Interest Rate Parity

11 Key excerpts on "Interest Rate Parity"

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  eBook - ePub

  Macroeconomics

  (With Study Guide CD-ROM)

  • Jagdish Handa(Author)
  • 2010(Publication Date)
  • WSPC

    (Publisher)

  The Interest Parity Theory implies that the interest rates should be identical between them. However, as the following graph shows, there is almost always a differential between them. The Canada T-bill rate was higher in Canada from the early 1970s to the mid-1990s; outside this period, the Canadian rate was sometimes higher and sometimes lower than in the USA. Therefore, the value of the interest rate premium/discount α is usually not zero, even for closely integrated economies, and also not constant over time. 3.5.6 The relative importance of PPP and IRP in determining exchange rates International capital flows are nowadays potentially much larger than the value of commodity flows for developed economies with open capital markets, so that anticipated changes in interest rates can set up massive capital flows. These flows — entering on either the demand or supply side of the foreign exchange market of a country — dominate over other flows and determine the exchange rate — unless the governments have fixed the exchange rate or try to manage it through offsetting sales or purchases of foreign exchange from their reserves. 15 Further, since capital is extremely mobile and very large amounts can be transferred among countries with well-developed financial markets at a few minutes’ notice, IRP determines exchange rate changes on a continuous basis in free exchange markets, while, as we have already argued, PPP holds at best in a long-run context. Hence, in well-developed financial markets, IRP provides the short-term determination of the exchange rates while PPP or its relative version at best only provides a long-term tendency, so that exchange rates determined through IRP can deviate from PPP for considerable periods. 3.6 The Balance of Payments The balance of payments can be defined or presented in an economic or accounting form

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  eBook - ePub

  International Financial Transactions and Exchange Rates

  Trade, Investment, and Parities

  • I. Kallianiotis(Author)
  • 2013(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  Graph 2.5 . The Interest Rate Parity line shows the equilibrium state, but in reality transaction costs cause the line to be a band rather than a thin line. Transaction costs are from investment brokerage fees relating to buying and selling securities and foreign exchange cost relating to buying and selling currencies in the spot and forward markets.

  Interest Rate Parity [equation (2.27)] takes on two distinctive forms: (1) uncovered Interest Rate Parity (CIP) or uncovered interest arbitrage (UIA), which refers to the parity condition that uninhibitedly exposes investors to foreign exchange risk (i.e., unanticipated changes in exchange rates) and (2) covered Interest Rate Parity or covered interest arbitrage (CIA) refers to the condition in which a forward contract has been used to cover (i.e., hedge the foreign exchange exposure) the exchange rate risk.

  Graph 2.5 Interest Rate Parity (IRP)

  Note: IRP Line = Interest Rate Parity line (the 450 red line), CIA = covered interest arbitrage, interest rate differential,

  fp

  or

  fd

  = forward premium or forward discount. There is a zone around the IRP line, where covered interest arbitrage is not feasible, due to transaction costs.

  Source: Economagic. com

  Each form of the parity condition demonstrates a unique relationship with implications for the forecasting of future exchange rates: the forward exchange rate and the expected future spot exchange rate. Economists have found empirical evidence that covered Interest Rate Parity generally holds, though not with precision, due to the effects of various risks, costs, taxation, and ultimate differences in liquidity. When both covered and uncovered Interest Rate Parity hold, they expose a relationship suggesting that the forward rate is an unbiased predictor of the expected future spot rate (discussed in section 2.1.4.1).

