Interest Rate Parity
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
the forward rate for country B’s currency should be at a premium sufficient to prevent arbitrage
.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.
According to IRP:
F/S = (1+rd)/(1+rf) OR (1+rd) F = ----------. S (1+rf)
Thus. it does not matter whether you
invest in domestic country or foreign country.rf) ---------- (1+rf)
If IRP holds. if rf < rd
Forward Premium/Discount of a foreign currency: (rd . arbitrage is not possible. if rf > rd and F is more than S. your rate of return will be the same as if you invested in home country when measured in domestic currency
. F is less than S.
Implications of IRP
If domestic interest rates are less than foreign interest rates. arbitrage opportunity exists for domestic investors. Domestic investors can benefit by investing in the foreign market
. 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.
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. Foreign investors can benefit by investing in the domestic market
. arbitrage opportunity exists for foreign investors. If domestic interest rates are more than foreign interest rates.