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:
“The psychoanalysis of individual human beings, however, teaches us with quite special insistence that the god of each of them is formed in the likeness of his father, that his personal relation to God depends on his relation to his father in the flesh and oscillates and changes along with that relation, and that at bottom God is nothing other than an exalted father.”
—Sigmund Freud (1856–1939)
“Science is the language of the temporal world; love is that of the spiritual world. Man, indeed, describes more than he explains; while the angelic spirit sees and understands. Science saddens man; love enraptures the angel; science is still seeking, love has found. Man judges of nature in relation to itself; the angelic spirit judges of it in relation to heaven. In short to the spirits everything speaks.”
—Honoré De Balzac (1799–1850)
“The true colour of life is the colour of the body, the colour of the covered red, the implicit and not explicit red of the living heart and the pulses. It is the modest colour of the unpublished blood.”
—Alice Meynell (1847–1922)
“But what would interest you about the brook,
It’s always cold in summer, warm in winter.”
—Robert Frost (1874–1963)
“Put God in your debt. Every stroke shall be repaid. The longer the payment is withholden, the better for you; for compound interest on compound interest is the rate and usage of this exchequer.”
—Ralph Waldo Emerson (1803–1882)
“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)