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Covered Interest Arbitrage (application of IRP for forex forecast)

The basic concept of covered interest arbitrage & Interest Rate parity is helpful in discerning the probability and magnitude of future currency movements.  Covered interest arbitrage, is the process of capitalizing on interest rate differentials.  So in essence funds move in the direction of currencies where real interest rates are higher.

A basic schema would surmise to using local funds to purchase international currency, investing in the international market with higher interest rate and then make a forward purchase of local currency.  Therefore, by investing in a market with a high interest rate, a better rate of return on investment is achieved on a fund which more than offsets the currency rate differentials.  If real arbitrage opportunities persist, and the activity of covered interest arbitrage starts picking up, it places an upward pressure on the foreign currency spot value and a discount on the forward rate of that currency.  A point is ultimately reached whereby the forward rate has dropped to a point where covered interest arbitrage is no longer feasible.  This because the forward rate of home currency has appreciated to a point that reconverting the foreign currency back to local currency offsets any interest rate advantage the foreign investment has to offer.  This equilibrium state is referred to as “Interest Rate Parity” and forms the fundamental basis of currency parity shifts.

The relationship between forward discount (or premium) of the foreign currency and the interest rate representing these foreign currencies can be calculated as follows:

Ah = Amount of home currency invested

S = Spot rate of foreign currency in US$’s

If = Interest rate of foreign deposit

Ih= Local currency Interest rate

F = Forward rate in US$ at which the foreign currency will be converted back to US$’s

An = Amount of home currency received at the end of the investment cycle

R = Rate of Return

An = (Ah/S)(1+ If)F

Note: F = (1 + P) where P is forward premium or discount

An = (Ah/S)(1+ If)P

R = (An – Ah)/Ah

R = [{Ah(1+ If)(1+p)}- Ah]/ Ah

R = (1+ If)(1+p)-1

At IRP  R = Ih

(1+ If)(1+P)-1 = Ih

Solving for P

P = (1+iH)/(1+if) – 1

Therefore for IRP to hold, if, for example, US $ exhibits a interest rate of 5 % and foreign currency, Euro, exhibits an interest rate of 6%, then, based on the above equation, then Euro should exhibit a 0.94% forward discount against the US$.  Reviewing the US$:UK £ the precipitous fall in interest rates in UK, was indicative of a very different mood prevalent in the

Forex Exchange RateUS market, where a steady hike in interest rates was witnessed.  Therefore, in the backdrop of such an environment the £ depreciated against the $.  After the sudden drop a period of stability is witnessed from 1994 – 2000, as the interest rates in both economies followed a parity declining path.


While empirically the IRP route seems straight forward and logical, however, human behavior is also driven by sentiments, which displaces rationality.  Socio economic and political conditions are always impacting social moods and thus behavior.  It would not be incorrect to assert that while the IRP theory seems generally correct, and does provide general guidance for bias, however, departures do occur.  Finally from 2000 to 2004 US interest rates noticeably declined against UK interest rate.  This difference manifested quite well into the exchange range difference, with a noticeable appreciation of £ against the $.

Interest Rates

 

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