Interest Rate Parity

1
Interest Rate Parity

• The relationship between EXCHANGE RATE AND
  PRICES is called PURCHASING POWER PARITY.

2
Interest Rate Parity

• The relationship between the EXCHANGE RATES AND
  INTEREST RATES is called Interest rate parity or
  covered interest arbitrage.

3
Interest Rate Parity

• The relationship between the EXCHANGE RATES AND
  INTEREST RATES is called Interest rate parity or
  covered interest arbitrage.
• let
• i interest rate in the US
• i interest rate in the UK

4
Interest Rate Parity

• The relationship between the EXCHANGE RATES AND
  INTEREST RATES is called Interest rate parity or
  covered interest arbitrage.
• let
• i interest rate in the US
• i interest rate in the UK
• If you invest 1 in the US by the end of the
  first period you will have
• (1 i)

5
Interest Rate Parity

• If you wanted to invest in the UK you will have
  to go through several steps
• 1-- you need to exchange your into
• 1/Rs number of s that one could receive for
  one dollar in the spot market.

6
Interest Rate Parity

• If you wanted to invest in the UK you will have
  to go through several steps
• 1-- you need to exchange your into
• 1/Rs number of s that one could receive for
  one dollar in the spot market.
• 2-- you need to lend the money in the UK
• 1/Rts (1 i) number of s that you will
  have at the end of one period.

7
Interest Rate Parity

• If you wanted to invest in the UK you will have
  to go through several steps
• 3-- you need to sell your s when you want to
  bring back your money to the US.
• Rt1s1/ Rts (1 i) number of s that you
  will have at the end of one period.

8
Interest Rate Parity

• Now you can compare your yields and decide
  whether or not to invest here or in the UK.
• (1 i) Rt1s1/ Rts (1 i)

9
Covered Interest Parity

• 4-- When you lend your money you know exactly
  how much s you have to sell. You could sell
  them right away in the forward market and cover
  yourself.
• (1 i) Rtf 1/ Rts (1 i)
• or
• (1 i) Rtf / Rts (1 i)

10
Covered Interest Parity

• (1 i) Rtf / Rts (1 i)
• (1 i) / (1 i) Rtf / Rts
• (1 i) / (1 i) - 1 Rtf / Rts - 1
• (i - i) / (1 i) (Rtf - Rts )/ Rts

11
Interest Rate Parity

• Example
• i 10 which means at the end of the period
  you would have 1.1
• i 10
• Rtf 1.55
• Rts 1.65

12
Interest Rate Parity

• which means at the end of the period you would
  have
• 1.55/1.65(1.1) 1.033
• Therefore you could invest in the US and earn a
  higher yield.