because of the Greek bankruptcy, causing investors to question the viability of the European economy and whether or not the EURO would survive the crisis: Thus, the EURO’s rate plummeted to $1.3294. It increased briefly when European leaders gathered to resolve their economic crisis, but at year’s close, it sunk back down to $1.33.

EURO to USD 2012. As Amadeo (2013) elaborated, the full effect of the economic crisis in Europe was being fully realized at the opening of 2012, the EURO opening at $1.274. It rose for only a month to $1.3452 because investors’ fears were quelled because of an agreement between nations was signed in December of the previous year. However, in May, the EURO again bottomed out to $1.2405 as Greece headed towards bankruptcy and was in instiutional and political uncertainty, unable to elect a President. When Greece was bailed out and they elected a new President in June, the EURO increased to $1.27, but plummeted again when Spain and Italy increased the interest rates on bonds to 7%, decreasing the EURO again to $1.2149 in August. By December, the crisis had resolved, and the year closed with EURO value at $1.3186.

EURO to USD 2013. As Amadeo (2013) explained, the EURO opened the year at $1.3195 and increased to $1.396 one month later, signaling the nearing resolution of the debt crisis in Europe. However, the strength of the EURO could damage exporting with a weak European economy, and thus decreased slightly $1.2990; but by June, recovery was becoming evident with the increase to $1.3113. With these signals, it is hopeful that the European countries will continue to recover.

History of JPY to USD Conversion

(Formula omited for preview. Available via download)

JPY to USD 2008. According to the Federal Reserve (2013), the JPY opened the year with 109.7000 per USD and steadily increased to 96.8800 by the middle of February. The Federal Reserve stated the dollar increased, hitting a high of 108.0500 yen per USD in June. In the third quarter, stated the Federal Reserve, the JPY fluctuated little, ending the third quarter at 105.9400 because of Japan’s minimal inflation rates and its healthy export market (The Economist, 2008). In October, according to the Federal Reserve, the dollar was devalued and began its steady decline because of the loan default of the U. S. housing market (The Economist, 2008), causing investors to sell off their assets to finance foreign currency loans (The Economist, 2008), closing at a value of 90.7900 (Federal Reserve).

JPY to USD 2009. At the start of 2009, according to the Federal Reserve (2013), the JPY opened with a value of 91.1200 per USD. It fluctuated a bit in the beginning, stated the Federal Reserve, then the USD began to rally for the end of the first quarter with a value of 99.1500 with the announcement that Japan will intervene in currency rates (The Economist, 2009). The Federal Reserve stated for the second quarter, the yen hovered between mid nineties and upper nineties per USD, closing the quarter at 96.4200 due to the Bank of Japan budgeting and holding their interest rates at .1% (Rediff Business, 2009). The third quarter and closed with 89.4900. The yen per USD hovered in the high eighties and low nineties, closing the year with a value of 93.0800, stated the Federal Reserve, and the USD devalued in the last quarter because of the Bernake scandal (Tharp, 2009). 

JPY to USD 2010. The Federal Reserve (2013) stated the year opened with a value of 92.550. The yen per USD, according to the Federal Reserve, hovered between the high eighties and low nineties until the end of the second quarter with an ending value of 88.4900. As Fujioka and Ito (2010) stated, the yen usually performs well against the USD and EURO during recessions overseas, because the yen is seen by investors as a low-risk investment because of its deflation. In the third quarter, stated the Federal Reserve, the yen slowly and steadily increased against the USD with 83.5300 as a result of Japan government intervention. The yen closed against the USD with 81.6700 (Federal Reserve).

JPY to USD 2011. In January, explained the Federal Reserve (2013), the yen opened with a value of 81.5600. It hovered around the 80.0000 mark for all of the first and second quarters (Federal Reserve). It remained steady because investors were convinced that even after the earthquake and tsunami in Japan, assets were going to be pooled and funneled back into Japan to help rebuild the country (Ito & Ujikane, 2011). In the third quarter, the yen started to increase until it hit 76.4100 per USD in the first half of August, stated the Federal Reserve. The yen remained high but stable, closing the year with 76.9800, according to the Federal Reserve. The Japanese economy recovered after the tsunami in March, but the European economic crisis was too overwhelming and brought the Japanese economy down with it, while investors continued to buy the yen because of the devaluation of the dollar (Ito, 2012). This is good for currency rates, but bad for exports, which is how Japan brings in a bulk of its revenues (Ito, 2012)

JPY to USD 2012. The opening value for the yen, according to the Federal Reserve (2013), was 76.6700 against the USD. The yen decreased in the first quarter to a high of 83.6200 in the middle of March, the highest value for the dollar for the first half of the year, stated the Federal Reserve. The yen increased against the USD again for the third quarter into the high seventies, and Japan was burdened by the debt accumulated to rebuild the country after the tsunami and a weak global economy and strong currency limiting exports (Mayger, 2012), but then the yen devalued again for the fourth quarter, ending the year with 86.6400 (Federal Reserve). Speculators bought up yen because of the election of Shinzo Abe (Bennett, 2012). 

