70-398 INTERNATIONAL FINANCE

SPRING 2023

Ch.6 Covered Interest Rate Parity

Prof. Serkan Akguc

The Theory of Covered Interest Rate Parity

• Interest rate parity describes a no-arbitrage relationship between spot and forward
exchange rates and the two nominal interest rates associated with these currencies
• Interest rate parity implies that forward premiums and discounts in the foreign
exchange market offset interest differentials to eliminate possible arbitrage that
would arise from borrowing the low-interest-rate currency, lending the high-interest-
rate currency, and covering the foreign exchange risk
• Covered interest arbitrage is done in four steps
– borrowing one currency
– converting to a second currency
– investing in the second currency
– selling the interest plus principal on the second currency in the forward market for the first
currency
• When domestic and foreign interest rates and spot and forward exchange rates are in
equilibrium no covered interest arbitrage is possible
– Markets should also be efficient and no government control should exist
The Theory of Covered Interest Rate Parity

An investor (Kim) has €10M to invest, and following data is available

iEuro = 3.52% per annum (p.a.)
iJPY = 0.5938% p.a.
Spot = ¥ 146.03 / € F1-yr = ¥ 141.9021 / €

Invest in Euro or Yen?

Euro Return: € 10M * 1.0352 = € 10,352,000
Yen Return can be calculate as follows

1. Convert into forex using spot rate: € 10M x (¥ 146.03 / € ) = ¥ 1,460,300,000

2. Invest at Yen interest rate: ¥ 1,460,300,000 * 1.005938 = ¥ 1,468,971,261
3. Hedge: convert back at forward rate
(¥ 1,468,971,261) / (¥ 141.9021 / € ) = € 10,352,005

Invest home or abroad ➔ ~ same outcome

Example 2
An investor (Kevin) has $10M to invest, and following data is available
iU.S.=8%;
iU.K.= 12%;
S=$1.60/£ F1-yr=$1.53/£

Invest in U.S. or U.K.?

$ Return: $ 10M * 1.08 = $10.8M

£ Return can be calculate as follows

1. Convert into forex using spot rate: $10M/$1.60/£) = £6.25M

2. Invest at foreign interest rate: £6.25M * 1.12 = £7M
3. Convert back at forward rate: £7M * $1.53/£) = $10.71M

Investing at home (U.S.) is more profitable for Kevin.

But what if he could borrow/lend? Is the answer still the same?
The Theory of Covered Interest Rate Parity

iU.S.=8%; iU.K.= 12%; S=$1.60/£; F1-yr=$1.53/£

1. Borrow pounds: £1M * 1.12 = £1.12M (what Kevin owes at end of investment
term)
2. Convert pounds to dollars: £1M * ($1.60/£) = $1.6M
3. Invest at U.S. interest rate: £1.6M * 1.08 = $1.728M
4. Convert back at forward rate: $1.728M * $1.53/£) = £1,129,411.76

Kevin would make £9,411.76 (Step 4 – Step 1) profit for every £1M
that is borrowed!
 The Theory of Covered Interest Rate Parity

• Deriving interest rate parity

– when the forward rate is priced correctly, an investor is indifferent
between investing at home or abroad
– General expression for interest rate parity

[1+i] = [1/S] * [1+i*] * F

Rearrange 1+𝑖 𝐹 𝑖 − 𝑖∗ 𝐹 − 𝑆
= =
1 + 𝑖∗ 𝑆 1 + 𝑖∗ 𝑆

If the result of this equation is (+) ➔ the forward is selling at a premium

(-) ➔ the forward is selling at a discount
 The Theory of Covered Interest Rate Parity

Recall Example 1 of Kim

EUR interest rate: 3.5200% per annum (p.a.)

JPY interest rate: 0.5938% p.a.
Spot exchange rate: ¥146.0300/€
1-year forward exchange rate: ¥141.9021/€

calculate the forward premium on the yen

By investing now in the yen and selling the yen proceeds forward after 1 year, Kim earns
this premium. This premium compensates her for the lower interest rate that yen
investments offer.

