A Note on Interest Rate Parity

International Financial Management

Doa nay 12/12/2005

TABLE OF CONTENTS Cover Page...1 Table of Contents.2 Scope................................................................................................................................... 3 What is Interest Rate Parity ? ......................................................................................... 3 Impact of Interest Rate Changes on Exchange Rates.................................................... 5 Impact of Changes in Expectations on Exchange Rates................................................ 5 References........................................................................................................................... 7 Appendix............................................................................................................................. 8

Note on the Determinants of Exchange Rates Scope Among some other models such as purchasing power parity, sticky price monetary model etc. interest rate parity is one of the methods developed to explain exchange rate movements. This paper focuses on explaining exchange rate movements using uncovered interest rate parity condition. What is Interest Rate Parity ? Interest rate parity condition states that foreign exchange markets are in equilibrium when expected returns on deposits in a given period in one currency are equal to the expected returns on deposits in another currency when both the returns are measured in terms of a common currency. (1) There is a simple rule that helps us compare rates of return on different currency deposits. To do that, an investor needs to know two pieces of information: first, the rate of return offered by each currency deposit and second, the expected return due to one currency appreciating against the other currency. These two components can be combined and formulated as follows: RA =
Country A interest rates on currency a

RB +

{ (E1a/b - E0a/b)/E0a/b }
Expected b appreciation against a in one period

(2)

Country B interest rates on currency b

Here: RA = Rate of return on currency a deposits in country A RB = Rate of return on currency b deposits in country B E1a/b =Expected exchange rate of a/b one year from now. E0a/b =a/b spot rate In summary, equation (2) tells us that interest rates in A shall be equal to the interest rates in B for a similar deposit with similar maturity plus the expected rate of appreciation of a against b. Here is a simple numerical example demonstrating the interest rate parity concept: Assume that US dollar deposits pay 10% per year interest rates (so, an investor would expect his $1000 deposit to become $1100 in one year). At the same time, euro deposits pay 5% per year. Now assume that, the euro is expected to appreciate 5% against the

(1) Covered interest rate parity essentially uses the forward rate for future expected currency spot rate.

dollar in one year. In this case foreign exchange markets would be in equilibrium because individuals would expect the same return from both dollar and euro deposits and therefore they would prefer to hold either type of deposit: 10% ($ interest rate on a one year deposit) = 5%(interest rates on a similar deposit) + 5% (expected appreciation against $) Interest parity condition tells us that foreign exchange markets move to establish equilibrium. For example, if the interest rates on the dollar would be 12%, euro interest rates 5% and expected euro appreciation 5%, no one would like to hold euro deposits and all individuals would prefer dollar deposits since 12% > 10% (5%+5%). Also, assuming currencies are freely tradable and there are minimal transactions costs, then a profitable arbitrage is possible if the equation doesn't hold. An investor can easily borrow euros from a bank at 5%, convert it to dollars on the spot market and buy US dollar deposits. Assuming spot $/ rate is 1 and expected $/ in one year is 1.05 (a 5% euro appreciation against dollar), if an investor borrows 100 at 5%, converts it to $100 in the spot market and buy dollar deposits, at the end of one year his $100 becomes $112 (12% interest rate). Assuming the expected future $/ rate comes true, the investor can convert his $112 into euros at $/ rate of 1.05 receiving $112/1.05 $/ = 106.67. Then, he can pay his debt of 105 to the bank making a handsome profit of 1.67. In summary, as a result of actions of individuals who try to maximize their returns in foreign exchange markets, exchange rates will adjust to satisfy interest rate parity. This statement is based on the inherit assumption we are making that is individuals in any part of the world prefer to invest in assets paying higher expected returns. It implies that potential holders of foreign deposits view them all as equally desirable assets (in terms of similar risk and liquidity). Therefore, should any arbitrage opportunities arise investors would take advantage driving the difference among expected returns on deposits of different currencies to zero. Spot rates adjust as a result of actions of arbitrageurs in the following way: since everybody would prefer dollar deposits, euro deposit holders would try to sell euro deposits for dollar deposits. Expecting better returns, dollar deposit holders would reject these offers. In response, euro deposit holders would try to tempt dollar deposit holders by offering better price for dollars. This would cause the dollar to appreciate against the euro. Appreciation would stop until the equilibrium described in equation (2) is reached making both assets equally attractive to investors. Equation (2) above predicts that: Assuming expectations on /$ for one year from now, E1$/, unchanged, spot dollar rate, E0$/, has to appreciate reducing the E0$/ figure (less $ per ) causing E1$/ - E0$/)/E0$/ to increase bringing both side of the equation (2), Rus and Re+ { (E1$/ - E0$/)/E0$/ }, to equilibrium. The nest few pages will explore how interest rate parity condition helps explain the impact of certain changes in the economy on exchange rates.

