What affects the mood of the foreign exchange market? Almost everything. This is one market that follows our lives round the clock, and that too without losing its balance. One of our theoretical models suggests that the exchange rates of two currencies find short-term equilibrium based on what is known as interest rate parity. However, we can’t accept any theoretical model as the last word. There is always evidence to support as well as contradict any model.
Johnny: There would always be contrary views. But can you first explain what is meant by interest rate parity?
Jinny: Interest rate parity is a condition that is supposed to move the exchange rates of two currencies towards an arbitrage-free equilibrium. In a condition of interest rate parity, the relative exchange rates of two currencies rise or fall depending on the level of interest rates in the two countries. The adjustment in exchange rates is such that no one is able to earn a higher return simply by taking advantage of the difference in interest rates. The presumption is that the difference in the interest rates for the two currencies ought not to lead to a difference in overall returns. Making investments in currencies earning different interest rates produces the same return once we take into account changes in their exchange rates. This is what we call a condition of interest rate parity—a world that does not offer free lunches.
For example, if deposits denominated in dollars are earning 10% interest and deposits denominated in euros are earning 15% interest, then for establishing interest rate parity, the value of the euro must depreciate by 5% with respect to the dollar; or conversely, the value of the dollar must appreciate by 5% with respect to the euro, so that the overall return generated by the two currencies is the same once we take into account their appreciation or depreciation.
Johnny: Can you tell me about the practical implications of interest rate parity?
Jinny: What interest rate parity implies is that it makes no sense to borrow in one currency and invest in another just because of the difference in interest rates. If it were not so, then anybody could earn a risk-less profit by borrowing in a currency available at a lower interest rate and converting the same into a deposit denominated in a currency offering a higher interest rate and hedging the exchange rate risk in the forward currency market. But the cost involved in hedging the exchange rate risk takes away the margin of profit. That’s why any opportunity of interest rate arbitrage, or what we also call the opportunity of carry trade between two currencies, evaporates quickly.
Illustration: Jayachandran / Mint
But you may be wondering how the market keeps everything in such a good order. You can understand this interest parity equation by thinking in terms of demand and supply.
Johnny: Could you give an example?
Jinny: Let’s presume that the dollar can be borrowed at 5% and invested into a euro-denominated deposit at 8%. What would be the effect of this action in terms of demand and supply? Any increase in the demand of loans denominated in dollars should push borrowing rates in dollars upwards, whereas an increase in the supply of deposits denominated in euros should push deposit rates in euros downwards. But despite the obvious imbalance in demand and supply, interest rates in the two countries might not change. In that case, exchange rates should change. The conversion of dollars into euros for investing in euro-denominated deposits should lead to appreciation in current exchange rate of euros in terms of dollars. But in future, for paying back the loan, the deposits in euros would be required to be converted into dollars, which means that the euro should depreciate in terms of dollars. The forward currency market keeps this in mind. That’s the reason why a currency having a lower interest rate sells at a premium to the currency having higher interest rate in the forward market. The premium that you pay for hedging the exchange rate more or less nullifies the gain made due to difference in interest rates. All in all, it’s about market common sense. No one would be willing to hold a currency offering a lower interest rate in case there is no other incentive. Appreciation in exchange rates of a currency in a way provides compensation for lower interest rates.
The whole idea of interest rate parity sounds convincing, but there are certain drawbacks which we should keep in mind. First, the condition interest rate parity requires is full mobility of capital between two countries. Many countries impose restrictions on capital movement due to which interest rate parity may not actually exist. Further, this theory presumes that there are no risks other than exchange rate risk for holding deposits denominated in different currencies—which again may not be true. Sometimes a deposit in a particular currency may be offering a high interest rate just to compensate for default risk.
Johnny: If I got your point right, there are sometimes gaps between what we read in textbooks and what we see in reality.
What: The exchange rates of two currencies move towards an arbitrage-free equilibrium, depending on the difference in their interest rates.
How: A currency offering lower interest rate appreciates whereas a currency offering higher interest rate depreciates so that the overall return generated by the two currencies is the same.
Why: Two currencies are able to move towards an arbitrage-free equilibrium due to short-term changes in their demand and supply.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at firstname.lastname@example.org