JPY to USD 2013. The year began with 87.1000, then the yen declined against the dollar through the first quarter and part of the second quarter until it hit a first half of the year dollar at 103.5200 in the middle of May (Federal Reserve, 2013). A few days later, the yen increased again into the high- and mid-nineties per USD and has been hovering between the mid nineties and 101 mark until summer months (Federal Reserve) Japan’s ballooning debt with the rising cases of welfare and impending consumer tax increases influencing exchange rates (Detrixhe, J. 2013). The dollar fell in the summer months against ten other currencies from developed countries because investors anticipate actions from the federal government to be postponed until the end of the year rather than in September (Detrixhe, 2013).   

History of RUB to USD Conversion

(Formula omited for preview. Available via download)

RUB to USD 2008. According to Freecurrencyrates.com (2013), the Russian ruble opened the year with 24.57 against the USD. The Russian ruble climbed very slow and steadily against the declining dollar at the end of the first quarter until the value was 23.4522, stated Freecurrencyrates.com. The RUB held steadily around this range until the end of the third quarter with a value of 25.6542 per USD. The trend for the fourth quarter was declining values, the amount of RUB per USD ending the quarter with the closing value of 29.3427. The decline in ruble values triggered worsening economic conditions after investors pulled out when Russia’s main export, crude oil, dropped below $50 per barrel and because of the war with Georgia and a dispute with the Ukraine (O’Brien & Levitov, 2008).  

RUB to USD 2009. According to Freecurrencyrates.com (2013), the Russian ruble opened the year at 29.5508 per USD and declined further in the quarter. This trend was intentional to help Russian exports (Miller, 2009). As a general trend, the ruble’s value increased steadily against the USD but was still down from previous years because of the Great Recession (Miller, 2009) throughout the second and third quarters until the end of the year, closing at 30.3122, said Freecurrencyrates.com.

RUB to USD 2010. According to Freecurrencyrates.com (2013), the Russian ruble opened with a value of 30.3122. The ruble, stated Freecurrencyrates.com, generally increased until the month of May, then started on a decline through May and June. The ruble remained fairly strong and steady throughout the rest of the year, hovering between 29 USD and 31 USD, stated Freecurrencyrates.com, indicating a two-year expansion since the Great Recession hit (Abelsky, 2010). This is because the price of oil remained higher, and because Russia began to open up the sale of the ruble to other markets: first to Belarus, allowing Belarus to sell bonds in the ruble (Levitov, 2010) and then trading the ruble with the Chinese Yuan (O’Brien & Danielyan, 2010). Russia sought to establish the Russian ruble as a world reserve denomination to diversify the international finance marketplace (Abelsky, 2010). 

RUB to USD 2011. According to Freecurrencyrates.com (2013), the RUB started the year with a value of 30.5437. The ruble and USD exchange remained fairly stable, although the dollar declined slightly and steadily until September by a few dollars, stated Freecurrencyrates.com. The ruble was strong during this period due to the price of crude oil rising to over 90USD a barrel (Webb, 2011), and even topping as high as over $110 USD per barrel (Chechel, 2011). Said Freecurrencyrates.com, the year remained stable and unremarkable, with no major dips or increases, and closed with 32.109 RUB per USD.  

RUB to USD 2012. According to Freecurrencyrates.com (2013), the year opened with the dollar performing well against the ruble with 32.0986 RUB per USD. As the first and second quarter progressed, the Feds sought to decrease the value of the dollar. Explained Kadlec (2012): “The Fed’s zero interest rate policy accentuates the negative consequences of this steady erosion in the dollar’s buying power by imposing a negative return on short-term bonds and bank deposits” (para. 4). The U. S. currency, stated Freecurrencyrates.com, declined in value through the first and the first part of the second quarter, hovering around 29 rubles per USD. The value went back up the second month of the second quarter and remained steady around the 32 rubles per USD through the third quarter, stated Freecurrencyrates.com. The exception was in June, where the RUB lost 2.2 percent. The reason for the drop was tied to the decrease in crude oil, and when a decrease in crude oil is realized, the Russian economy suffers because its main industry and export is in crude oil (Vasilyeva, 2012). In addition, Vasilyeva stated, when investors are worried about the global economy, investors pull out of the ruble because it is seen as high risk, and instead favor U. S. Treasuries or German bonds. In the fourth quarter, the dollar declined slowly and steadily until it reached 30.3665 by year’s end. This was due to the strengthening of the ruble, Pronina and Galouchko (2012) stated, because Russian companies bought the Russian ruble to pay their taxes and support the ruble.

