The interest rate parity theory is a powerful idea with real implications. This theory argues that the difference between the risk free interest rates offered for different kinds of currencies will determine the rate at which these currencies can be converted to each other in a forward transaction. To better understand how it all works, let us start by looking at a forward currency transaction.
A forward contract, or in financial lingo simply a "forward," is a binding agreement to buy or sell something at a future date and a predetermined price. A farmer may, for example, sign an agreement to sell wheat to a flour manufacturer at $2 per pound in six months. Such contracts eliminate the risk for both buyer and seller and allow for easy budgeting. Forwards are particularly common in the foreign exchange market and allow importers, exporters, banks, producers and governments to reduce risks for future transactions. A forward contract may for example mandate that Party A sell $200,000 to Party B on Dec. 1 for a total of 100,000 British Pounds.
The interest rate parity theory states that the relationship between the current exchange rate among two currencies and the forward rate is determined by the difference in the risk free rates offered for investors holding these currencies. More specifically, if investors can obtain a higher risk free interest rate in one currency than they can in the other, the currency offering the higher rate will change hands at a more expensive future price than the current price.
Assume banks in Britain offer 10 percent annual interest on British Pound deposits, while banks in America offer 5 percent. Further assume that right now you can buy 1 Pound for $2. According to the interest rate parity theory, it should be more expensive to buy pounds in a one-year forward contract than it is right now. To see why, imagine what an American bank can do if it is possible to lock in a $2 equals 1 Pound rate in a one-year forward contract. Such a bank can accept $1 million in one-year deposits, promising to return principal plus 5 percent in a year, which makes $1.05 million. It can then buy 500,000 Pounds right now and invest this in a British bank. At the end of the one year, it would have 550,000 pounds and use the forward contract to convert this into $1.1 million. After paying the depositor $1.05 million, the bank is left with $50,000 in easy money.
As long as bank deposits and government bonds in a country are truly risk free, the parity theory holds perfectly in real life. In our example, the one year future rate cannot be equal to the present rate because American banks would make enormous risk free profits by exploiting this abnormality. The rates thus adjust to eliminate the possibility of such easy profits. In an economy where the banks or the government may not be able to honor payment promises due to severe distress, there is no truly risk free rate available and the parity theory may not hold.
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