Impact of Interest Rate Changes on Exchange Rates Now continuing with dollar euro example, assume that interest rates on euro deposits decrease. Using the equation lets try to interpret the consequences: If Re decreases, assuming Rus and E1$/ staying constant, for interest rate parity equation to hold euro today has to depreciate against dollar: Rus= () Re+ () (E1$/ - E0$/)/ E0$/ Now, lets explain how this happens. A change in interest rates in Euro has no impact on US interest rates therefore Rus stays constant. assuming expected Euro/Dollar exchange rate one year from now, E1$/ , doesnt change due to a change in Euro interest rates, for (E1$/ - E0$// E0$/ ) part of the equation to increase in order to make up for the decrease in Re, then E0$/ has to decrease (one euro can buy less dollars). As a general rule, when interest rates in one country increases relative to another country, its currency appreciates against the other countrys currency. The converse is also true, that is when interest rate in one country decreases relative to another country, its currency depreciates against the other countrys currency. In reality direction and magnitude of exchange rate movement depends on why interest rate changes. In the example above it is assumed that interest rates can rise and fall independent of expectations on future currency rates (E1$/), however, in many cases changes in interest rates are closely linked to inflationary expectations, (that is interest rates rise as a result of inflationary expectations) and inflationary expectations have an impact on future rates of currencies. Without getting in much detail, when interest rate moves are related to inflationary expectations, then spot exchange rate would be expected to depreciate. More on this can be found in reference (1) which can be found at the end of this document. Impact of Changes in Expectations on Exchange Rates Keeping dollar, euro interest rates constant, if expectations about future dollar/euro rate changes spot rate will adjust to maintain interest rate parity. Here is an example: Assume investors responding to a certain type of news change their expectations about euro appreciation against dollars, say they expect euro to appreciate even more now. Equation (2) helps us predict how the spot rate would change. Since an increase in expected euro appreciation means E1$/ to increase. This would make (E1$/ - E0$//E0$/) part of the equation to increase initially. Because Rus and Reurope are constant to maintain the equilibrium E0$/ has to increase. This means euro has to appreciate now. The intuition behind this is, when the expectations about euro appreciation changes, euro deposits become more attractive then dollar deposits. Holders of dollar deposits then would try to sell their deposits in order to buy euro deposits. Euro deposit holders, knowing they expect to get better return by holding on to their euro deposits would reject

these offers. In response dollar deposit holders would try to convince euro deposit holders by offering more dollars per euro, which would cause euro to appreciate against dollar. As a general rule, if one currencys expected appreciation rate rises against another currency, the first currency would appreciate against the second currency on the spot market. The opposite is also true, that is if one currencys expected appreciation falls against another currency, the first currency would depreciate against the second currency on the spot market. How well does IRP predict Exchange Rate Movements? Not so well, is the short answer. Menzie Chinn says, Uncovered interest parity (UIP) has been almost universally rejected in studies of exchange rate movements. I performed a brief analysis to see the correlation between European Central Bank (ECB) interest rate change decisions on spot /$ rate using interest rate parity condition. From BGIE class last year, I knew that central bank interest rate decisions have a direct impact on interest rates on deposits. I wanted to see how well interest rate parity predicts the change in spot rates in response to ECB decisions. To do that, I regressed difference in exchange rates between the day of the announcement and the day before the announcement (Y variable), with the magnitude of change of interest rate increase or decrease (X variable). (Data and regression results can be found in the appendix) I found that p value was not significant at 95% level, giving me p=0.33. Also R2 was very small 0.06. Paul Krugman says, Like stock prices, exchange rates respond strongly to news, that is to unexpected economic and political events, and like stock prices, they therefore are very difficult to forecast. I didnt control the impact of interest rate decisions by ECB on spot /$ for changes in expectations, changes in dollar interest rates or any other news that could have impacted the spot exchange rate, so I didnt expect to find a high correlation. However, it was interesting to see that the coefficient of the X variable was in line with the predictions of interest rate parity, that is an interest rate hike decision by ECB caused the euro to appreciate against the dollar. Menzie Chinn in a recent article compares predictability of exchange rates using different exchange rate models including the interest rate parity model. He finds that interest rate parity models does better than other models when it comes to predicating the direction of the exchange rate move when measured over a long period of time such as 5 years.

