In the example shown above, the U. Can forward rates be used to predict future spot rates or interest rates? On both counts, the answer is no. A number of studies have confirmed that forward rates are notoriously poor predictors of future spot rates. Given that forward rates are merely exchange rates adjusted for interest rate differentials , they also have little predictive power in terms of forecasting future interest rates. Consider U. Using the above formula, the one-year forward rate is computed as follows:.
The difference between the forward rate and spot rate is known as swap points. In the above example, the swap points amount to If this difference forward rate minus spot rate is positive, it is known as a forward premium; a negative difference is termed a forward discount. With covered interest rate parity, forward exchange rates should incorporate the difference in interest rates between two countries; otherwise, an arbitrage opportunity would exist.
In other words, there is no interest rate advantage if an investor borrows in a low-interest rate currency to invest in a currency offering a higher interest rate. Typically, the investor would take the following steps:. The returns in this case would be the same as those obtained from investing in interest-bearing instruments in the lower interest rate currency.
Under the covered interest rate parity condition, the cost of hedging exchange risk negates the higher returns that would accrue from investing in a currency that offers a higher interest rate. Consider the following example to illustrate covered interest rate parity. Further, assume that the currencies of the two countries are trading at par in the spot market i. An investor does the following:. The investor can use the one-year forward rate to eliminate the exchange risk implicit in this transaction, which arises because the investor is now holding Currency B, but has to repay the funds borrowed in Currency A.
Under covered interest rate parity, the one-year forward rate should be approximately equal to 1. What if the one-year forward rate is also at parity i. Assume the investor:. After one year, the investor receives , of Currency B, of which , is used to purchase Currency A under the forward contract and repay the borrowed amount, leaving the investor to pocket the balance — 2, of Currency B.
This transaction is known as covered interest rate arbitrage. Market forces ensure that forward exchange rates are based on the interest rate differential between two currencies, otherwise arbitrageurs would step in to take advantage of the opportunity for arbitrage profits. In the above example, the one-year forward rate would therefore necessarily be close to 1.
Uncovered interest rate parity UIP states that the difference in interest rates between two countries equals the expected change in exchange rates between those two countries. In reality, however, it is a different story. Since the introduction of floating exchange rates in the early s, currencies of countries with high interest rates have tended to appreciate, rather than depreciate, as the UIP equation states.
Relentless selling of the borrowed currency has the effect of weakening it in the foreign exchange markets. The Canadian dollar has been exceptionally volatile since the year After reaching a record low of US Looking at long-term cycles, the Canadian dollar depreciated against the U. It appreciated against the U. From that low, it then appreciated steadily against the U. For the sake of simplicity, we use prime rates the rates charged by commercial banks to their best customers to test the UIP condition between the U.
Based on prime rates, UIP held during some points of this period, but did not hold at others, as shown in the following examples:. Forward rates can be very useful as a tool for hedging exchange risk. The caveat is that a forward contract is highly inflexible, because it is a binding contract that the buyer and seller are obligated to execute at the agreed-upon rate.
Understanding exchange risk is an increasingly worthwhile exercise in a world where the best investment opportunities may lie overseas. Consider a U. Because currency moves can magnify investment returns, a U. Of course, at the beginning of , with the Canadian dollar heading for a record low against the U. With the benefit of hindsight, the prudent move in this case would have been to not hedge the exchange risk.
However, it is an altogether different story for Canadian investors invested in the U. Hedging exchange risk again, with the benefit of hindsight in this case would have mitigated at least part of that dismal performance. Interest rate parity is fundamental knowledge for traders of foreign currencies.
In order to fully understand the two kinds of interest rate parity, however, the trader must first grasp the basics of forward exchange rates and hedging strategies. Armed with this knowledge, the forex trader will then be able to use interest rate differentials to his or her advantage.
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Interest rate parity (IRP) is the fundamental equation that governs the relationship between interest rates and currency exchange rates. Interest rates are crucial to day traders due to the higher the rate of return. More interest accrues on currency invested and profits are higher. Foreign Currency Exchange Rate. Online and ATM exchange rates · Rates for card transfers and payments. Выбрать валюту. USD, EUR. Choose your service package.