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Home > Interest parity condition

The IPC assumes that financial assets are perfectly mobile and similarly risky. The basic interest parity condition is:

where:

A more approximate version is sometimes given, although it is less correct for countries with high exchange rates.

The chief implication of the IPC is that if a country's interest rates are relatively low compared to other countries, then that country's currency will tend to appreciate. Conversely, if the country's interest rates are relatively high, then the country's currency will tend to depreciate. If these conditions are not met, there exist arbitrage opportunities.

Covered Interest Parity

Why is there a close connection between forward and spot rates in the real world?

It follows directly from the interest parity condition that a forward exchange rate equals the spot exchange rate expected to prevail on the forward contract's value date.

Let's assume you wanted to pay for something in Yen in a months time. There are two ways to do this. (a) You could avoid exchange rate risk by buying some Yen now and selling your Yen forward for 30 days (for example in a Japanese 30 day fixed deposit). This is called covering because you now have covered yourself and have no exchange rate risk. (b) You could also invest the money in dollars and change it for Yen in a month. According to the IPC you would get the same number of Yen as with (a) (but you would still have some exchange rate risk.)

Without going into too much detail, these two methods are similar to what an exchange trader would do to get the 30 day forward rate (method a) and the expected spot rate in 30 days (method b). This links the two rates.

(as an aside, it is only the expected rate in 30 days that method (b) relies on. This may be different to the actual rate on that day, of course).

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Topics: Interest Parity Condition Rate Exchange Rates Yen Currency...

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