References (1) Krugman, Paul R., Obstfeld, Maurice, International economics : theory and policy, Addison-Wesley series in economics 6th edition. (2) Menzie, Chinn, Whither the dollar?, October 12, 2005, www.econbrowser.com, accessed December 8, 2005. (3) Data analysis is based on data from www.oanda.com , http://www.ecb.int/stats/monetary/rates/html/index.en.html , ECB past key interest rate decisions, accessed December 3, 2005.

Appendix Data
Date of ECB decision 12/1/2005 6/5/2003 3/6/2003 12/5/2002 11/8/2001 9/17/2001 8/30/2001 5/10/2001 10/5/2000 8/31/2000 6/8/2000 4/27/2000 3/16/2000 2/3/2000 11/4/1999 4/8/1999 1/21/1999 In effect date Increase/ (Reduction) New Interest Rate 1.25% 1.00% 1.50% 1.75% 2.25% 2.75% 3.25% 3.50% 3.75% 3.50% 3.25% 2.75% 2.50% 2.25% 2% 1.50% 2% Previous interest Rate 1.00% 1.50% 1.75% 2.25% 2.75% 3.25% 3.50% 3.75% 3.50% 3.25% 2.75% 2.50% 2.25% 2% 1.50% 2% 2.75% EXC rate 1 day before Annncment Date 0.8533 0.8524 0.9187 1.0035 1.1172 1.088 1.0975 1.1319 1.1386 1.1209 1.0484 1.0861 1.0336 1.029 0.9526 0.9267 0.8642 Exchange Rate @ Anncmt Date 0.8462 0.8592 0.9125 0.9999 1.1143 1.088 1.0992 1.1302 1.1439 1.1196 1.04 1.0829 1.0332 1.0246 0.954 0.9254 0.8639 Change in Exc rate Alt 2calc -0.83% 0.80% -0.67% -0.36% -0.26% 0.00% 0.15% -0.15% 0.47% -0.12% -0.80% -0.29% -0.04% -0.43% 0.15% -0.14% -0.03%

6-Dec-05 6-Jun-03 7-Mar-03 6-Dec-02 9-Nov-01 18-Sep01 31-Aug01 11-May01 6-Oct-00 1-Sep-00 9-Jun-00 28-Apr-00 17-Mar00 4-Feb-00 5-Nov-99 9-Apr 1/22/1999

0.25% -0.50% -0.25% -0.50% -0.50% -0.50% -0.25% -0.25% 0.25% 0.25% 0.50% 0.25% 0.25% 0.25% 0.50% -0.50% -0.75%

Regression analysis
SUMMARY OUTPUT Regression Statistics Multiple R 0.247911755 R Square 0.061460238 Adjusted R Square -0.001109079 Standard Error 0.00420498 Observations 17 ANOVA df Regression Residual Total 1 15 16 SS 1.73684E-05 0.000265228 0.000282596 Standard Error 0.001044175 0.253909528 MS 1.74E05 1.77E05 F 0.982274 Significance F 0.337357

Coefficients Intercept Increase/ (Reduction) -0.0017 -0.25

t Stat 1.65678 -0.9911

P-value 0.118327 0.337357