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Interest Rate Parity By P. Sai Prathyusha (Pondicherry University)

INTEREST RATE PARITY # ASSUMPTIONS # IMPLICATIONS OF IRP THEORY # EXAMPLE TAKING INDIAN AND CANADIAN SPOT RATE AND THEIR RESPECTIVE RISK FREE RATES # CONCLUSIONS

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Interest Rate Parity By P. Sai Prathyusha (Pondicherry University)

  1. 1. INTEREST RATE PARITY SUBMITTED BY P. SAI PRATHYUSHA 2ND M.COM (BUSINESS FINANCE)
  2. 2. WHAT IS INTEREST RATE PARITY (IRP)  IT IS A THEORY IN WHICH THE DIFFERENTIAL BETWEEN THE INTEREST RATES OF TWO COUNTRIES REMAINS EQUAL TO THE DIFFERENTIAL CALCULATED BY USING THE FORWARD EXCHANGE RATE AND THE SPOT EXCHANGE RATE TECHNIQUES. IT PLAYS A CRUCIAL ROLE IN FOREX MARKETS AND IT IS A NO-ARBITRAGE CONDITION REPRESENTING THE EQUILIBRIUM STAGE.  IRP THEORY COMES HANDY IN ANALYSING THE RELATIONSHIP BETWEEN THE SPOT RATE AND A RELEVANT FORWARD (FUTURE) RATE OF CURRENCIES.  ACCORDING TO THIS THEORY, THERE WILL BE NO ARBITRAGE IN INTEREST RATE DIFFERENTIALS BETWEEN TWO DIFFERENT CURRENCIES AND THE DIFFERENTIAL WILL BE REFLECTED IN THE DISCOUNT OR PREMIUM FOR THE FORWARD EXCHANGE RATE ON THE FOREIGN EXCHANGE.  THE THEORY ALSO STRESSES ON THE FACT THAT THE SIZE OF THE FORWARD PREMIUM OR DISCOUNT ON A FOREIGN CURRENCY IS EQUAL TO THE DIFFERENCE BETWEEN THE SPOT AND FORWARD INTEREST RATES OF THE COUNTRIES IN COMPARISON.
  3. 3. ASSUMPTIONS INTEREST RATE PARITY RESTS ON CERTAIN ASSUMPTIONS,  FIRST BEING THAT CAPITAL IS MOBILE - INVESTORS CAN READILY EXCHANGE DOMESTIC ASSETS FOR FOREIGN ASSETS.  SECOND ASSUMPTION IS THAT ASSETS HAVE PERFECT SUBSTITUTABILITY, FOLLOWING FROM THEIR SIMILARITIES IN RISKINESS AND LIQUIDITY. GIVEN CAPITAL MOBILITY AND PERFECT SUBSTITUTABILITY, INVESTORS WOULD BE EXPECTED TO HOLD THOSE ASSETS OFFERING GREATER RETURNS, BE THEY DOMESTIC OR FOREIGN ASSETS. HOWEVER, BOTH DOMESTIC AND FOREIGN ASSETS ARE HELD BY INVESTORS. THEREFORE, IT MUST BE TRUE THAT NO DIFFERENCE CAN EXIST BETWEEN THE RETURNS ON DOMESTIC ASSETS AND THE RETURNS ON FOREIGN ASSETS. THAT IS NOT TO SAY THAT DOMESTIC INVESTORS AND FOREIGN INVESTORS WILL EARN EQUIVALENT RETURNS, BUT THAT A SINGLE INVESTOR ON ANY GIVEN SIDE WOULD EXPECT TO EARN EQUIVALENT RETURNS FROM EITHER INVESTMENT DECISION.
  4. 4. IMPLICATIONS OF IRP THEORY IF IRP THEORY HOLDS, THEN IT CAN NEGATE THE POSSIBILITY OF ARBITRAGE. IT MEANS THAT EVEN IF INVESTORS INVEST IN DOMESTIC OR FOREIGN CURRENCY, THE ROI WILL BE THE SAME AS IF THE INVESTOR HAD ORIGINALLY INVESTED IN THE DOMESTIC CURRENCY.  WHEN DOMESTIC INTEREST RATE IS BELOW FOREIGN INTEREST RATES, THE FOREIGN CURRENCY MUST TRADE AT A FORWARD DISCOUNT. THIS IS APPLICABLE FOR PREVENTION OF FOREIGN CURRENCY ARBITRAGE.  