The Interest Rate Parity states that the interest rate difference between two countries is equal to the percentage difference between the forward exchange rate and the spot exchange rate.
It plays essential role in foreign exchange markets.
The difference between the interest rates in any two countries is the same as the difference between the forward and the spot rates of their respective currencies.
Interest rate parity A currency is worth The return on a currency is the interest rate on that currency plus the expected rate of appreciation over a given period.
When the returns on two currencies are equal, interest rate parity prevails.
The relationship can be seen when you follow the two methods an investor may take to convert foreign currency into U.S. dollars. Option A would be to invest the foreign currency locally at the risk-free rate for a specific time period. Then convert the proceeds from the investment into U.S. dollars at the maturity.
Option B would be to invest the same dollars in the (U.S.) market for the same time period. When no arbitrage opportunities exist, the cash flows from both options are equal.
Rate of return in local Currency(say $) Rate of return in foreign Currency(say £) =
In equilibrium, returns on both the currencies will be the same i. e. No profit will be realized and interest rate parity exists which can be written r h is the interest rate in home currency r f is the interest rate in foreign currency
F is the forward rate between the 2 currencies and
If interest rate parity is violated, then an arbitrage opportunity exists. The simplest example of this is what would happen if the forward rate was the same as the spot rate but the interest rates were different, then investors would: borrow in the currency with the lower rate convert the cash at spot rates enter into a forward contract to convert the cash plus the expected interest at the same rate invest the money at the higher rate convert back through the forward contract
repay the principal and the interest, knowing the latter will be less than the interest received.
If domestic interest rates are less than foreign interest rates, you will invest in foreign country at higher interest rates.
Domestic investors can benefit by investing in the foreign market
If domestic interest rates are more than foreign interest rates, you will invest in domestic market at higher interest rates Implications of IRP
Foreign investors can benefit by investing in the domestic market
Factors that influence the level of market interest rates include: Expected levels of inflation General economic conditions Foreign exchange market activity Levels of sovereign debt outstanding
Financial and political stability
F o = forward rate S o = current spot rate i c = interest rate in home country i b = interest rate in foreign country } IRP
A Canadian company is expected to receive Kuwaiti dinars in 1 years time. The spot rate is CAD/Dinar 5.4670. The company could borrow in dinars at 9% or in Canadian dollars at 14%. There is no forward rate for one year’s time. Predict what the exchange rate is likely to be in one year
S o = 5.4670 i c = 14% or 0.14 i b = 9% or 0.09 F = 5.4670 x (1 + 0.14) (1 + 0.09) F = 5.7178
Exchange Rate Forecasts Differences in Interest Rates International Fischer Effect Differences in Inflation Rates Forward Rate Premium or Discount Interest Rate Parity Fisher Effect Purchasing Power Parity Unbiased Forward Rate