8/5/2019 Foreign Exchange Markets | A Matter of Course

A Matter of Course

Companion webage-cum-blog for PGP-1 Financial Markets class

Archive for the ‘Foreign Exchange Markets’ Category

[FM] FX Interest Parity Conditions

with one comment

We’ve already been exposed to forward rates when we talked about the term structure of interest
rates. Our work-horse model for introducing forward exchange rates isn’t too different from the toy
model we used when introducing forward rates in the interest rate world.

Forward on Foreign Exchange: Covered Interest Rate Parity

Let’s say there is an exporter who has receivables, say 1 million USD at the end of 1 year. If she does not
have natural offse ing payable around the same time, she is exposed to the exchange rate fluctuations.
And unless her business is dealing with exchange rates, she is faced with a business headache. It turns
out that there is a way that she can get rid of her headache and lock-in a rate today itself.

And the way to do so is not too unlike the way we went about introducing forward rates in the interest
rate world. There we said that a borrower who needed money at the end of 1 year for one year could do
so by borrowing for two years and lending for one year. Here we do something similar.

If she had a natural matching import expense, she would not be bothered about exchange rates. USD
comes in from export and goes out to import. But she needn’t be too bothered. If she does not have a
natural payable, it does not mean she cannot artificially create one. Good that it is not too difficult either.

One way to create such a payable is to, well, simply borrow the ‘right’ amount of USD today itself for 1
year. This ensures that she has a payable to the bank at the same time she gets money from the business.
So assuming there are no capital controls, if she can borrow PV of 1 million USD from a US bank, at the
end of 1 year the money from the business could go straight to the bank.

https://pgpfm.wordpress.com/category/foreign-exchange-markets/ 1/5
8/5/2019 Foreign Exchange Markets | A Matter of Course

In the process she is left with PV of 1 million USD today, which can be immediately converted into INR.
Since our focus is end of 1 year, we know how much this is worth then. This is exactly the the future
value of money of the INR equivalent today.

So graphically:

(Click to zoom; Note the color coding. The green arrow represents the final receivable in INR after
paying back the 1 million USD due to the US bank from the business.)

That is, by borrowing USD and investing in INR, the exporter has locked-in the receivables in the
domestic currency, and the effective ‘forward exchange rate’ for the exporter is:

or using continuous compounding as:

where, denotes the foreign currency interest rate. If the financial institution offered a ‘forward price’
different from this price there’ll be a possible arbitrage opportunity.

In general, for a contract expiring at time , using continuous compounding, the forward price of FX
will be:

For completeness sake, this is how an importer will lock in her forward price (as should be clear all
signs/direction of arrows have reversed, and borrowings have become lending and vice-versa):

https://pgpfm.wordpress.com/category/foreign-exchange-markets/ 2/5
8/5/2019 Foreign Exchange Markets | A Matter of Course

(Click to zoom; Note the color coding. The green arrow represents the final payable in INR after ge ing
‘back’ the 1 million USD from the US bank due to the business.)

When the forward exchange rate is more (less) than the spot rate, one says that the foreign currency (say,
USD) is trading at a forward premium (discount). Given that the covered parity condition is about
interest rates, forward premium/discount are also described in terms of percentages (assuming annual
periods) as:

As should be clear, all of this assumes no transaction cost and absence of any default risk. But this is one
parity which tends to work fairly well in most times because banks need large corporations as much as
the corporations need them, banks are happy to provide such services for a minimal fee.

Uncovered Interest Rate Parity

The uncovered interest parity is really a bond markets / investments story. It’s a sort of law of one price
for capital account, and says that return from money invested in the domestic country bank account
must be same as that achieved from the money invested in the foreign country bank account.

Like in the example we discussed, from the vantage point of a US national, there are two choices:

1. Put money in a USD bank: This gives USD at the end of 1 year
2. Put equivalent money in an INR bank, and convert the proceeds back to USD at the end of 1 year:
Let’s see this one step-by-step:
Converting to INR ‘today’ gives INR, where represents the spot exchange rate
Investing in the INR bank gives at the end of 1 year
The proceeds converted back to USD gives at the end of 1 year in terms of USD

The theory says that the two amounts should be equal, as:

https://pgpfm.wordpress.com/category/foreign-exchange-markets/ 3/5
8/5/2019 Foreign Exchange Markets | A Matter of Course

The uncovered parity then says that forward exchange rate captures the expected future spot exchange
rate .

This is not too different from the expectations hypothesis we encountered in our discussion on the term
structure of interest rates. And just like in that case, as should be clear, this ignores risk premium. In
practice it has been found that high yielding currencies do not depreciate ‘as much’ as the theory would
suggest, which shows up in an active carry trade.

What remains a puzzle is that the parity does not even hold for currencies of seemingly equal risk
categories, and this remains a puzzle to this day for empirical finance and macroeconomics.

Advertisements

REPORT THIS AD

REPORT THIS AD
Wri en by Vineet

October 12, 2015 at 5:25 pm

Posted in FM, Foreign Exchange Markets

Tagged with Covered Interest Parity, FM-2015-16, Foreign Exchange Markets, Session 16, Uncovered
Interest Parity

https://pgpfm.wordpress.com/category/foreign-exchange-markets/ 4/5
8/5/2019 Foreign Exchange Markets | A Matter of Course

Blog at WordPress.com.

https://pgpfm.wordpress.com/category/foreign-exchange-markets/ 5/5