Forex Trading: The Use of Interest Rate Parity

 Forex Trading: The Use of Interest Rate Parity

The interest rate parity or IRP is the fundamental equation that governs the relationship between interest rates and currency exchange rates. Also, the basic premise of interest rate parity is that hedged returns from investing in a variety of currencies must be the same, regardless of the level of their interest rates.

Then, there are two types of interest rate parity – the covered interest rate parity and uncovered interest rate parity.

Calculation of Forward Rates

Currencies’ forward exchange rates are exchange that expects the rate at a future point in time. Opposing the spot exchange rates, these are current rates. Further understanding of forward rates is fundamental to interest rate parity. And this is because it pertains to arbitrage – the simultaneous buy and sell of an asset to gain from a difference in the price.

There is a basic equation in calculating forward rates with U.S. dollars as the base currency.

Forward Rate = Spot Rate x 1+ IRO/1+IRD

Here, the IRO is the interest rate of an overseas country. And IRD is the interest rate of a domestic country.

The Availability of Forward Rates

Now, forward rates are available from banks and currency dealers for periods ranging from less than a week to as long as five years and beyond. And with spot currency quotations, they quote forwards with a bid-ask spread.

In addition to that, a currency with lower interest rates will trade at a forward premium linked to a currency with a higher interest rate. For example, the U.S. dollar trades at a forward premium against the Canadian dollar. Contrarily, the Canadian dollar trades at a forward discount versus the U.S. dollar.

Also, some might ask if forward rates can be used in predicting future spot rates or interest rates. Clearly, the answer here, on both counts, is no. Several studies have cleared out that forward rates are notoriously poor predictors of future spot rates. Knowing that forward rates are merely rates adjusted for interest rate differentials, they, too, have a slight predictive power in terms of forecasting future interest rates.

Now, the difference between the forward rate and spot rate is what they call the swap points. Then, if the difference – forward rate minus spot rate – is positive, it is called the forward premium. On the other hand, a negative difference is dubbed as a forward discount.

 

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