Arbitrage in the Context of Interest Rate Parity

Introduction

According to Roberts (14), interest rate parity is a process through which two countries engage in a business transaction that involves interest rates under no arbitrage conditions. These conditions will create a scenario of equality between two countries involved in forward exchange as well as spot exchange rates. Interest Rate Parity (herein referred to as IRP) is an important aspect of the foreign exchange market. It plays a crucial role in the foreign market in which the interest rate, spot exchange as well as the foreign exchange rates are interlinked.

In this paper, the researcher will address arbitrage in the context of interest rate parity. The definition of this term ‘arbitrage’ is a controversial one pitting financial experts against each other. However, the experts agree that it is the process through which two countries engage in business at the same time so that they can benefit from the price difference (Roberts 25).

IRP is characterized by capital mobility as well as actual substitutability in relation to local and foreign markets. This brings about two kinds of IRPs which defines the environment within which the market operates. For example the first form of IRP involves uncovered interest rate parity. In this case the IRP is subjected to various risks during the exchange but the risks are uninhibited. The other type of IRP is called the covered interest rate parity. It is a situation where the future market has been protected from exchange risks.

Literature Review

Interest Rate Parity

Corporations involved in currency matters across the world are always alert on the changes in rates of currency such that if a currency weakens they will be advised accordingly. For example if a currency goes below the parity they will advice the other firms to take advantage of this and buy it. On the other hand if the currency is above parity they will advice their clients to wait until a suitable rate is achieved before acting. This process of trading depending on the rate of the currency has influenced the equilibrium of foreign exchange. In the long run it has increased demand for the weaker currency (Frederic 17).

Disparity may also be evident in short term interest rates. This is whereby firms may exchange foreign currency with domestic currency creating a decline in the supply of funds. This will affect the equilibrium in that the short term interest rates will rise in the domestic market. This trend will inhibit investors from borrowing in the country using the affected currency since it will be too expensive to buy.

IRP is efficient in maintaining equilibrium in the foreign market. It helps in addressing the huge discrepancies that may emerge in the future enabling efficient transactions between two countries in the market. The monetary authorities have the capacity to intervene to make sure that the market’s level of transaction is headed in the right direction. For example regulation of interest rates provides for adequate and open market by ensuring that equilibrium is attained under all market conditions (Frederic 24).

Foreign market is also a topic of concern for this paper. This is a universal market for currency exchange. The trading in currencies takes place allowing countries to purchase goods from each other. For example the United States can purchase goods and services from Europe and pay in Euros despite the fact that the traders are operating from America. The interest rate in the two countries becomes an important factor in IRP since the rate of exchange for the currency varies with time. Sometimes a large discrepancy may occur which may be a disadvantage to one of the two countries (Madura 31).

Forward Exchange, Spot Transaction and Forward Transaction

Currency transaction may take place simultaneously between the two countries. This direct transaction is referred to as spot transaction (Madura 31). On the contrary, a given country may decide to enter into transactional business but decide to make payments at a later date. This process of exchanging rates at a date in the future (after about three months) is referred to as forward transaction. For example a firm in the United Kingdom may have an obligation to pay an American based company in dollars within the next three months. Within the three months period, the rate of exchange for the US dollar may appreciate and the UK based company will have to pay more Pounds to the American company. To avoid this, the UK firm may decide to buy US dollars right away without waiting for future developments that may hurt their business. Conversely, the firm may decide to pay for the transaction using the already agreed- upon rate of exchange. They will pay after the expiry of the three months period as stipulated.

For the two firms above to be at par, the interest rate parity comes into play. This is to ensure that none of the two parties is disadvantaged in terms of the currency transactions (Madura 43).

When the interest rate parity comes into operation, the question will arise on how such parity will be determined or in other words, how to arrive at the correct IRP. This is to ensure that neither of the two countries involved in the transaction is negatively affected by its decision to participate in the transaction. It is noted that sometimes it is difficult to determine the correct rate of exchange since it may fall below or above the prevailing IRP. The US Dollar and the Sterling Pound are the two currencies that have been mainly used to come up with the correct IRP in the forward transaction. This is by using their current exchange rates (Madura 45).

