Interest rate parity 1
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  • 1.  
  • 2.
    • 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.
  • 3.
    • 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.
  • 4.
    • Interest rate parity A currency is worth
    • what it can earn.
    • 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.
  • 5.
    • 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.
  • 6. Rate of return in local Currency(say $) Rate of return in foreign Currency(say £) =
  • 7.
    • 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
    • (1 + r h ) = F
    • (1 + r f ) S
    • where
    • 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
    • S is the spot rate
  • 8.
    • 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.
  • 9.
    • 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
  • 10.
    • If domestic interest rates are more than foreign interest rates, you will invest in domestic market at higher interest rates
    • Foreign investors can benefit by investing in the domestic market
    Implications of IRP
  • 11.
    • Factors that influence the level of market interest rates include:
    • Expected levels of inflation
    • General economic conditions
    • Monetary policy
    • Foreign exchange market activity
    • Foreign investor
    • Levels of sovereign debt outstanding
    • Financial and political stability
  • 12. F o = forward rate S o = current spot rate i c = interest rate in home country i b = interest rate in foreign country } IRP
  • 13.
    • 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
  • 14. 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
  • 15.  
  • 16. 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
  • 17.