IF A FOREIGN CURRENCY DOES NOT HAVE A FORWARD DISCOUNT OR WHEN THE FORWARD DISCOUNT IS NOT LARGE ENOUGH TO OFFSET THE INTEREST RATE ADVANTAGE, ARBITRAGE OPPORTUNITY IS AVAILABLE FOR THE DOMESTIC INVESTORS. SO, DOMESTIC INVESTORS CAN SOMETIMES BENEFIT FROM FOREIGN INVESTMENT.  WHEN DOMESTIC RATES EXCEED FOREIGN INTEREST RATES, THE FOREIGN CURRENCY MUST TRADE AT A FORWARD PREMIUM. THIS IS AGAIN TO OFFSET PREVENTION OF DOMESTIC COUNTRY ARBITRAGE.  WHEN THE FOREIGN CURRENCY DOES NOT HAVE A FORWARD PREMIUM OR WHEN THE FORWARD PREMIUM IS NOT LARGE ENOUGH TO NULLIFY THE DOMESTIC COUNTRY ADVANTAGE, AN ARBITRAGE OPPORTUNITY WILL BE AVAILABLE FOR THE FOREIGN INVESTORS. SO, THE FOREIGN INVESTORS CAN GAIN PROFIT BY INVESTING IN THE DOMESTIC MARKET.
  5. 5. EXAMPLE COUNTRIES CHOSEN : INDIAN RUPEE AND CANADIAN DOLLAR SPOT RATES ARE : 1 ₹ = 0.13 USD $ 1 CAN $ = 0.76 USD $ RISK FREE RATES : INDIAN RATE = 3.57% AND CANADIAN RATE IS 0.18% (TAKEN FROM GOOGLE)  MR X, AN INVESTOR WHO IS A CANADIAN RESIDENT HAS 10,000 CAN$ AND FACES AN INTEREST RATE IN THE CANADIAN ZONE OF 0.18%  SO, IF THE INVESTOR INVESTS IN CANADA ITSELF, IN ONE YEAR HE WOULD GET A CASH OUTFLOW OF 10,018 CAN$ (I.E. CAN$ 10,000 + 10,000 * 1.0018)  TO UTILIZE THE HIGHER INTEREST RATE AVAILABLE IN INDIA, HE WOULD LIKE TO INVEST IN INDIA, FOR WHICH HE WOULD HAVE TO CONVERT HIS CAN$ TO ₹ AT THE RATE OF 1 CAN$ = 0.17 ₹ (I.E. S(₹/ CAN$) = S($/₹) / S($/CAN$)) Taken from Thomson Reuters
  6. 6.  SO WHEN HE CONVERTS HIS CAN$ TO ₹ HE WOULD GET ₹1760.69 10,000 CAN$ *(0.17₹/1CAN$) *1.0357  IRP SAYS THAT THE ONE YEAR FORWARD EXCHANGE RATE MUST BE ₹ 0.1757/ CAN$ USING THE FORMULAE F1= S0* (1+ INT₹) / (1+ INTCAN$) F1(₹/CAN$) = ₹0.17 * (1.0357)/(1.0018) = ₹0.1757/CAN$ (OR) F1 = ₹ 1760.69/10,018 CAN$ = ₹0.1757/CAN$  HENCE, AT THIS FORWARD EXCHANGE RATE, THE IRP HOLDS AND THERE IS NO ARBITRAGE PROFIT.
  7. 7.  IF THE FORWARD RATE IS LITTLE BIT LOW (I.E. 0.1757-0.0001= 0.1756) THEN, 1760.69/0.1756 = 10,026.70 10,026.70 – 10,018 = 8.7 PROFIT  IF THE FORWARD RATE IS LITTLE BIT HIGH (I.E. 0.1757+0.0001= 0.1758) THEN, 1760.69/0.1758 = 10,015.30 10,015.30 – 10,018 = 2.7 LOSS AN INVESTOR WOULDN’T CHOOSE TO INVEST IF HE WOULD KNOW THAT HE WOULD GET A LOSS AND SINCE THE PROFIT IS MINIMAL, WE CAN SAY THAT THE IRP HOLDS AND THAT THERE IS NO ARBITRAGE POSSIBLE.
  8. 8. CONCLUSION TO SUM UP, WE CAN SAY THAT  IRP IS THE CONCEPT OF NO-ARBITRAGE IN THE FOREIGN EXCHANGE MARKETS (THE SIMULTANEOUS PURCHASE AND SALE OF AN ASSET TO PROFIT FROM A DIFFERENCE IN THE PRICE).  IT IS THE FUNDAMENTAL EQUATION THAT GOVERNS THE RELATIONSHIP BETWEEN THE INTEREST RATES AND THE CURRENCY EXCHANGE RATES.  THE BASIC PREMISE OF IRP IS THAT HEDGED RETURNS FROM INVESTING IN DIFFERENT COUNTRIES SHOULD BE THE SAME, REGARDLESS OF THEIR INTEREST RATES.  PARITY IS USED BY FOREX TRADERS TO FIND ARBITRAGE OPPORTUNITIES.

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