Notice that the interest rate differential (Euro – Yen) is 3.52% – 0.5938% = 2.93%,
which is approximately equal to the forward premium.
 The Theory of Covered Interest Rate Parity

When interest rates are continuously compounded, interest rate parity

has a particularly elegant representation

Type equation here.

Recall

1 + 𝐸𝐴𝑅 = [1 + 𝑇𝑥𝐴𝑃𝑅] 1/𝑇

1 + 𝐸𝐴𝑅 = lim [1 + 𝑇𝑥𝐴𝑃𝑅] 1/𝑇
𝑇→0
1 + 𝐸𝐴𝑅 = 𝑒 𝑟𝑐𝑐
 Diagram of
Covered Interest
Arbitrage

revisit Example 2 – Kevin

direct $ investment at
home was more profitable

Write an expression that

shows direct $ investment at
home is more profitable than
investing abroad (in £)
Covered Interest Rate Parity in Practice

• The External currency market

• Currency market for deposits and loans that are denominated in foreign
currencies (from the perspective of the bank)
• Example: pound-denominated deposits and loans made by banks in
Frankfurt
• Market prospers because it is a way to get around reserve requirements,
which are usually lower in this market
• The domestic bank acts like a foreign bank in the domestic country. For
example, U.S. financial regulations allow U.S.–chartered depository
institutions to establish international banking facilities (IBFs) that accept
dollar deposits from and make dollar loans to noncitizens of the United
States.
• The IBF’s accounts are subject to different regulations and reserve
requirements.
 Interest Rates in the External Currency Market

Transaction costs (bid-ask spread) is lower than they would be due to the reduced
regulations and increased competition

Annualized rate * (1/100) * (number of days/360) = de-annualized rate

Source: Financial Times, January 31, 2019

Minimum amount traded is typically $1million in the external currency markets

 Interest Rates in the External Currency Market
Lending rate is typically quoted as a fixed spread or margin over the external currency market
interbank lending rate.

For example, 3-month lending rate for GBP is 0.92% p.a. If Corporation XYZ’s spread over the
interbank rate is 50 bp, then lending rate will be 0.92% + 0.5% = 1.42% p.a.
(or 0.355% for 3-months)

Source: Financial Times, January 31, 2019

Minimum amount traded is typically $1million in the external currency markets

 Covered Interest Rate Parity in Practice

Influence over other markets

➢ External currency market influences rates elsewhere
➢ Loans to investors/corporations are based on these interbank rates
➢ Most important of rates is LIBOR
• Calculated by the British Banker’s Association (BBA) for 10 currencies and
15 maturities ranging from overnight to 1 year
• USD LIBOR is the “trimmed” arithmetic mean of 16 multinational banks’
interbank offered rates; that is, only the eight middle rates are used in
calculating the mean. These rates are sampled at approximately 11:00 a.m.
London time.
• Borrowing agreements involving corporations and sovereign nations often
specify that the interest rate on a loan is a fixed spread over LIBOR
Covered interest arbitrage with transaction costs

• In the presence of transaction costs in the foreign exchange

and external currency markets, arbitrage must be impossible
either by
– borrowing the domestic currency and lending the foreign currency
or
– borrowing the foreign currency and lending the domestic currency.

• In each case, the transaction foreign exchange risk must be

eliminated with the appropriate forward market transaction
Covered Interest Rate Parity with Bid-Ask Rates

Absence of covered arbitrage opportunity

➔ Start with £1 but end with less than 1

Similarly for $ above

 An Example with Transaction Costs

• Convert $10M to yen:

$10M * ¥82.67/$ = ¥826.7M $10M to invest
Bid Ask
Spot (¥/$) 82.67 82.71
• Invest for 3 months
Forward (¥/$) 82.5895 82.6495
0.46 * (1/100) * (90/360) = 0.00115
Dollar int. rate 0.91 1.11
¥826.7M * 1.00115 = ¥827,650,705
Yen int. rate 0.46 0.58

• Sell forward (enter into forward contract)

(¥827,650,705)/ (¥82.6495/$) = $10,013,983

• Compare to what we would owe in the U.S.