Under normal circumstances, forward arbitration is controlled by putting on hold the arbitrage condition. It is important to note that movement of funds may not be put on hold waiting for the stipulated period of three months to expire. This is given the fact that in most cases, it may exceed the period without any hope of the currency normalizing.

IRP works on the assumption that the capital market is always mobile and different firms across the world can engage in transactions at any given time. Perfect substitutability exists in the mobile markets with reference to riskiness and liquidity (Maurice 33). This calls for different strategies to address the returns from both the domestic and foreign assets. However this does not postulate that the two countries will record equal returns when operating on a particular rate of exchange in their transaction (Madura 49).

Types of IRP

Uncovered Interest Rate Parity

This type of IRP involves a no- arbitrage scenario. There is no arbitrage that takes place during the forward transaction. The interest rate is expected to adjust itself after the returns in dollar are equalized with the deposits made in the foreign market. This criterion will help solve the spot exchange problem.

It is noted that uncovered interest rate parity boosts the confidence of the investors and encourages them to engage in transactions. This is given the fact that the returns on dollar are equal to the returns on foreign deposits. For example if the difference between interest rates in two countries is 4%, uncovered interest rate parity postulates that the currency used by the country whose rate is high is expected to depreciate at the rate of 4% against the country whose interest rate is lower. This is especially so if borrowing using the lower currency is done consistently. In this case the chances of weakening the currency are high (Maurice 15).

Covered Interest Rate Parity

The covered interest rate parity is evident when the arbitrage condition is upheld during the forward transaction. This is in an attempt to avoid risk of an increase in the transaction rate. In the long run covered IRP helps to realize the forward transaction rates by stabilizing transactions in currency. Covered interest rate parity comes into operation in open capital market scenarios especially in situations with inadequate capital control. This is consistent in all currencies exchanged in the current world economy. A classic illustration of this phenomenon is the transactions between the United Kingdom and the United States of America. The two are the largest players in the world’s economy (Maurice 25).

Transactions using the prevailing currency exchange rates are enabled by the forward exchange rates. This is after obtaining the difference between the rates of the two countries. If this is not upheld, the arbitrage condition will come into play. Consequently, it will not make economic sense if a country borrows with the lower currency and invests using the prevailing high rates. If this were to happen, the country that borrowed using the low interest rates has to undertake several steps in order to avoid the arbitrage scenario. First the borrowed currency should be converted into the higher interest rate currency. Then the country will invest using the currency with the high interest rate and not the one with the low interest rate (Maurice 29).

IRP and Swap Points

If investors in a given country are holding onto a given currency such as the Sterling Pound and the demand for dollar increases sharply, the value of dollar in the global market will rise. Standards and regulations are put in place to ensure that a given country does not have surpluses or deficits in the exchange currency. The forward and spot exchange rates are not always at par. The variation between them is referred to as swap points by economists (Madura 38). The swap points may be positive or negative depending on the strength of the currency at a given time.

Economic analysts refer to a positive swap as forward premium while the negative one is referred to as a forward discount. Therefore, trading in currency depends on the forward premium or forward discount. If for example a currency is trading at a lower interest rate it will affect the transactions carried out using the currency with higher interest rates. For example the United States and the United Kingdom trades using different transaction rates (Maurice 34).

It should be noted that forward interest rate parity is not suitable for predicting future interest rates (not even spot interest rates). Economists have argued that the idea behind the use of forward rates is to acquire differential interest rates. In most cases they are said to have low predictive power as far as the interest rates are concerned. Various measures have been put in place to address the short term and long term uncertainties.

