Are you planning to invest in Forex markets? Well, you may need to learn more about theories such as Interest Rate Parity models. These theories are used to regulate markets, and some knowledge about them can help you make informed investment decisions. Interest Rate Parity or IRP is a theory that plays a critical role in the Forex markets where it is used to connect foreign exchange rates, spot exchange, and interest. The theory keeps the interest rates between two countries equal to a differential, which is obtained by use of spot exchange rate techniques and forward exchange rate.
The IRP theory is used to find the relationship between a future rate (forward rate) of currencies and a spot rate. The theory states that there will be no arbitrage in the interest differentials between two currencies. Moreover, the differential will be reflected in the premium or discount included in the future exchange rate (forward exchange rate) on the foreign exchange.
Moreover, the theory stresses that the future discount or premium on a foreign currency is equal to the difference between the forward interest and spot interest of the countries in question.
Since there is no arbitrage, regardless f the investment choice taken, the Return On Investment (ROI) is equal in all cases. Arbitrage is the practice of buying currency or shares in one market and then selling them on another market to make a profit.
Covered Interest Rate Parity
This is a variation of the Interest Rate Parity and is commonly referred to as CIRP, and it states that the exchange rate when used in the forward premium will cancel out the difference in interest rate between two countries. Therefore, the interest rate between two countries is always cancelled out by the forward/spot currency premiums. That makes it impossible for investors to earn an arbitrage profit.
Uncovered Interest Rate Parity (UIRP)
This is also another variation of the interest Rate Parity theory. It states that expected depreciation or appreciation of a currency is cancelled out by a lower or higher interest rate.
Covered (CIRP) and Uncovered Interest Rate (UIRP)
Many financial analysts have concluded that the UIRP theory is not applicable in all scenarios. However, there are not many violations as was previously estimated. Moreover, most of the violations happen in the currency domain instead of being dependent on time.
On the other hand, CIRP is widely accepted theory, especially among the OECD countries, and used to make financial decision on short term investments. Any deviations that come up from sing those models are added to the transaction costs.
What are the Implications of Interest Rate Parity?
When the IRP theory is applicable to a financial transaction in Forex trade, it negates any chance of an arbitrage. That means that the investor will not have any advantage for investing in a foreign market. Instead, they will get the same advantage they could have gotten for investing using their local currency.
Any time that the domestic interest rate is lower than foreign interest rates, the foreign currency should be traded at a future (forward) discount. That will prevent any foreign arbitrage from being practiced.
On the other hand, when the foreign currency has a forward discount that is not significantly large so as to offset any interest rate, or it is not there at all, then the domestic investor will have some arbitrage opportunities. That means that domestic investors may be able to benefit from their foreign investment.
When the domestic rates are higher than foreign interest rates, investors have to trade the foreign currency at a future or forward premium. That will work to offset arbitrage in the domestic country.
Moreover, when the foreign currency’s forward premium is not significant to cancel out the domestic country’s advantage, foreign investor will have an arbitrage advantage. The foreign investors will therefore profit by investing in the domestic market.
We hope that you found this article on Interest Rate Parity to be informative and engaging. Investing in the Forex trade can be a challenge especially when you consider that it is a negative trade. That is because the broker makes some fees, regardless of whether the investor made a profit or not. The good news is that with sound financial knowledge, you can make informed investment decisions, and avoid investments that will obviously lead to losses.