Interest rate parity

Presented by:Ekta Thalani (MBA-IB III Sem.)Sujata Singh (MBA-IB III Sem.)

Flow of Presentation: Spot rate Forward rate Interest rate parity Arbitrage Illustration

Spot rate: The price quoted for immediate settlement

on a commodity, a security or a currency. based on the value of an asset at the

moment of the quote.  value is in turn based on how much

buyers are willing to pay and how much sellers are willing to accept, with certain determining factors.

Spot rate Other names: “benchmark rate,” “straightforward rate” or “outright rate.”

Sources providing spot rate info:A number of sources, including Bloomberg, Morningstar, Thomson Reuters etc.

Some terms… Spot settlement: the transfer of funds

that completes a spot transaction, 

Spot date: the day when settlement occurs.

Forward rate A rate applicable to a financial transaction

that will take place in the future.

Forward rates are based on the spot rate, adjusted for the cost of carry and refer to the rate that will be used to deliver a currency, bond or commodity at some future time.

Forward Premium And Forward Discount

A Forward Premium is the proportion by which a country's forward exchange rate exceeds its spot rate.

A Forward Discount is an indication by the market that the current domestic exchange rate is going to depreciate in value against another currency.

Interest Rate Parity

Interest Rate Parity (IRP) theory is used to analyze the relationship between the spot rate and corresponding forward (future) rate of currencies.

The IPR theory states interest rate differentials between two different currencies will be reflected in the premium or discount for the forward exchange rate .

The theory further states size of the forward premium or discount on a foreign currency should be equal to the interest rate differentials between the countries in comparison.

Arbitrage By purchasing a foreign currency and

depositing it abroad, investors can effectively capitalize on the difference in interest rates.

Arbitrage can be of two types: Covered interest rate arbitrage Uncovered interest rate arbitrage

Illustration:Interest rate: 5% (US) 8%(UK)Spot rate: £=$1.50Forward rate: £=$1.48Borrow $1 million and capitalize the difference in interest rates.Solution:step1: borrow in USD for 1 year @5%Step2: convert $1million in £ at prevailing rate.(666,667)Step3: invest 666,667 in UK @8% for 1 year(53,334)Step4: sell your £ proceeds after 1 year @$1.48/£

i.e. 720,000*1.48 =$1,065,600Step5: return $1 million and the residual income is the outcome of your interest rate arbitrage.Hence, $(1,065,600-1,000,000)

=$65600

UTILITY of the theoryTwo methods an investor may take to convert foreign

currency into U.S. DollarOption A would be to invest the foreign currency locally at

the foreign risk-free rate for a specific time period. The investor would then simultaneously enter into a forward rate agreement to convert the proceeds from the investment into U.S. dollars, using a forward exchange rate, at the end of the investing period.

Option B would be to convert the foreign currency to U.S. dollars at the spot exchange rate, then invest the dollars for the same amount of time as in option A, at the local (U.S.) risk-free rate.

Illustration: For our illustration purpose consider investing €

1000 for 1 year. We'll consider two investment cases viz: Case I: Domestic Investment In the U.S.A., consider the spot exchange rate

of $1.2245/€ 1. So we can exchange our € 1000 @ $1.2245 =

$1224.50 Now we can invest $1224.50 @ 3.0% for 1 year

which yields $1261.79 at the end of the year.

Case II: Foreign Investment Likewise we can invest € 1000 in a foreign European

market, say at the rate of 5.0% for 1 year. But we buy forward 1 year to lock in the future

exchange rate at $1.20025/€ 1 since we need to convert our € 1000 back to the domestic currency, i.e. the U.S. Dollar.

So € 1000 @ of 5.0% for 1 year = € 1051.27 Then we can convert € 1051.27 @ $1.20025 =

$1261.79 Thus, in the absence of arbitrage, the Return on

Investment (RoI) is same regardless of our choice of investment method.

Types of IRP Covered Interest Rate Parity (CIRP)Covered interest rate theory holds that interest rate

differentials between two countries are offset by the spot/forward currency premiums as otherwise investors could earn a pure arbitrage profit.

Example Assume Google Inc., the U.S. based multi-national company,

needs to pay it's European employees in Euro in a month's time. Google Inc. can achieve this in several ways viz: Buy Euro forward 30 days to lock in the exchange rate. Then

Google can invest in dollars for 30 days until it must convert dollars to Euro in a month. This is called covering because now Google Inc. has no exchange rate fluctuation risk.

Convert dollars to Euro today at spot exchange rate. Invest Euro in a European bond (in Euro) for 30 days (equivalently loan out Euro for 30 days) then pay it's obligation in Euro at the end of the month.

Under this model Google Inc. is sure of the interest rate that it will earn, so it may convert fewer dollars to Euro today as it's Euro will grow via interest earned.

This is also called covering because by converting dollars to Euro at the spot, the risk of exchange rate fluctuation is eliminated.

Uncovered Interest Rate Uncovered Interest Rate theory states that

expected appreciation (depreciation) of a currency is offset by lower (higher) interest.

the other method that Google Inc. can implement is:

Google Inc. can also invest the money in dollars today and change it for Euro at the end of the month.

This method is uncovered because the exchange rate risks persist in this transanction

Comparison Recent empirical research has identified that

uncovered interest rate parity does not hold, although violations are not as large as previously thought and seems to be currency rather than time horizon dependent.

In contrast, covered interest rate parity is well established in recent decades amongst the OECD economies for short-term instruments. Any apparent deviations are credited to transaction costs.

Implications of the theory If IRP theory holds then arbitrage in not possible. No matter whether an

investor invests in domestic country or foreign country, the rate of return will be the same as if an investor invested in the home country when measured in domestic currency.

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. So 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. So foreign investors can benefit by investing in the domestic market.

Interest rate parity is fundamental knowledge for traders of foreign currencies. In order to fully understand the two kinds of interest rate parity, however,

the trader must first grasp the basics of forward exchange rates and hedging strategies. Armed with this knowledge,

the forex trader will then be able to use interest rate differentials to his or her advantage.

Limitations In recent years the interest rate parity

model has shown little proof of working. In many cases, countries with higher

interest rates often experience it's currency appreciate due to higher demands and higher yields and has nothing to do with risk-less arbitrage.