Question

Explain the concept of interest rate parity. What does this concept imply about the long-run profit opportunities from investing in international markets? What market conditions must prevail for the concept to be valid?

Answer 1

INTEREST RATE PARITY THEORY (IRPT) DEFINES THE RELATIONSHIP BETWEEN THE INTEREST RATES AND THE EXCHANGE RATES OF TWO COUNTRIES. IT STATES THAT THE FORWARD PREMIUM / DISCOUNT ON A CURRENCY SHOULD BE EQUAL TO THE INTEREST RATE DIFFERENTIAL BETWEEN THE COUNTRIES CONCERNED. THE HIGH INTEREST RATE ON A CURRENCY IS OFFSET BY THE FORWARD DISCOUNT AND LOW INTEREST RATE IS OFFSET BY FORWARD PREMIUM.

SIMPLY PUT , EXCHANGE RATE DIFFERENTIAL (FORWARD RATE AND SPOT RATE) WILL BE EQUIVALENT TO THE INTEREST RATE DIFFRENTIAL BETWEEN THE TWO COUNTRIES , I.E , IT EQUATES INTEREST RATE DIFFFERENTIALS TO FORWARD PREMIUM/DISCOUNT ON THE FOREIGN CURRENCY.

EXCHANGE RATE DIFFERENTIAL = INTEREST RATE DIFFERENTIAL

FORWARD RATE / SPOT RATE = [ 1 + INTEREST RATE IN HOME COUNTRY ] / [ 1 + INTEREST RATE IN FOREIGN COUNTRY ]

IF HOME COUNTRY INTEREST RATE IS :

GREATER THAN FOREIGN CURRENCY INTEREST RATE	LOWER THAN FOREIGN CURRENCY INTEREST RATE
FOREIGN CURRENCY SHOULD BE TRADED AT PREMIUM	FOREIGN CURRENCY SHOULD BE TRADED AT DISCOUNT

IRPT PLAYS A FUNDAMENTAL ROLE IN FOREIGN EXCHANGE MARKETS PROVIDING A DIRECTION OF CURRENCY RATE TO INVESTORS. CAPITAL WILL FLOW TO COUNTRY WITH HIGHER INTEREST RATE , APPRECIATING THE CURRENCY. USING THE IRPT , INVESTORS CAN PROFIT FROM THE DIFFERENCES OF INTEREST RATES IN TWO COUNTRIES. IF IRPT IS UNAPPLICABLE , THE INVESTOR CAN ALSO MAKE A RISKLESS PROFIT BY USING ARBITRAGE .

ASSUMPTIONS :

1. FREE CAPITAL FLOW ACROSS COUNTRIES.

2. TAX RATES OF THE COUNTRIES ARE SIMILAR .