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  eBook - PDF

  International Financial Management

  • Alan C. Shapiro, Peter Moles(Authors)
  • 2014(Publication Date)
  • Wiley

    (Publisher)

  The Economist’s instinct that there is no such thing as a free lunch, includ- ing in international financial markets, was borne out with a vengeance. Perhaps Icelanders will better trust eco- nomic theory in the future. 4.5 Interest Rate Parity Theory Spot and forward rates are closely linked to each other and to interest rates in different currencies through the medium of arbitrage. Specifically, the movement of funds between two currencies to take advantage of interest rate differentials is a major determinant of the spread between forward and spot rates. In fact, the forward discount or premium is closely related to the interest differential between the two currencies. According to Interest Rate Parity (IRP) theory, the currency of the country with a lower interest rate should be at a forward premium in terms of the currency of the country with the higher rate. More specifically, in an efficient market with no transaction costs, the interest differential should be (approximately) equal to the forward differential. When this condition is met, the forward rate is said to be at Interest Rate Parity, and equilibrium prevails in the money markets. Interest parity ensures that the return on a hedged (or “covered”) foreign investment will just equal the domestic interest rate on investments of identical risk, thereby eliminating the possibility of hav- ing a money machine. When this condition holds, the covered interest differential —the difference between the domestic interest rate and the hedged foreign rate—is zero. To illustrate this condition, suppose an investor with US$1, 000, 000 to invest for 90 days is trying to decide between invest- ing in U.S. dollars at 8% per year (2% for 90 days) or in euros at 6% per year (1.5% for 90 days). 158 CURRENCIES: EXPECTATIONS, PARITIES, AND FORECASTING New York Alternative investment: Invest $1,000,000 in New York for 90 days at 2% and receive $1,020,000 in 90 days Start: $1,000,000 Finish: $1,020,000 Today 90 days 3.

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  International Financial Management

  • Geert Bekaert, Robert Hodrick(Authors)
  • 2017(Publication Date)
  • Cambridge University Press

    (Publisher)

  International Parity Conditions and Exchange Rate Determination Part II Interest Rate Parity 6 In June 2015, six-month Indian rupee Treasury bill rates exceeded 7.50% per annum, whereas US Treasury bill rates were less than 10 basis points. Why would US investors accept such low returns when they could invest in India? First and foremost, US investors face transaction foreign exchange risk when investing in an Indian security. The Indian rupee might weaken, wiping out the interest gain. If investors hedge this risk, the relative return on Indian Treasury bills versus US Treasury bills is driven by four variables: the Indian interest rate, the spot and forward exchange rates, and the US interest rate. After hedging, perhaps the dollar return on the Indian Treasury bill looks much lower. Interest Rate Parity describes a no-arbitrage relationship between spot and forward exchange rates and the two nominal interest rates associated with these currencies. The relationship is called covered Interest Rate Parity. This chapter shows that Interest Rate Parity implies that forward premiums and discounts in the foreign exchange market offset interest differentials to eliminate possible arbitrage that would arise from borrowing the low-interest-rate currency, lending the high-interest-rate currency, and covering the foreign exchange risk. Interest Rate Parity is a critical equilibrium relationship in international finance. However, it does not always hold perfectly – and we discuss why, which will bring us back to the Indian example above. The availability of borrowing and lending opportunities in different currencies allows firms to hedge transaction foreign exchange risk with money market hedges. We demonstrate that when Interest Rate Parity is satisfied, money market hedges are equivalent to the forward mar- ket hedges of transaction exchange risk that were presented in Chapter 3. Moreover, we can use Interest Rate Parity to derive long-term forward exchange rates.

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  eBook - ePub

  Introduction to Foreign Exchange Rates

  • Thomas J. O'Brien(Author)
  • 2013(Publication Date)
  • Business Expert Press

    (Publisher)

