Interest rate parity

Interest rate parity is a no-arbitrage condition representing an equilibrium state under which

investors will be indifferent to interest rates available on bank deposits in two countries. It can be
used to predict the movement of exchange rates between two currencies when the risk free
interest rates of the two currencies are known. The fact that this condition does not always hold
allows for potential opportunities to earn riskless profits from covered interest arbitrage. Two
assumptions central to interest rate parity are capital mobility and perfect substitutability of
domestic and foreign assets. Given foreign exchange market equilibrium, the interest rate parity
condition implies that the expected return on domestic assets will equal the exchange rate-
adjusted expected return on foreign currency assets. Investors then cannot earn arbitrage profits
by borrowing in a country with a lower interest rate, exchanging for foreign currency, and
investing in a foreign country with a higher interest rate, due to gains or losses from exchanging
back to their domestic currency at maturity. Interest rate parity takes on two distinctive
forms: Uncovered interest rate parity refers to the parity condition in which exposure to foreign
exchange risk(unanticipated changes in exchange rates) is uninhibited, whereas covered interest
rate parity refers to the condition in which a forward contract has been used to cover (eliminate
exposure to) exchange rate risk. Each form of the parity condition demonstrates a unique
relationship with implications for the forecasting of future exchange rates: the forward exchange
rate and the future spot exchange rate.
Economists have found empirical evidence that covered interest rate parity generally holds,
though not with precision due to the effects of various risks, costs, taxation, and ultimate
differences in liquidity. When both covered and uncovered interest rate parity hold, they expose
a relationship suggesting that the forward rate is an unbiased predictor of the future spot rate.
This relationship can be employed to test whether uncovered interest rate parity holds, for which
economists have found mixed results. When uncovered interest rate parity and purchasing power
parity hold together, they illuminate a relationship named real interest rate parity, which suggests
that expected real interest rates represent expected adjustments in the real exchange rate. This
relationship generally holds strongly over longer terms and among emerging market countries.

Assumptions
Interest rate parity rests on certain assumptions, the first being that capital is mobile - investors
can readily exchange domestic assets for foreign assets. The second assumption is that assets
have perfect substitutability, following from their similarities in riskiness and liquidity. Given
capital mobility and perfect substitutability, investors would be expected to hold those assets
offering greater returns, be they domestic or foreign assets. However, both domestic and foreign
assets are held by investors. Therefore, it must be true that no difference can exist between the
returns on domestic assets and the returns on foreign assets. That is not to say that domestic
investors and foreign investors will earn equivalent returns, but that a single investor on any
given side would expect to earn equivalent returns from either investment decision.

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Covered Interest Rate Parity

Covered interest rate parity is when the relationship between interest rates and the spot and forward
currency values of two countries are balanced. 

Uncovered Interest Rate Parity

Uncovered interest rate parity states that the difference in two countries' interest rates is equal to the
expected changes between the two countries' currency exchange rates.

Parity

Parity refers to things being equal to each other. It can thus refer to two securities having equal value.

Uncovered Interest Arbitrage

Uncovered interest arbitrage involves switching from a a lower interest rate currency to a higher interest
rate currency in order to increase returns.

Covered Interest Arbitrage

Covered interest arbitrage is a strategy where an investor uses a forward contract to hedge against
exchange rate risk, returns are typically small but it can prove effective. 

Interest Rate Differential - IRD

An interest rate differential measures the gap in interest rates between two similar interest-bearing assets.

Differential – IRD

The interest rate differential (IRD) weighs the contrast in interest rates between two
similar interest-bearing assets. Traders in the foreign exchange market use interest rate
differentials (IRD) when pricing forward exchange rates. Based on the interest rate parity,
a trader can create an expectation of the future exchange rate between two currencies and
set the premium, or discount, on the current market exchange rate futures contracts.

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Covered vs. Uncovered Interest Rate Parity
The interest rate parity is said to be covered when the no-arbitrage condition could be
satisfied through the use of forward contracts in an attempt to hedge against foreign
exchange risk. Conversely, the interest rate parity is said to be uncovered when the no-
arbitrage condition could be satisfied without the use of forward contracts to hedge
against foreign exchange risk.

Covered Interest Rate Parity Example

For example, assume Australian Treasury bills are offering an annual interest rate of
1.75%, while U.S. Treasury bills are offering an annual interest rate of 0.5%. If an
investor in the United States seeks to take advantage of the interest rates in Australia, the
investor would have to translate U.S. dollars to Australian dollars to purchase the
Treasury bill. Thereafter, the investor would have to sell a one-year forward contract on
the Australian dollar. However, under the covered interest rate parity, the transaction
would only have a return of 0.5%, or else the no-arbitrage condition would be violated.

THE PORTFOLIO BALANCE APPROACH

The Portfolio Balance approach is a modern theory based on the relationship between the relative price of
bond and exchange rate. The portfolio balance approach is an extension of the monetary exchange rate
models focusing on the impact of bonds. According to this approach, any change in the economic
conditions of a country will have a direct impact on the demand and supply for the domestic and the
foreign bond. This shift in the demand/supply for bonds will in turn influence the exchange rate between
the domestic and foreign economies.

The key advantage of the portfolio approach when compared to traditional approaches is that the financial
assets tend to adjust considerably faster to news economic conditions than tradable goods. Nevertheless,
based on empirical evidence, the portfolio balance approach is not an accurate predictor of exchange
rates.