1. Interest Rate Parity

2. Recall Covered Interest Arbitrage Example 1
Foreign Currency = French Francs
Investable Amount = $ 1,000,000
Sj : Spot rate = $ 0.10 = ff 1
Fj : Forward rate = $ 0.10 = ff 1
In interest = 5%
In interest = 6%

3. If you Deposited in France CALCULATION
Step 1 : Convert $ into spot rate of $ 0.10
$ 1,000,000 / 0.10
= ff 10,000,000
Step 2 : Deposit on interest of 6% in France
ff 10,000,000 * 6 %
= ff 600,000
Total = ff 10,600,000
Step 3 : Convert ff into forward rate 0.10
ff 10,600,000 * 0.10
= $ 1,060,000

4. IF YOU DEPOSITED IN US CALCULATION : Investment: $ 1,000,000 * 5 %
US = 5 %
CALCULATION :
Investment: $ 1,000,000 * 5 %
Profit = $
Total = $ 1,050,000

5. RESULT : Profit from France is more than US
From US
$ 1,050,000
From France
$ 1,060,000
So invest in France

6. Interest Rate Parity (IRP) Definition
“If there is a difference in the interest rate of the two countries,
The forward rate will have a premium / discount equal to the interest rate differential ,
Then there will be no difference in profit to invest in home or foreign country”

7. Calculating Premium/Discount Formula:
P = (1+ih) / (1+if) – 1
Where
P = Forward Premium
ih = Home Interest Rate
if = Foreign Interest Rate

8. Calculation Interest rate in US = ih = 5% It shows forward discount
DATA
interest rate in France = if = 6%
Interest rate in US = ih = 5%
P / D = (1+5%)/(1+6%) – 1 * 100
D = approx %
It shows forward discount
It means US investors will receive 0.94% Less when they will convert the currency on forward Rate

9. FORWARD RATE CALCULATION
FORMULA
Fj = Sj ( 1 + p)
Where
Fj = Forward rate
Sj = Spot rate
P = Premium or Discount

10. DATA Fj : Forward rate = ? Sj : Spot rate = $ 0.10 = ff 1
D : Discount = %

11. CALCULATION Fj = 0.10 ( 1 + (- 0.94 %) ) Fj = $ 0.09906 Formula
Fj = Sj ( 1 + D)
Fj = 0.10 ( 1 + ( %) )
Fj = $

12. Example 2 You have two options for investment 1. In US @ interest = 5%
2. In interest = 6%

13. DATA Foreign Currency = French Francs Investable Amount = $ 1,000,000
Sj : Spot rate = $ = ff 1
Fj : Forward rate = $ = ff 1
In interest = 5%
In interest = 6%

14. IF YOU DEPOSITED IN FRANCE
Calculation
Step 1 : Convert $ into Spot of $ 0.10
$ 1,000,000 / 0.10
= ff 10,000,000
Step 2 : Deposit on interest of 6% in France.
ff 10,000,000 * 6 %
= ff 600,000
Total = ff 10,600,000
Step 3 : Convert ff into forward $
ff 10,600,000 *
= $ 1,050,036

15. IF YOU DEPOSITED IN US CALCULATION : Investment: $ 1,000,000 * 5 %
US = 5 %
CALCULATION :
Investment: $ 1,000,000 * 5 %
Profit = $
Total = $ 1,050,000

16. RESULT : It is approx equal profit From US & France
$ 1,050,000
From France
$ 1,050,036

17. CONCLUSION Therefore we can say that IRP exists because
Investing in home country or foreign country provides the same profit
Even there was a difference in the interest rate