This document discusses interest rate parity theory. It begins by defining spot and forward rates. Spot rates are prices for immediate settlement, while forward rates refer to rates for future currency delivery adjusted for cost of carry. Interest rate parity theory states that interest rate differentials between currencies will be reflected in forward premiums or discounts. The theory prevents arbitrage opportunities by making returns equal whether investing domestically or abroad when measured in the home currency. The document provides an example of covered and uncovered interest rate parity. Covered parity involves hedging exchange rate risk while uncovered parity does not. Empirical evidence shows uncovered parity often fails while covered parity generally holds for major currencies over short time horizons.

1. Interest rate parity
Presented by:
Ekta Thalani (MBA-IB III Sem.)
Sujata Singh (MBA-IB III Sem.)

2. Flow of Presentation:
 Spot rate
 Forward rate
 Interest rate parity
 Arbitrage
 Illustration

3. Spot rate:
 The price quoted for immediate settlement on
a commodity, a security or a currency.
 based on the value of an asset at the
moment of the quote.
 value is in turn based on how much buyers
are willing to pay and how much sellers are
willing to accept, with certain determining
factors.

4. Spot rate
 Other names:
“benchmark rate,” “straightforward rate” or
“outright rate.”
 Sources providing spot rate info:
A number of sources, including Bloomberg,
Morningstar, Thomson Reuters etc.

5. Some terms…
 Spot settlement: the transfer of funds that
completes a spot transaction,
 Spot date: the day when settlement
occurs.

6. Forward rate
 A rate applicable to a financial transaction
that will take place in the future.
 Forward rates are based on the spot rate,
adjusted for the cost of carry and refer to the
rate that will be used to deliver a currency,
bond or commodity at some future time.

7. Forward Premium And Forward
Discount
 A Forward Premium is the proportion by
which a country's forward exchange rate
exceeds its spot rate.
 A Forward Discount is an indication by the
market that the current domestic
exchange rate is going to depreciate in
value against another currency.

8. Interest Rate Parity
 Interest Rate Parity (IRP) theory is used to analyze the
relationship between the spot rate and corresponding
forward (future) rate of currencies.
 The IPR theory states interest rate differentials between
two different currencies will be reflected in the premium
or discount for the forward exchange rate .
 The theory further states size of the forward premium or
discount on a foreign currency should be equal to the
interest rate differentials between the countries in
comparison.

9. Arbitrage
 By purchasing a foreign currency and
depositing it abroad, investors can
effectively capitalize on the difference in
interest rates.
 Arbitrage can be of two types:
 Covered interest rate arbitrage
 Uncovered interest rate arbitrage

10. Illustration:
Interest rate: 5% (US) 8%(UK)
Spot rate: £=$1.50
Forward rate: £=$1.48
Borrow $1 million and capitalize the difference in
interest rates.
Solution:
step1: borrow in USD for 1 year @5%
Step2: convert $1million in £ at prevailing rate.(666,667)
Step3: invest 666,667 in UK @8% for 1 year(53,334)
Step4: sell your £ proceeds after 1 year @$1.48/£

11. i.e. 720,000*1.48 =$1,065,600
Step5: return $1 million and the residual income is the
outcome of your interest rate arbitrage.
Hence, $(1,065,600-1,000,000)
=$65600

12. UTILITY of the theory
Two methods an investor may take to convert foreign
currency into U.S. Dollar
Option A would be to invest the foreign currency
locally at the foreign risk-free rate for a specific time
period. The investor would then simultaneously enter
into a forward rate agreement to convert the
proceeds from the investment into U.S. dollars, using
a forward exchange rate, at the end of the investing
period.
Option B would be to convert the foreign currency to
U.S. dollars at the spot exchange rate, then invest the
dollars for the same amount of time as in option A, at
the local (U.S.) risk-free rate.

13. Illustration:
 For our illustration purpose consider investing €
1000 for 1 year.
 We'll consider two investment cases viz:
 Case I: Domestic Investment
 In the U.S.A., consider the spot exchange rate
of $1.2245/€ 1.
 So we can exchange our € 1000 @ $1.2245 =
$1224.50
 Now we can invest $1224.50 @ 3.0% for 1 year
which yields $1261.79 at the end of the year.

