Interest rate parity (IRP) is the basic equation that governs the relationship between interest rates and exchange rates. The basic premise of interest rate parity is that hedged returns from investments in different currencies must be the same regardless of their interest rate level.
There are two versions of interest rate parity.
- Target interest rate parity
- Uncovered interest rate parity
Read on to learn what determines interest rate parity and how to use it to trade forex markets.
- Interest rate parity is the basic equation that governs the relationship between interest rates and exchange rates.
- The basic premise of interest rate parity is that hedged returns from investments in different currencies must be the same regardless of their interest rate level.
- Parity is used by Forex traders to find arbitrage and other trading opportunities.
Forward rate calculation
A currency futures exchange rate is an exchange rate that predicts a rate at a future point in time, as opposed to the current rate, the spot exchange rate. Understanding the forward rate is the basis of interest rate parity, especially as it involves arbitrage (simultaneous purchase and sale of assets to profit from price differences).
The basic equation for calculating the forward rate with the US dollar as the base currency is:
..Forward rate = = Spot rate XX 1 + IRD1 + IRO..where:IRO = = Overseas interest rates....
Forward rates are available from banks and currency dealers for less than a week to more than five years. Similar to spot currency quotes, futures are quoted on bid-ask spreads.
Low interest rate currencies trade at futures premiums compared to high interest rate currencies. In the example above, the US dollar is trading at a futures premium against the Canadian dollar. Conversely, the Canadian dollar is traded at a futures discount against the US dollar.
Can I use the forward rate to predict future spot rates or interest rates? In both respects, the answer is no. Many studies have confirmed that forward rates are poorly predictive of future spot rates. Since futures interest rates are simply exchange rates adjusted for interest rate differentials, they have little predictive power in predicting future interest rates.
As an example, consider the rates in the United States and Canada. Suppose the Canadian dollar spot rate is currently 1 USD = 1.0650 CAD (ignoring bid-ask spreads for now). Using the above formula, the one-year futures rate is calculated as follows:
US $ 1 = = 1..06Five0 XX 1 + 3..1Five%1 + 3..6Four%.. = = 1..0700 CAD..
The difference between the futures rate and the spot rate is known as the swap point. In the above example, the swap point would be 50. If this difference (forward rate minus spot rate) is positive, then Forward premium; Negative difference is called Forward discount.
Target interest rate parity
With covered interest rate parity, futures exchange rates should incorporate interest rate differences between the two countries. Otherwise, there will be arbitrage opportunities. In other words, if an investor borrows in a currency with a low interest rate and invests in a currency that offers a higher interest rate, there is no interest rate advantage. Investors typically do the following:
- Borrow money in a low interest rate currency.
- Converts the borrowed amount into a currency with a higher interest rate.
- Invest your earnings in interest-bearing products in this high interest rate currency.
- At the same time, hedging foreign exchange risk by purchasing forward contracts that convert return on investment into the first (low interest rate) currency.
The return in this case is the same as the return obtained by investing in interest-bearing products in low interest rate currencies. Under covered interest rate parity conditions, the cost of hedging foreign exchange risk counteracts the higher returns that result from investing in currencies that offer higher interest rates.
The formula for the target interest rate parity is
..(((1+MeNS..).= =NSNS..∗(((1+MeNS..).where:MeNS..= =Interest rates in domestic or base currencyMeNS..= =Interest rates in foreign or quoted currenciesNS= =Current spot exchange rate....
Target interest rate arbitrage
To illustrate the interest rate parity in question, consider the following example. Assume that Country A has a one-year borrowing rate of 3% and Country B has a one-year deposit rate of 5%. Furthermore, assume that the currencies of both countries are trading equally in the spot market (that is, currency A = currency B).
Investors do the following:
- 3% borrowing in currency A
- Convert the borrowed amount to currency B at the spot rate
- Invest these earnings in currency B deposits and pay 5% annually
Investors can use the one-year futures rate to eliminate the foreign exchange risk inherent in this transaction. This happens because the investor currently holds currency B, but has to repay the funds borrowed in currency A. -According to the above formula, the annual futures rate is approximately equal to 1.0194 (that is, currency A = 1.0194 currency B).
What if the one-year futures rates are also equivalent (ie currency A = currency B)? In this case, the investor in the above scenario can get a 2% risk-free profit. Here’s how this works. Imagine an investor:
- Borrow 100,000 currency A at 3% for one year.
- Immediately convert borrowed earnings to currency B at spot rate.
- The full amount will be put into a 5% one-year deposit.
- At the same time, we will conclude a one-year forward contract for the purchase of 103,000 currency A.
A year later, the investor receives 105,000 currency B, of which 103,000 is used to buy currency A under a forward contract and repay the borrowed amount, while the investor uses the remaining 2,000 currency B. Put it in your pocket. Interest rate arbitrage.
The power of the market ensures forward exchanges …