Interest rate parity

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The interest rate parity is the basic identity that relates interest rates and exchange rates. The identity is theoretical, and usually follows from assumptions imposed in economics models. There are data evidences that support as well as reject the interest rate parity.

Two versions of the identity are commonly presented in academic literature: covered interest rate parity and uncovered interest rate parity.

1 Covered interest rate parity
- 1.1 Covered interest arbitrage example
2 Uncovered interest rate parity
- 2.1 Uncovered interest parity example
- 2.2 Uncovered vs. covered interest parity example
3 Cost of carry model
4 External links

[edit] Covered interest rate parity

The basic covered interest parity (also called interest parity condition) is:

$(1 + i_\$) = (F/S) (1 + i_c)\;$

where:

$i_\$$ is the domestic interest rate, $i c$ is the interest rate in the foreign country,

$F$ is forward exchange rate between domestic currency ($) and foreign currency (c), i.e. $/c, and

$S$ is spot exchange rate between domestic currency ($) and foreign currency (c), i.e. $/c.

The covered interest parity states that the interest rate difference between two countries' currencies is equal to the percentage difference between the forward exchange rate and the spot exchange rate. The parity condition assumes that financial assets are perfectly mobile and similarly risky. If the parity condition does not hold, there exists an arbitrage opportunity. (see covered interest arbitrage and an example below).

Another way to express the interest rate parity is:

$i_\$ = i_c + \frac {F - S} {S} (1 + i_c)$

A more approximate version is sometimes given, although it is less correct for countries with highly volatile exchange rates:

$i_\$ = i_c + \frac {F - S} {S}$

An implication of this equation is that when the domestic interest rate is lower than the foreign interest rate, the forward price of the foreign currency will be below the spot price. Conversely, if the domestic interest rate is above the foreign interest rate, then the forward price of the foreign currency will be above the spot price.

[edit] Covered interest arbitrage example

In short, assume that

$(1 + i_\$) < (F/S)(1 + i_c)$ .

This would imply that one dollar invested in the US < one dollar converted into a foreign currency and invested abroad. Such an imbalance would give rise to an arbitrage opportunity, where in one could borrow at the lower effective interest rate in US, convert to the foreign currency and invest abroad.

The following is a rudimentary example to understand covered interest rate arbitrage (CIA)

Consider the interest rate parity (IRP) equation,

$(1 + i_\$) = (F/S)(1 + i_c)\;$

Assume,

the 12-month interest rate in US is 5%, per annum

the 12-month interest rate in UK is 8%, per annum

the current Spot Exchange is 1.5 $/£

the current Forward Exchange is 1.5 $/£

From the given conditions it is clear that UK has a higher interest rate than the US. Thus the basic idea of covered interest arbitrage is to borrow in the country with lower interest rate and invest in the country with higher interest rate. All else being equal this would help you make money riskless. Thus,

Per the LHS of the interest rate parity equation above, a dollar invested in the US at the end of the 12-month period will be,

$1 * (1 + 5%) = $1.05

Per the RHS of the interest rate parity equation above, a dollar invested in the UK (after conversion into £ and back into $ at the end of 12-months) at the end of the 12-month period will be,

$1 * (1.5/1.5)(1 + 8%) = $1.08

Thus, one could carry out a covered interest rate (CIA) arbitrage as follows,

Borrow $1 from the US bank at 5% interest rate.
Convert $ into £ at current spot rate of 1.5$/£ giving 0.67£
Invest the 0.67£ in the UK for the 12 month period
Purchase a forward contract on the 1.5$/£ (i.e. cover your position against exchange rate fluctuations)

At the end of 12-months

0.67£ becomes 0.67£(1 + 8%) = 0.72£
Convert the 0.72£ back to $ at 1.5$/£, giving $1.08
Pay off the initially borrowed amount of $1 to the US bank with 5% interest, i.e $1.05

Making an arbitrage profit of $1.08 - $1.05 = $0.03 or 3 cents per dollar.

Obviously, any such arbitrage opportunities in the market will close out almost immediately.

