INTEREST RATE PARITY

International Financial Management

Kristu Jayanti College, Bangalore
 Interest Rate Parity (IRP)
Due to the action of market forces, the forward rate differs
from the spot rate by an amount that sufficiently offsets the
interest rate differential between two currencies.

This equilibrium state achieved is referred to as interest rate

parity (IRP)

covered interest arbitrage is no longer feasible when IRP sets

in.

Interest Rate Parity

2 JNM
 Derivation of IRP
When IRP exists, the rate of return achieved from covered
interest arbitrage should equal the rate of return available in
the home country.

End-value of a $1 investment in covered interest arbitrage

= (1/S)(1+iF)F
= (1/S)(1+iF)[S(1+p)]
= (1+iF)(1+p)
where p is the forward premium.

Interest Rate Parity

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 Derivation of IRP
End-value of a $1 investment in the home country = 1 + iH

Equating the two and rearranging terms:

p = (1+iH) 1
(1+iF)
i.e.

forward (1 + home interest rate)

= 1
premium (1 + foreign interest rate)

Interest Rate Parity

4 JNM
 Determining the Forward Premium
Example
Suppose 6-month ipeso = 6%, i$ = 5%.
From the U.S. investors perspective,
forward premium = 1.05/1.06 1 -.0094
If S = $.10/peso, then
6-month forward rate = S (1 + p)
_
.10 (1 .0094)
$.09906/peso

Interest Rate Parity

5 JNM
 Determining the Forward Premium
The IRP relationship can be rewritten as follows:
F S S(1+p) S
= = p = (1+iH) 1 = (iHiF)
S S (1+iF) (1+iF)

The approximated form, p iH iF, provides a reasonable

estimate when the interest rate differential is small.

Interest Rate Parity

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Graphic Analysis of Interest Rate Parity
Interest Rate Differential (%)
home interest rate foreign interest rate
4

Z IRP line
2

B X

Forward -3 -1 1 3 Forward
Discount (%) Premium (%)

Y
A -2

W
Interest Rate Parity
7 JNM -4
Graphic Analysis of Interest Rate Parity
Interest Rate Differential (%)
home interest rate foreign interest rate
4
Zone of potential covered
interest arbitrage by foreign
investors IRP line
2

Forward -3 -1 1 3 Forward
Discount (%) Premium (%)

Zone of potential covered

-2 interest arbitrage by local
investors

Interest Rate Parity

8 JNM -4
Graphic Analysis of Interest Rate Parity
Interest Rate Ratio
(1+ih)/(1+if)-1
4
Zone of potential covered
interest arbitrage by foreign
investors IRP line
2

Forward -3 -1 1 3 Forward
Discount (%) Premium (%)

Zone of potential covered

-2 interest arbitrage by local
investors

9 Interest Rate Parity

-4
JNM
Comparison of the IRP, PPP, and IFE Theories
Interest Rate Parity Forward Rate
(IRP) Discount or Premium

Interest Rate Fisher Inflation Rate

Differential Effect Differential
Purchasing
Power Parity (PPP)
International Exchange Rate
Fisher Effect (IFE) Expectations
Interest Rate Parity
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Comparison of the IRP, PPP, and IFE Theories
Interest rate parity
Forward rate premium p
p
1 ih
1 i if
1 i
Interest rate differential ih if h
f

Purchasing power parity

% in spot exchange rate ef

1 Ih
1 I If
1 I
Inflation rate differential Ih If ef h
f

International Fisher effect

% in spot exchange rate ef

1 ih
1 i if
1 i
Interest rate differential ih if ef h
Interest Rate Parity
f
11 JNM