Exchange Rates, Interest Rates, and Interest Parity Chapter 15 Exchange Rates, Interest Rates, and Interest Parity

Topics to be Covered Interest Rate Parity Nominal Interest Rate Real Interest Rate Fisher Equation Exchange Rates, Interest Rates, and Inflation Expected Exchange Rates and the Term Structure of Interest Rates

Interest Parity The interest parity relationship is a result of profit-seeking arbitrage activity called covered interest arbitrage. A U.S. investor deciding between investing in the U.S. or in the U.K. must consider: The interest rates, i$ and i£ The spot exchange rate, E , (in $/ £) The forward exchange rate, F, (in $/ £)

Interest Parity (cont.) By investing $1 at home, the U.S. investor can earn 1 + i$ for one period. Or, since $1 = 1/E pounds, the U.S. investor can invest in the U.K. and earn (1 + i£)/E. Since future spot rates are unknown, the investor can eliminate the uncertainty over the future dollar value of the investment with a forward exchange contract.

Covered Return Covered return is the domestic currency value of a foreign investment when the foreign currency proceeds are sold in the forward market. In our example, the covered return is equal to (1 + i£)F/E dollars. Arbitrage between the two investment opportunities results in:

Interest Rate Parity Interest rate parity states that the forward premium (or discount) is equal to the interest differential. This parity is approximated by the equation:

Effective Return The effective return on a foreign investment is given by the interest rate plus the expected change in the exchange rate. Using our example, the effective return is:

Reasons Why Interest Rate Parity May Not Hold Buying and selling foreign exchange and international securities involve transaction costs. Taxes may differ according to an investor’s residence. Government controls on financial capital flows may exist (see Global Insights 15.1). There may be political risks. There are time lags between observing the profit opportunity and actually trading to realize the profit.

Interest Rates and Inflation Nominal Interest Rate—the interest rate actually observed in the market. Real Interest Rate—the nominal interest rate minus or adjusted for inflation.

Fisher Equation The relationship between interest rates and inflation is given by the Fisher equation: where i is the nominal interest rate, r is the real interest rate, and π is the expected rate of inflation. Refer to Table 15.1

TABLE 15.1 Interest Rates and Inflation Rates for Selected Countries, 20071

Exchange Rates, Interest Rates, and Inflation Real interest rates are equalized across countries when the Fisher equation, interest rate parity, and relative purchasing power parity all hold. Given our U.S. and U.K. investment example: Interest rates, inflationary expectations, and exchange rates are all jointly determined and affected by government policy changes and other news.

Term Structure of Interest Rates There is no such thing as the interest rate for a country. Term structure of interest rates—the pattern of interest rates over different terms of maturity.

Expected Exchange Rates and Term Structure of Interest Rates Refer to Figure 15.1 Eurocurrency Interest Rates If the term structure lines for two countries are: Parallel, then exchange rate changes are expected to be constant Diverging, then the high-interest-rate currency is expected to depreciate at an increasing rate over time Converging, then the high-interest-rate currency is expected to depreciate at a declining rate relative to the low-interest-rate currency

FIGURE 15.1 Eurocurrency Interest Rates for July 13, 2008