Interest rate parity

Examples of Interest rate parity in the following topics:

• Interest Rate Parity Theorem

  • Investors use Interest Rate Parity Theorem to price forward contracts.
  • Domestic nominal interest rate in APR equals id while the rate of return is rd.
  • Foreign nominal interest rate in APR is if while the foreign rate of return equals rf.
  • Expected rate of return equals 2%, which is identical to the U.S. interest rate.
  • Although Japan has a greater interest rate, the depreciating yen wipes out any gains from the higher interest rate.

• A Random Walk

  • We will study the random walk, Purchasing Power Parity Theory, the Relative Purchasing Parity Theory, Interest Rate Parity Theorem, and International Fisher Effect.
  • Value of the spot exchange rate today is st, which equals yesterday's exchange rate, st-1, plus a random disturbance, et.
  • For example, if the U.S. dollar-euro exchange rate equals $1.3 per euro today, then we expect the exchange rate to be $1.3 per euro tomorrow plus a random fluctuation.
  • We show the monthly U.S. dollar-euro exchange rate in Figure 1.
  • First difference of the U.S. dollar per euro exchange rate

• Overview of Exchange Rates

  • In finance, an exchange rate (also known as the foreign-exchange rate, forex rate, or FX rate) between two currencies is the rate at which one currency will be exchanged for another.
  • There are many factors that impact exchange rates, such as inflation, interest rates, balance of payments, and government policy.
  • Uncovered interest rate parity states that an appreciation or depreciation of one currency against another currency might be neutralized by a change in the interest rate differential.
  • If US interest rates increase while Japanese interest rates remain unchanged, the US dollar should depreciate against the Japanese yen by an amount that prevents arbitrage.
  • In sum, if other things remain unchanged, one currency will appreciate or depreciate if interest rates in the country increase or decrease.

• Chapter Questions

  • If the exchange rate equals 3 rm per U.S. dollar yesterday, what is your best forecast for the exchange rate today?
  • Russian has a 7% inflation rate while the United States has a 3%.
  • Using the approximation, how much should the exchange rate change if the home interest rate is 10%, the foreign interest rate equals 5%, and you plan to invest for 180 days?
  • Foreign interest rate equals 16%, and the exchange rate is appreciating at 4% per year.
  • Domestic interest rate for Europe is id = 7% while the United States interest rate equals if = 5%.

• Finding an Equilibrium Exchange Rate

  • Countries have a vested interest in the exchange rate of their currency to their trading partner's currency because it affects trade flows.
  • Purchasing power parity is a way of determining the value of a product after adjusting for price differences and the exchange rate.
  • The concept of purchasing power parity is important for understanding the two models of equilibrium exchange rates below.
  • Like purchasing power parity, the balance of payments model focuses largely on tangible goods and services, ignoring the increasing role of global capital flows .
  • The asset market model of exchange rate determination states that the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies.

• Quantity Theory of Money

  • We can use the Quantity Theory of Money to expand the Purchasing Power Parity Theory.
  • The interest rate ensures the supply and demand of money equal each other.
  • We can substitute the Quantity Theory of Money into the Purchasing Power Parity Equation, yielding Equation 13.
  • Thus, the exchange rate equals U.S. dollars per euro.

• Overview of Convertible Securities

  • Convertible securities are convertible bonds or preferred stocks that pay regular interest and can be converted into shares of common stock.
  • Convertible securities can be bonds or preferred stocks that pay regular interest and can be converted into shares of common stock (sometimes conditioned on the stock price appreciating to a predetermined level).
  • Although a CB typically has a coupon rate lower than that of similar, non-convertible debt, the instrument carries additional value through the option to convert the bond to stock, and thereby participate in further growth in the company's equity value.
  • Conversion premium: Represent the divergence of the market value of the CB compared to that of the parity value.
  • From the issuer's perspective, the key benefit of raising money by selling convertible bonds is a reduced cash interest payment.

• Purchasing Power Parity (PPP) Theory

  • Purchasing Power Parity (PPP) Theory is based on the Law of One Price.
  • Nevertheless, the Purchasing Power Parity helps predict changes in exchange rates.
  • Thus, Purchasing Power Parity estimates the equilibrium exchange rate.
  • The Absolute Purchasing Power Parity states the foreign exchange rate between two currencies is the ratio of the two countries' general price levels.
  • The Relative Purchasing Power Parity Theory is changes in products' prices between countries vary the exchange rate.

• Real Versus Nominal Rates

  • Real exchange rates are nominal rates adjusted for differences in price levels.
  • A measure of the differences in price levels is Purchasing Power Parity (PPP) .
  • The concept of purchasing power parity allows one to estimate what the exchange rate between two currencies would have to be in order for the exchange to be on par with the purchasing power of the two countries' currencies.
  • If all goods were freely tradable, and foreign and domestic residents purchased identical baskets of goods, purchasing power parity (PPP) would hold for the exchange rate and price levels of the two countries, and the real exchange rate would always equal 1.
  • Purchasing Power Parity evaluates and compares the prices of goods in different countries, such as groceries.

• The Interest Rate Risk

  • Interest rates became volatile during the 1980s, forcing banks to become more concerned with interest-rate risk.
  • If the interest-rate sensitive liabilities exceed the interest-rate sensitive assets, then rising interest rates cause banks' profits to plummet, while falling interest rates cause banks' profits to increase.
  • If the interest-rate sensitive liabilities are less than interest-rate sensitive assets, subsequently, increasing interest rates cause banks' profits to soar, while declining interest rates cause banks' profits to plummet.
  • If the interest-rate sensitive liabilities equal the interest-rate sensitive assets, then fluctuating interest rates do not affect bank profits.
  • If the interest rate rises, subsequently, the banks increase the interest rate on the loans.