Interest Rate Parity: Forward Exchange Rates Explained

The covered interest rate parity helps forward exchange rates to incorporate the difference in interest rates between two countries. Without it, an…

The covered interest rate parity helps forward exchange rates to incorporate the difference in interest rates between two countries. Without it, an arbitrage opportunity will exist. To understand more, there is no interest rate advantage if an investor will borrow in a low-interest rate currency to spend in a currency offering the highest interest rate.

Usually, the investor will do steps like:

Borrow in a currency with a much lower interest rate.
Change the borrowed amount into a currency with a higher interest rate.
Invest the gains in an interest-bearing instrument in this higher-interest-rate currency.
Simultaneously hedge exchange risk by purchasing a forward contract to convert the investment proceeds into the first – lower interest rate – currency.

In this case, the return would be the same as the one gained from investing in interest-bearing instruments in a much lower interest rate currency. In the covered interest rate parity condition, the cost of hedging exchange risk refutes the higher returns that will accrue from investing in a currency offering a higher interest rate.

Covered Interest Rate Parity Formula

(1+id) = F/S x (1+if)

Here, the id stands for the interest rate in the domestic currency. The if is the interest rate in the foreign currency. The S will be the current spot exchange rate. And the F stands for the forward foreign exchange rate.

Uncovered Interest Rate Parity

The uncovered interest rate parity (UIP) explains that the difference in interest rates between the two countries ties the expected change in exchange rates between the two countries. Apparently, if the interest rate differential between two countries is 3%, it means that the nation’s currency with the higher interest rate might likely depreciate 3% against the other currency.

But in reality, this is a different story. Ever since the introduction of floating exchange rates in the early 1970s, currencies of countries with high-interest rates have tended to appreciate instead of depreciating, as the UIP equation states. The well-known conundrum – also known as the forward premium puzzle – has been the subject of some academic research papers.

Maybe, the anomaly might be explained by the carry trade. Here, speculators borrow in low-interest currencies like the Japanese yen. After that, sell the borrowed amount and invest in the proceeds in higher-yielding currencies and instruments. The Japanese yen became the favorite target for this activity until mid-2007. In estimation, about $1 trillion tied up in the yen carry trade by that year.