Definition of Interest Rate Parity and an Example of It
Definition of Interest Rate Parity
The theory of interest rate parity suggests a strong relationship between interest rates and currency values. The current exchange rate (also known as the “buy and sell rate”) and the future exchange rate (which refers to the exchange rate agreed upon by the bank to exchange one currency for another in the future) are the two main rates of exchange.
Interest rate parity means that it does not matter whether a person invests their money in their home country and then converts those profits into another currency, or converts the money first and invests it abroad. The investor achieves the same amount of money regardless of how the investment is made.
Without interest rate parity, banks could exploit differences in currency values to easily make money.
An Example of Interest Rate Parity
Suppose country ABC has an interest rate of 4%, while country XYZ has an interest rate of 2%. If an investor from ABC invests in XYZ, they will convert their local currency to XYZ currency at the current exchange rate, invest their money, and achieve a return of 2% for one year. However, the investor secures the future exchange rate at which the money will be exchanged from XYZ currency back to ABC currency at the end of the year.
On the surface, it may seem that the investor is losing 2% by investing in XYZ when they could earn 4% in their home country ABC. However, the future exchange rate is calibrated to take into account the interest rate differential between the two countries. In other words, the future exchange rate gives the investor a larger amount of money exchanged initially to account for the 2% interest rate differential.
How Does Interest Rate Parity Work?
Suppose there is a current exchange rate for the British pound against the US dollar of 0.75 GBP per USD. We can exchange 1000 dollars and get 750 pounds.
If interest rates in the UK are at 3%, we can invest 750 pounds at 3% for one year, meaning we will have 772.50 dollars.
Now, suppose instead of exchanging our currency and investing in the UK, we invest our money in the US and convert it to British pounds after a year. Let’s say the interest rate in the US is 5%.
In this case, the future exchange rate will be calculated using the interest rate differential. The formula is: (0.75 × 1.03) / (1 × 1.05), or (0.7725/1.05). Rounding the result, the total comes to 0.736.
Suppose we start with 1000 dollars and invest it in the US at 5%. This results in having 1050 dollars at the end of the year. Then, we exchange 1050 dollars at the future exchange rate of 0.736, or 772.80 dollars. In other words, we end up with the same amount of money as if we exchanged our money first and then invested it in the UK. (Rounding causes a difference of 0.30 dollars.)
With interest rate parity, it does not matter whether a person invests the money and converts the profits into another currency first, or converts the money and invests it. Thanks to the relationship between interest rates and future exchange rates of currencies, the investor ends up making the same amount of money.
Covered Interest Rate Parity vs. Uncovered Interest Rate Parity
When discussing foreign exchange rates, you may often hear about “uncovered interest rate parity” and “covered interest rate parity.” Uncovered interest rate parity occurs when there are no contracts related to future interest rates. Instead, the parity simply relies on the expected exchange rate. For covered interest rate parity, there is a contract that secures the future interest rate.
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In reality, there is often a very small difference between uncovered interest rate parity and covered interest rate parity, because the expected exchange rate and the future exchange rate are usually equal. The difference is that with covered interest rate parity, future prices are locked in today. In contrast, with uncovered interest rate parity, you are simply forecasting what prices will be in the future.
What Does Interest Rate Parity Mean for Investors?
Without interest rate parity, banks can easily exploit differences in currency rates to make money.
Imagine, for example, if you could pay $1.39 to obtain a British pound. Without interest rate parity, the American bank could secure a futures contract for a year at that price. It could then accept $1 million in deposits and promise a return of 3%. Using that $1 million, it could purchase £730,000 and invest it in a British bank. If British banks pay an interest rate of 5%, the American bank could obtain £766,500. It could then convert that back to U.S. dollars and receive a total of $1,065,435, or a profit of $65,435.
The theory of interest rate parity relies on the notion that investment returns are “risk-free.” In other words, in the examples above, returns of 3% or 5% are guaranteed for investors.
In reality, there is no such thing as a risk-free investment, but when the economies and monetary systems of countries are stable, investors can feel very confident in the returns of treasury bonds. In fact, there has never been a failing U.S. currency, and thus it is viewed globally as risk-free. There are many other high-rated countries, including many European nations, whose bonds are considered risk-free.
Source: https://www.thebalancemoney.com/what-is-interest-rate-parity-4164249
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