INTEREST RATE PARITY

Covered and Uncovered Interest Rate Parity

Covered and Uncovered Interest Rate Parity

Introduction

Fluctuations in interest rates and changes in the exchange rates create significant impact on the business decision and financial management aspects of a company, if it is involved in transactions with foreign countries. This paper explores the impact of interest rate parity for the countries of US and UK. This discussion assumes the exchange rate difference between the six months time, when it is invested abroad to repatriation of funds. Data has been selected for the countries of US and UK from the data of 29th July 2010 onwards. Following section presents an analysis of covered interest rate parity.

Covered Interest Rate Parity (CIRP) - Analysis

The interest rate is a key factor in determining the exchange rates with respect to interest rate parity. Countries steer their interest rates in the short term; the underlying question is to explore the impact of changes in the interest rate on the exchange rate of country along with possible gain by witching the transaction in another country currency (Shamah, 2003, 71). The parity of interest rates covered in exchange that links the interest rates, forward exchange rate, and current exchange rate of the two currencies (Mathieson, 2000, 94). Arbitragers aim at gaining the benefit of changes in the differences in exchange rates and differences in interest rates (Horcher, 2011, 123).

Graph presented below shows the equivalent three month interest rate for US and UK country. Red line presents the change in the 3m-interest rate of US; whereas, blue line shows the 3m-interest rate change in the UK. Data has been obtained for 3-m interbank offering rate that help in determining the covered interest rate parity factor. Chart enclosed in the appendix shows the interest rate figures along with calculation of exchange rate to determine the CIRP. Graph present below shows that interest rate has been in continuum for the three months following 29th July 2011. This shows that interest rate of both countries are consistent with no marginal change in the interest rate values with respect to exchange rate that help in determining the possibility of arbitrage from exchange rate differences in the two countries.

The differences in interest rate have been calculated by dividing the 3-month interest rate with 100 and adding one to the value. This provides an annual factorial movement in the interest rate that present an accurate estimation of the differences in the interest rates. Following formula has been used to calculate the difference in interest rates.

iUk - iUS = (1+ 3m iUk / 100) - (1+ 3m iUS / 100)

Using the above stated formula, difference between the interest rate of the two countries has been shown in the below presented graph, which shows the change has been consistent after one month from the selected date of analysis.

The percentage change in the exchange rate over the following three months has been displayed in the graph presented below. Graph shows that continuous variation occur in the exchange ...