$10,013,983 - ($10M * 1.002775) = -$13,767

We lose money this way – no arbitrage but

borrowing yen results in losses as well
 Covered Interest Rate Parity in Practice

• Does covered interest rate parity hold?

– Prior to 2007, documented violations of interest rate parity were very rare
– Frequency, size and duration of apparent arbitrage opportunities do
increase with market volatility

– Akram et al. (2008) detected multiple short-lived deviations from covered

interest rate parity that provided possible arbitrage profits for the pound,
euro, and yen, all versus the dollar, for a short period from February 13 to
September 30 of 2004. Nevertheless, the deviations tended to persist only
for a few minutes and represented a tiny fraction of all possible
transactions
• Akram, Farooq, Dagfinn Rime, and Lucio Sarno, 2008, “Arbitrage in the Foreign
Exchange Market: Turning on the Microscope,” Journal of International Economics 76,
pp. 237–253
 Why Deviations from Interest Rate Parity May
Seem to Exist?

• Too good to be true?

– Default risks
• risk that one of the counterparties may fail to honor its contract

– Exchange controls
• Limitations
• Taxes

– Political risk
• A crisis in a country could cause its government to restrict any
exchange of the local currency for other currencies.
• Investors may also perceive a higher default risk on foreign
investments.
Covered Interest Parity Deviations During
the Financial Crisis
 Hedging Transaction Risk in the Money
Market

• When Interest Rate Parity holds, there are two ways to hedge a
transaction (either a liability or a receivable)
1. Having an appropriate forward contract to buy or sell the
foreign currency (chapter 3)
2. Borrowing/lending foreign currency and making a
transaction in the spot market – called synthetic forward
• Money market hedge – if an underlying transaction gives you a
liability, you use a money market asset to hedge the position (and
vice versa) – a forward contract can be manufactured this way
Hedging Transaction Risk in the Money Market

There are several reasons for using such hedges

• First, in some currency markets (e.g. in certain developing countries),
forward contracts may not be available. Nevertheless, a forward contract can
be manufactured using a money market hedge.
• Second, individual companies are not able to borrow and lend at the interest
rates available in the interbank market, which means the two strategies may
not be equivalent, depending on the forward quote that the company
receives.
• Third, when time horizons are long, forward contracts can be expensive as
the bid–ask spread widens substantially.

Therefore, it may be advantageous to consider borrowing and

lending to hedge one’s currency risk.
Hedging Transaction Risk in the Money Market
Hedging a foreign currency liability – Euro denominated Accounts Payable

CMU Food Inc. is importing grapes from France for €4 million. It is payable in 90 days

Spot exchange rate $1.10/€

90-day forward $1.08/€
90-day dollar interest rate 6.00% p.a.
90-day euro interest rate 13.519% p.a.

Choice #1: Enter into a Forward Contract

Cost in 90 days is: € 4 million * ($1.08/€) = $4,320,000

Choice #2: Money Market Hedge

Invest X amount now to become what you owe in 90 days but HOW MUCH?

€ 4 million / [1+(0.13519)*(90/360)] = € 3,869,229.71

Buy this amount at spot rate: € 3,869,229.71*$1.10/€ = $4,256,152.68

To compare the two, we need to take PV of the forward hedge

$4,320,000 / [1+(0.06)(90/360)] = $4,256,157.64

Forward contract is more expensive but only SLIGHTLY

Hedging Transaction Risk in the Money Market

Hedging a foreign currency receivable – Yen denominated A/R

London Sweaters is selling sweaters to Japanese Customers. They will receive ¥ 500,000,000 in 30 days

Spot exchange rate ¥ 179.5 / £

30-day forward ¥ 180 / £
30-day pound interest rate 2.7 % p.a.
30-day yen interest rate 6.01 % p.a.

