The parity of interest rate refers to the basic equation governing a relationship between the rate of interest and the rate of currency exchange. The general premises of the parity of rate of interest are the hedged returns from the investment in various currencies should be similar, in spite of the interest rate level.
There are two forms of parity of interest rate:
• Covered parity of interest rate
• Uncovered parity of interest rate
Continue reading about the things that helps in determining the parity of rate of interest and how is it used for trading in the Forex market.
Evaluating the Forward Rates
Forward rates of exchange for the currencies refer to the rate of exchange at future, when opposed to the spot rate of exchange, referring to the existing rates. A clear understanding about the forward rate is regarded to be fundamental to the parity of rate of interest mainly as this pertains to the arbitrage. The general equation for measuring the forward charges with U.S dollar acts asa base currency. The forwards rates are found from the banks and the dealers of currency for the periods fluctuatingfrom less than one week to five years or less than that. As far as quotations of spot currency is concerned, forwards are generally quoted with the bid-asking spread.
Consider the rates of Canada and U.S in the form of an example. Imagine that a spot rate for a Canada dollar is 1 USD which is equal to 1.0650 CAD. One year rates of interest are at nearly 3.15 per cent for dollar and nearly 3.64 per cent for Canadian dollar. Utilizing the above mentioned formula, a single year rate is evaluated in this manner:
The dissimilarity between the spot rate and forward rate is called as the swap points. In an above example, swap points are an amount to fifty. If this dissimilarity is regarded to be positive, this iscalled the forward premium whereas on the other hand negative differencesareknown as forward discount. Currency with a low rate of interest will deal at the forward premium in connection with the currency with high rate of interest. In the above mentioned example, U.S dollar deals at the forward premium against Canadian dollars in a converse manner, Canadian dollar deals at the forward discount withdollar.
Can one use the forward rate for predicting spot rates or the rate of interest? On both the counts, the reply is no. It has been confirmed by several studies that the forward rates are disreputably bad predictors of the future spot ratings. Provided that the forward rates as just the rates of exchange adjusted with the differentials of rate of interest, they even have few prediction powersin accordance to the future rate of interest.
Covered Parity of Interest Rate
Based on the parity of covered rate of interest, forward rate of exchange should include a difference in the rate of interest between two nations: otherwise an opportunity of an arbitrage will exist. In simple words, there are no advantages related to the rates of interest if in case an investor exchanges a rate of low interest for investing in the currency providing a high rate of interest. Typically, an investor will follow these steps:
• Exchange an amount in the currency with low rate of interest.
• Convert the exchanged amount into the currency with high rate of interest.
• Invest in the proceedings in in the instrument that is beard by an interest in this mode of currency.
• Simultaneously, hedge the risk of exchange by purchasing a forwarding contract for converting the proceedings of investment into the initial currency.
The earnings in such a case will be as similar as those are obtained from the investment in the instruments beard by an interest in the currency of low rate. Under a covered parity condition of rate of interest, the charge of hedging the exchange negates high returns that will accrue from the investment in the currency offering a high rate of interest.
Covered Arbitrage of Rate of Interest
Regard the following instance for illustrating a covered parity of rate of interest. Assume that the rate of interest for exchanging money for a period of one year in nation A is about 3 per cent per annum and the deposit rate of one year in nation B is five per cent. Furthermore, think that currencies of two nations trade in a spot market.
• Exchanges in money A at three per cent
• Also converts the exchanged amount into B at a spot rate
• Does the proceedings of the investment in the deposit denominated in the Currency B and pays about 5 per cent per annum
An investor can utilize forward rate of one yearfor eliminating the risk of exchange that implicit the transition, that arises because an investor now hold the currency B but repays money exchanged in Currency A. In the covered parity of rate of interest, forward rate of one year needs to be nearly equal to nearly 1.0194 as per the formula mentioned. What in case if the forward rate of one-year is at the parity? In such a case, adepositorin such a situation can reap the riskless gains of two per cent. Here is how it works. Assume an investor:
• Exchanges one lakh of the currency A at nearly three per cent for a period of one year
• Instantly converts the borrowing proceedings to the currency B at a spot rate
• Keeps the whole amount in a deposition of one year at nearly five per cent
After a year, an investor attains 105,000 of the currency B among which nearly 103,000 is utilized for purchasing currency A under forward contract and repaying the exchanged amount, which leaves an investor for pocketing a balance of 2,000 of exchange B. It iscalled as arbitrage of covered rate of interest. The forces of market makes sure that the rates of forward exchange depends on the rate of interest between two different currencies, otherwise the arbitrageurs will step for taking benefits of the chances for attaining huge gains. In the above mentioned example, forward rate of one year will thus get closed to nearly 1.0194.