  CHAPTER 6 Topics in Uncovered Interest Rate Parity This chapter covers some applications and issues related to the uncovered Interest Rate Parity (UIRP) condition. We first show the simple expected rate of change of the short-run intrinsic foreign exchange (FX) rate, given the UIRP condition. This concept has important implications in international finance, including converting an asset's cost of capital from one currency into another. The chapter also analyzes the impact on the spot FX rate if a currency's interest rate abruptly changes. This exercise is intended to help us see the dynamic forces that affect FX rates. We shall also describe Siegel's paradox, which is a minor mathematical problem for the UIRP theory. Finally, we shall cover the idea of how real interest rates connect the short-run intrinsic FX rate (consistent with financial market conditions and the UIRP condition) with the long-run intrinsic FX rate (consistent with goods market conditions and the absolute purchasing power parity (APPP) condition.) Expected Rate of Short-Run Intrinsic FX Change If the spot FX rate is correctly valued relative to financial market conditions, the expected rate of FX change is the expected rate of short-run intrinsic FX change. The notation E* (x Sf/$) denotes the expected annualized percentage change in the short-run intrinsic spot FX price of the U.S. dollar (relative to the Swiss franc), where the asterisk conveys the notion of short-run intrinsic FX valuation consistent with financial market conditions

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  eBook - ePub

  Introduction to Foreign Exchange Rates, Second Edition

  • Thomas J. O'Brien(Author)
  • 2016(Publication Date)
  • Business Expert Press

    (Publisher)

  CHAPTER 6 Topics in Uncovered Interest Rate Parity

  This chapter covers some applications and issues related to the uncovered Interest Rate Parity (UIRP) condition. We first show the expected rate of change of the short-run intrinsic foreign exchange (FX) rate, given the UIRP condition. This concept has important implications in international finance, including converting an asset’s cost of capital from one currency into another.

  The chapter also analyzes the impact on the spot FX rate if a currency’s interest rate abruptly changes. This exercise is intended to help us see the dynamic forces that affect FX rates. The chapter also describes Siegel’s paradox, which is a minor mathematical problem for the UIRP theory.

  Finally, we cover the idea of how real interest rates connect the short-run intrinsic FX rate that is consistent with financial market conditions and the UIRP condition, with the long-run intrinsic FX rate that is consistent with goods market conditions and the absolute purchasing power parity (APPP) condition.

  Expected Rate of Short-Run Intrinsic FX Change

  If the spot FX rate is correctly valued relative to financial market conditions, the expected rate of FX change is the expected rate of short-run intrinsic FX change. Let denote the expected percentage change in the short-run intrinsic spot FX price of the U.S. dollar (relative to the Swiss franc), where the asterisk conveys the notion of short-run intrinsic FX valuation consistent with financial market conditions. If the UIRP condition is the correct model of short-run intrinsic FX value, then is given as a linear approximation in Equation 6.1 .

  Expected Rate of Short-Run Intrinsic FX Change

  Linear Approximation UIRP Condition

  (6.1)

  In Equation 6.1 , the interest rate for the “denominator currency” is subtracted from the interest rate of the “numerator currency.” Let us do a numerical example. Assume , and . The linear approximation in Equation 6.1 says that −0.02, or −2 percent. By way of comparison with the UIRP condition in Equation 5.1 , assume . Thus the UIRP condition in Equation 5.1 says that today’s spot FX rate should be , and the expected rate of intrinsic spot FX change, given that the UIRP condition holds, is (1.57 Sf/$)/(1.60 Sf/$) − 1 = −0.019, or −1.9 percent, So the linear approximation in Equation 6.1 is close.1

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  eBook - ePub

  International Money and Finance

  • Michael Melvin, Stefan C. Norrbin, Stefan Norrbin(Authors)
  • 2017(Publication Date)
  • Academic Press

    (Publisher)

  www.deposits.org , Sep. 2015.

  Exchange Rates, Interest Rates, and Inflation

  If we combine the Fisher Eq. (6.5) and the interest parity Eq. (6.3) , we can determine how interest rates, inflation, and exchange rates are all linked. First, consider the Fisher equation for the United States and the United Kingdom:

  i $

  =

  r $

  +

  π $ e

  for the United States ,

  and

  i £

  =

  r £

  +

  π £ e

  for the United States .

