Interest Rate Parity

Topics: Foreign exchange market, United States dollar, Pound sterling Pages: 2 (399 words) Published: September 6, 2012
Interest rate parity is a situation where an investor is at a no profit- no loss situation i.e he is at a no-arbitrage condition, when investing in a particular currency. An investors will be indifferent to interest rates available on bank deposits in two countries. Two assumptions in the midst of interest rate parity are mobility of capital and perfect substitutability of domestic and foreign assets. The IRP condition implies that the expected return on domestic assets will equal the expected return on foreign currency assets, due to an equilibrium in the foreign exchange market resulting from changes in the exchange rate between two countries. Now answering your specific question, that the Current Exchange Rate between Japan and U.K. is One British Pound Equals 150 Japanese Yen. The one year Annual Interest Rate in Japan is 1%, while the Annual Interest Rate in U.K. is 4%. Given this, what would you expect the Forward Rate to be between Japanese Yen and British Pounds, one year from now? Current Exchange rate = 1GBP = 150 Yen

You can alternatively, also write it as 150yen/GBP
Now, we will apply the following formula = 150yen/GBP *(1+interest rate of Japan)/( (1+interest rate of UK) = 150(1+0.01)/(1+0.04) = 145.67308
So one year from now the exchange rate will be 1GBP = 145.67308 Yen answer
Lets verify the above situation:
Suppose you are have GBP 1000 to invest.
Scenerio 1 – Investing in UK
Amount to be received after 1 year = 1000*1.04 = GBP 1040
Scenerio 2 – Investing in Japan
First lets convert the GBP to Yen = 1000GBP*15oYen = 150000Yen Amount received after 1 year = 150000*1.01 = 151500 yen
Lets convert the YEN received to GBP, with the exchange rate calculated above = 151500/145.67308 = GBP 1040 Interest rate parity rests on certain assumptions, the first being that capital is mobile - investors can readily exchange foreign assets for domestic assets and vice versa. The second assumption is that assets have perfect substitutability, following...
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