Interest rate parity:- According to the Interest rate parity principle, suppose you invest in your home country and earn a return, this return has to be equal to the return you achieve by borrowing a foreign currency and investing in that country and then converting it back to your home currency. To understand this better let us consider a small example.
Suppose you are an NRI and you live in US, the interest rate in India is 10% and the interest rate in US is say 5%. Superficially it might look that there is this great investment opportunity in India. Borrow in US at 5% and invest in India. Doing so earn 10% in India, pay back 5% as interest and hence make a clear riskless profit of 5%. But to our dismay this isn’t the case. Interest rate parity says that you will earn the same 5% return if you are a US investor. To understand this let us extend this example.
Suppose you are sitting in US having $1million to invest. You decide to invest this sum in India which is “An emerging market”. The current exchange rate is INR 45/$. Therefore you invest a total of 1million*45= 45 million Indian rupees in India. After a year at 10% you earn a handsome 10%*45 million= 4.5 million. As you are a US investor you want your returns to be in US$, so you convert the Indian rupee returns to $. Now the question is what will be the exchange rate one year from now. This is where INTEREST RATE PARITY comes into play. It says that there is no incentive of remaining unhedged in foreign currency. In other words you will get a return of only 5% that is the return you will get by investing in US markets. This can only be because of currency rate movements. Here are two golden principles to remember
· The country whose return is higher in nominal terms with respect to another country’s return, currency will depreciate for that country with respect to the other country.
· The country whose return is lower in nominal terms with respect to another country’s return, currency will appreciate for that country with respect to the other country.
In our example as we have seen that the Indian nominal rate of return (10%) is higher than that of US (5%). Therefore the Indian rupee will depreciate and the US $ will appreciate so that the return in both the currencies is same. Going back to the example, the US investor has 45+4.5 million INR. And we know that he gets only 5% return in US $ terms or 1.05 million US dollars, the exchange rate after 1 year has to be 49.5/1.05= 47.14INR/$ or the rupee has depreciated and the $ appreciated. To make it more generalized
Expected spot rate after t years = So * (1+Rdc)T/(1+Rfc)T
Where
So= Current (spot) exchange rate domestic currency in foreign currency terms. (ex 45/$ is So for an Indian investor.
Rdc= Interest rate in domestic market.
Rfc= Interest rate in foreign market.
As forward rate is an unbiased predictor of Expected spot rate. Forward rate = Expected spot rate.
In the next issue we will see how the forward contracts are priced before expiry.
Shubham GoelIIM Rohtak
