Interest Rate Parity

Outline  Meaning of Interest Rate Parity  Implications of Interest Rate Parity  What if Interest Rate Parity holds?  What if Interest Rate Parity does not hold? –The concept of covered interest arbitrage  Other considerations when assessing Interest Rate Parity

Meaning of Interest Rate Parity  Uses nominal interest rates to analyze the relationship between spot rate and a corresponding forward rate  Relates interest rate differentials between home country and foreign country to the forward premium/discount on the foreign currency  The size of the forward premium or discount on a currency should be equal to the interest rate differential between the countries of concern  If nominal interest rates are higher in country A than country B, the forward rate for country B’s currency should be at a premium sufficient to prevent arbitrage

 According to IRP: F/S = (1+r d )/(1+r f ) OR (1+r d ) F =  S (1+r f )

 Thus, F is less than S, if r f > r d and  F is more than S, if r f < r d  Forward Premium/Discount of a foreign currency:  (r d - r f )   (1+r f )  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 IRP  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. 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. Foreign investors can benefit by investing in the domestic market