Question

Interest Rate Parity (IRP). Give an example and application of each one of this theory in the international market place and exchange rate risk using a real example.

Answer 1

Interest Rate Parity - it represents a condition under which the rates of bank deposits of different countries will be similar post considering the effects of exchange rates. It represents a no arbitrage condition.

The IRP means that the return on domestic assets = the exchange rate-adjusted return on foreign assets.

The assumption of IRP is that Capital is mobile which means investors can freely exchange domestic assets with foreign assets.

The formula for Interest rate Parity is as follows:-

where F= Forward Rate

Ic= Interest rate in Country Ce4a

So= Spot Rate

Ib= Interest Rate in Country B

This means that investors will not be able to earn Arbitrage profits despite difference in Interest Rates of Bank Deposits of two countries as exchange rates of two countries would nullify that effect.

Therefore the application of IRP is determination of Exchange Rates of two countries. IRP can also be used to compute Interest rates of two countries given their Exchange Rates.

Example of IRP is as follows:-

USD/CAD spot rate is 1.50 CAD 1 Yr Forward Rate is 1.45 CAD. Rf is 4% for USD and 5.33% for CAD.

Now As per IRP

Ratio of Forward to Sport Rate = 1.45/1.50= 0.96667

Ratio of Return = (1.05333/1.04)¹=0.96667

which proofs that IRP exists.