Interest rate parity

Interest rate parity is a no-arbitrage condition representing an equilibrium state under which investors will be indifferent to interest rates available on bank deposits in two countries.[1]

The fact that this condition does not always hold allows for potential opportunities to earn riskless profits from covered interest arbitrage. Two assumptions central to interest rate parity are capital mobility and perfect substitutability of domestic and foreign assets. Given foreign exchange market equilibrium, the interest rate parity condition implies that the expected return on domestic assets will equal the exchange rate-adjusted expected return on foreign currency assets. Investors then cannot earn arbitrage profits by borrowing in a country with a lower interest rate, exchanging for foreign currency, and investing in a foreign country with a higher interest rate, due to gains or losses from exchanging back to their domestic currency at maturity.[2]

Interest rate parity takes on two distinctive forms: uncovered interest rate parity refers to the parity condition in which exposure to foreign exchange risk (unanticipated changes in exchange rates) is uninhibited, whereas covered interest rate parity refers to the condition in which a forward contract has been used to cover (eliminate exposure to) exchange rate risk. Each form of the parity condition demonstrates a unique relationship with implications for the forecasting of future exchange rates: the forward exchange rate and the future spot exchange rate.[1]

Economists have found empirical evidence that covered interest rate parity generally holds, though not with precision due to the effects of various risks, costs, taxation, and ultimate differences in liquidity. When both covered and uncovered interest rate parity hold, they expose a relationship suggesting that the forward rate is an unbiased predictor of the future spot rate. This relationship can be employed to test whether uncovered interest rate parity holds, for which economists have found mixed results. When uncovered interest rate parity and purchasing power parity hold together, they illuminate a relationship named real interest rate parity, which suggests that expected real interest rates represent expected adjustments in the real exchange rate. This relationship generally holds strongly over longer terms and among emerging market countries.

References

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  8. ^Baba, Naohiko; Packer, Frank (2009). “Interpreting deviations from covered interest parity during the financial market turmoil of 2007-08”. Journal of Banking & Finance. 33 (11): 1953–1962. doi:10.1016/j.jbankfin.2009.05.007.
  9. ^ Jump up to:ab Delcoure, Natalya; Barkoulas, John; Baum, Christopher F.; Chakraborty, Atreya (2003). “The Forward Rate Unbiasedness Hypothesis Reexamined: Evidence from a New Test”. Global Finance Journal. 14 (1): 83–93. doi:10.1016/S1044-0283(03)00006-1.
  10. ^Ho, Tsung-Wu (2003). “A re-examination of the unbiasedness forward rate hypothesis using dynamic SUR model”. The Quarterly Review of Economics and Finance. 43 (3): 542–559. doi:10.1016/S1062-9769(02)00171-0.
  11. ^Bekaert, Geert; Wei, Min; Xing, Yuhang (2007). “Uncovered interest rate parity and the term structure”. Journal of International Money and Finance. 26 (6): 1038–1069. CiteSeerX 10.1.1.629.4876. doi:10.1016/j.jimonfin.2007.05.004.
  12. ^Anker, Peter (1999). “Uncovered interest parity, monetary policy and time-varying risk premia”. Journal of International Money and Finance. 18 (6): 835–851. doi:10.1016/S0261-5606(99)00036-4.
  13. ^Baillie, Richard T.; Osterberg, William P. (2000). “Deviations from daily uncovered interest rate parity and the role of intervention”. Journal of International Financial Markets, Institutions and Money. 10 (4): 363–379. doi:10.1016/S1042-4431(00)00029-9.
  14. ^Chaboud, Alain P.; Wright, Jonathan H. (2005). “Uncovered interest parity: it works, but not for long”. Journal of International Economics. 66 (2): 349–362. CiteSeerX 10.1.1.531.4902. doi:10.1016/j.jinteco.2004.07.004.
  15. ^Beyaert, Arielle; García-Solanes, José; Pérez-Castejón, Juan J. (2007). “Uncovered interest parity with switching regimes”. Economic Modelling. 24 (2): 189–202. doi:10.1016/j.econmod.2006.06.010.
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  21. ^Baharumshah, Ahmad Zubaidi; Haw, Chan Tze; Fountas, Stilianos (2005). “A panel study on real interest rate parity in East Asian countries: Pre- and post-liberalization era” (PDF). Global Finance Journal. 16 (1): 69–85. doi:10.1016/j.gfj.2005.05.005.
  22. ^Chinn, Menzie D. (2007). “Interest Parity Conditions”. In Reinert, Kenneth A.; Rajan, Ramkishen S.; Glass, Amy Jocelyn; et al. (eds.). Princeton Encyclopedia of the World Economy. Princeton, NJ: Princeton University Press. ISBN 978-0-69-112812-2.

Ofer Abarbanel – Executive Profile

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