Interest Rate Parity (IRP) is an economic theory that highlights the strong correlation between the interest rate and a currency’s exchange rate. It is an important metric that helps determine the returns from investing in two different currencies. However, Interest Rate Parity may not always exist because of the difference in interest rates between the currency pair. The situation arises when there is an anticipation that the domestic or foreign asset will appreciate or depreciate.
This article is an easy guide to understanding Interest Rate Parity, its importance, covered and uncovered interest rate parity, how it works, and more. Read on!
To understand how Interest Rate Parity works, let’s first understand the two critical concepts that constitute the basis of the theory:
It is the current or prevailing exchange rate between a currency pair in the foreign exchange market.
It is the exchange rate for a pair of currencies at a future date.
Now let’s look at how the Interest Rate Parity theory works.
Suppose there are two countries: country X with an interest rate of 5% and country Y with an interest rate of 7%. An investor from country X invests in the currency of country Y at the prevailing spot rate and earns an interest of 7%. At the end of the year, he exchanges country Y’s currency for country X’s currency at a forward exchange rate agreed upon by the investor. The investor should have earned a profit of 2% through currency trading, right?
But, no, that’s not the case. It’s because the forward exchange rate accounts for the interest rate differentials between the two countries and adjusts itself so that the investor neither loses nor earns profit through currency trading. The above Interest Rate Parity example reflects this equilibrium.
Interest Rate Parity (IRP) is a vital financial metric in the foreign exchange market that highlights the interconnection between the interest rate, spot exchange rate, and forward exchange rate. The no-arbitrage principle protects the foreign currency market from extreme volatility and exploitation from institutions such as banks to earn arbitrage profits.
Furthermore, it helps understand exchange rate determination, i.e., the value of one currency against another and how they may fluctuate due to market changes.
For investors and market stakeholders, the Interest Rate Parity theory helps them understand the foreign exchange market and make the best possible investment decisions. However, it’s important to note that several factors and events can destabilise the market and bring volatility into ‘risk-free’ investments. The actual forward exchange rate at a future date might result in situations of earning forward premiums or losses through forward discounts.
While you can rely on an interest rate parity calculator to calculate the forward exchange rate, it is best to know the IRP formula to understand the concept. The Interest Rate Parity formula is given below:
The three components of the Interest Rate Parity formula are interconnected in a way that brings into application the no-arbitrage concept in the foreign currency market.
The IRP equation states that there exists a close connection between interest rates, spot rates, and forward rates in the foreign exchange market. The forward exchange rate (Fo) takes into account the interest rates of the two countries (ix and iy) so that investors cannot exploit the interest rate differentials to earn profits.
The IRP forward exchange rate should not be higher than the actual forward exchange rate to prevent earning forward premiums. The situation arises when an investor exchanges currency X for currency Y at the spot rate and invests it at the foreign interest rate with a forward contract. On completion of the duration of the forward contract, the investor exchanges currency Y back to currency X. If the forward exchange rate is higher than the IRP forward exchange rate, then the investor earns a forward premium.
When the Interest Rate Parity conditions are met, the principle of no-arbitrage applies to the foreign exchange market, meaning that the return on investment (ROI) would be the same for both currencies. However, the IRP does not always lead to an equilibrium situation.
The Interest Rate Parity formula is based on certain assumptions which may not hold in a real-world scenario. The first is that capital is mobile, and there is no restriction on capital flows between countries. The second condition is that the assets, in this case, the currency pairs, are perfectly interchangeable and have comparable liquidity and risk. Third, the no-arbitrage concept holds. Lastly, the foreign exchange market must be in equilibrium.
To better understand IRP, let’s look at an example of Interest Rate Parity.
Suppose INR 80 equals USD 1. The spot exchange rate of INR/USD is 80. The interest rate for INR for a year is 2%, and the interest rate for USD is 5%.
An investment of Rs.8000 at the end of the year would lead to a return of Rs.8160.
If an investor were to exchange Rs.8000 for $100 and invest it at the interest rate of 5%, the return on investment would be $105. On exchanging USD back to INR, the return would equal Rs.8400 at the end of the year. It would lead to earning a riskless profit of Rs.240.
However, according to the Interest Rate Parity formula, the return on investment can become equal by determining the forward exchange rate.
Fo= 80 + 1+ 0.021+ 0.05 = 77.71
Given a forward exchange rate of 77.71, USD 105 would convert to Rs.8159.55. Therefore, the return on investment in both cases would amount to the same value despite interest rate differentials.
Interest Rate Parity is an essential metric in currency trading. It helps currency traders make risk-free investments by determining the forward exchange rate, which would ensure that the investment returns on currency assets remain the same for a pair of currencies. As a result, it prevents arbitrage from causing volatility in the foreign exchange market and prevents financial institutions and corporations from exploiting it for profit.
Additionally, since the conditions for Interest Rate Parity do not always hold, investors can gauge how differential interest rates can lead to the appreciation or depreciation of currency assets. This can help them make sound investment decisions and even earn some profit or avoid losses through currency trading.
Covered and Uncovered Interest Rate Parity are two critical concepts when dealing with IRP. Covered Interest Rate Parity is when the no-arbitrage condition is maintained by locking in the forward interest rate using a forward contract to avoid the risks associated with the foreign exchange market. The rate is ‘covered’ against external threats that can cause disequilibrium in the market.
Uncovered Interest Rate Parity, on the other hand, relies on expected spot exchange rates to hold the conditions of IRP rather than on forward contracts. The no-arbitrage principle is fulfilled even in this instance, but it depends on predicting future interest rates.
The primary difference between covered and uncovered interest rate parity is whether or not one is employing forward contracts. In the case of covered interest rate parity, one is locking in the future rates through forward contracts, while uncovered interest rate parity predicts the future rates. However, the expected and forward spot rates are generally the same.
Interest Rate Parity is an essential economic and financial theory highlighting the interconnections between the spot exchange rate, forward exchange rate, and interest rates in currency trading. It follows the concept of no-arbitrage in the foreign exchange market to prevent the exploitation of price inefficiencies between two currencies for gains. Simply put, the return on investment will be the same at a fixed point in time for both currencies.
Interest Rate Parity relies on assumptions that are difficult to maintain or replicate in a real-world scenario. Some external risks and factors can destabilise the foreign exchange market and extinguish the IRP equilibrium.
Ans: Purchasing Power Parity (PPP) links spot exchange rates to the price levels of a country, while Interest Rate Parity (IRP) links spot exchange rates, nominal interest rates, and forward exchange rates.
Ans: If the interest rate parity relationship does not hold true, it allows for the use of an arbitrage strategy and makes riskless profits.
Ans: The theory states that there is no opportunity for interest rate arbitrage for investors of two countries. However, it requires the free flow of capital and perfect substitutability.
Ans: Interest rate parity is a no-arbitrage condition representing an equilibrium state. The fact that it does not always hold enables investors to earn riskless profits from covered interest arbitrage.
Ans: It is the standard equation governing the relationship between interest rates and currency exchange rates. The interest rate parity implies that returns from investing in different currencies should be the same, regardless of the difference in interest rates.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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