Using Interest Rate Parity to Trade Forex

Using Interest Rate Parity to Trade Forex

The fundamental equation determining the connection between interest rates and currency exchange rates is interest rate parity (IRP). Interest rate parity is divided into two types. Uncovered Interest Rate Parity and Covered Interest Rate Parity are two types of interest rate parity.

Forward Rates Calculation 

In contrast to spot exchange rates, current rates, forward exchange rates for currencies anticipate the pace at a future point in time. Understanding forward rates are essential for interest rate parity, particularly when it comes to arbitrage (the simultaneous purchase and sale of an asset to profit from a difference in the price).

Banks and currency dealers can provide forward rates for periods ranging from less than a week to five years and beyond. Forwards are offered with a bid-ask spread, just like spot currency quotes.

Compared to a currency with a higher interest rate, a currency with a lower interest rate will trade at a forward premium.

Is it possible to estimate future spot rates or interest rates using forward rates? The answer is no on both counts. According to several studies, forward rates are notoriously poor forecasts of future spot rates. The forward rate has little predictive ability to anticipate future interest rates because they are just exchange rates adjusted for interest rate differentials.

Parity of Covered Interest Rates 

Forward exchange rates should include the difference in interest rates between two nations with covered interest rate parity; otherwise, an arbitrage opportunity would exist. In other words, if an investor borrows in a low-interest currency to invest in a higher-interest currency, there is no interest rate advantage.

In this situation, the returns would be the same as if you invested in interest-bearing securities in the lower-interest currency. The cost of hedging exchange risk eliminates the higher gains accrue from investing in a currency with a higher interest rate under the covered interest rate parity condition.

Interest Rate Arbitrage that is covered. 

Arbitrageurs aim to help take advantage of the chance for arbitrage profits if forward exchange prices were not dependent on the interest rate gap between two currencies. As a result, the one-year forward rate would have to be close to 1.0194 in the case above.

What happens if the one-year future rate is equal (i.e., Currency A = Currency B)? In this circumstance, the investor could earn a risk-free profit of 2%. Top 10 forex brokers follow the tips visit website to know them.

Uncovered interest rate parity (UIP) 

It asserts that the difference between two countries’ interest rates equals the predicted change in their exchange rates. In case of difference between the interest rate of the two countries is 3%, the country’s currency with the higher interest rate should devalue by 3% against the other money.

However, the truth is somewhat different. According to the UIP equation, since the advent of flexible exchange rates in the early 1970s, currencies of nations with high-interest rates have tended to appreciate rather than devalue. Several academic research articles have been written about this well-known issue, often known as the “forward premium puzzle.”

Final Words

Interest rate parity is essential knowledge for foreign currency dealers. However, a trader must first understand the fundamentals of forwarding exchange rates and hedging methods to comprehend the two interest rate parity types completely.