INTREST RATE

PARITY
 IRP
• The IRP theory states that
equilibrium is achieved when the
forward rate differential is
approximately equal to the interest
rate differential.

• It thus helps determine forward

exchange rate.
 Covered Interest Arbitrage
• Covere Intrest Arbitrage involves
borrowing and lending in two market
and also buying spot and selling
forward the respective currency so
as to attain benefit or parity
conditon.
• Q. Assume there are 2 markets India
and US
• In India
• Spot market-Rs/$ 40
• 3m forward – Rs/$ 40.28
• Interest rate- 18%

• In United States-
• Interest Rate-12%
• Borrow $ 1000 and 12%
• Converting $ in Rs as per spot price Rs 40,000
• Invest 40,000 and 18%
• Selling the Rs 3m forward at Rs 40.28
• After 3 m months we would be getting 41,800
• Selling Rs 41,800 for the rate of Rs/$ 40.28 = $
1038
• Repaying the loan in US $ 1030
• Profit= $ 1038-$ 1030= $ 8
 But this arbitrage opportunity
would not exist for long time-

• 1) Borrowing in the USA will raise the interest rate

there.
• Investing in India would increase funds which would
lead to lower the interest rate
• Buying Rs at spot rate will increase spot rate of the
Rs,
• Selling Rs forward will depress the forward rate of Rs.
 Uncovered Interest
Arbitrage
• UIA does not involve forward market
transactions as interest rate
differential leads to change in future
spot price.