Question

Describe two situations from practice when the interest rate parity, or covered interest rate arbitrage, was outstanding success.

Answer 1

Interest rate parity:

As per Interest rate parity the difference in spot fate and forward rate exits due to differences in interest rate between two countries.

The two main success of IRP is that:
1. It helps in predicting the future spot rates and tells us on forward premium or discount.
2. It helps in creating a no-arbitrage situation between the two countries.

For example: the USA has a lower interest rate than compared to India, therefore there is an inflow of money to India to earn higher interest rate in Indian rupees and convert back to USD, thus the demand for USD increases. And hence USD appreciates.

There are two types of interest rate parties:
1. Covered interest rate parity.
2. Uncovered interest rate parity.

1. Covered interest rate parity.

F/S = (1+ra)/(1+rb)
F= forward exchange rate.
S = spot exchange rate.
ra = interest rate of price currency.
rb= interest rate of base currency.

If the above equation does not hold good then there is a chance of Arbitrage between the forward exchange rate and spot exchange rate.

Covered interest rate parity is focused on forward premium or discount.

2. Uncovered interest rate parity.

E(S)/S = (1+ra)/(1+rb)
E(S)= expected spot exchange rate.
S = spot exchange rate.
ra = interest rate of price currency.
rb= interest rate of base currency.

If the above equation does not hold good then there is a chance of Arbitrage between the forward exchange rate and spot exchange rate.

Expert uncovered IRP if a country has a lower interest rate then another country. The currency of that country should appreciate.

Uncovered interest rate parity is focused on appreciation or depreciation.