  Global investors now want to have as high as possible real returns from their investments. If global markets allow free flow of capital, one might expect that the real returns across countries equalize. If we assume that the real rate of interest is the same internationally, then r $ =r £ . In this case, the nominal interest rates, i $ and i £ , differ solely by expected inflation, so we can write

  i $

  −

  i £

  =

  π $ e

  −

  π £ e

  (6.6)

  (6.6)

  The interest parity condition of Eq. (6.3) indicates that the interest differential is also equal to the forward premium, or

  i $

  −

  i £

  =

  π $ e

  −

  π £ e

  = ( F − S )   /   E

  (6.7)

  (6.7)

  Eq. (6.7) summarizes the link among interest, inflation, and exchange rates.

  In the real world the interrelationships summarized by Eq. (6.7) are determined simultaneously, because interest rates, inflation expectations, and exchange rates are jointly affected by new events and information. For instance, suppose we begin from a situation of equilibrium, where interest parity holds. Suddenly there is a change in US policy that leads to expectations of a higher US inflation rate. The increase in expected inflation will cause dollar interest rates to rise. At the same time exchange rates will adjust to maintain interest parity. If the expected future spot rate is changed, we would expect F

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  eBook - ePub

  2022 CFA Program Curriculum Level II Box Set

  • (Author)
  • 2021(Publication Date)
  • Wiley

    (Publisher)

  The difference in expected inflation rates equals the expected change in the exchange rate. Combining these two expressions, we derive the following:

  The nominal interest rate spread is equal to the difference in expected inflation rates. We can therefore conclude that if uncovered Interest Rate Parity and ex ante PPP hold,

  (rf − rd ) = 0.

  The real yield spread between the domestic and foreign countries (rf − rd ) will be zero, and the level of real interest rates in the domestic country will be identical to the level of real interest rates in the foreign country.

  The proposition that real interest rates will converge to the same level across different markets is known as the real Interest Rate Parity condition.

  Finally, if real interest rates are equal across markets, then it also follows that the foreign–domestic nominal yield spread is determined solely by the foreign–domestic expected inflation differential:

  This is known as the international Fisher effect . The reader should be aware that some authors refer to uncovered Interest Rate Parity as the “international Fisher effect.” We reserve this term for the relationship between nominal interest rate differentials and expected inflation differentials because the original (domestic) Fisher effect is a relationship between interest rates and expected inflation.

  The international Fisher effect and, by extension, real Interest Rate Parity assume that currency risk is the same throughout the world. However, not all currencies carry the same risk. For example, an emerging country may have a high level of indebtedness, which could result in an elevated level of currency risk (i.e., likelihood of currency depreciation). In this case, because the emerging market currency has higher risk, subtracting the expected inflation rate from the nominal interest rate will result in a calculated real interest rate that is higher than in other countries. Economists typically separate the nominal interest rate into the real interest rate, an inflation premium, and a risk premium. The emerging country’s investors will require a risk premium for holding the currency, which will be reflected in nominal and real interest rates that are higher than would be expected under the international Fisher effect and real Interest Rate Parity conditions.

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  No longer available |Learn more

  CFA Program Curriculum 2020 Level II, Volumes 1-6 Box Set

  • (Author)
  • 2019(Publication Date)
  • Wiley

    (Publisher)

  The difference in expected inflation rates equals the expected change in the exchange rate. Combining these two expressions, we derive the following:

  The nominal interest rate spread is equal to the difference in expected inflation rates. We can therefore conclude that if uncovered Interest Rate Parity and ex ante PPP hold,

  (rf – rd ) = 0.

  The real yield spread between the domestic and foreign countries (rf – rd ) will be zero, and the level of real interest rates in the domestic country will be identical to the level of real interest rates in the foreign country.

  The proposition that real interest rates will converge to the same level across different markets is known as the real Interest Rate Parity condition.

