Question

Explain the concept of interest rate parity. Provide the rationale for its possible existence. Assume that the existing U.S. one‑year interest rate is 10 percent and the Canadian one‑year interest rate is 11 percent. Also assume that interest rate parity exists. Should the forward rate of the Canadian dollar exhibit a discount or a premium? If U.S. investors attempt covered interest arbitrage, what will be their return? If Canadian investors attempt covered interest arbitrage, what will be their return?

Answer 1

The concept of interest rate parity is that difference between interest rate between 2 countries is reflected in forward currency exchange rate between those 2 countries. If country A offers lower interest rate and country B offers higher interest rates, the forward currency exchange rate of country A is at a premium and the forward current exchange rate of country B is at discount.

The rationale behind interest rate parity is to provide a equilibrium state where investor will be indifferent towards investing in any of the country. He will earn same profit by investing in any country. It eliminates the arbitrage profit.

Covered interest arbitrage is defined by following steps-

Step 1 -Investor borrows amount in home currency

Step 2-Investor converts borrowed amount in forgein currency at spot rate

Step 3- Investor invest the amount converted in step 2 at interest rate in forgein country

Step 4- the amount received from forgien country along with interest is converted back into home currency at rate applicable that time (forward rate) .

Step 5- Repay the amount borrowed in home currency along with interest (rate applicable in home currency)

Covered interest arbitrage gives profit opportunity where interest rate parity does not hold. If intrest rate parity hold, there is no arbitrage profit.

If the interest rate in US is 10% and interest rate in Canada is 11% , the forward rate of Canadian dollar shall exhibit a forward discount against US dollar if interest rate parity exist.

In both the cases where of US investor and Canadian investor attempting covered interest arbitrage where interest parity exist, the net return in their own currency would be equal to zero (nil) This is because when US investor will earn extra 1% return by investing in Canada, it will get offset against the loss on converting Canadian dollar back into US dollar after one year (since Canadian dollar will be at forward discount to US dollar) and Canadian investor earning 1% less by investing in US dollar will be offset when converted to Canadian dollar (since US dollar will at forward premium) .

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