1. Interest Rate Parity: Practical Implications

2. Equal return on $ investment
Interest Rate Parity
Interest Rate Parity
Return on a dollar invested must be the same everywhere through arbitrage in financial markets
Equal return on $ investment
(1+iUS) = 𝑓 𝑒 (1+iforeign)
e = $/€ Spot market
f = $/€ Forward market

3. Interest Rate Parity
Risk adjusted return on a dollar invested must be the same everywhere.
Interest Parity Mechanism
A difference in the return on a dollar invested in a foreign currency creates arbitrage opportunities. The ensuing investment decisions will go on until the arbitrage opportunity disappears.

4. iUS = 2% iGer = 4% Spot rate (e): 1$ = 1€
Interest Rate Parity
Example:
U.S. Investor wants to benefit from higher interest rates for one year Government bonds in Germany. The default risk is the same for both countries.
iUS = 2%
iGer = 4%
Spot rate (e): 1$ = 1€
Future rate (e): 1$ = €
1€ = 0.98 $

5. ? e: 1$ = 1€ f: 1€ = $0.98 Interest Rate Parity Invest in U.S.
$100
e: 1$ = 1€
Invest in Germany
€100 2% 4% ?
$102
€104
f: 1€ = $0.98
Once you eliminate the currency exchange rate risk you cannot take advantage of the higher interest rate

6. iUS = 5% iJap = 1% Spot rate (e): 1¥ = 0.01$ 1$ = 100¥
Interest Rate Parity
Example:
U.S. Company wants to benefit from lower interest rates for a one year loan in Japan.
iUS = 5%
iJap = 1%
Spot rate (e): 1¥ = 0.01$
1$ = 100¥

7. ? e: 1$ = 100¥ Interest Rate Parity Finance in U.S. Finance in Japan
$100
e: 1$ = 100¥
Finance in Japan
¥10,000 5% 1% ?
$105
¥10,100
1¥ = $
1$ = ¥96.19
Once you eliminate the currency exchange rate risk you cannot take advantage of the lower interest rate

8. Interest Rate Parity
Interest Rate Parity holds. Why do many managers still try to take advantage of interest differentials in foreign countries?
Agency Issue
- Stock options
- Bonus based on profit
Ignorance of Board / Stockholders