Trading Forex with Interest Rate Parity

Interest rate parity (IRP) is a theory based on interest rates that describe the link between the spot exchange rate and the predicted spot rate or forward exchange rate of two currencies. According to the theory, the forward exchange rate should be equal to the spot currency exchange rate multiplied by the home country’s interest rate, divided by the foreign country’s interest rate.

 

The fundamental equation that determines the connection between interest rates and currency exchange rates is interest rate parity (IRP). Interest rate parity is based on the idea that hedged returns from investing in multiple currencies should be the same regardless of interest rates.

 

Interest rate parity is divided into two types:

 

 

• Covered Interest Rate Parity

 

 

A theoretical condition in which the relationship between interest rates and the spot and forward currency values of two countries is in equilibrium is known as covered interest rate parity. Because of the covered interest rate parity, there is no chance for forwarding contract arbitrage, which is common in nations with different interest rates.

 

According to the covered interest rate parity criterion, two countries’ interest rates and spot and forward currency values are in balance.

It is assumed that there is no possibility of arbitrage utilizing forward contracts.

When forward and projected spot rates are the same, covered and uncovered interest rate parity is the same.

 

 

What Is Covered Interest Rate Parity and What Does It Mean?

 

 

Theoretically, covered interest rate parity (CIRP) describes the link between interest rates and the current and forward currency rates of two countries. It proves that forward contracts, which are frequently utilized to earn sloppy profits by leveraging interest rate differentials, offer no potential for arbitrage. The difference in interest rates should equal the forward and spot exchange rates, according to this theory.

 

Covered interest rate parity is a no-arbitrage condition that can be used to establish the forward foreign exchange rate in the foreign exchange markets. Investors could also use the condition to mitigate the foreign exchange risk of unanticipated exchange rate volatility.

 

As a result, the risk of foreign exchange fluctuation is stated to be mitigated. Interest rate parity may exist for a short period, but it does not guarantee that it will last. Rates of interest and currency fluctuate throughout time.

 

 

• Uncovered Interest Rate Parity

 

 

According to the uncovered interest rate parity (UIP) theory, the difference in interest rates between two countries over the same period will equal the relative change in currency foreign exchange rates. It’s a type of interest rate parity (IRP) that’s utilized in conjunction with covered interest rate parity.

 

If the uncovered interest rate parity relationship does not hold, currency arbitrage or Forex arbitrage can be used to create a risk-free profit.

 

Uncovered interest rate parity (UIP) is a basic economics equation that determines the connection between foreign and domestic interest rates, as well as currency exchange rates. The primary concept of interest rate parity is that, in a global economy, after interest rates and currency exchange rates are factored in, the price of goods should be the same everywhere (the law of one price). Covered interest rate parity, on the other hand, includes forex dealers employing future contracts to hedge exchange rates.

 

 

What Can You Learn From Uncovered Interest Rate Parity?

 

 

There are two return streams in uncovered interest rate parity conditions: one from the foreign money market interest rate on the investment and the other from the change in the foreign currency spot rate. To put it another way, uncovered interest rate parity assumes foreign exchange equilibrium, which means that after adjusting for changes in foreign currency exchange spot rates, the expected return of a domestic asset (such as a risk-free rate like a U.S. Treasury Bill or T-Bill) will equal the expected return of a foreign asset.

 

There can be no excess gain from concurrently going long a higher-yielding currency investment and shorting a distinct lower-yielding currency investment or interest rate spread if uncovered interest rate parity holds. The assumption of uncovered interest rate parity is that the country with the higher interest rate or risk-free money market yield will see its domestic currency depreciate against the foreign currency.

 

When currency exchange rates are taken into account, the price of identical security, commodity, or product traded anywhere in the world should have the same price regardless of location—if it is traded in a free market with no trade restrictions. UIP is related to the so-called “law of one price,” which is an economic theory that states that the price of identical security, commodity, or product traded anywhere in the world should have the same price regardless of location.

