How do I understand interest rate parity (IRP)?
The idea of interest rate parity (IRP) says that the difference in interest rates between two countries equals the difference in exchange rates between the two countries.
How to Understand Interest Rate Parity (IRP)
Interest rate parity (IRP) is essential in foreign exchange markets because it links interest rates, live exchange rates, and foreign exchange rates.
A fundamental equation called the IRP shows how interest and foreign exchange rates relate. IRP is based on the idea that investments in different currencies should give the same guaranteed returns, even if the interest rates on those currencies change.
IRP is the idea of “no-arbitrage” in the foreign exchange markets, which means buying and selling an object simultaneously to make money from a price difference. Investors can’t lock in the current exchange rate for one currency at a lower price and buy another from a country with a higher interest rate.
Rate of Change Forward
To understand IRP, especially regarding trading, you must know about forward rates. Spot exchange rates are the rates that are in effect right now. Forward exchange rates, on the other hand, are the rates that will be in effect in the future. You can get forward rates from banks and currency traders for terms that range from less than a week to five years or more in the future. A bid-ask spread is used to quote futures, just like it is used to quote spot currencies.
Swap points are the gap between the forward rate and the spot rate. If the difference between the forward and spot rates is positive, it is called a forward premium. If the difference is negative, it is called a forward discount.
In forward trade, a currency with lower interest rates will be worth more than one with higher interest rates. In this case, the U.S. dollar usually deals at a higher rate than the Canadian dollar. The Canadian dollar, on the other hand, trades at a forward cost to the U.S. dollar.
Difference Between Covered and Uncovered Interest Rates
The IRP is “covered” when the no-arbitrage condition can be met using forward contracts to protect against foreign exchange risk. On the other hand, the IRP is “uncovered” when the no-arbitrage condition can be met without forward contracts to protect against foreign exchange risk.
The two ways an investor can change foreign cash into U.S. dollars show how they relate to each other.
The first thing an investor can do is put the foreign currency into local currency at the foreign risk-free rate for a certain amount of time. The investor would then sign a forward rate agreement simultaneously, agreeing to use a forward exchange rate to turn the investment’s profits into U.S. dollars at the end of the investment period.
In the second choice, you could change the foreign currency into U.S. dollars at the spot exchange rate and then put the dollars at the local (U.S.) risk-free rate for the same time as in choice A. If there are no trade chances, the money flows from both choices are the same.
Arbitrage is when you buy and sell the same asset at the same time in different places to make money off of slight differences in the asset’s price. When you trade foreign exchange, arbitrage trading means buying and selling different kinds of currencies to take advantage of price differences.
People have said bad things about IRP because of the expectations that go along with it. For example, the covered IRP model assumes that an endless number of funds can be used for currency arbitrage, which is invalid. IRP that isn’t hedged with futures or forward contracts doesn’t always hold in the real world.
Example of Covered Interest Rate Parity
The interest rate on Australian Treasury bills is 1.75 percent per year, and on U.S. Treasury bills, it is 5 percent per year. To buy the Treasury bill, an investor from the U.S. must change U.S. dollars into Australian dollars. However, the investor could take advantage of Australia’s interest rates.
After that, the owner would have to sell an Australian dollar forward contract for one year. The trade would only earn 0.5% in the protected IRP; any greater would violate the no-arbitrage clause.
How does the idea behind IRP come about?
The relationship between interest and foreign exchange rates is based on the irreducible rate of return (IRP). Its main idea is that investments in different countries should have the same hedged returns, even if the interest rates change. Arbitrage should be possible in the foreign exchange markets. Arbitrage is when you buy and sell an object simultaneously to make money from a price difference. When buyers buy one currency at a lower price and lock in the current exchange rate, they can’t buy another currency from a country with a higher interest rate.
What do forward exchange rates mean?
Spot exchange rates are the rates that are in effect right now. Forward exchange rates, on the other hand, are the rates that will be in effect in the future. You can get forward rates from banks and currency traders for terms that range from less than a week to five years or more in the future. A bid-ask spread is used to quote futures, just like it is used to quote spot currencies.
What do swap points mean?
Swap points are the gap between the forward rate and the spot rate. If the difference between the forward and spot rates is positive, it is called a forward premium. If the difference is negative, it is called a forward discount. In forward trade, a currency with lower interest rates will be worth more than one with higher interest rates.
What’s the difference between an IRP that is covered and another that is not?
To protect against foreign exchange risk, forward contracts can be used to meet the no-arbitrage condition. This means that the IRP is protected. However, the IRP is identified when the no-arbitrage criteria can be fulfilled without forward contracts to mitigate foreign currency risk.
Conclusion
- The basic equation that shows how interest and foreign exchange rates are related is called interest rate parity.
- Interest rate parity is based on the idea that investments in different currencies should have the same guaranteed returns, even if the interest rates on those currencies change.
- Forex traders use parity to look for chances to make money through arbitrage.
