What is Interest Rate Parity?

Let's discuss Interest rate parity!

Global trade gave rise to currency pair quotes in the Foreign Exchange market.                          

When a product priced in USD needed to be purchased by someone in India, he would look for a forex price in USD/INR. If he was paying for the product today, he would ask for the Current Spot price (now Rs. 79 per USD approx.)

Let’s say he needs to pay only three months later. The Forex market would show that it would cost him approximately, Rs. 79.35 per USD, called a 3-month forward price which is higher than the Spot. 

This Forward rate is not merely a forex price between USD and INR. It has an add-on amount over the Spot, which constitutes an Interest rate component. This is related to the Interest rate differential between both countries. Hence, the forward rate can be predicted if the Spot forex rate and Interest rates of the two currencies, were known. Such an equilibrium is called the Interest rate parity. 

Interest Rate Parity: Meaning

The Indian Currency Market is a dynamic one where forex trading market makers, quote rates for the Indian Rupee (INR) against many major global currencies, in the Spot and Forward time zones. 

Simply put, in Forex trading, Forward rates differ from their Spot rates, by mirroring the interest rate differential (in per cent) between the two countries, whose currencies are being exchanged. 

So, the Interest Rate Parity is really a predictive mechanism that gives us an equation to demonstrate the relationship existing between Foreign Exchange and Interest Rates. 

Using this equation, major movements in Forward rates in the Indian Currency market can be arrived at, between INR and most currencies.

We can understand Interest Rate Parity better from the following information:

•    A forward premium (ie. the interest component added on) indicates that the market expects currency rates to move higher in future, between the pair. The forward rate is today’s expectation of where the spot rate will be, at a projected future date

•    If the USD is stronger against the INR fetching a premium, it can be assumed that, when the rate is quoted indirectly, USD forwards will be at a discount against INR

•    Interest rate parity is a logical concept. If interest on investments (ie Rates of return) between the two countries is unequal, money will move to the country where earning potential will be higher. Hence when in equilibrium, the Interest rate parity theory equation makes market rates arbitrage-free (Covered arbitrage). This implies that when the forward rates are not in sync with the interest rate differential, there would be room for arbitrage (the choice of taking advantage of price differentials to make profits).
Does it always happen? Maybe not! In reality, many factors may affect this hypothesis, making forward rates imperfect, in spite of which this equation holds its own.

Different Rates in Interest Rate Parity

Let’s compare the possible forward scenarios when the market quotes are :

                                            Bid(Buy) / Ask(Sell)               Mid-rate
USD/INR Spot rate Rs. :     79.00     /   79.05 
1-month forward-Paise:         20    /        22                          79.21   
3-month forward-Paise:         38    /        40                          79.39
6-month forward-Paise:         56    /        58                          79.57

In the above USD/INR example, a higher Forward rate in comparison to the Spot rate, indicates that INR Forward rates are at a premium (costlier) against the US Dollar.  

If the Forwards were below the Spot rate, they are said to be at a discount (less costly). Premiums are always added to the Spot rate and deducted in case of discounts, which has a minus sign.
Why should an interest percentage be added to arrive at a currency exchange rate at a later time? Suppose a USD forward purchase rate is contracted today, and USD interest rates are lower than INR. In that case, the interest differential for the forward period becomes an added cost for the buyer, as he earns a higher return on the INR, during the forward period. This is consistent with the Interest Rate Parity Theory (IRPT), which is considered a fundamental law.

How to Calculate Interest Rate Parity?

In India, domestic interest rates are higher than USD interest rates and so the forward premium has been positive mostly. Interest Rate Parity theory hinges on the assumption that the difference in Interest rates between the two countries is reflected in the difference between Spot and Forward currency exchange rates or forex rates.

While this theory is generally applicable, most often the forward prices forecast by the theory and the actual market-related forward rates, deviate on account of various factors. Such differences give rise to opportunities for traders to carry out profitable arbitrage deals. 
 
Taking a current-day example of USD/INR rates (As of 28th June 2022):

The last two columns show how in reality, other factors have impacted the IRPT forward rate forecast. It’s evident that a non-covered arbitrage room exists, especially in 3-month forwards(@) for USD buyers. This may or may not be viable enough, due to transactional costs, taxes or political risks. It also demonstrates that perfect equality is impossible to achieve as per IRPT.

Importance of Interest Rate Parity

The relevance of the Interest rate parity equation in Currency rates:

·     •   It is a handy tool for calculating and forecasting forex forward rates 

·       •  Simple market data in the form of Spot exchange rates and Interest rates in the two countries, is all that is required as inputs to predict forward forex rates

·        •  Forward rates ensure that the trader locks in a future rate today and books profits early. They help fight against volatility and market risk (namely price risk)

On the negative side:

•    Forward contracts are fixed deliverable contracts, which if cancelled, incur costs.
•    A trader who buys foreign currency based on this theory, may have to forego profit potential if the market moves lower below the contracted rate. If he sells forward, he may potentially lose profits if the market moves above the forward rate
•    Forward contracts also require margin maintenance till the delivery date hence adds to funding costs.

Conclusion

Currency exchange through Forward Contracts, can be used in the market for both hedging future exposures and speculation based on forecasts. Speculators typically do not deliver on due dates, but only settle differences in Profit or Loss.
The accuracy and reliability of IRPT generally goes up with the level of global integration of the currency market in a country.
Traders need to look out for sudden illiquidity in forward markets, especially in longer maturities (say beyond 6m) as a risk factor. 
With no centralized trading (eg. through Exchanges), currency exchange contracts in forwards, open the trader to counterparty risk, as they are contracted one-to-one(OTC).
 
The best use of IRPT is that it allows the trader a method of looking into the future, with current market inputs and also:

-    It enables the comparison of domestic and global rates of return
-    Make financial decisions for the future without facing currency risk
-    And helps run multi-currency balance sheets, minimizing translation risk.
It is fair to conclude that Interest Rate Parity generally holds validity, as has been proven by many studies. Even when deviations occur in the market, more often than not 
-    It may be small divergences.
-    It may be of transient nature till arbitrage catches up.
-    And may be due to identifiable reasons such as political or economic turbulences.