Global Economic Analysis - Interest Applications
Interest Rate Parity
Interest rate parity enforces an essential link between spot exchange currency rates, forward currency exchange rates and short-term interest. It specifies a relationship that must exist between the spot interest rates of two different currencies if no arbitrage opportunities are to exist. The relationship depends on the spot and forward exchange rates between the two currencies.
The following example illustrates what interest rate parity is and why it must exist.
Assume the following data for the euro (¬) and the U.S. dollar ($):
One-year forward exchange rate ¬/$ = 0.909
Spot exchange rate ¬/$ = 0.901
One-year interest rate, euro 7%
One-year interest rate, dollar 5%
A speculator could borrow dollars at 5%, convert them into euros and invest the euros at 7%. The speculator would be making a profit of 2%.
However, at the end of the time period, euros will need to be converted to dollars so that the initial borrowing can be repaid. The speculator runs the risk that dollars may have depreciated relative to the euro during that time period.
The speculator's position can potentially be made into a risk-free one by purchasing a forward exchange contract so that the exchange rate used to convert euros back to dollars is a known one.
Over one year, the speculator would experience the following exchange rate loss:(0.901 - 0.909) ÷ 0.901 = -0.9%
Because of the 2% interest rate differential, the speculator makes a net profit of 1.1% for each dollar borrowed. This is a certain gain, as all exchange and interest rates were fixed and known at the beginning of the trade, and no capital had to be invested in the position either!
If such rates existed in the real world, enormous swaps of capital would be made to take advantage of such a risk-free arbitrage. To prevent this from occurring, the forward discount rate would have to equal the difference in interest rates. Note that if the discount forward rate is greater than the interest rate differential, the arbitrage will be made in the other direction.
The actual mathematical relationship is slightly more complicated than what was specified above because a perfect arbitrage would require that the forward contract cover both the initial principal borrowed plus the accrued interest. For the rates discussed above, the speculator would actually need to hedge, for every dollar borrowed, 0.901 (1.07) = 0.964.
The interest rate parity relationship between two currencies can be expressed (using indirect quotes) as:
(Forward rate - Spot rate) ÷ Spot rate = (rfc - rdc) ÷ (1 + rdc)
or (F - S) ÷ S= (rfc - rdc) ÷ (1 + rdc)
Where rdc is the risk-free interest rate of the domestic currency, rfc is the risk-free interest rate of the foreign currency and the exchange rates quoted are indirect quotes expressed as the number of units of the foreign currency used to obtain one unit of the domestic currency.
The interest rate parity relationship can also be expressed as:
F × (1+ rdc) = S × (1 + rfc)
Note that currencies trading at a premium are associated with lower interest rates. Weak currencies must have high risk-free interest rates to compensate for expected depreciation.
Career Education & ResourcesLearn about the difficulty of the CFA exams with a description of the tests, some statistics on pass rates and suggestions that can help you pass the exams.
ProfessionalsBecome one of the elite who pass these exams by using these simple study methods.
Financial AdvisorsPotential financial advisors, analysts or asset managers have many credentials and degrees from which to choose. Here's a look at the CFA vs. the MBA.
Your PracticeIf you want to become an RIA all you have to do is pay a $165 fee to the SEC and pass the Series 65 exam. Is the bar set too low?
ProfessionalsTo pass the CFA exam, get organized, develop an effective study program and review.
ProfessionalsHere are some pros and cons to consider before you take the CFA charter plunge.
ProfessionalsFinding that first finance job is not easy, but these five tips can boost your chances even before you graduate.
ProfessionalsThe right accounting certification can open the doors of opportunity.
ProfessionalsA financial analyst researches companies and economic conditions to make business, sector and industry recommendations.
Career Education & ResourcesRead about what it takes to become a financial analyst in a corporation or securities firm, and learn how far you can rise in the profession.
A professional designation given by the CFA Institute (formerly ...
Professionals who help individuals manage their finances by providing ...
Formerly known as the Association for Investment Management and ...
A financial professional who studies various industries and companies, ...
Understand the differences between a Chartered Financial Analyst and a Certified Financial Planner. Learn how each approaches ... Read Answer >>
Understand what it means to hold the Chartered Financial Analyst designation. Learn how a candidate can work to become a ... Read Answer >>
Understand what types of positions a Chartered Financial Analyst can hold. Learn what is available to those who have only ... Read Answer >>
Learn who benefits most when expenses are prepaid. Individuals and businesses often make payments, such as rent or insurance, ... Read Answer >>
If you are looking specifically for an investment banking position, an MBA may be marginally preferable over the CFA. The ... Read Answer >>
You may still pass the Chartered Financial Analysis (CFA) Level I even if you fare poorly in the ethics section, but don't ... Read Answer >>