Interest Rate Parity

Sarrah BuotPresentor

Interest Rate Parity is a theory in which the interest rate differential

between two countries is equal to the differential between the forward exchange rate and spot exchange rate.

establishes the break-even condition where the return on a domestic currency investment is identical with the return on a foreign currency investment covered against exchange risk.

Forward Exchange Rate vs. Spot Exchange Rate

Forward Exchange Rate (Forward Rate) • exchange rate fixed today for exchanging

currency at some future date.

Spot Exchange Rate (Spot Rate) • exchange rate on currency for immediate

delivery.

Covered Interest Rate Parity

• states that "forward exchange rates should incorporate the difference in interest rate between two countries, otherwise an arbitrage opportunity would exist.

• As a result, there are no interest rate arbitrage opportunities between those two countries.

"Kim Deal's Investment Opportunities”

Kim Deal, a European-based portfolio manager is trying to decide how to invest € 10,000,000. She must choose between 1-year euro deposits and 1-year yen investments. Kim worries about the foreign exchange risk she might face but she also understands that she can use the appropriate forward contract to eliminate it.

Suppose Kim has the following data:

EUR interest rate

3.5200% per annum (p.a.)

JPY interest rate

0.5938% p.a

Spot exchange rate

¥ 146.0300/€

1-year forward exchange rate

¥ 141.9021/€

Which of the two bank investments should Kim choose to get the highest

euro return?

Option A (Europe)- Euro Deposits

Calculate the euro return from investing in euro-denominated asset:

FV= PV (1+r)n FV= € 10,000,000 ( 1.0352)= € 10,352,000

€ 10,352,000-€ 10,000,000= € 352,000 (return)

Option B (Japan)- Yen InvestmentsCalculate the euro return from investing in yen

denominated asset:

Step 1. Convert the euro principal yen in spot foreign market.

€ 10,000,000 X (¥ 146.0300/€)= ¥ 1,460,300,000

Step 2. Calculate yen denominated interest plus the principal.

¥ 1,460,300,000 (1.005938)= ¥ 1,468,971,261

Step 3. Hedge the transaction exchange risk with a 1-year forward contract.

(NOTE: The transaction for foreign exchange risk can be eliminated by selling yen forward for euro).

• In this case, Kim would contract to sell ¥ 1,468,971,261 for euros at a 1-year forward rate at ¥ 141.9021/€

• In 1 year, she would receive: ¥ 1,468,971,261/ (¥ 141.9021/€)= € 10,352,005

€ 10,352,000- €10,000,000= € 352,005 (return)

To Calculate for Forward Rate:

Forward Rate = Spot Rate X (1 + Interest Rate of Overseas country)

(1 + Interest Rate of Domestic country)

Using the previous data of Kim deal, calculate the forward rate:

= ¥ 146.0300/€ X 1.005938

1.035200

= ¥ 141.9021/€

where, F – forward rate S – spot rateUsing the previous data of Kim deal, calculate the forward

Premium/Discount :

= ¥ 141.9021/€ -1 ¥ 146.0300/€ = -0.028267479 x 100 = -2.8267 or -2.83%

If P is: positive (+) = Forward Premium negative (-)= Forward Discount

Violation of IRPIf 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.

References:

https://msb040.msb.edu/.../Bekaert-Hodrick_Chapter6_

Interest%20Rate.pdf

www.investopedia.com/articles/forex/08/interes-rate-parity.asp

http://en.wikipedia.org/wiki/Forward_exchange_rate