Interest Rate Parity

OutlineMeaning of Interest Rate ParityImplications of Interest Rate ParityWhat if Interest Rate Parity holds?What if Interest Rate Parity does not hold?The concept of covered interest arbitrageOther considerations when assessing Interest Rate Parity

Meaning of Interest Rate ParityUses nominal interest rates to analyze the relationship between spot rate and a corresponding forward rateRelates interest rate differentials between home country and foreign country to the forward premium/discount on the foreign currencyThe size of the forward premium or discount on a currency should be equal to the interest rate differential between the countries of concernIf nominal interest rates are higher in country A than country B, the forward rate for country Bs currency should be at a premium sufficient to prevent arbitrage

According to IRP:

F/S = (1+rd)/(1+rf)OR(1+rd)F = ----------- S (1+rf)

Thus, F is less than S, if rf > rd andF is more than S, if rf < rd

Forward Premium/Discount of a foreign currency: (rd - rf) ----------- (1+rf)If IRP holds, arbitrage is not possible; it does not matter whether you invest in domestic country or foreign country, your rate of return will be the same as if you invested in home country when measured in domestic currency

Implications of IRPIf 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 arbitrageIf 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. 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 arbitrageIf 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. Foreign investors can benefit by investing in the domestic market