Interest Rate Parity (IRP): Definition, Types, and Applications
Interest rate parity states that the differences in interest rates between the currencies of two countries should be equal to the difference between the spot and forward exchange rates, thereby enabling zero arbitrage opportunities. This allows investors to earn the same returns on their money, irrespective of the currency in which the latter are denominated, after accounting for fluctuations in exchange rates and interest rate differentials.
So, if the parity holds, investors will have better opportunities to earn risk-free profits through leveraging these differences in exchange and interest rates. For example, in the case of treasury bills, investors need to be indifferent towards investing in foreign/domestic treasury bills after taking currency exchange risks into account.
Covered Interest Rate Parity (CIRP)
Interest rate parity branches out into two types - Covered Interest Rate Parity (CIRP) and Uncovered Interest Rate Parity (UIRP). Here are some key aspects of CIRP -
- CIRP is a theory stating that the interest rate difference between two countries should be equal to the difference between the spot and forward exchange rates, thereby avoiding arbitrage opportunities when hedging the risk of exchange rates with forward contracts.
- There is the no-arbitrage condition for currency markets, i.e., if the difference is not equal to the difference between the spot and forward exchange rates, then arbitrage opportunities would exist, enabling investors to earn risk-free profits.
- Covered here indicates the usage of forward contracts for effectively hedging against exchange rate risks, thereby covering the exposure of the investor to exchange rate fluctuations.
- CIRP may be helpful in determining the forward exchange rate and also ensuring that the investment return on various currencies is equal whenever exchange rate risk is hedged. However, it does not always hold, and there may be deviations resulting from imperfections in the market, transaction costs, and changing expectations of investors.
Uncovered Interest Rate Parity (UIRP)
Here are some key aspects regarding Uncovered Interest Rate Parity (UIRP)-
- UIRP states that the nominal interest rate differences between two countries should be equal to the expected change in their exchange rate. This means that investors may expect similar returns, irrespective of where they invest, post accounting for currency fluctuations.
- The theory is based on the assumption that there are zero arbitrage opportunities, i.e,. investors cannot earn risk-free profits consistently through leveraging differences in interest rates and exchange rate fluctuations.
- So, if a country has a higher interest rate, its currency is anticipated to depreciate against a currency with a lower interest rate and vice versa.
- UIRP thus depends on the assumption of free movement of capital across countries, enabling investors to quickly shift their funds to take advantage of emerging opportunities. Yet, it may not always hold good in markets owing to imperfections, changing behavior of investors, and other factors.
- Deviations from the theory may lead to carry trades, where investors borrow in a low-interest currency prior to investing the same in a high-interest currency. UIRP thus focuses on the expected spot rate and does not involve any hedging.
The Interest Rate Parity Formula
The formula for interest rate parity is -
Fo = So x (1 + id) / (1 + if)
In this case, Fo is the forward exchange rate and So is the spot exchange rate. At the same time, id is the interest rate in domestic currency, and if is the interest rate in the foreign currency.
Example of Interest Rate Parity
Suppose the spot exchange rate is $1.10 for each Euro and the interest rate for the former is 3%, with the interest rate in Euro being 4%, then the forward exchange rate will be $1.09 per Euro
Interest rate parity = 1.10 * (1 + 0.03) / (1 + 0.04) = 1.09
Thus, with the rate of interest being higher for the Euro, the currency will depreciate in relation to the dollar, which will unlock a lower forward rate.
Conclusion
Interest rate parity plays a crucial role eliminating the opportunities for arbitrage by ensuring that the differences in interest rates and the currency exchange rate movements are aligned. While UIRP depends on the expectations of the investors without the hedging mechanisms, CIRP uses the forwards contracts to hedge against currency risks.