 

The “rule of one price” exists because arbitrage opportunities should eventually eradicate disparities in asset pricing in different regions. The law of one price theory is the grounding of the idea of purchasing power parity (PPP) (PPP). When a basket of identical commodities is priced the same in both nations, Purchasing Power Parity states that the value of two currencies is equal. This is a formula for comparing securities across marketplaces that trade in several currencies. Because currency rates fluctuate so often, the method can be redone on a regular basis to spot mispricings in a variety of foreign markets.

 

 

Forward Rates Calculation

 

 

In contrast to spot exchange rates, which are current rates, forward exchange rates for currencies anticipate the rate at a future point in time. Understanding forward rates is essential for interest rate parity, particularly when it comes to arbitrage (the simultaneous purchase and sale of an asset in order to profit from a difference in the price).

 

Banks and currency dealers can provide forward rates for periods ranging from less than a week to five years and beyond. Forwards are offered with a bid-ask spread, just like spot currency quotes.

 

In comparison to a currency with a higher interest rate, a currency with a lower interest rate will trade at a forward premium. The US dollar trades at a forward premium against the Canadian dollar in the example above, whereas the Canadian dollar trades at a forward discount against the US dollar.

 

Is it possible to estimate future spot rates or interest rates using forward rates? The answer is no on both counts. Forward rates are notoriously poor forecasts of future spot rates, according to a number of studies. Forward rates have little predictive ability in terms of anticipating future interest rates because they are just exchange rates adjusted for interest rate differentials.

 

Swap points are the difference between the forward rate and the spot rate. The swap points in the case above are 50. A forward premium is created when the difference between the forward rate and the spot rate is positive; a forward discount is created when the difference is negative.

 

 

Parity Of Covered Interest Rates

 

 

Forward exchange rates should include the difference in interest rates between two nations with covered interest rate parity; otherwise, an arbitrage opportunity would exist. In other words, if an investor borrows in a low-interest currency to invest in a higher-interest currency, there is no interest rate advantage. The investor would typically take the following steps:

 

1. Borrow money in a currency with a cheaper rate of interest.

 

1. Convert the borrowed funds to a currency with a greater rate of interest.

 

1. Invest the funds in a higher-interest-rate currency’s interest-bearing instrument.

 

1. Hedging exchange risk at the same time by purchasing a forward contract to convert investment proceeds into the first (lower interest rate) currency.

 

In this situation, the returns would be the same as if you invested in interest-bearing securities in the lower-interest currency. The cost of hedging exchange risk eliminates the higher gains that would accrue from investing in a currency with a higher interest rate under the covered interest rate parity condition.

 

 

Arbitrage Of Covered Interest Rates

 

 

Take a look at the following example to see how covered interest rate parity works. Assume that the interest rate on a one-year loan in Country A is 3%, and that the one-year deposit rate in Country B is 5%. Assume that the two countries’ currencies are trading at par in the spot market (that is, Currency A = Currency B).

 

The following is what an investor does:

 

• Borrows in Currency A at a 3% interest rate

 

• Converts the borrowed funds to Currency B at the current exchange rate.

 

• Invests the profits in a Currency B-denominated deposit with a 5% annual interest rate.

 

The one-year forward rate can be used to remove the exchange risk inherent in this transaction, which arises since the investor now holds Currency B but must repay the cash borrowed in Currency A. According to the calculation stated above, the one-year forward rate should be nearly equal to 1.0194 (i.e., Currency A = 1.0194 Currency B) under covered interest rate parity.

 

What happens if the one-year future rate is also equal (i.e., Currency A = Currency B)? In this circumstance, the above-mentioned investor could earn a risk-free profit of 2%. This is how it would go down. Assume the following scenario for the investor:

 

• For a one-year term, he borrows 100,000 of Currency A at a rate of 3%.
• Converts the borrowed funds to Currency B at the current spot rate.
• Place the entire sum in a 5-percentage-point one-year deposit.
• Concurrently, a one-year forward contract for the purchase of 103,000 Currency A is entered upon.

