International Financial Management

In June 2015, six-month Indian rupee Treasury bill rates exceeded 7.50% per annum, whereas US Treasury bill rates were less than 10 basis points. Why would US investors accept such low returns when they could invest in India? First and foremost, US investors face transaction foreign exchange risk when investing in an Indian security. The Indian rupee might weaken, wiping out the interest gain. If investors hedge this risk, the relative return on Indian Treasury bills versus US Treasury bills is driven by four variables: the Indian interest rate, the spot and forward exchange rates, and the US interest rate. After hedging, perhaps the dollar return on the Indian Treasury bill looks much lower.

Interest rate parity describes a no-arbitrage relationship between spot and forward exchange rates and the two nominal interest rates associated with these currencies. The relationship is called covered interest rate parity. This chapter shows that interest rate parity implies that forward premiums and discounts in the foreign exchange market offset interest differentials to eliminate possible arbitrage that would arise from borrowing the low-interest-rate currency, lending the high-interest-rate currency, and covering the foreign exchange risk. Interest rate parity is a critical equilibrium relationship in international finance. However, it does not always hold perfectly – and we discuss why, which will bring us back to the Indian example above.

The availability of borrowing and lending opportunities in different currencies allows firms to hedge transaction foreign exchange risk with money market hedges. We demonstrate that when interest rate parity is satisfied, money market hedges are equivalent to the forward market hedges of transaction exchange risk that were presented in Chapter 3. Moreover, we can use interest rate parity to derive long-term forward exchange rates. Knowledge of long-term forward rates is useful in developing multi-year forecasts of future exchange rates, which are an important tool in the valuation of foreign projects.

The Theory of Covered Interest Rate Parity

In international money markets, the interest rate differential between two currencies approximately equals the percentage spread between the currencies’ forward and spot rates. If this is not the case, traders have an opportunity to earn arbitrage profits. In this section, we first derive intuition for this interest rate parity relationship using a number of examples, and then we derive it formally.