Interest rate parity

Examples of Interest rate parity in the following topics:

• Interest Rate Parity Theorem

  • Investors use Interest Rate Parity Theorem to price forward contracts.
  • Domestic nominal interest rate in APR equals id while the rate of return is rd.
  • Foreign nominal interest rate in APR is if while the foreign rate of return equals rf.
  • Expected rate of return equals 2%, which is identical to the U.S. interest rate.
  • Although Japan has a greater interest rate, the depreciating yen wipes out any gains from the higher interest rate.

• A Random Walk

  • We will study the random walk, Purchasing Power Parity Theory, the Relative Purchasing Parity Theory, Interest Rate Parity Theorem, and International Fisher Effect.
  • Value of the spot exchange rate today is st, which equals yesterday's exchange rate, st-1, plus a random disturbance, et.
  • For example, if the U.S. dollar-euro exchange rate equals $1.3 per euro today, then we expect the exchange rate to be $1.3 per euro tomorrow plus a random fluctuation.
  • We show the monthly U.S. dollar-euro exchange rate in Figure 1.
  • First difference of the U.S. dollar per euro exchange rate

• Overview of Exchange Rates

  • In finance, an exchange rate (also known as the foreign-exchange rate, forex rate, or FX rate) between two currencies is the rate at which one currency will be exchanged for another.
  • There are many factors that impact exchange rates, such as inflation, interest rates, balance of payments, and government policy.
  • Uncovered interest rate parity states that an appreciation or depreciation of one currency against another currency might be neutralized by a change in the interest rate differential.
  • If US interest rates increase while Japanese interest rates remain unchanged, the US dollar should depreciate against the Japanese yen by an amount that prevents arbitrage.
  • In sum, if other things remain unchanged, one currency will appreciate or depreciate if interest rates in the country increase or decrease.

• Chapter Questions

  • If the exchange rate equals 3 rm per U.S. dollar yesterday, what is your best forecast for the exchange rate today?
  • Russian has a 7% inflation rate while the United States has a 3%.
  • Using the approximation, how much should the exchange rate change if the home interest rate is 10%, the foreign interest rate equals 5%, and you plan to invest for 180 days?
  • Foreign interest rate equals 16%, and the exchange rate is appreciating at 4% per year.
  • Domestic interest rate for Europe is id = 7% while the United States interest rate equals if = 5%.

• Quantity Theory of Money

  • We can use the Quantity Theory of Money to expand the Purchasing Power Parity Theory.
  • The interest rate ensures the supply and demand of money equal each other.
  • We can substitute the Quantity Theory of Money into the Purchasing Power Parity Equation, yielding Equation 13.
  • Thus, the exchange rate equals U.S. dollars per euro.

• Purchasing Power Parity (PPP) Theory

  • Purchasing Power Parity (PPP) Theory is based on the Law of One Price.
  • Nevertheless, the Purchasing Power Parity helps predict changes in exchange rates.
  • Thus, Purchasing Power Parity estimates the equilibrium exchange rate.
  • The Absolute Purchasing Power Parity states the foreign exchange rate between two currencies is the ratio of the two countries' general price levels.
  • The Relative Purchasing Power Parity Theory is changes in products' prices between countries vary the exchange rate.

• Overview of Convertible Securities

  • Convertible securities are convertible bonds or preferred stocks that pay regular interest and can be converted into shares of common stock.
  • Convertible securities can be bonds or preferred stocks that pay regular interest and can be converted into shares of common stock (sometimes conditioned on the stock price appreciating to a predetermined level).
  • Although a CB typically has a coupon rate lower than that of similar, non-convertible debt, the instrument carries additional value through the option to convert the bond to stock, and thereby participate in further growth in the company's equity value.
  • Conversion premium: Represent the divergence of the market value of the CB compared to that of the parity value.
  • From the issuer's perspective, the key benefit of raising money by selling convertible bonds is a reduced cash interest payment.

• The Interest Rate Risk

  • Interest rates became volatile during the 1980s, forcing banks to become more concerned with interest-rate risk.
  • If the interest-rate sensitive liabilities exceed the interest-rate sensitive assets, then rising interest rates cause banks' profits to plummet, while falling interest rates cause banks' profits to increase.
  • If the interest-rate sensitive liabilities are less than interest-rate sensitive assets, subsequently, increasing interest rates cause banks' profits to soar, while declining interest rates cause banks' profits to plummet.
  • If the interest-rate sensitive liabilities equal the interest-rate sensitive assets, then fluctuating interest rates do not affect bank profits.
  • If the interest rate rises, subsequently, the banks increase the interest rate on the loans.

• Differences Between Real and Nominal Rates

  • In the case of a loan, it is this real interest that the lender receives as income.
  • If the lender is receiving 8% from a loan and inflation is 8%, then the real rate of interest is zero, because nominal interest and inflation are equal.
  • Where r is the real rate, i is the inflation rate, and R is the nominal rate.
  • The real rate can be described more formally by the Fisher equation, which states that the real interest rate is approximately the nominal interest rate minus the inflation rate: 1 + i = (1+r) (1+E(r)), where i = nominal interest rate; r = real interest rate; E(r) = expected inflation rate.
  • The relationship between real and nominal interest rates is captured by the formula.

• Macroeconomic Factors Influencing the Interest Rate

  • Taylor explained the rule of determining interest rates using three variables: inflation rate, GDP growth, and the real interest rate.
  • An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender in the market.
  • The interest rates are influenced by macroeconomic factors.
  • In other words, (πt - π*t)is inflation expectations that influence interest rates.
  • Taylor explained the rule in simple terms using three variables: inflation rate, GDP growth, and the equilibrium real interest rate.