International Finance
Exchange rates and parity
Covered interest parity ties the forward rate to the two interest rates, and purchasing power parity anchors the long-run spot rate to inflation.
Definition
An exchange rate is a price of one currency in another, and it must be read with its units attached. Covered interest parity then sets the forward rate so that borrowing in one currency and lending in the other cannot produce a riskless gain.
Purchasing power parity is the longer-run counterpart: a currency whose country has higher inflation is expected to depreciate, so that a basket of goods costs the same across countries over time.
Intuition
Higher interest rates attract capital, and that demand is exactly offset by a weaker forward rate. The market never hands out a free lunch for simply holding the higher-yielding currency.
When to use it
- Pricing a currency hedge or comparing a local and foreign borrowing rate.
- Judging whether a quoted forward rate is expensive relative to parity.
- Forming a long-run view on an exchange rate using inflation differentials.
When not to use it
- As a short-term trading signal; parity says nothing about next week.
- When capital controls or credit limits prevent arbitrage from working.
Formula
Covered interest parity
F = S × (1 + i_domestic) ÷ (1 + i_foreign)
The forward rate that removes the arbitrage between the two money markets.
- S
- Spot rate, domestic per foreign
- i_domestic
- Domestic interest rate
- i_foreign
- Foreign interest rate
Formula
Relative purchasing power parity
Expected spot ≈ S × (1 + Inflation differential)
The currency with higher inflation is expected to depreciate.
Worked example
A parity forward rate
The spot rate is 118 taka per dollar, the taka rate is 9%, and the dollar rate is 4%.
- 1
Interest ratio
1.09 ÷ 1.04 = 1.048077.
- 2
Forward rate
118 × 1.048077 = 123.67 taka per dollar.
- 3
Check with a round trip
৳1,00,000 grows to ৳1,09,000 either directly or through the dollar market and the forward.
The taka is at a forward discount because it pays the higher interest rate, and the discount exactly offsets the extra interest.
Common mistakes
- Writing the exchange rate upside down and reversing the conclusion.
- Expecting purchasing power parity to hold every year instead of on average.
- Ignoring the bid-ask spread when comparing a quoted rate with parity.
How it connects
requires
Learn the source first; the target assumes it.
- Time value of money: Parity is a present-value relationship between two money markets.
relates to
Useful to study together, in either order.
- Compounding and discounting: The interest differential compounds into the forward premium.