Interest Rate Parity

If we invest in our own country or other country or foreign

country, return of the investment must be same that is called
Interest rate parity
This term refers to a condition where the relationship between
interest rates and the spot and forward currency values of two
countries are in equilibrium. As a result, there are no interest
rate arbitrage opportunities between those two currencies

Interest Rate
Parity (I.R.P)

An interest parity condition stating that the difference in

interest rates between two countries is equal to the expected
change in exchange rates between the countries currencies.
If this parity does not exist, there is an opportunity to make a
profit.
Sr = Spot Rate

Fr = Forward Rate

Rd (id) =Interest in domestic country

Foreign country

Rf (if) = Interest in

Numerical Example 01:

Let us suppose a US citizen who has saved $100. He wants to invest it in
UK pound.
i$ = 3% p.a. ; i = 4% p.a. ;
1.4925/

Sr = $1.5/ ;

Fr = $

Suppose the investment is done for 1 year. What value he will be having
after 1 year.

Numerical Example 02:

Assume the following information, (You had $800,000)
The current spot rate of the pound is $1.62.
The 90-day forward rate of the pound is $1.5888.
The 90-day interest rate in the US is 2%.
The 90-day interest rate in the UK is 4%.
Verify the presence of interest parity.

Numerical Example 03:

The following exchange rates and one-year interest rate exist.
Bid Quote

Ask Quote

$1.12

$1.13

1.12

1.13

Deposit Rate

Loan Rate

Interest rate on
dollars

6.0%

9.0%

Interest rate on euros

6.5%

9.5%

Euro Spot
Euro one year
forward

You have $100,000 to invest for one year. Would you benefit from engaging in
covered interest arbitrage?

Calculating Forward Rates:

FORWARD
EXCHANGE RATE:
Forward exchange rates for currencies refers to exchange rates at a future point in time,
as opposed to spot exchange rates, which refers to current rates.
The basic equation for calculating forward rates with the U.S. dollar as the base currency
is:

Forward rates are available from banks and currency dealers for periods ranging from
less than a week to as far out as five years and beyond. As with spot currency
quotations, forwards are quoted with a bid-ask spread also.


Example:
Consider U.S. and Canadian rates as an illustration. Suppose that the spot rate for
the Canadian dollar is presently 1 USD = 1.0650 CAD (ignoring bid-ask spreads for
the moment).
One-year interest rates are at 3.15% for the U.S. dollar and 3.64% for the Canadian
dollar.
Using the formula, the one-year forward rate is computed as follows:

1 USD =

Example Cont.:
If this difference (forward rate spot rate) is positive, it is known as a
forward premium;
& a negative difference is termed a forward discount.
A currency with lower interest rates will trade at a forward premium in
relation to a currency with a higher interest rate.
In the example, the U.S. dollar trades at a forward premium against
the Canadian dollar; conversely, the Canadian dollar trades at a
forward discount versus the U.S. dollar.

Some Useful Formula w.r.t time:

Parity Condition:

If investment is made for 1 year we use above formula.

Similarly if investment is made by 6 months:

Similarly if investment is made by 3 months:

Something to remember always:

Forward Discount:
If D% is the domestic
interest rate on deposit and F
% is foreign interest rate on
deposit. &
If [ D% - F% ] is negative than
it means the foreign interest
rate is bigger than domestic
and for sure now the foreign
currency must be on forward
discount to hold parity.

Forward Premium:
If D% is the domestic
interest rate on deposit and F
% is foreign interest rate on
deposit. &
If [ D% - F% ] is positive than
it means the domestic interest
rate is bigger than foreign and
for sure now the foreign
currency must be on forward
premium to hold parity.

Thanks