Interest rate parity refers to the fundamental equation that governs the relationship between interest rates and currency exchange rates. The basic premise of interest rate parity is that hedged returns from investing in different currencies should be the same, regardless of the level of their interest rates.
The Forex Walkthrough There are two versions of interest rate parity: Covered Interest Rate Parity 2. Uncovered Interest Rate Parity. Read on to learn about what determines interest rate parity and how to use it to trade the forex market.
Calculating Forward Rates Forward exchange rates for currencies refers to exchange rates at a future point in time , as opposed to spot exchange rates , which refers to current rates. An understanding of forward rates is fundamental to interest rate parity, especially as it pertains to arbitrage. The basic equation for calculating forward rates with the U. Forward rates are available from banks and currency dealers for periods ranging from less than a week to as far out as five years and beyond.
As with spot currency quotations , forwards are quoted with a bid-ask spread. One-year interest rates priced off the zero-coupon yield curve are at 3. Using the above formula, the one-year forward rate is computed as follows: The difference between the forward rate and spot rate is known as swap points. In the above example, the swap points amount to If this difference forward rate — spot rate is positive, it is known as a forward premium ; a negative difference is termed a forward discount.
A currency with lower interest rates will trade at a forward premium in relation to a currency with a higher interest rate. In the example shown above, the U. Can forward rates be used to predict future spot rates or interest rates? On both counts, the answer is no. A number of studies have confirmed that forward rates are notoriously poor predictors of future spot rates.
Given that forward rates are merely exchange rates adjusted for interest rate differentials, they also have little predictive power in terms of forecasting future interest rates. Covered Interest Rate Parity According to covered interest rate parity , forward exchange rates should incorporate the difference in interest rates between two countries; otherwise, an arbitrage opportunity would exist. In other words, there is no interest rate advantage if an investor borrows in a low-interest rate currency to invest in a currency offering a higher interest rate.
Typically, the investor would take the following steps: Invest the proceeds in an interest-bearing instrument in this higher interest rate currency. Simultaneously hedge exchange risk by buying a forward contract to convert the investment proceeds into the first lower interest rate currency. The returns in this case would be the same as those obtained from investing in interest-bearing instruments in the lower interest rate currency.
Under the covered interest rate parity condition, the cost of hedging exchange risk negates the higher returns that would accrue from investing in a currency that offers a higher interest rate.
Covered Interest Rate Arbitrage Consider the following example to illustrate covered interest rate parity. Further, assume that the currencies of the two countries are trading at par in the spot market i. The investor can use the one-year forward rate to eliminate the exchange risk implicit in this transaction, which arises because the investor is now holding Currency B, but has to repay the funds borrowed in Currency A. Under covered interest rate parity, the one-year forward rate should be approximately equal to 1.
What if the one-year forward rate is also at parity i. Here's how it would work. After one year, the investor receives , of Currency B, of which , is used to purchase Currency A under the forward contract and repay the borrowed amount, leaving the investor to pocket the balance - 2, of Currency B.
This transaction is known as covered interest rate arbitrage. Market forces ensure that forward exchange rates are based on the interest rate differential between two currencies, otherwise arbitrageurs would step in to take advantage of the opportunity for arbitrage profits.
In the above example, the one-year forward rate would therefore necessarily be close to 1. Combining Forex Spot And Futures Transactions Uncovered Interest Rate Parity Uncovered interest rate parity UIP states that the difference in interest rates between two countries equals the expected change in exchange rates between those two countries. In reality, however, it is a different story.
Since the introduction of floating exchange rates in the early s, currencies of countries with high interest rates have tended to appreciate, rather than depreciate, as the UIP equation states.
This well-known conundrum, also termed the "forward premium puzzle," has been the subject of several academic research papers. The anomaly may be partly explained by the " carry trade ," whereby speculators borrow in low-interest currencies such as the Japanese yen , sell the borrowed amount and invest the proceeds in higher-yielding currencies and instruments.
Relentless selling of the borrowed currency has the effect of weakening it in the foreign exchange markets. The Bank of Japan's target rate over that period ranged from 0 to 0. The Canadian dollar has been exceptionally volatile since the year After reaching a record low of US Looking at long-term cycles, the Canadian dollar depreciated against the U. It appreciated against the U. From that low, it then appreciated steadily against the U. For the sake of simplicity, we use prime rates the rates charged by commercial banks to their best customers to test the UIP condition between the U.
Based on prime rates, UIP held during some points of this period, but did not hold at others, as shown in the following examples: Commodity Prices And Currency Movements. Hedging Exchange Risk Forward rates can be very useful as a tool for hedging exchange risk. The caveat is that a forward contract is highly inflexible, because it is a binding contract that the buyer and seller are obligated to execute at the agreed-upon rate. Understanding exchange risk is an increasingly worthwhile exercise in a world where the best investment opportunities may lie overseas.
Because currency moves can magnify investment returns, a U. The Canadian dollar's appreciation against the U. Of course, at the beginning of , with the Canadian dollar heading for a record low against the U.
With the benefit of hindsight, the prudent move in this case would have been to not hedge the exchange risk. However, it is an altogether different story for Canadian investors invested in the U.
Hedging exchange risk again, with the benefit of hindsight in this case would have mitigated at least part of that dismal performance.
In order to fully understand the two kinds of interest rate parity, however, the trader must first grasp the basics of forward exchange rates and hedging strategies. Armed with this knowledge, the forex trader will then be able to use interest rate differentials to his or her advantage.
The case of U. Dictionary Term Of The Day. A conflict of interest inherent in any relationship where one party is expected to Broker Reviews Find the best broker for your trading or investing needs See Reviews. Sophisticated content for financial advisors around investment strategies, industry trends, and advisor education.
A celebration of the most influential advisors and their contributions to critical conversations on finance. Become a day trader. Uncovered Interest Rate Parity Read on to learn about what determines interest rate parity and how to use it to trade the forex market. Borrow an amount in a currency with a lower interest rate.
Convert the borrowed amount into a currency with a higher interest rate. Converts the borrowed amount into Currency B at the spot rate. Immediately converts the borrowed proceeds to Currency B at the spot rate. Simultaneously enters into a one-year forward contract for the purchase of , Currency A. The Canadian prime rate was higher than the U. During most of this period, the Canadian dollar appreciated against its U.
The Canadian prime rate was lower than the U. As a result, the Canadian dollar traded at a forward premium to the U. The UIP condition held for most of the period from , when the Canadian dollar commenced its commodity -fueled rally , until late , when it reached its peak.
The Canadian prime rate was generally below the U. A conflict of interest inherent in any relationship where one party is expected to act in another's best interests.
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