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

 

The Interest Rate Parity Theorem says that the relation between (a) foreign and domestic interest rates and (b) the forward and spot exchange rates is given by

 

                         =        ,

 

where F$/F denotes the (direct) forward exchange rate between the dollar and an arbitrary foreign currency F, S$/F denotes the spot rate, with RUS and RF respectively denoting the U.S. and foreign interest rates.  The Interest Rate Parity Theorem implies that the currency with the higher interest rate will always be at a forward premium to the currency having the lower interest rate.  In other words, the forward exchange rate will be greater (less) than the spot rate whenever the U.S. interest rate is greater (less) than the foreign interest rate.

 

Since the direct and indirect exchange rate quotations are reciprocals of one another, the interest rate parity can also be expressed in terms of the indirect quotations for the spot and forward exchange rates,

 

                         =        .

 

An violation of Interest Rate Parity would allow investors in either the U.S. or the country denoted by F to earn more than their domestic risk-free rate of interest (i.e., RF for a U.S. investor).  For example, a violation of interest rate parity may permit a U.S. investor to simultaneously (1) convert dollars to foreign currency at the spot rate, (2) invest in risk-free foreign securities at a rate of RF , and (3) hedge the future value of the investment against fluctuations in the exchange rate by selling the foreign currency to be received in the forward market.  Thus, the Interest Rate Parity Theorem essentially states that an investor must earn the same rate of return by investing in risk-free money market securities at home (e.g., the U.S.) as could be earned from a hedged investment in risk-free foreign money market securities.