What Is Interest Rate Parity?
It’s not always easy to grasp why the value of currencies can change. But you may understand it more when you realize how currency rates and interest rates are intertwined.
Interest rate parity is a theory that suggests a strong relationship between interest rates and the movement of currency values. In fact, you can predict what a future exchange rate will be simply by looking at the difference in interest rates in two countries.
Exchange Rates and Interest Rates
To understand interest rate parity, you should first get familiar with the notion of currency exchange rates. If you’ve ever traveled to another country, you’ve probably exchanged U.S. dollars for a certain amount of another currency. For example, if you are traveling to England, you can currently exchange $1 for .72 British Pounds.
To understand interest rate parity, you should understand two key exchange rates: the “spot” rate and the “forward” rate. The spot rate is the current exchange rate, while the forward rate refers to the rate that a bank agrees to exchange one currency for another in the future.
In addition to understanding exchange rates, it’s also important to know that interest rates are different in various countries. For example, you may be able to get a 5 percent return on a treasury bond in the United States, while a similar bond in the United Kingdom might yield 3 percent.
Coming Out Equal
The underlying concept behind interest rate parity is that it doesn’t matter whether a person invests money in their home country and then converts those earnings to another currency, or converts the money first and invests the money overseas. Because interest rates and forward currency rates are intertwined, the investor makes the same amount of money either way.
Here’s How This Works
Let’s say there is a spot exchange rate of .75 British Pounds for every U.S. dollar. (£.75/$1). This means we can exchange $1,000 and receive £750.
If interest rates in Britain are 3 percent, we can invest £750 at 3 percent for the year, yielding us $772.50.
Now let’s say that instead of exchanging our currency and investing it in Britain, we first invest our money in the United States and exchange it for British Pounds in a year. And let’s say the interest rate in the United States is 5 percent. In this case, the exchange rate will be the forward exchange rate, which is calculated using the difference in interest rates. In this case, the formula is: (0.75 x 1.03) / (1 x 1.05), or (0.7725/1.05). Rounding up, the resulting total is 0.736.
Now let’s say we start with $1,000 and invest it in the United States at 5 percent. This results in $1,050 at year’s end. If we then exchange the $1,050 at the forward exchange rate of .736, or about $772.50. In other words, you end up with the same amount of money as if you had exchanged your money first and then invested it in Britain.
Covered vs. Uncovered Interest Parity
When discussing foreign exchange rates, you may often hear about “uncovered” and “covered” interest rate parity. Uncovered interest rate parity exists when there are no contracts relating to the forward interest rate. Instead, parity is simply based on the expected spot rate. With covered interest parity, there is a contract in place locking in the forward interest rate. In truth, there is often very little difference between uncovered and covered interest rate parity, because the expected spot rate and forward spot rate are usually the same.
The difference is that with covered interest parity, you are locking in future rates today. With uncovered interest parity, you are simply forecasting what rates will be in the future.
Why Interest Rate Parity Matters
Without interest rate parity, it would be very easy for banks to exploit differences in currency rates and make easy money. Imagine, for example, if you could pay $1.39 for a British Pound. Without interest rate parity, an American bank could lock in a one-year forward contract at that rate. Then, it could accept $1 million in deposits and promise a 3 percent return. Using that $1 million, it could buy 730,000 Pounds and invest it in a British bank. If British banks pay a 5 percent interest rate, the American bank could end up with 766,500 British Pounds.
Then, it could convert that back to U.S. dollars, ending up with a total of $1,065,435, or a profit of $65,435.
The theory of interest rate parity is based on the notion that the returns on investing are “risk-free.” In other words, in the examples above, investors are guaranteed the 3 percent or 5 percent returns. In reality, there is no such thing as a risk-free investment. But, when the economies and monetary systems of countries are stable, investors can feel very confident about the returns on treasury bonds. In fact, U.S. Treasury bonds never default and are therefore viewed worldwide as risk-free. There are many other highly rated countries, including most in Europe, that are considered free of risk.