 

After a year, the investor receives 105,000 of Currency B, of which 103,000 is used to acquire Currency A under the forward contract and repay the loan, leaving the investor with 2,000 of Currency B to pocket. Covered interest rate arbitrage is the term for this type of transaction.

 

Arbitrageurs would step in to take advantage of the chance for arbitrage profits if forward exchange prices were not dependent on the interest rate gap between two currencies. As a result, the one-year forward rate would have to be close to 1.0194 in the case above.

 

 

Uncovered Interest Rate Parity

 

 

Uncovered interest rate parity (UIP) asserts that the difference between two countries’ interest rates equals the predicted change in their exchange rates. Theoretically, if the interest rate differential between two countries is 3%, the currency of the country with the higher interest rate should devalue by 3% against the other currency.

 

However, the truth is rather different. According to the UIP equation, since the advent of flexible exchange rates in the early 1970s, currencies of nations with high-interest rates have tended to appreciate rather than devalue. Several academic research articles have been written about this well-known issue, often known as the “forward premium puzzle.”

 

The “carry trade,” in which speculators borrow in low-interest currencies like the Japanese yen, sell the borrowed amount, and invest the proceeds in higher-yielding currencies and products, may explain some of the anomalies. Until mid-2007, the Japanese yen was a popular target for this activity, with an estimated $1 trillion in yen carry trade by that time.

 

In the foreign exchange markets, relentless selling of the borrowed currency has the effect of weakening it. The Japanese yen declined over 21% versus the US dollar from the beginning of 2005 to the middle of 2007. The Bank of Japan’s target rate ranged from 0 to 0.50 percent over that time period; if the UIP hypothesis had held true, the yen should have risen versus the dollar only due to Japan’s lower interest rates.

 

 

Interest Rate Parity Between The United States And Canada

 

 

Let’s take a look at the historical link between interest rates and exchange rates for the world’s two largest trading partners, the United States and Canada. Since the year 2000, the Canadian dollar has been extremely volatile. It climbed nearly 80% in the following years after hitting a record low of US61.79 cents in January 2002, reaching a modern-day high of more than US$1.10 in November 2007.

 

The Canadian currency fell against the US dollar from 1980 to 1985, according to long-term patterns. From 1986 to 1991, it appreciated against the US dollar before beginning a long decline in 1992, culminating in a record low in January 2002. It subsequently steadily appreciated against the US dollar for the next five and a half years after that low.

 

We examine the UIP condition between the US dollar and the Canadian dollar from 1988 to 2008 using prime rates (the rates charged by commercial banks to their best customers).

 

UIP held during some times of this period based on prime rates, but not at others, as seen in the following examples:

 

• From September 1988 to March 1993, the Canadian prime rate was higher than the US prime rate. The Canadian currency appreciated versus its US equivalent during the majority of this time, which runs as opposed to the UIP relationship. 

 

• From mid-1995 until the beginning of 2002, the Canadian prime rate was lower than the US prime rate for the majority of the time. As a result, for much of this time, the Canadian dollar traded at a forward premium to the US dollar. However, the Canadian dollar fell 15% versus the US dollar during this time, showing that UIP did not hold up as well.

 

• The UIP condition persisted for most of the time between 2002, when the Canadian dollar began its commodity-fueled climb, and late 2007 when it peaked. For the most part, the Canadian prime rate was lower than the US prime rate, with the exception of an 18-month period from October 2002 to March 2004.

 

 

Final Thoughts

 

 

Interest rate parity is essential knowledge for foreign currency dealers. However, a trader must first understand the fundamentals of forwarding exchange rates and hedging methods in order to completely comprehend the two types of interest rate parity.

 

The forex trader will be able to take advantage of interest rate differentials if armed with this knowledge. The rise and depreciation of the US dollar against the Canadian dollar highlights how profitable these trades can be with the correct circumstances, plan, and understanding.

 

 

 

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