8.2 Interest rate parity

arbitrage prots. Actions taken by arbitrageurs to reap these prots act to remove the

inconsistencies.

Secondly, speculators who believe that the existing price is, for example, above

the equilibrium price will sell the asset or currency in question, helping the price

to fall to its equilibrium level. As long as the speculator is correct about the equilib-

rium position, he will be able to prot by buying in again later at the lower price.

Speculation in this case is stabilising.

Stabilising speculation:Speculation is the buying or selling of an asset for the purpose

of proting from changes in the market price of the asset. Speculation is stabilising

when it moves the market price towards the equilibrium price and speeds up the

process of moving to an equilibrium position.

Although economists employ a variety of approaches to the determination of

exchange rates, many depend on one or more of a number of important relationships

among interest rates, exchange rates and rates of ination.

8.2Interest rate parity

The forex market consists of two distinct markets – the spot and forward markets.

In the spot market, currencies are bought and sold for delivery within two working

days. In the forward market, exchange rates are agreed for the delivery of currency

at some later time. The usual contract periods in the forward market are one month

and three months, although longer periods are possible, especially for heavily traded

currencies. The forward market allows businesses to insure themselves against exchange

rate changes by buying and selling currencies ahead. Forward foreign exchange rates

are quoted as being at either a premiumor discountto the spot exchange rate. If a

currency is at a forward premium, it is more expensive to buy forward than to buy

spot. If it is at a discount, it is less expensive forward than spot. If the spot and forward

rates for a currency are equal, the currency is said to be at.

Consider the position of two investors, X and Y. Each of them has a1 million to

invest in a secure form for three months (the forex market is a market for large players).

X buys German government securities at existing euro interest rates. However, Y

notices that interest rates on sterling securities are higher than euro interest rates.

She thus decides to sell the a1 million for sterling in the spot forex market and to

use the sterling to buy British government securities. At the end of the three months,

the British securities mature and Y then sells the sterling for euro in the spot market.

Who nishes up with more euro at the end of three months?

Clearly, there are only two factors involved:

l	the difference in interest rates on UK and German securities; and
l	the difference in the £/euro exchange rate at the beginning and at the end of thethree months.

Since interest rates in the UK are higher than in Germany, then, if there were

no changes in exchange rates during the period, Y would nish up with more

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Chapter 8 • Foreign exchange markets

euro. However, X could nish up with more euro if the value of sterling against the

euro fell sufciently during the three months. For example, let the interest rates

be 5 per cent on the UK security and 3 per cent on the German security. Assume an

initial exchange rate of £1 a1.50. X buys German securities, obtaining 3 per cent

for three months and nishing up at the end of the period with a1,007,500. Y

converts her euro into sterling and obtains £666,667, on which she receives 5 per

cent interest for three months. Y therefore nishes up with £675,000 and converts

this back into euro. We can easily work out that for Y to nish up no worse off

than X, she would need an exchange rate of £1 a1.493. That is, at the beginning

of the period Y must have thought that the value of sterling against the euro would

not fall lower than a1.493. If it fell to a lower value than that, Y would do worse

than X.

The position in which these strategies of X and Y are thought likely to produce

the same result is known as uncovered interest parity. The word ‘uncovered’ simply

indicates that Y would be taking a risk in following her strategy because she does not

know what is going to happen to the exchange rate over the ensuing three months.

It is the expected future spot rate of exchange that is crucial to her decision.

Let us consider next how we might arrive at uncovered interest parity. It is clear

in our example above that if investors do not switch from euro into sterling and

nothing else happens to move the exchange rate away from the £1 a1.50 rate,

they will have missed a prot opportunity. They could have moved their funds into

sterling and back and nished up with more euro than they did by keeping their

funds at home. Thus, in practice, investors who think that the rate of exchange is

unlikely to move will take advantage of the apparent prot opportunity and will

follow the strategy proposed for Y above. Think what then happens.

A large amount of euro are sold for sterling at the beginning of the period, increas-

ing the demand for sterling and pushing up the price of sterling. As this happens, the

value of sterling rises above a1.50 and later investors receive less sterling in exchange

for their euro. At the same time, the increased demand for British securities pushes

their price up and pushes the rate of return on them below 5 per cent. The interest

rate differential between British and German securities falls below 2 per cent. Clearly,

Y’s strategy of buying British securities is becoming less attractive for two reasons –

British interest rates have fallen and the prospects of investors losing on the currency

exchange are increasing. They are now paying more than a1.50 for each pound but

have no reason for changing their view that the exchange rate in three months’ time

will be £1 a1.50.

As interest rates and exchange rates change, the advantage of Y’s strategy over X’s

is steadily reduced. When the prot opportunity from following Y’s strategy has

disappeared altogether and there is no longer any incentive to exchange euro for

sterling in order to buy British securities, we have uncovered interest parity.

Uncovered interest parity:When the gains from investing in a country with a higher

interest rate are equal to the expected losses from switching into that country’s currency

and back into the original currency.

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