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The Interest Rate Parity (IRP) Is a Theory Regarding the Relationship

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The Interest Rate Parity (IRP) Is a Theory Regarding the Relationship What is the Interest Rate Parity (IRP)? The interest rate parity (IRP) is a theory regarding the relationship between the spot exchange rate and the expected spot rate or forward exchange rate of two currencies, based on interest rates. The theory holds that the forward exchange rate should be equal to the spot currency exchange rate times the interest rate of the home country, divided by the interest rate of the foreign country. Uncovered Interest Rate Parity vs Covered Interest Rate Parity The uncovered and covered interest rate parities are very similar. The difference is that the uncovered IRP refers to the state in which no-arbitrage is satisfied without the use of a forward contract. In the uncovered IRP, the expected exchange rate adjusts so that IRP holds. This concept is a part of the expected spot exchange rate determination. The covered interest rate parity refers to the state in which no-arbitrage is satisfied with the use of a forward contract. In the covered IRP, investors would be indifferent as to whether to invest in their home country interest rate or the foreign country interest rate since the forward exchange rate is holding the currencies in equilibrium. This concept is part of the forward exchange rate determination. What is the Interest Rate Parity (IRP) Equation? The covered and uncovered IRP equations are very similar, with the only difference being the substitution of the forward exchange rate for the expected spot exchange rate. The following shows the equation for the uncovered interest rate parity: The following is the equation for the covered interest rate parity: Interest rate parity is also often shown in the form that isolates the interest rate of the home country: For all forms of the equation: • St(a/b) = The Spot Rate (In Currency A Per Currency B) • ST(a/b) = Expected Spot Rate at time T (In Currency A Per Currency B) • Ft(a/b) = The Forward Rate (In Currency A Per Currency B) • ia = Interest Rate of Country A • ib = Interest Rate of Country B • T = Time to Expiration Date To sum up: • Interest Rate Parity suggests that the difference in interest rates between two countries is equal to the difference between the forward exchange rate and the spot exchange rate • IRP helps define the relationship between interest rates, spot rates, and forward rates and suggests that there will be no scope for arbitrage in interest rate differentials since the difference in the exchange rates would be reflected as either forward premium or forward discount. • Interest Rate Parity can be either covered interest rate parity or uncovered interest rate parity depending upon the existence or non-existence of a forward contract • IRP is based on assumptions of capital mobility and asset substitutability KEY TAKEAWAYS o Covered interest arbitrage uses a strategy of arbitraging the interest rate differentials between spot and forward contract markets in order to hedge interest rate risk in currency markets. o This form of arbitrage is complex and offers low returns on a per trade basis. But trade volumes have the potential to inflate returns. o It is often believed that interest rate parity governs exchange rates between currencies of various countries. If interest rate parity does not exist there is an opportunity for covered interest rate arbitrage Recall : what is arbitrage? Answer: Arbitrage can be defined as the act of simultaneously buying and selling the same or equivalent assets or commodities for the purpose of making certain, guaranteed profits. .
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