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Interest Rate Parity (IRP) theory establishes the correlation between the spot exchange rate and the anticipated future exchange rate or forward exchange rate of two currencies, relying on interest rates. According to this theory, the forward exchange rate is expected to align with the spot currency exchange rate multiplied by the home interest rate and divided by the foreign interest rate. For a deeper understanding of interest rate parity and its implications, read on.
Table of Contents
Understanding Interest Rate Parity
Interest rate parity refers to the equation used to manage currency exchange and interest rates. Investors use it to connect foreign exchange rates, spot exchange rates, and interest rates on foreign exchange markets.
IRP posits that the interest rate differential between two countries mirrors the difference between spot and forward exchange rates. The forward exchange rate aligns with the spot exchange rate multiplied by the home country’s interest rate and divided by the foreign currency’s interest rate.
Despite interest rate fluctuations, investing in different currencies should yield consistent hedged returns.
No-arbitrage principles stem from IRP, preventing traders in foreign exchange markets from exploiting price disparities by simultaneously buying at a lower rate and selling at a higher rate in different countries.
Covered Vs Uncovered Interest Rate Parity
There is only one difference between uncovered and covered IRP, which is the use of forward contracts.
IRP is ‘covered’ when the no-arbitrage condition can be met with forward contracts to hedge against risk. If the condition can be met without forward contracts, this is called uncovered interest rate parity.
Covered Interest Rate Parity (CIRP) Example
- An American investor plans to convert USD to INR in India.
- Investing USD locally at a risk-free foreign rate and entering a forward rate agreement to convert returns into INR at the forward exchange rate.
The covered approach entails using forward contracts to manage the exchange rate risk. By investing in the local currency (INR) and simultaneously entering into a forward contract, the investor safeguards against potential fluctuations in the INR-USD exchange rate. At the end of the investment period, the investor can convert the INR returns into USD at the pre-agreed forward exchange rate, thereby ensuring a known USD return irrespective of exchange rate movements.
Uncovered Interest Rate Parity (UIRP) Example
- Converting USD into INR using the spot exchange rate and then investing INR at the local risk-free rate in India.
- Investing without forward contracts exposes the investor to potential fluctuations in exchange rates, aligning with the concept of UIRP in the Indian scenario.
In the uncovered approach, the investor forgoes using forward contracts to hedge against currency risks. By directly converting USD to INR using the spot exchange rate and investing in the local market, the investor is exposed to potential fluctuations in the INR-USD exchange rate during the investment period. Any changes in the exchange rate between USD and INR could impact the investor’s returns when converting INR back into USD at the end of the investment period, thereby aligning with the concept of UIRP.
Interest Rate Parity Formula
The most important thing to understand is the terminology used in the interest rate parity formula. The spot exchange rate refers to the current exchange rate, while the forward exchange rate refers to the future exchange rate. Various banks and currency dealers offer forward rates from days to years.
A swap point is the difference between a spot rate and a forward rate. In the case of a positive difference, it is called a forward premium. The term forward discount refers to a negative difference. The forward premium occurs when a currency with a lower interest rate trades against one with a higher interest rate.
IRP equations for covered and uncovered IRPs are different. Covered IRP shows the forward exchange rate, while uncovered IRP shows the spot exchange rate.
The uncovered interest rate parity formula is as follows:
ST(a/b) = St(a/b) * (1+ ia) / (1 + ib)
The covered interest rate parity formula is:
Ft(a/b) = St(a/b) * (1+ ia)T / (1 + ib)T
The components of the equation are as follows:
- ST(a/b) = Spot Rate
- St(a/b) = Expected Spot Rate at time T
- Ft(a/b) = Forward Rate
- T = Time to Expiration Date
- ia = Interest Rate of Country A
- ib = Interest Rate of Country B
Importance of Interest Rate Parity
It is important to understand interest rate parity. If IRP does not hold, you could make a riskless profit. In the absence of IRP, an arbitrage strategy could be used.
Consider the following case where the forward exchange rate is not in equilibrium with the spot exchange rate.
- An arbitrage profit can be made if the actual forward exchange rate is higher than the IRP forward exchange rate.
- To do this, you would borrow money, exchange it at the spot rate, invest at the foreign interest rate, and lock in the forward contract.
- After the forward contract matures, you’ll exchange the money back into your home currency and repay the borrowed amount.
- You would have more than the amount you have to repay if the forward price you locked in was higher than the IRP equilibrium forward price.
- Essentially, you have made riskless money through borrowing.
To understand exchange rate determination, IRP is also important. By using the IRP equation, we can predict what the spot rate will be in the future if the interest rate changes. We might expect the home country’s currency to appreciate if the foreign country’s interest rate is kept steady and the home country’s interest rate is increased. A change in this would affect the expected exchange rate.
Conclusion
IRP stands as a crucial concept in finance, delineating the correlation between interest rates and exchange rates in global markets. It clarifies the equilibrium between spot and forward exchange rates based on interest rate differentials. By following IRP, investors discern arbitrage opportunities, making informed currency market decisions. The IRP formula predicts future exchange rate shifts due to interest rate changes, aiding in anticipating currency fluctuations. Understanding and applying IRP empowers individuals and entities to navigate international finance adeptly.