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What is ‘Interest Rate Parity’
Interest rate similitude is a theory in which the interest rate differential between two countries is fitted to the differential between the forward exchange rate and the spot exchange measure. Interest rate parity plays an essential role in foreign traffic markets, connecting interest rates, spot exchange rates, and transpacific exchange rates.
BREAKING DOWN ‘Interest Rate Parity’
If one territory offers a higher risk-free rate of return in one currency than that of another, the hinterlands that offers the higher risk-free rate of return will be exchanged at a numberless expensive future price than the current spot price. In other in briefs, the interest rate parity presents an idea that there is no arbitrage in the overseas exchange markets. Investors cannot lock in the current exchange compute in one currency for a lower price and then purchase another currency from a wilderness offering a higher interest rate.
Covered vs. Uncovered Interest Valuation Parity
The interest rate parity is said to be covered when the no-arbitrage teach could be satisfied through the use of forward contracts in an attempt to hedge against strange exchange risk. Conversely, the interest rate parity is said to be uncovered when the no-arbitrage ready could be satisfied without the use of forward contracts to hedge against tramontane exchange risk.
Options of Converting Currencies
The relationship can be seen in the two methods an investor may burlesque to convert foreign currency into U.S. dollars.
One option an investor may establish would be to invest the foreign currency locally at the foreign risk-free regardless for a specific time period. The investor would then simultaneously come in into a forward rate agreement to convert the proceeds from the investment into U.S. dollars, put into practicing a forward exchange rate, at the end of the investing period.
The second option transfer be to convert the foreign currency to U.S. dollars at the spot exchange rate, then venture the dollars for the same amount of time as in option A, at the local (U.S.) risk-free status. When no arbitrage opportunities exist, the cash flows from both privileges are equal.
Covered Interest Rate Parity Example
For example, adopt Australian Treasury bills are offering an annual interest rate of 1.75%, while U.S. Bank bills are offering an annual interest rate of 0.5%. If an investor in the Like-minded States seeks to take advantage of the interest rates in Australia, the investor thinks fitting have to translate U.S. dollars to Australian dollars to purchase the Treasury pecker. Thereafter, the investor would have to sell a one-year forward diminish on the Australian dollar. However, under the covered interest rate equivalence, the transaction would only have a return of 0.5%, or else the no-arbitrage persuade would be violated.