Interest rate parity

Ms. Nguyen Thu Trang Faculty of banking and finance trannhatxu@gmail.com

Objectives
Provides the link between interest rates and exchange rates between two countries Interest rate arbitrage (covered and uncovered Interest rate parity (covered and uncovered)

An introduction
The Forex markets efficiency: international investors will have no desire to switch investments from domestic to foreign currency denominated assets, or vice versa. - Forex market participants are risk neutral - Forex participants (in an aggregate sense) act as if they are endowed with rational expectations (adjusted for risk and formed rationally) Prices should fully reflect information available to market participants

Arbitrage strategy
Trading strategies involve no market risk (all prices are locked in) at that time the strategy is initiated - buy low, sell high - Transactions executed simultaneously These strategies also involve no initial investment (any funds required can be borrowed at known rates, so again no market risk) Other risks (counterparty credit risk) No profitable arbitrage opportunities

Interest arbitrage: is an operation that aims to benefit from the short-term employment of liquid funds in the financial central where the yield is highest.

Covered interest arbitrage

Covered interest arbitrage involves the coverage of economic agents (not speculators) against exchange risk by having recourse to the forward exchange market

Covered interest arbitrage

Supposed, Vnese investor has VND1,000,000 and decide investing in bank debentures in 6 months. The current market parameters as follows: - 1 year interest rate in VN: 8% - 1 year interest rate in US: 4% - The spot exchange rate S=20,000VND/$ - The 6 months forward exchange rate F=22,000VND/$ Investor should be prompted to select one of two investment plans to be most effective: - Investing in VND - Investing in USD

Uncovered interest arbitrage

Supposed, Japanese investor wants to borrow 10,000,000 in 1 year. The current market parameters as follows: - 1 year interest rate in US: 5% - 1 year interest rate in Japan: 0.4% - The spot exchange rate S=120.00/$ If investor borrows Japanese Yen to buy the US bank debentures, What will happen?

Determining the currency of investment

1+i
0 If 1 + > F. 1/S F
1 S

. (1 + )

=> JPY deposit choosing if 1 + < F.

1 S

. (1 + )

=> USD deposit choosing 0

1+

Determining the currency in which to borrow

1+i
0 if 1 + > F. 1/S F
1 S

. (1 + )

=> USD borrowing If 1 + < F. S . (1 + ) => JPY borrowing

1

1+

Borrowing and investing for arbitrage profit

1+i
0 If 1 + > F. S . (1 + ) => JPY investing, USD borrowing If 1 + < F.
1 S 1

1/S

. (1 + )

=> JPY borrowing, USD investing 0 1+

Interest rate parity

Interest rate parity (IRP) is an arbitrage condition that must hold when international markets are in equilibrium (provides the linkage between the foreign exchange markets and the international money markets). IRP derives with the assumptions that there are no transaction costs, political risks of investing abroad and taxes.

IRP theory states the difference in the national interest rates for securities of similar risk and maturity should be equal to, but opposite in sign to, the forward discount or premium for the foreign currency, except for transaction costs.

Supposed, US investor has $1,000,000 and decide investing in bank debentures. The current market parameters as follows: - 1 year interest rate in US: 8% - 1 year interest rate in Switzerland: 4% - The spot exchange rate S=0.6756USD/SF - The 1 year forward exchange rate F=0.6824$/SF Investor should be prompted to select one of two investments plans to be most effective: - Investing in US dollar - Investing in Swiss Fran

1 1 + = . . (1 + ) No differences in investing in two different currencies.

Covered interest rate parity

CIP formation mechanism If i - Investing in foreign currencies with covered exchange rate risk will get more profits than investing in local currency. - Borrowing domestic currencies with covered exchange rate risk will pay less costs than borrowing in foreign currencies. - You will get profit if borrowing in currency A and investing in currency B at the same time.

i : temporary, the market forces always make 2 sides balance in long term.
=> 1 + = . If i (similarly) Conclusion: Market forces tend to cause the interest rates of different currencies being equal. CIP is precisely the law of one price in the currency market.
1

. (1 + )

Absolute CIP

Relative CIP p: the forward premium or discount (the percentage difference between the spot and forward exchange rate) = = = i i 1 + P>0 (F>S): Forward premium P<0 (F<S): forward discount

1 + = . 1 +

Uncovered interest rate parity)

Uncovered interest rate parity: wherein investors borrow in countries and currencies exhibiting relatively low interest rates and convert the proceeds into currencies that offer much higher interest rates. The transaction is uncovered because the investor does not sell the higher yielding currency proceeds forward, choosing to remain uncovered and accept the currency risk .

 = : the difference between the expected spot exchange rate in the future and the current spot exchange rate Absolut UIP 1 + = . 1 + Relative UIP = = 1 +

The meaning of UIP

If the market is effective, the difference of interest rate between 2 currencies must reflect the fluctuation of the expected exchange rate.

International Fisher effect

PPP: = IRP: = => = => = The Fisher effect: the real rate of return is the nominal rate of interest rate less the expected rate of inflation. Assuming efficient and open markets, the real rates or return should be equal across currencies.

Applications
dollar rate = 8% / annum Start $1,000,000 X1.04 Dollar money market End $1,040,000 $1,044,638

S=0.0094$/

180 days

F=0.0097$/

106,000,000

JPY money market X1.02 yen rate = 4%/annum

108,120,000

The premium on the Yen: 360 = 100 = 4.8309% 180 Investing in JPY and selling on the forward market => interest rate is 4.8309% in 180 days. Investing in USD money market => interest rate is 4% in 180 days

Arbitrage rule of thumb

CIP - > : invest in the higher interest yielding currency. - < : invest in the lower yielding currency UIP - Borrow low yielding currencies and invest in high yielding currencies - Accept the currency risk

Prices, Interest rates and Exchange rates in equilibrium

Using the US dollar and Japanese Yen: - The forecasted inflation rate for Japan: 1% - The forecasted inflation rate for the US: 5% - The nominal interest rate in the US dollar market: 8% - The nominal interest rate in the JPY market: 4% - The spot rate: 104 /$ - The one year forward rate: 100 /$

Forecast change in spot exchange rate (Yen strengthens 4%)

Uncovered IRP (D)

PPP (A)

Forward premium on foreign currency (Yen strengthens 4%)

Forecast difference in rates of inflation (4% less in Japan)

Interest rate parity (C)

Fisher effect (B)

Difference in nominal interest rates (4% less in Japan)

Problems
The interest rate in Australia for 2012 is 3.25%, in the US is 4.25%, the spot exchange rate at the beginning of 2012 was 0.7676USD/AUD. Using IRP theory to answer the following questions: 1. Forecast for the spot rate at the end of 2012, 2. Estimated business results if you sign one year forward contract to purchase $ 10 million duration 31/12/2012 at forward exchange rate 0.7800USD/AUD? 3. If the spot rate on the market at the end of 2012 was 0.800USD/AUD, how much will u get? 4. Comment on Interest Rate Parity theory.