Interest Rate Parity

The relationship between EXCHANGE RATE AND PRICES is called PURCHASING POWER PARITY.

Interest Rate Parity

The relationship between the EXCHANGE RATES AND INTEREST RATES, is called Interest rate parity or covered interest arbitrage.

Interest Rate Parity

The relationship between the EXCHANGE RATES AND INTEREST RATES, is called Interest rate parity or covered interest arbitrage.

let:

• i$ = interest rate in the US

• i = interest rate in the UK

Interest Rate Parity

The relationship between the EXCHANGE RATES AND INTEREST RATES, is called Interest rate parity or covered interest arbitrage.

let:

• i$ = interest rate in the US

• i = interest rate in the UK

If you invest $1 in the US by the end of the first period you will have:

(1+ i$)

Interest Rate Parity

If you wanted to invest in the UK, you will have to go through several steps:

1-- you need to exchange your $ into &

1/Rs = number of &s that one could receive for one dollar in the spot market.

Interest Rate Parity

If you wanted to invest in the UK, you will have to go through several steps:

1-- you need to exchange your $ into &

1/Rs = number of &s that one could receive for one dollar in the spot market.

2-- you need to lend the money in the UK

[1/Rts] (1+ i) = number of &s that you will

have at the end of one period.

Interest Rate Parity

If you wanted to invest in the UK, you will have to go through several steps:

3-- you need to sell your &s when you want to bring back your money to the US.

Rt+1s[1/ Rt

s] (1+ i) = number of $s that you will have at the end of one period.

Interest Rate Parity

Now you can compare your yields and decide whether or not to invest here or in the UK.

(1+ i$) = Rt+1s[1/ Rt

s] (1+ i)

Covered Interest Parity

4-- When you lend your money, you know exactly how much &s you have to sell. You could sell them right away in the forward market and cover yourself.

(1+ i$) = Rtf [1/ Rt

s] (1+ i)

or

(1+ i$) =[Rtf / Rt

s] (1+ i)

Covered Interest Parity

(1+ i$) =[Rtf / Rt

s] (1+ i)

[(1+ i$) / (1+ i)] =[Rtf / Rt

s]

[(1+ i$) / (1+ i)] - 1 =[Rtf / Rt

s] - 1

[(i$ - i) / (1+ i)] = [(Rtf - Rt

s )/ Rts]

Interest Rate Parity

Example

• i $ = 10% which means at the end of the period you would have $1.1

• i & = 10%

• Rtf = 1.55

• Rts = 1.65

Interest Rate Parity

which means at the end of the period you would have

[1.55/1.65](1.1) = 1.033

Therefore, you could invest in the US and earn a higher yield.