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Interest Rate Parity Theory
The interest rates prevailing in two countries shall be the basis for determining the Fair Forward Price. The actual forward rate has to be same as Fair Forward Price. Otherwise, Arbitrage Opportunity arises. Arbitrage means “making risk free gains”.
The theory believes that the exchange rate between the two currencies purely depend upon the interest rates prevailing in the two respective countries.
For example, interest rate prevailing in India is 12% p.a. and that in US is 7% p.a., one would try to take advantage of the given situation i.e. by borrowing in US at 7% p.a. and investing in India at 12% p.a. thereby earning the net differential interest of 5% p.a., this is somehow not that simple.
In fact as per Interest Rate Parity Theory this is not possible. By the end of the year the exchange rates between ` and $ would have changed adversely in such a way that the interest differential so earned shall be compensated by the exchange loss arising on repayment of US loan.
If Interest Rate Parity Theory does not hold good, it will give rise to possibility of arbitrage i.e., making risk free assured gains. The moment arbitragers start using this opportunity for arbitrage gain, the interest rates as well as exchange rates start fluctuating until the equilibrium is achieved i.e., to say Interest Rate Parity Theory starts working.
Example on Interest Rate Parity Theory
Interest rate prevailing in India 12% p.a.
Interest rate prevailing in US 7% p.a.
Spot Rate: 1 $ = ` 64
In the given scenario, anyone would want to take advantage of earning interest rate differential of 12% – 7% = 5% by borrowing in US and investing in India. As a result the total gain that can be made in one year based on $ 1,00,000:
$ 1,00,000 X `64/$ X 5% = ` 3,20,000
In reality, this gain cannot be made because by end of the year the exchange rate between $ and ` will not be the same. Let us make approximation of such exchange rate using concept of FFR.
made through interest rate differentials will be off-set against the resulting exchange loss.
Amount Borrowed $ 1,00,000
Add: Interest @ 6% $ 7,000
Total Amount Payable $ 1,07,000
Exchange Rate at the year-end = 66.9907
Therefore, Total Amount Payable = 66.9907 X $ 1,07,000 = ` 71,68,000
Amount Payable as per prevailing Spot Rate at the beginning of the year:
$ 1,07,000 X ` 64 = ` 68,48,000
Excess Amount Payable because of Changes in Exchange Rate:
` 71,68,000 – ` 68,48,000 = ` 3,20,000
As per Interest Rate Parity Theory, the resulting exchange loss has completely off-set the gain made through interest rate differential.
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