Using Interest Rate Parity to Trade Forex

Interest rate parity is the fundamental equation that governs the relationship between interest rates and currency exchange rates. The basic premise of interest rate parity is that hedged returns from investing in different currencies should be the same, regardless of the level of their interest rates.

There are two versions of interest rate parity:

1. Covered Interest Rate Parity
2. Uncovered Interest Rate Parity

Read on to learn what determines interest rate parity and how to use it to trade the forex market.

Forward exchange rates for currencies are exchange rates at a future point in time, as opposed to spot exchange rates, which are current rates. An understanding of forward rates is fundamental to interest rate parity, especially as it pertains to arbitrage (the simultaneous purchase and sale of an asset in order to profit from a difference in the price). 

The basic equation for calculating forward rates with the U.S. dollar as the base currency is:

\begin{aligned} &\text{Forward Rate}\ =\ \text{Spot Rate}\ \times\ \left[\frac{1\ +\ \text{IRO}}{1\ +\ \text{IRD}}\right]\\ &\textbf{where:}\\ &\text{IRO}\ = \ \text{Interest rate of overseas country}\\ &\text{IRD}\ = \ \text{Interest rate of domestic country} \end{aligned}​Forward Rate = Spot Rate × [1 + IRD1 + IRO​]where:IRO = Interest rate of overseas countryIRD = Interest rate of domestic country​

Forward rates are available from banks and currency dealers for periods ranging from less than a week to as far out as five years and beyond. As with spot currency quotations, forwards are quoted with a bid-ask spread.

Consider U.S. and Canadian rates as an illustration. Suppose that the spot rate for the Canadian dollar is presently 1 USD = 1.0650 CAD (ignoring bid-ask spreads for the moment). Using the above formula, the one-year forward rate is computed as follows:

$\text{1 USD}=1.0650\times [(1+3.15\%)(1+3.64\%)]=1.0700\text{ CAD}$

The difference between the forward rate and spot rate is known as swap points. In the above example, the swap points amount to 50. 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.

A currency with lower interest rates will trade at a forward premium in relation to a currency with a higher interest rate. In the example shown above, the U.S. dollar trades at a forward premium against the Canadian dollar; conversely, the Canadian dollar trades at a forward discount versus the U.S. dollar. 

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.

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:

1. Borrow an amount in a currency with a lower interest rate.
2. Convert the borrowed amount into a currency with a higher interest rate.
3. Invest the proceeds in an interest-bearing instrument in this higher-interest-rate currency.
4. Simultaneously hedge exchange risk by buying a forward contract to convert the investment proceeds into the first (lower interest rate) currency.

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. Assume that the interest rate for borrowing funds for a one-year period in Country A is 3% per annum, and that the one-year deposit rate in Country B is 5%. Further, assume that the currencies of the two countries are trading at par in the spot market (i.e., Currency A = Currency B).

An investor does the following:

• Borrows in Currency A at 3%
• Converts the borrowed amount into Currency B at the spot rate
• Invests these proceeds in a deposit denominated in Currency B and paying 5% per annum

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 1.0194 (i.e., Currency A = 1.0194 Currency B), according to the formula discussed above.

What if the one-year forward rate is also at parity (i.e., Currency A = Currency B)? In this case, the investor in the above scenario could reap risk-free profits of 2%. Here’s how it would work. Assume the investor:

• Borrows 100,000 of Currency A at 3% for a one-year period.
• Immediately converts the borrowed proceeds to Currency B at the spot rate.
• Places the entire amount in a one-year deposit at 5%.
• Simultaneously enters into a one-year forward contract for the purchase of 103,000 Currency A.

After one year, the investor receives 105,000 of Currency B, of which 103,000 is used to purchase Currency A under the forward contract and repay the borrowed amount, leaving the investor to pocket the balance – 2,000 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 1.0194.