What is interest rate parity?
It is a question asked by many students in my ACCA financial management class.
In financial management, interest rate parity is one of important theories in risk management. It is about the forward exchange rate quote on two currencies.
Students are easily mixed up interest rate parity with purchasing power parity.
However, they are not only different in formula, but also in real world application.
In this short article, I will share with you on interest rate parity formula, which is provided to you in ACCA financial management exam.
In addition, an example is extracted from ACCA past paper to illustrate how to apply the knowledge in answer exam question.
Formula
Where,
F0 = Forward rate (quoted now)
S0 = Current spot rate
ic = Interest rate in country c
ib = Interest rate in country b
Q: Which area of interest rate parity relevant?
A: Interest rate parity is relevant under risk management.
Q: What is interest rate parity?
A: Interest rate parity is a theory in which the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate.
Interest rate parity plays an essential role in foreign exchange markets, connecting interest rates, spot exchange rates and foreign exchange rates.
Q: What does interest rate parity indicate?
A: IRP formula indicates that a country (e.g. Country C) quoted forward rate will be at premium if its interest rate is lower than another country (e.g. Country B).
In other words, fewer amount of Country C currency can exchange the same amount of Country B currency under the forward rate arrangement than spot rate.
Q: What does interest rate parity apply?
A: IRP is generally applied in forward rate quotation in which it is not a forecasting model in guiding the exchange rate movement in future.
Illustration
It is quite often to see ACCA Financial Management exam question asking about Interest Rate Parity.
Here is an example extracted from 2016 Specimen paper to explain how to apply the formula.
Acknowledgement: The question above is extracted from ACCA past paper which is only for our explanation here.
The question asks calculation of six-month forward exchange rate.
In our explanation above, Interest Rate Parity is used for forward exchange rate quote by financial institutions while Purchasing Power Parity is used for forecasting future (spot) exchange rate.
So, you need to read the Interest Rate Parity formula in the formulae sheet for this question.
Next, you have to decide how to put 6-month interest rate figures in the formula.
Remember the rule:
If the exchange rate quoted is -
Foreign Currency / Home Currency
then, followed the same in your Interest Rate Parity calculation.
Here, spot exchange rate quote is 20.00 Dinar per Dollar while dollar is home currency. By finding the 6-month forward exchange rate quote, the calculation is -
20.00 x (1+3.5%) / (1+1.5%)
where
20.00 Dinar per 1 Dollar
3.5% is 6-month home country interest rate;
1.5% is 6-month foreign country interest rate.
So, the 6-month forward quote is 20.39 Dinar per Dollar.
Option A is the correct answer.
Conclusion
Interest Rate Parity is a commonly used formula in foreign exchange market given you need to have a forward hedge.
Once you need to have a forward quote, this formula applies.
On the other hand, Interest Rate Parity is not for forecasting future exchange rate.
In ACCA Financial Management exam, students are often confused between Interest Rate Parity and Purchasing Power Parity.
In addition, they are confused how to apply the formula even all information have been provided.
If you would like to try more questions on this area, just feel free to visit our Practice Questions or Mock Exam.
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