Choice #1: Enter into a forward contract and sell yen forward
Receipt in 30 days is: ¥ 500,000,000 * (¥ 180 / £ ) = £ 2,777,778

Choice #2: Money Market Hedge

Borrow PV of ¥ 500,000,000 ➔ ¥ 500,000,000 / (1+0.0601)(30/360) = ¥ 497,508,313

Pound revenue: sell yen at Spot: ¥ 497,508,313 / (¥ 179.5 / £) = £ 2,771,634

To compare the two, we need to take FV of the MM hedge

£ 2,771,634 *[(1+0.027)(30/360)] = £ 2,777,785

Money Market hedge provides higher value but only SLIGHTLY

The Term Structure of Forward Premiums and
Discounts

• The term structure of interest rates – description of different

spot interest rates for various maturities into the future
 Euro Area Yield Curves

https://www.ecb.europa.eu/stats/financial_markets_and_interest_rates/euro_area_yield_curves/html/index.en.html
The Term Structure of Forward Premiums and
Discounts
• A review of bond pricing
– Price of a 10-year pure discount bond with a face value of $1,000 is $463.19.
What is the spot interest rate for the 10-year maturity expressed in percentage per
annum?
$463.19[1+i(10)]10 = $1,000 ; solving i=8%

– Yield to maturity – the discount rate that equates the present value of the n
coupon payments plus the final principal payment to the current market price

Assume a 2-year bond with face value equal to $1,000, an annual coupon of $60
and a market price of $980. If the 1-year spot rate is 5.5%, the 2-year spot rate is
found by solving:
$980 = ($60/1.055) + $1060/[1+i(2)]2
 The Term Structure of Forward Premiums
and Discounts

• Long-term forward rates and premiums

– Let i(2,¥) and i(2,$) denote the spot interest rates for yen and dollar investments
with 2-year maturities

– If no arbitrage opportunities exist, then the rate of yen per dollar for the 2-year
maturity must be

[1 + 𝑖 2, ¥ ]2
𝐹 2 =𝑆𝑥
[1 + 𝑖 2, $ ]2

Intuition: A Japanese investor must be indifferent between investing in Yen for two
years and getting [1 + 𝑖 2, ¥ ]2 for each yen or converting yen into dollars (1/S) and
invest these dollars and get (1/S)*[1 + 𝑖 2, $ ]2 after two years and contracting to sell
these dollars forward at F(2) to get a yen return of F(2)*(1/S)*[1 + 𝑖 2, $ ]2
Example
Spot: ¥110/$ Investor has ¥10M to invest
i(2,$) = 5% p.a.
i(2, ¥) = 4% p.a.

Investing in Japan (pure discount bond): ¥10M * (1.04)2 = ¥10.816M

Investing at Home : ¥10M / (¥110/$) = $90,909.09 at current spot

$90,909.09 * (1.05)2 =$100,227.27

You are indifferent between the two if the forward rate is realized such that

¥10.816M / F(2) = $100,227.27 ➔ F(2) = ¥107.91/$

If quoted forward rate > ¥107.91/$ ➔ $ investor receives more $ if invest in $ bond
If quoted forward rate < ¥107.91/$ ➔ $ investor receives more ¥ if invest in ¥ bond
What would happen if Forward Rate did not satisfy the
following Equation?

[1+𝑖 2,¥ ]2
𝐹 2 =𝑆𝑥
[1+𝑖 2,$ ]2

Suppose rate favored investing in $ bonds. Then, investors move funds out of
Japanese yen bonds into US dollar bonds
➢ Price of Yen bonds drop, their yields rise
➢ Dollar strengthens
➢ Dollar bond prices increase, their yields fall
➢ Forward rate of yen per dollar fall as investors sold dollars forward to
acquire yen in the future

We have ignored transaction costs (i.e. bid-ask spreads). These transaction costs become wider as
maturities lengthen. They are the source of the development of currency swaps (later in Chapter 21)