MBA – Calcutta University Alipur Campus

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INTEREST RATE PARITY

It’s no-arbitrage condition representing an equilibrium state under which investors will be different to interest rates available on deposits in two countries. The fact that this condition doesn’t always hold allows for potential opportunities to earn risk less profits from covered interest arbitrage.

Two assumptions central to interest parity are capital mobility and perfect sustainability of domestic and foreign assets. Given foreign exchange market equilibrium the interest rate parity condition implies that the unexpected return on domestic assets will be equal to the exchange rate adjusted expected on foreign currency assets. Inventors that can’t earn arbitrage profits by borrowing in a country with a higher interest rate, due to gain or losses from exchanging back to their domestic currency at maturity.

Interest rate parity takes 2 distinctive forms:-

Uncovered Interest Rate Parity (UIRP): it refers to the parity condition in which exposure to foreign exchange risk(unanticipated change in exchange rates) is unhabituated

Covered Interest Rate Parity (CIRP): it refers to the condition in which a forward contract has been used to cover (eliminate exposure to) exchange rate risk.

In Simple with examples:-

This theory assumes that if two countries have different interest rates, this difference will lead to a discount or a premium for the exchange rate in order to avoid arbitrage opportunities. IRP has to do with the idea that money should (after adjusting risk) earn an equal rate of return.

A simple example would be a situation, where interest rates in the UK are say 2%; while interest rates in Japan are say 1%. The sterling (British money) will need to depreciate 1% against the Japanese yen, so that the arbitrage opportunities can be avoided. The future exchange rate of GBP/JPY is reflected in the forward exchange rate known today.

Suppose an investor can earn 6% interest with a dollar deposit in the United States bank; or can earn 4% interest with a British pound deposit in a London bank. The investor can earn greater interest income by keeping funds in dollars and, therefore, one might expect all of his funds to flow to US banks. However, exchange rate expectations also come into play. Suppose the investor expects the British pound to appreciate at the rate of 2% in terms of dollar. That investor would then be indifferent to either investment choices, as both are expected to earn 6%.

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PURCHASING POWER PARITY

It’s a component of some economic theories and it’s a technique to determine the relative value of different currencies. The concept of Purchasing Power Parity (PPP) allows one to estimate what the exchange rate between two countries would have to be in order for the exchange to be at par with the purchasing power of the two countries’ currencies.

Using PPP rate for hypothetical currency conversions, a given amount of one currency thus has the same purchasing power whether used directly to purchase a market basket of goods or used to convert at the PPP rate to the other currency and then purchase the market basket using the currency. Observed deviations of the exchange rate from purchasing power parity are measured by deviation of the real exchange rate from its PPP value of 1.

PPP exchange rate helps to minimise misleading international comparisons that can arise with the use of market exchange rates. The PPP exchange rate serves two main functions:

PPP exchange rates can be useful for making comparisons between countries.

Over a period of years, exchange rates do tend to move in the general direction of the PPP exchange rate.

In Simple with examples:-

The theory of Purchasing Power Parity postulates the foreign exchange rates should be evaluated by the relative prices of a similar basket of goods between two nations. A possible change in the rate of inflation in a given country should be balanced byt the opposite change of country exchange rate. If prices in the country are surging because of inflation, country’s exchange rate should decrease in order to return to parity. PPP expresses the idea that a bundle of good in one country should cast the same in another country after exchange rates are taken into account.

Suppose that with existing relative prices and exchange rates, a basket of goods can be purchased with fewer US dollars in Canada than in US. We would then expect US consumers to buy those goods in Canada. Such actions would cause US dollars to be sold in exchange for Canadian dollars. As a result, the US dollars would depreciate in relation with the Canadian dollars. We would expect the currency depreciation to continue until the bundle of goods cost the same in both countries.

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...Thank You...

Sumit Kumar Das

95/MBA/130020

MBA (Major Finance, Minor Marketing)

Calcutta University – Alipur Campus