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Hello Sir,
I am having difficulties with interest rate parity.
It was mentioned that “A currency with lower interest rates will trade at a forward premium in relation to a currency with a higher interest rate. For example, the U.S. dollar typically trades at a forward premium against the Canadian dollar. Conversely, the Canadian dollar trades at a forward discount versus the U.S. dollar.” on a website.
I do not understand how can a currency having lower interest rates causes the currency to appreciate. Instead, should the currency have low interest rates, should hot money flow out? since the deposit amounts are offering lower return and we are selling the currency to invest in a higher interest rate currency.
Thanking in anticipation,
Pas Cave Dire.Let me explain with a small example, but remember that interest rate parity is used to determine forward rates (in real life as well as in exams) i.e a rate quoted now for conversion on a future date.
Suppose the current spot rate for the € against the $ is €2 = $1. So $1 will buy 2 euros.
If the inflation rate in Euroland is 2% and in the US is 4%, then according to IRP the 1 year forward rate will be
€/$ 2 x 1.02/1.04 = 1.9615.The reason that this has to be the case is as follows.
Suppose you were to borrow $100 dollars at 4%, convert it to €’s now, so you would get €200, and then put the €200 on deposit at 2%.
So in 1 years time you would have 200 x 1.02 = €204, and at the same time you would be owing 100 x 1.04 = $104.If at the same time as converting the money now, you had agreed a forward rate of 1.96 then in 1 years time you could convert the €’s back into $’s and receive 204/1.9615 = $104, and this is exactly the amount needed to repay the $ borrowing.
If the forward rate was anything different from 1.9615 then you could borrow one currency now, convert it to the other currency now, and then deposit the other currency and then convert in 1 years time at the forward rate agreed now and end up making a profit. The foreign exchange markets would not let this happen – everyone would be doing it and it would force the current spot rate to change so as to end up with equilibrium.
It is a difficult thing to explain just by typing, but I hope that makes sense. It is exactly the same reasoning as the use of money market hedging, as I do explain in my free lectures. (Forward rates and money market hedging are exactly the same, but because money market hedging is only really feasible when there are large amounts of money involved, the banks quote forward rates as a way of allowing people to do it with smaller amounts.)
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