The Interest Rate Parity states that the interest rate difference between two countries is equal to the percentage difference between the forward exchange rate and the spot exchange rate.

It plays essential role in foreign exchange markets.

The difference between the interest rates in any two countries is the same as the difference between the forward and the spot rates of their respective currencies.

Interest rate parity A currency is worth what it can earn.

The return on a currency is the interest rate on that currency plus the expected rate of appreciation over a given period.

When the returns on two currencies are equal, interest rate parity prevails.

The relationship can be seen when you follow the two methods an investor may take to convert foreign currency into U.S. dollars.

Option A would be to invest the foreign currency locally at the risk-free rate for a specific time period. Then convert the proceeds from the investment into U.S. dollars at the maturity.

Option B would be to invest the same dollars in the

(U.S.) market for the same time period. When no arbitrage opportunities exist, the cash flows from both options are equal.

Rate of return in localCurrency(say $)

Rate of return in foreignCurrency(say £)=

In equilibrium, returns on both the currencies will be the same i. e. No profit will be realized and interest rate parity exists which can be written

(1 + rh) = F

(1 + rf) S where rh is the interest rate in home currency

rf is the interest rate in foreign currency

F is the forward rate between the 2 currencies and

S is the spot rate

If interest rate parity is violated, then an arbitrage opportunity exists. The simplest example of this is what would happen if the forward rate

was the same as the spot rate but the interest rates were different, then investors would:

borrow in the currency with the lower rate

convert the cash at spot rates

enter into a forward contract to convert the cash plus the expected interest at the same rate

invest the money at the higher rate

convert back through the forward contract

repay the principal and the interest, knowing the latter will be less than the interest received.

If domestic interest rates are less than foreign interest rates, you will invest in foreign country at higher interest rates.

Domestic investors can benefit by investing in the foreign market

If domestic interest rates are more than foreign interest rates, you will invest in domestic market at higher interest rates

Foreign investors can benefit by investing in the domestic market

Implications of IRP

Factors that influence the level of market interest rates include:

- Expected levels of inflation- General economic conditions- Monetary policy- Foreign exchange market activity- Foreign investor- Levels of sovereign debt outstanding- Financial and political stability

Fo = forward rateSo = current spot rateic = interest rate in home country ib = interest rate in foreign country

} IRP

A Canadian company is expected to receive Kuwaiti dinars in 1 years time. The spot rate is CAD/Dinar 5.4670. The company could borrow in dinars at 9% or in Canadian dollars at 14%. There is no forward rate for one year’s time. Predict what the exchange rate is likely to be in one year

So = 5.4670ic = 14% or 0.14ib = 9% or 0.09

F = 5.4670 x (1 + 0.14) (1 + 0.09)

F = 5.7178

Exchange Rate Forecasts

Differences in Interest Rates

InternationalFischer Effect

Differences in Inflation Rates

Forward RatePremium or

Discount

Interest Rate Parity

Fisher Effect

Purchasing Power Parity

Unbiased ForwardRate