FREE online courses on Investment Decisions in Exchange Rates - Implications Of Interest Rate Parity

 

To explore the implications of interest rate parity further, consider the fact that an investor who wishes to invest $1 in risk-free securities has two alternatives.

 

1.       By investing at home in dollar-denominated money market securities, an investor earns interest at a rate of RF per period.  Thus, at the end of one period the investor receives

 

                   $1 x (1 + RUS)  .

 

2.       Alternatively, if the investor invests one dollar in foreign bonds, then the investor must

 

          a.       Convert one dollar to units of foreign currency,

 

          b.       Invest in foreign securities at an interest rate of RF, giving units of foreign currency at maturity,

 

          c.       Eliminate any exchange rate risk by selling the currency to be received in the forward market at the current forward rate of F$/F giving future dollar proceeds of

 

                   F$/F  .

 

The search by investors for the highest possible risk-free returns implies that prices must adjust so that the return from investing in dollars is equal to the hedged return from investing in the foreign money market securities.  In other words, 

 

                   $1 x (1 + RUS)    =    F$/F  ,

 

which implies that (1 + RUS)/(1 + RF) must equal to F$/F /S$/F  .

 

Example:

 

Suppose that you can invest in U.S. Government Treasury bill for one year at an interest rate of 5 percent.  The spot exchange rate between dollars and French francs (S$/F) is $0.2000/FF1, while the forward exchange rate (F$/F ) is $0.2020/FF1.  Assuming that you are able to invest in risk-free French bonds for one year at an interest rate of 4.25 percent , the returns from investing in domestic and foreign bonds are respectively equal to

 

 

1.       Domestic Investment

 

                   $1 x (1 + RUS)         =     $1 x 1.05

 

                             =     $1.05  .

 

 

2.       Foreign Investment

 

                   F$/F         =     x 1.0425 x $0.2020/FF1

 

                             =     $1.0529  .

 

In other words, we can earn 5.0 percent by investing in the U.S..  However, we could earn 5.29 percent by converting dollars to Francs, investing at 4.25 percent, and purchasing forward cover by selling the French francs to be received one year from now in the forward market for $0.2020/FF1.