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Interest Rate Parity
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
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 Bs currency should be at a premium sufficient to prevent arbitrage
According to IRP:
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