Interest Rate Parity (IRP)
{PARITY = Equivalence, similarity,}
Interest Rate Parity
• The Interest Rate Parity states that the interest
rate difference between two countries is equal
to the percentage difference between the
forward exchange rate and the spot exchange
rate.
• It plays essential role in foreign exchange
markets.
• The difference between the interest rates in
any two countries is the same as the difference
between the forward and the spot rates of their
respective currencies.
• Interest rate parity A currency is worth
what it can earn.
• The return on a currency is the interest rate on that
currency plus the expected rate of appreciation over a
given period.
• When the returns on two currencies are equal, interest
rate parity prevails.
Explanation
The relationship can be seen when you follow the two methods
an investor may take to convert foreign currency into U.S.
dollars.
• Option A would be to invest the foreign currency locally at the
risk-free rate for a specific time period. Then convert the
proceeds from the investment into U.S. dollars at the maturity.
• Option B would be to invest the same dollars in the (U.S.)
market for the same time period. When no
arbitrage opportunities exist, the cash flows from both options
are equal.
Mathematically
Rate of return in local Rate of return in foreign
=
currency currency
In equilibrium, returns on currencies will be the same i. e. No
profit will be realized and interest rate parity exits which can
be written
(1 + rh) = F
(1 + rf) S
Violation of IRP
If interest rate parity is violated, then an arbitrage opportunity exists. The
simplest example of this is what would happen if the forward rate was the
same as the spot rate but the interest rates were different, then investors
would:
• borrow the currency with the lower rate
• convert the cash at spot rates
• enter into a forward contract to convert the cash plus the expected interest
at the same rate
• invest the money at the higher rate
• convert back through the forward contract
• repay the principal and the interest, knowing the latter will be less than the
interest received.
Implications of IRP
• If domestic interest rates are less than foreign
interest rates, you will invest in foreign
country at higher interest rates.
• Domestic investors can benefit by investing in
the foreign market
Implications (suggestions) of IRP
• If domestic interest rates are more than foreign
interest rates, you will invest in domestic
market at higher interest rates
• Foreign investors can benefit by investing in
the domestic market
Purchasing power parity (PPP)
Purchasing power parity (PPP)
The purchasing power of a country’s currency.
The number of units of currency required to
purchase a basket of goods in Pakistan and the
same basket of goods and services that a USD
would buy in United states.
Need for PPP
• Because the exchange rates only reflects when
goods are traded. Also, currencies are traded
for purposes other than trade in goods and
services, e.g., to buy capital assets. Also,
different interest rates, speculation or
interventions by central banks can influence
the foreign-exchange market.
Purpose
• Differences in living standards between
nations because PPP takes into account the
relative cost of living and the inflation rates of
the countries,
Assumption
• In the absence of transportation and other
transaction costs, competitive markets will
equalize the price of an identical good in two
countries when the prices are expressed in the
same currency.
Example
• For example, a TV set that sells for 750 Canadian Dollars
[CAD] in Vancouver should cost 500 US Dollars [USD] in
Seattle when the exchange rate between Canada and the US is
1.50 CAD/USD. If the price of the TV in Vancouver was only
700 CAD, consumers in Seattle would prefer buying the TV
set in Vancouver due to which the US consumers buying
Canadian goods will bid up the value of the Canadian Dollar,
thus making Canadian goods more costly to them. This
process continues until the goods have again the same price.
Fluctuations
• PPP rate fluctuations are mostly due to
different rates of inflation in the two
economies which would result in the
difference in prices at home and abroad
Reasons for different measures
The main reasons why different measures
do not perfectly reflect standards of living
are:
• PPP numbers can vary with the specific basket of
goods used, making it a rough estimate.
• Differences in quality of goods are hard to measure
and thereby reflect in PPP.
Range and quality of goods
• Local, non-tradable goods and services (like electric
power) that are produced and sold domestically.
• Tradable goods such as non-perishable commodities
that can be sold on the international market
Rank Country GDP (PPP) $M
1 United States 14,264,600
2 China 7,916,429
3 Japan 4,354,368
4 India 3,288,345
5 Germany 2,910,490
6 Russia 2,260,907
27 Pakistan 439,558
List by the International Monetary Fund (2008)
Factors effecting
IRP and PPP
Factors of PPP
• Technology
• Luxury goods
• Raw materials
• Energy prices
Factors for IRP
Factors that influence the level of market interest rates
include:
- Expected levels of inflation
- General economic conditions
- Monetary policy
- Foreign exchange market activity
- Foreign investor
- Levels of sovereign debt outstanding
- Financial and political stability
Formulas
Fo = forward rate
} IRP
So = current spot rate
ic = interest rate in country c
ib = interest rate in country b
S1 = expected spot rate
} PPP
So = current spot rate
ic = expected inflation rate in country c
ib = expected inflation rate in country b
Question
IRP
A Canadian company is expected to receive Kuwaiti
dinars in 1 years time. The spot rate is CAD/Dinar
5.4670. The company could borrow in dinars at 9%
or in Canadian dollars at 14%. There is no forward
rate for one year’s time. Predict what the exchange
rate is likely to be in one year
Solution
So = 5.4670
ic = 14% or 0.14
ib = 9% or 0.09
F = 5.4670 x (1 + 0.14)
(1 + 0.09)
F = 5.7178
Question
PPP
The spot exchange rate between UK sterling and
Danish kroner is £1 = 8 kroners. Assuming that there
is now purchasing parity an amount of commodity
costing £110 in UK will cost 880 kroners in
Denmark. Over the next year price inflation in
denmark is expected to be 5% while in UK it is
expected to be 8%. What is the expected spot
exchange rate at the end of the year?
Solution
So = 8
ic = 5% or 0.05
ib = 8% or 0.08
S1 = 8 x (1 + 0.05)
(1 + 0.08)
S = 7.78
1
UK price = £110 x 1.08= £118.80
Danish price = 880 x 1.05= 924 Kroner
= 924 = 7.78
118.80
Thank you
