Interest Rate Parity (IRP) or what is known as interest rate parity is a condition without arbitrage that represents an equilibrium state in which investors will position themselves in a neutral position, compared to the interest rates available on bank deposits in the two countries. The fact that this condition is not always allowed, as it determines the potential opportunity to make a risk-free profit from covered interest arbitrage. The two central assumptions for interest rate parity are capital mobility and perfect substitution of domestic and foreign assets.
Given the equilibrium of the foreign exchange market or forex market under conditions of interest rate parity, assume that the expected return on domestic assets will equal the expected return adjusted for the exchange rate of the asset denominated in foreign currency i.e. forex. Thus investors cannot gain arbitrage profits by borrowing in a country with a lower interest rate, exchanging foreign currencies and investing in a foreign country with a higher interest rate, due to gains or losses from the exchange rate of their internal currency.
Interest rate parity has two different forms:
1. Uncovered interest parity refers to a parity condition in which exposure to foreign exchange rate risk (forex) and unanticipated changes in exchange rates is unimpeded.
2. While covered interest rate parity refers to the conditions in which the contract is used for hedging, which means eliminating exposure to exchange rate risk. Each form of parity condition exhibits a unique relationship, with implications for forecasting future exchange rates.
Economists have found empirical evidence that interest rate parity is generally stable, although inaccurate, due to the effects of various risks, costs, taxation, and differences in final liquidity.
When parity masks the interest rate, it exhibits a relationship indicating that the default rate is an unbiased predictor of the visible future rate. This relationship can be used to test for undisclosed interest rate parity, for which economists have found mixed results. When overdraft parity and purchasing power parity are closely related, they describe a relationship called real interest rate parity, which indicates that the expected real interest rate is the expected adjustment to the real exchange rate; this relationship is generally maintained in the long run and between developt countries.
Hypothesis
Interest rate parity is based on certain assumptions, the first is that capital is mobile investors can easily exchange domestic assets for foreign assets. The second assumption is that assets have perfect substitutes, following their similarities in terms of risk and liquidity. Given the mobility of capital and perfect substitution, investors are expected to own assets that offer higher returns, both domestic and foreign assets.
However, domestic and foreign assets are held by investors. It must therefore be true that there should be no difference between returns on domestic assets and returns on foreign assets. This does not mean that domestic investors and foreign investors will get equal returns, but it can mean that one investor from anywhere can expect equal returns from the investment decision.
Interest Parity
If the non-arbitrage conditions are met without using a forward contract to hedge the exposure to exchange rate risk, it is likely that interest rate parity is found. Risk-neutral investors will be indifferent to the interest rates available in the two countries, as exchange rates between these countries are expected to adjust so that the USD returns on USD deposits equals USD returns on EURO deposits, eliminating the potential for unraveling. So the interest parity found helps to explain the determination of the spot exchange rate.
The interest parity found states that investors with USD deposits will earn the available interest rate on USD deposits, while investors holding EURO deposits will earn the available interest rate in the EURO region but also the potential profit or loss per EURO, depending on the rate of appreciation or depreciation. on the EURUSD currency pair.
Economists have extrapolated useful estimates from found interest rate parity, which intuitively follows one of these assumptions. If overdraft interest rate parity is maintained, leaving investors indifferent between USD and EURO deposits, then any excessive returns on EURO deposits must be offset by the expected losses of EURO against USD. On the other hand some shortfalls in EURO deposit returns should be offset by the expected gains in EURUSD appreciation.
Closed Interest Rate Parity
If the arbitrage conditions are not met by the use of forward contracts to hedge exposure to exchange rate risk, interest parity appears to be covered. Investors will continue to be indifferent to the interest rates available in the two countries because the forward exchange rate maintains equilibrium, so that the USD’s return on USD deposits equals the USD’s returns on foreign deposits, thus eliminating potential arbitrage gains.
In addition, the interest rate parity covered helps explain the determination of the forward exchange rate.
Empirical Evidence
Covered interest rate parity (CIRP) is held when there is open capital mobility and limited capital controls, and this finding is confirmed for all currently freely traded currencies.
One example is when the UK and Germany abolished capital controls between 1979 and 1981. Maurice Obstfeld and Alan Taylor calculated the hypothetical profit as implied by the expression for potential inequality in the CIRP equation i.e. the difference in returns on domestic assets, compared to foreign assets in the 1960s and 1970s. -an, which will provide opportunities for arbitration.
But given the financial liberalization and resulting capital mobility, arbitration becomes possible temporarily until balance is restored. Since the abolition of capital controls in the UK and Germany, the potential profit for arbitrage is close to zero. Given the transaction fees that result from fees and other regulations, arbitrage opportunities are temporary or non-existent when these fees exceed the deviation from parity.
The researchers found evidence that significant deviations from CIRP during the start of the 2007 and 2008 global financial crises were driven by concerns about the risks posed by counterparties to European and US banks and financial institutions in the foreign exchange (Forex) market.
The European Central Bank’s efforts to provide US dollar liquidity to the foreign exchange market, as well as the Federal Reserve’s similar efforts, have had a moderate impact on the CIRP deviation between the USD and EURO. Such a scenario proved reminiscent of the CIRP drift of the 1990s, which was caused by competing Japanese banks seeking the foreign exchange market to try to buy USD in an attempt to consolidate their creditworthiness.