In the above example, any one or combination of the following may occur to re-establish the equilibrium of the IRP to close out the arbitrage opportunity,

US interest rates will go up
Forward exchange rates will go down
Spot exchange rates will go up
UK interest rates will go down

[edit] Uncovered interest rate parity

The uncovered interest rate parity postulates that

$(1 + i^\$_{t,t+1}) = \frac {E_t[ S_{t+1} ]} {S_t} (1 + i^c_{t,t+1})\;$

The equality assumes that the risk premium is zero, which is the case if investors are risk-neutral. If investors are not risk-neutral then the forward rate ( $F t, t + 1$ ) can differ from the expected future spot rate ( $E t [S t + 1]$ ), and covered and uncovered interest rate parities cannot both hold.

The uncovered parity is not directly testable in the absence of market expectations of future exchange rates. Moreover, the above rather simple demonstration assumes no transaction cost, equal default risk over foreign and domestic currency denominated assets, perfect capital flow and no simultaneity induced by monetary authorities. Note also that it is possible to construct the UIP condition in real terms, which is more plausible.

[edit] Uncovered interest parity example

An example for the uncovered interest parity condition: Consider an initial situation, where interest rates in the US and a foreign country (e.g. Japan) are equal. Except for exchange rate risk, investing in the US (home) or Japan would yield the same return. If the dollar depreciates against the yen, an investment in Japan would become more profitable than an US-investment - in other words, for the same amount of yen, more dollars can be purchased. By investing in Japan and converting back to the dollar at the favorable exchange rate, the return from the investment in Japan, in the dollar term, is higher than the return from the direct investment in the US. In order to persuade an Investor to invest in the US nonetheless, the dollar interest rate would have to be higher than the yen interest rate by an amount equal to the devaluation (a 20% depreciation of the dollar implies a 20% rise in the dollar interest rate).

[edit] Uncovered vs. covered interest parity example

Let's assume you wanted to pay for something in Yen in a months time. There are two ways to do this.

(a) Buy Yen forward 30 days to lock in the exchange rate. Then you may invest in dollars for 30 days until you must convert dollars to Yen in a month. This is called covering because you now have covered yourself and have no exchange rate risk.

(b) Convert spot to Yen today. Invest in a Japanese bond (in Yen) for 30 days (or otherwise loan Yen for 30 days) then pay your Yen obligation. Under this model, you are sure of the interest you will earn, so you may convert fewer dollars to Yen today, since the Yen will grow via interest. Notice how you have still covered your exchange risk, because you have simply converted to Yen immediately.

According to the IPC you would get the same number of Yen in all methods. Methods (a) and (b) are covered while (c) is uncovered.

In method (a) the higher (lower) interest rate in the US is offset by the forward discount (premium).
In method (b) The higher (lower) interest rate in Japan is offset by the loss (gain) from converting spot instead of using a forward.
Method (c) is uncovered, however, according to interest rate parity, the spot exchange rate in 30 days should become the same as the 30 day forward rate. Obviously there is exchange risk because you must see if this actually happens.

General Rules: If the forward rate is lower than what the interest rate parity indicates, the appropriate strategy would be: borrow pounds, convert to dollars at the spot rate, and lend dollars.

If the forward rate is higher than what interest rate parity indicates, the appropriate strategy would be: borrow dollars, convert to pounds at the spot rate, and lend the pounds.

[edit] Cost of carry model

A slightly more general model, used to find the forward price of any commodity, is called the cost of carry model. Using continuously compounded interest rates, the model is:

$\ F = S e^{(r+s-c)t}$

where $F$ is the forward price, $S$ is the spot price, $e$ is the base of the natural logarithms, $r$ is the risk free interest rate, $s$ is the storage cost, $c$ is the convenience yield, and $t$ is the time to delivery of the forward contract (expressed as a fraction of 1 year).

For currencies there is no storage cost, and c is interpreted as the foreign interest rate. The currency prices should be quoted as domestic units per foreign units.

If the currencies are freely tradeable and there are minimal transaction costs, then a profitable arbitrage is possible if the equation doesn't hold. If the forward price is too high, the arbitrageur sells the forward currency, buys the spot currency and lends it for time period t, and then uses the loan proceeds to deliver on the forward contract. To complete the arbitrage, the home currency is borrowed in the amount needed to buy the spot foreign currency, and paid off with the home currency proceeds of forward contract.

Similarly, if the forward price is too low, the arbitrageur buys the forward currency, borrows the foreign currency for time period t and sells the foreign currency spot. The proceeds of the forward contract are used to pay off the loan. To complete the arbitrage, the home currency from the spot transaction is lent and the proceeds used to pay for the forward contract.