Uncovered Parity of Interest Rate
Uncovered parity of interest rate states that a difference in the rate of interest between two nations is equal to the predictable change in the rate of exchange between these two nations. On a theory basis, if the differential rate of interest between two nations is three per cent, then currency of the country with high rate of interest is thought to depreciate by three per cent against another currency.
However, in reality it is a diverse case. As an introduction of the floating rate of exchange in 1970, currencies of nations with high rate of interest tend to escalate, instead of depreciating, as stated by “UIP equation.”The anomaly might be explained partly by “carry trade” whereas the speculators exchange low interest currencies like Yen, sell an exchanged amount and do the investment of proceedings in the high-yielding instruments and currencies. Japanese Yen was one of the favorite targets for this type of activity till the middle of 2007 with an estimation of one trillion dollar tied in the yen trade by that particular year.
Persistent selling of the exchanged currency has a weakening effect in the overseas exchange market. At the starting of 2005 to the middle of 2007, Japanese yen depreciated nearly twenty one per cent against dollar. The target rate of Bank of Japan over that particular period ranges fromnearly 0 to 0.50 per cent.
Let us check the relationship between the rate of interest and rate of exchange for Canada and U.S, the largest partners of trading in the whole world. Dollar of Canadahas been remarkably volatile since 2000. Once it reaches a low record of 61.79 per cent in 2002 in the month of January, it recovered close to eighty per cent in following years which in turn reaches modern high.Having a look at the permanent cycles, Canadian dollar started falling against dollar from the year 1980 to 85. It valued against a dollar from the year1986 to 91 and started commencing on the lengthy slide in the year 1992, concluding in January.
For simplicity, we utilize main rates for testing UIP condition between dollar and the Canadian dollar from the year 1998 to the year 2008. Depending on the main rates, UIP that continued certain points of this specific period, but do not hold others, as depicted in the below mentioned examples:
The Canadian chief rate was more than U.S main rate from 1988 to 1993. During this particular period, the dollar of Canada appreciated against counterpart of U.S, contrary to the relationship with UIP. The prime rate of Canada was less than the prime rate of U.S for large number of time from the middle of 1995 to the starting of 2002. As an effect, dollar traded in the premium to dollar of U.Sfor much time period. However, a Canadian dollar denigrated fifteen per cent against U.S dollar that implies the UIP which did not graspduring the specific period also.
The condition of UIP detained for large amount of time period from the year 2002, when Canadian dollar started commencing the rally fueled by commodity, till late in the year 2007 when it started reaching thepeak. Generally, Canadian chief rate was below the prime rate of U.S for much time period, exceptfor a span of eighteen month from 2002 to 2004.
Hedging Exchange Danger
Forward rate can be really useful in the form of tool used for hedging an exchange risk. Caveat is that the forward contract is much inflexible as it is binding the contract that the purchaser and seller get obligated for executing the rate that is agreed. Understanding the exchange danger is really a worthwhile exercise in the worldwhenthe best opportunities for investment might lie in the overseas. Consider an investor having a foresight for investing in equity market of Canada at the starting of 2002. The total returns from the benchmark of Canada S&P/TSX index from the year2002 to 2008 were nearly 106 per cent or nearly 11.5% on an annual basis. Compare the performance with S&P500 that has offered returns of 26 per cent over that specific period, or 3.5 per cent on an annual basis.
Here is a kicker. As the moves of currency can magnify the returns of investment, an investor generally invested in TSX/S&P at the startingof the year 2002 had total amount of returns by 208% by the month of August or 18.4 per cent on an annual basis. The appreciation of Canadian dollar against dollar over the time frame turned to be healthy return in the spectacular ones. Obviously, at the starting of the year 2002, with dollar leading for the low record against dollar, certain of the investors of United States might feel the demand for hedging the risk of exchange. In such a case, were they entirely hedged over a period discussed above, they might have predetermined the extra 102 per cent profit arising from the appreciation of Canadian dollar. With the advantage of hindsight, prudent shifts in this type of case will not be hedging for the danger related with exchange.
However, it is in total a different story for the investors of Canada in the market of U.S equity. In such a case, the returns by 26% offered by S&P five hundred from 2002 to 2008 turns to be a negative sixteen per cent because of the depreciation of dollar of U.S against dollar of Canada. Hedging exchange danger in such a case will be mitigated at the least part of dismal performance.
The parity of rate of interest is regarded as a basic knowledge for the dealers of foreign currencies. For totally understanding the two different types of the parity of rate of interest, however, a trader should at first grasp basics of the forward rate of exchange and strategies of hedging. Armed with this particular knowledge, the trader in the Forex market will have the ability to utilize the differentials of rate of interest to one’s benefits. The case of Canadian or U.S dollar depreciation and appreciation shows how gainful these dealers can be offered at perfect circumstance, knowledge and strategy.