  Finally, if real interest rates are equal across markets, then it also follows that the foreign–domestic nominal yield spread is determined solely by the foreign–domestic expected inflation differential:

  This is known as the international Fisher effect .15

  The international Fisher effect and, by extension, real Interest Rate Parity assume that currency risk is the same throughout the world. However, not all currencies carry the same risk. For example, an emerging country may have a high level of indebtedness, which could result in an elevated level of currency risk (i.e., likelihood of currency depreciation). In this case, because the emerging market currency has higher risk, subtracting the expected inflation rate from the nominal interest rate will result in a calculated real interest rate that is higher than in other countries.16

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  eBook - PDF

  Open Economy Macroeconomics

  • Asbjørn Rødseth(Author)
  • 2000(Publication Date)
  • Cambridge University Press

    (Publisher)

  Except by accident, uncovered Interest Rate Parity holds only when there is perfect capital mobi-lity. Among other things, this requires risk neutrality or absence of exchange rate risk. Forward parity is an equilibrium condition which equates the rates of return on two investments with identical risk characteristics. It holds irrespective of attitudes to exchange rate risk. The forward exchange rate is equal to the expected future exchange rate only when there is no risk premium in the interest rate. Covered Interest Rate Parity does not hold in all circumstances, however. Obviously the transactions involved in swaps must not be subject to exchange controls. The credit risk (risk of default of one of the contracting parties) must not differ between the swap and the ordinary loan contract. Since there are more parties involved in a swap, this is not always the case. Transaction costs will also differ between swaps and ordinary loans. This gives some scope for minor deviations from covered Interest Rate Parity (see Baille and McMahon, 1989). However, if there are no exchange controls, and if we are interested in the foreign exchange market from the macroeconomic point of view, we probably make no great error by assuming that forward parity holds con-tinuously. de Vries (1994, p. 353) states as one of his ‘stylised facts’ that covered Interest Rate Parity holds for all major traded currencies. However, Frankel (1993, ch. 2) gives some striking examples of countries which had large deviations from forward parity until exchange controls were abolished. From then on forward parity holds as a close approximation. Frankel found substantial deviations from forward parity for some OECD countries well into the 1980s (e.g. an average deviation of 1.7 percentage points for France), indicating that capital controls were still important then. Among the developing countries in his study forward parity holds for some, while capital controls create very large deviations for others.

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  International Economics

  • Dominick Salvatore(Author)
  • 2020(Publication Date)
  • Wiley

    (Publisher)

  The horizontal axis measures the forward exchange rate, with the minus sign indicating a forward discount and positive values indicating a forward premium on the foreign currency in percent per annum. The solid diagonal line is the covered interest parity (CIAP) line. Below the CIAP line, either the negative interest differential exceeds the forward discount or the forward premium exceeds the positive interest differential. In either case, there will be a capital outflow under covered interest arbitrage. Above the CIAP line, the opposite is true and there will be an arbitrage inflow. 390 Chapter 14 Foreign Exchange Markets and Exchange Rates Above the interest parity line, either the positive interest differential exceeds the forward premium on the foreign currency (point B in the figure) or the negative interest differential is smaller than the forward discount on the foreign currency (point B ′). In either case, it pays for foreigners to invest in our country, and there will be an arbitrage inflow . However, as the arbitrage inflow continues, the net gain diminishes and then disappears when the CIAP line is reached. In reality, interest arbitrage (inflow and outflow) will come to an end when the net gain reaches about 1 ⁄ 4 of 1 percent per year ( 1 ⁄ 16 of 1 percent for three months). This range is shown by the white area between the diagonal dashed lines in the figure. 14.6D Covered Interest Arbitrage Margin We have seen that points on the CIAP line indicate either that the negative interest dif-ferential (in favor of the foreign monetary center) equals the forward discount ( FD ) on the foreign currency or that the positive interest differential (in favor of the home monetary center) equals the forward premium ( FP ) on the foreign currency.

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