RUB to USD 2013. According to Freecurrencyrates.com (2013), the Russian ruble started the year strong with a value of 30.5585 rubles per USD. In the end of the first quarter and into the second quarter, stated Freecurrencyrates.com, the USD strengthened against the ruble until August. In July, the ruble fell due to economic instability in the BRIC nations (Brazil, Russia, India, and China) and increasing oil prices, causing investors to sell of their shares of the Russian ruble observed Xie, Levitov, and Galouchko (2013).

Exchange Rates and Risk: A Summary. From the preceding section, there are some takeaway pieces of information that are important to consider in terms of foreign currency and risk. The following is a summary of some of the main concepts.

Before the Great Recession, U. S. currency was considered a safe haven currency. After the Great Recession, investors fled the USD and looked for safer investments, such as the Japanese yen. This was not good for Japanese exports, since Japan relies on exports for its economy. The Japanese government had asked investors in 2010 and 2011 to stop buying yen currency. Yet, even though the USD isn’t stable yet, and the Feds are looking to drive down its worth, there are still some investments that are considered safe, such as U. S. Treasuries.

The EURO was also affected by the Great Recession, and many of its major banks had the same problem with unsecured loans. Another blow to the EURO was the Greek bankruptcy. The EURO and the USD have been struggling to recover ever since, trying their best to avoid another recession in 2010 through 2011. 

The Russian ruble seemed to have the best recovery after the Great Recession. President Medvedev pushed the ruble as a new world reserve currency to consider, along with the other BRIC nations. Yet, it might be a hard sell for Russia to establish the ruble as a world reserve currency because of the lack of economic diversity. The relationship between oil prices and its economy is a straight line: when oil drops, so does the Russian GNP and visa versa. When oil prices drop and talk of a recession looms, investors are wary and flock to safer investments, as they did most recently. 

The literature review explained the core concepts of this research paper. The introduction introduced the core concepts of the covered interest rate parity. The literature review explained the following subjects : why firms are interested in foreign financing, factors affecting the exchange of currency, unpredictable deviations from covered interest rate parity, predictable deviations from covered interest rate parity, why firms would want a forward contract, why firms should consider foreign exchange and interest rates in comparing domestic funding with international funding, the exchange rate dynamics between the U. S. Dollar and EURO, JPY, and RUB from 2008-2013 and Russian – Kazakhstan relations and the pegging of the Kazakhstan tenge. The next section will explain the methodology of this study. 

Methodology

The purpose of this study is to compare two options for a Russian or Kazakhstan company and discover which option is cheaper in terms of cost: to borrow in domestic market in ruble or Tenge and repay the loan and interest in 3 months, or to borrow in a foreign market (for example in USD), convert the money in ruble or Tenge and buy USD forward in order to be able to repay the loan in USD. The methodology used for this study will follow the concepts in Moosa’s (2002) research on covered interest rate parity. Moosa’s explanation of the calculations will be used for the entirety of this section. 

The covered interest rate parity presents the perfect opportunity to create a null hypothesis and alternate hypotheses, the null hypothesis being parity is held, or there are not any obstacles in the free flow of capital if CIP [covered interest parity] holds then the effective financing rate in currency y, given a base currency x, is equal to the effective financing rate in currency x, if y is the base currency. It will also be shown that the equality of these two rates in possible even if CIP is violated, provided that the violation follows a certain condition. (pp. 21-22) 

This concept follows along with Levich’s (2011) findings in past research, that interest parity can hold even with some obstacles under certain circumstances. 

When considering the effective financing in foreign currency y with base currency x, the exchange rate is dependent on the cost of obtaining y-currency and a change in the spot exchange rate between x and y. With S(x/y) equal to the currency rate, a loan in L units and time t, the equation relating the two into the effective financing is given by 

(Formula omited for preview. Available via download) 

This model incorporates the proper variables, but the exchange rate at the forwarded time is still unknown. The uncertainty of the exchange rate at the forwarded time creates a risk. A possible strategy would be to simply finance at the forwarded rate, in which the equation would be:

(Formula omited for preview. Available via download) 

The interest rate parity condition means that it is indifferent for the investor to invest in foreign currency or domestic currency. Due to transaction costs, it is likely domestic currency will be used, but it is essentially indifferent. 

Since the exchange rate at the forwarded time is represented by F(x/y), the risk of currency fluctuation has been accounted for and is therefore covered. If covered interest parity indeed minimizes the risk of currency fluctuation, then the equation with subscripts minimized is:

(Formula omited for preview. Available via download) 

And this is used at the null hypothesis for testing covered interest parity. The test subject is whether or not the effective financing rate in one currency will be equal to the effective financing rate if the roles are reversed. The condition is represented by:

(Formula omited for preview. Available via download) 

With this, it is shown that the equality of effective financing rate can be achieved without covered interest parity, which shows it is not a necessary condition. If covered interest parity is to a necessary condition, then uncovered interest parity must be a possible condition. If it is assumed that covered interest parity is violated, the equation is:

(Formula omited for preview. Available via download) 

And with this formula to measure the percentage deviation from CIP, the testing of hypothesis can begin.

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