Relation To Covered Interest Rate Parity
Covered interest rate parity is a no-arbitrage condition in foreign exchange markets which depends on the availability of the forward market. It can be rearranged to give the forward exchange rate as a function of the other variables. The forward exchange rate depends on three known variables: the spot exchange rate, the domestic interest rate, and the foreign interest rate. This effectively means that the forward rate is the price of a forward contract, which derives its value from the pricing of spot contracts and the addition of information on available interest rates.
The following equation represents covered interest rate parity, a condition under which investors eliminate exposure to foreign exchange risk (unanticipated changes in exchange rates) with the use of a forward contract – the exchange rate risk is effectively covered. Under this condition, a domestic investor would earn equal returns from investing in domestic assets or converting currency at the spot exchange rate, investing in foreign currency assets in a country with a different interest rate, and exchanging the foreign currency for domestic currency at the negotiated forward exchange rate. Investors will be indifferent to the interest rates on deposits in these countries due to the equilibrium resulting from the forward exchange rate. The condition allows for no arbitrage opportunities because the return on domestic deposits, 1+id, is equal to the return on foreign deposits, F/S(1+if). If these two returns weren't equalized by the use of a forward contract, there would be a potential arbitrage opportunity in which, for example, an investor could borrow currency in the country with the lower interest rate, convert to the foreign currency at today's spot exchange rate, and invest in the foreign country with the higher interest rate.
where
- F is the forward exchange rate
- S is the current spot exchange rate
- id is the interest rate in domestic currency
- if is the interest rate in foreign currency
This equation can be arranged such that it solves for the forward rate:
Read more about this topic: Forward Exchange Rate
Famous quotes containing the words relation to, relation, covered, interest, rate and/or parity:
“... a worker was seldom so much annoyed by what he got as by what he got in relation to his fellow workers.”
—Mary Barnett Gilson (1877–?)
“We must get back into relation, vivid and nourishing relation to the cosmos and the universe. The way is through daily ritual, and is an affair of the individual and the household, a ritual of dawn and noon and sunset, the ritual of the kindling fire and pouring water, the ritual of the first breath, and the last.”
—D.H. (David Herbert)
“King David was old and advanced in years; and although they covered him with clothes, he could not get warm.”
—Bible: Hebrew, 1 Kings 1:1.
“I cannot assent to a measure which stains our credit. We must keep that untainted. We are a debtor nation. Low rates of interest on the vast indebtedness we must carry for many years, is the important end to be kept in view. Expediency and justice both demand honest coinage.”
—Rutherford Birchard Hayes (1822–1893)
“Unless a group of workers know their work is under surveillance, that they are being rated as fairly as human beings, with the fallibility that goes with human judgment, can rate them, and that at least an attempt is made to measure their worth to an organization in relative terms, they are likely to sink back on length of service as the sole reason for retention and promotion.”
—Mary Barnett Gilson (1877–?)
“The U.S. is becoming an increasingly fatherless society. A generation ago, an American child could reasonably expect to grow up with his or her father. Today an American child can reasonably expect not to. Fatherlessness is now approaching a rough parity with fatherhood as a defining feature of American childhood.”
—David Blankenhorn (20th century)