Interest rate parity (IRP) is a theory. It tells us how interest rates and currency rates are related. IRP says that the difference between the interest rates of the two countries is the same as the difference between the future currency rate and the current currency rate. The future currency rate is the rate that a bank will use to change one currency to another in the future. The current currency rate is the rate that you can use to change one currency to another right now. IRP thinks that investors can move their money easily between countries and that they can avoid currency risk by using future contracts. Why is Interest Rate Parity Important? IRP means that investors should make the same amount of money no matter where they invest or which currency they use.
How Does Interest Rate Parity Work?
IRP can be shown by a simple equation. The equation uses the future currency rate, the current currency rate, and the interest rates of the two countries. The equation shows that if the interest rate in one country is higher than the interest rate in another country, then the currency of the first country should be cheaper in the future than it is now. This means that the future currency rate of the first country’s currency should be lower than its current currency rate. This means that the future currency rate of the first country’s currency should be higher than its current currency rate.
IRP also means that there should be no easy way to make money by just changing currencies. For example, if an investor can borrow money in one country at a low-interest rate, change it to another currency at the current currency rate, invest it in another country at a high-interest rate, and then change it back to the original currency at the future currency rate, they can make a risk-free profit. However, IRP says that this should not be possible, because the future currency rate should change to match the interest rate difference between the two countries.
Why is Interest Rate Parity Important?
Therefore, interest rate parity is an important concept for investors, traders, and policymakers who deal with international finance. IRP helps them understand how interest rates and currency rates are decided and how they affect each other. IRP also helps them compare different investment opportunities across countries and currencies. For example, if an investor wants to invest in a foreign bond, they need to think not only about the bond’s return but also about its currency risk. By using IRP, they can compare the bond’s return with its protected return, which is the return after considering the future currency rate. If IRP is true, then the protected return should be equal to the local interest rate. If IRP is not true, then there may be a chance to make more money or lose money.
Examples of Interest Rate Parity
To show how interest rate parity works, let us look at some examples using these numbers:
- The exchange rate between the U.S. dollar (USD) and the British pound (GBP) is 1.25 USD/GBP
- The future exchange rate between the USD and the GBP for one year is 1.23 USD/GBP
- The annual interest rate in the U.S. is 0.5%
- The annual interest rate in the U.K. is 1.75%
Example 1: Checking for Interest Rate Parity
Using the equation for IRP, we can check if the future exchange rate is right for the current exchange rate and the interest rates:
The equation tells us that if we multiply 1.25 by 1 plus 0.5% and divide it by 1 plus 1.75%, we should get 1.23.
The calculation gives us 1.23 as well.
The calculated future exchange rate matches the given future exchange rate, which means that interest rate parity holds in this case.
Example 2: Finding
the Future Exchange Rate
Using the same numbers, we can also find the future exchange rate if we only know
- the current exchange rate and
- the interest rates:
The equation tells us that if we multiply 1.25 by 1 plus 0.5% and divide it by 1 plus 1.75%, we should get
- the future exchange
- rate.
Conclusion
Interest rate parity is a theory that shows how interest rates and currency rates work together. It says that the difference between the interest rates of the two countries is the same as the difference between the future currency rate and the current currency rate. It also says that there should be no easy way to make money by just changing currencies. Interest rate parity is important for investors, traders, and policymakers who deal with international finance. It helps them understand and compare different investment opportunities across countries and currencies. As we have seen, interest rate parity can be shown by a simple equation and some examples.