Hedging

This is a term used to refer to assets that are in the process rather than “……potential assets which are not likely to be realized” (Madura 33). It is noted that it is prudent to subject the existing assets to trading criteria without holding onto them. For example a firm outside Britain and which is in possession of Sterling Pounds may feel that the currency is about to be devalued. The firm may therefore decide to release the funds and avoid the possible losses (Frederic 39). After the Sterling Pound has been remitted and in the process the currency weakens when the payments have not been fully settled (for example before the forward contract matures) the firm may obtain another foreign currency and then acquire the pound at a lower rate. This will save the investor from losses after devaluation of the pound.

The idea behind hedging is to protect the investors from losing their assets. This is carried out systematically to ensure that the investors attain the actual profits even after devaluation of currencies in a given country (Roberts 50).

Speculation

This is another strategy that is used to regulate currency transaction. It takes place when it is felt that there is a problem in currency rates which is likely to affect future transactions. Therefore the investor purchases the currency so that it can be sold in the future. Change in interest rate parity determines the currency which is speculated upon after the evaluation of exchange rates. However if there are any problems that are likely to be encountered the situation is radically reversed to save the investors from any losses.

Additionally, swap agreements have been noted to intervene by addressing the interest rate parity. To this end, central banks have established common grounds to help two countries move substantial funds across the borders. This is a precautionary measure meant to ensure that the currency is not affected negatively by the disparities (Roberts 57).

Interest Rate Parity in US and UK

The author has discussed several aspects of IRP using different approaches. At this juncture it is important to look at practical examples of IRP in operation. To this end the author will refer to the relationship between US and the UK.

It is noted that forward transactions are mainly used to calculate the interest rate parity for Sterling Pound and US Dollar. Although there have been some changes in the use of the currencies, the dollar has been used consistently to compute IRP in many countries in the world. This is despite the fact that Great Britain has the most expensive currency in the world. The Pound used to be the strongest currency in the world until the onset of the recent financial crisis which hit the entire world. The currency was trading at 1GBP against 2USD but as a result of the global financial crisis the currency has stabilized at around 1GBP to 1.6265 USD by the year 2011 (“Financial Rates 2011” 21).

The author will examine in detail the performance of the US and the UK currencies as far as their exchange rates are concerned. This is especially so considering that they are some of the greatest business partners in the world.

Britain’s prime rates were slightly higher as compared to the US dollar in the year 2010. At this time (and up to the year 2011) the UK Pound appreciated against the dollar which resulted to lower premium rates. As such the trading pattern was a forward transaction for the US. As a result of the recent financial crisis the US Dollar is peaking after the authorities adopted hedging financial risk management strategies. The financial agreements as far as the forward transactions are concerned were volatile as a result of their rigidity. This is given that the currency exchange rates were bound to change. As a result of this it is noted that a businessman from the US investing in the UK would make returns in USD that are twice as high as those of the investor in the UK in a given year (“Financial Rates 2011” 29).

Table I showing exchange rates history from 2000 to 2011.

Table 1: USD and the GBP Currency Performance

USD and the GBP Currency Performance

Table II showing interest rates from 2000 to 2011.

interest rates from 2000 to 2011.

Conclusion

Interest rate parity is an important tool in the regulation of foreign market transactions. Equipped with background information on this aspect of international trade, one is able to compute IRP from the differential exchange rates obtained. Profits incurred benefits traders from both countries. In the case of US and the UK, the appreciation and the depreciation noted can be used to analyze exchange rates under normal circumstances.

Works Cited

“Financial Rates 2011.” The Guardian Financial News Paper (UK): 29. Print.

Frederic, Stephen. Economics of Money, Banking, and Financial Markets, Boston, MA: Addison-Wesley, 2012. Print.

Madura, Jeff. International Financial Management: Abridged, Mason: Thomson South-Western, 2011. Print.

Maurice, David. International Finance, New York, NY: Routledge, 2011. Print.

Roberts, Charles. International Macroeconomics, New York, NY: Worth Publishers, 2008. Print.

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