14.  Case II: Foreign Investment
 Likewise we can invest € 1000 in a foreign
European market, say at the rate of 5.0% for 1
year.
 But we buy forward 1 year to lock in the future
exchange rate at
$1.20025/€ 1 since we need to convert our € 1000
back to the domestic currency, i.e. the U.S. Dollar.
 So € 1000 @ of 5.0% for 1 year = € 1051.27
 Then we can convert € 1051.27 @ $1.20025 =
$1261.79
 Thus, in the absence of arbitrage, the Return on
Investment (RoI) is same regardless of our choice
of investment method.

15. Types of IRP
 Covered Interest Rate Parity (CIRP)
Covered interest rate theory holds that interest rate
differentials between two countries are offset by the
spot/forward currency premiums as otherwise investors
could earn a pure arbitrage profit.

16. Example
 Assume Google Inc., the U.S. based multi-national company,
needs to pay it's European employees in Euro in a month's
time.
 Google Inc. can achieve this in several ways viz:
 Buy Euro forward 30 days to lock in the exchange rate. Then
Google can invest in dollars for 30 days until it must convert
dollars to Euro in a month. This is called covering because
now Google Inc. has no exchange rate fluctuation risk.
 Convert dollars to Euro today at spot exchange rate. Invest
Euro in a European bond (in Euro) for 30 days (equivalently
loan out Euro for 30 days) then pay it's obligation in Euro at
the end of the month.
 Under this model Google Inc. is sure of the interest rate that it
will earn, so it may convert fewer dollars to Euro today as it's
Euro will grow via interest earned.
 This is also called covering because by converting dollars to
Euro at the spot, the risk of exchange rate fluctuation is
eliminated.

17. Uncovered Interest Rate
 Uncovered Interest Rate theory states that
expected appreciation (depreciation) of a
currency is offset by lower (higher) interest.
 the other method that Google Inc. can
implement is:
 Google Inc. can also invest the money in
dollars today and change it for Euro at the
end of the month.
 This method is uncovered because the
exchange rate risks persist in this transanction

18. Comparison
 Recent empirical research has identified that
uncovered interest rate parity does not hold,
although violations are not as large as
previously thought and seems to be currency
rather than time horizon dependent.
 In contrast, covered interest rate parity is well
established in recent decades amongst the
OECD economies for short-term instruments.
Any apparent deviations are credited to
transaction costs.

19. Implications of the theory
 If IRP theory holds then arbitrage in not possible. No matter whether an
investor invests in domestic country or foreign country, the rate of return
will be the same as if an investor invested in the home country when
measured in domestic currency.
 If domestic interest rates are less than foreign interest rates, foreign
currency must trade at a forward discount to offset any benefit of
higher interest rates in foreign country to prevent arbitrage.
 If foreign currency does not trade at a forward discount or if the forward
discount is not large enough to offset the interest rate advantage of
foreign country, arbitrage opportunity exists for domestic investors. So
domestic investors can benefit by investing in the foreign market.
 If domestic interest rates are more than foreign interest rates, foreign
currency must trade at a forward premium to offset any benefit of
higher interest rates in domestic country to prevent arbitrage.
 If foreign currency does not trade at a forward premium or if the
forward premium is not large enough to offset the interest rate
advantage of domestic country, arbitrage opportunity exists for foreign
investors. So foreign investors can benefit by investing in the domestic
market.

20.  Interest rate parity is fundamental knowledge
for traders of foreign currencies. In order to
fully understand the two kinds of interest rate
parity, however,
 the trader must first grasp the basics of
forward exchange rates and hedging
strategies. Armed with this knowledge,
 the forex trader will then be able to use
interest rate differentials to his or her
advantage.

21. Limitations
 In recent years the interest rate parity
model has shown little proof of working.
 In many cases, countries with higher
interest rates often experience it's
currency appreciate due to higher
demands and higher yields and has
nothing to do with risk-less arbitrage.