Tuesday, April 20, 2010

Interest Rate Parity Condition

The Interest Rate Parity condition that is in the CFA and discussed in our Global Managerial Perspective (GMP) class talks about.

Long story short, it says: Regardless of what financial mechanisms are used, two countries which are considered to be default free should generate the same real returns for the same period.

For example:
  • You hold $1 USD
  • The FX rate is 100 yen per USD
  • The Japanse Bonds are yielding 5%

A year from now:

  • FX rate is expected to be 103 yen per USD

What does IRP imply the interest rate on the US bond should be?

This can be graphically represented by:

The blue path shows how $1 USD is convered to Japanese Yen, held in a bond, and converted back at the new exchange rate back into USD. IRP states that whether this route is taken or if the USD is just held in a US bond (Red path) should make no difference. It should result in the same amount otherwise there is an arbitrage opportunity.

This is the solution. Note that the US bond rate is reverse engineered from the information given such that the end result produced in the red path is the same as the blue path.
You also note that there is a relationship which is defined by IRP. That is:
Japanese Bond Rate = US Bond Rate + [Appreciation / Depreciation of Foreign Exchange Rate]
Notice that this framework can have a blank in any one cell which can be derived using algebra if the other cells are filled in.

No comments: