For the layman or even for those who are seasoned currency traders, it’s difficult to grasp all the factors or dynamics involved in the fluctuation of currency exchange rates. There are numerous factors to consider such as exports, supply of USD, NRI remittances, trade balance, activities of foreign institutional investors (FIIs), and of course, interest rates.
However, among all these factors, interest rate is the one that has the most impact on the valuation of the currency, especially in relation to a foreign currency. As you may be aware, in currency trading or forex trading, a currency’s value is measured in relation to the other currency.
For example, in the Indian currency market, traders can trade in foreign currency pairs such as INR/USD, INR/GBP, INR/YEN and INR/EURO. If an Indian citizen wants to trade in foreign currency pairs where there is more volatility, such as EUR/USD, GBP/USD and YEN/USD, they can take the currency futures or currency options route.
This brief guide on interest rate parity will give you a better understanding of the currency market and how interest rates and currency rates are bound together.
What is interest rate parity?
Interest rate parity is an economic theory which states that the difference between the interest rates of two countries is equal to the difference between the forward rate and the spot rate of both the countries.
Spot rate – Also called forex spot rate, it is the current exchange rate or current price of a currency pair in the market. When you are trading in forex with a broker such as Angel One, you will mostly trade in the spot rate.
How interest parity helps in currency trading
Interest rate parity doesn’t always exist because it only occurs when interest rates are the same for foreign and domestic assets. It is assumed that, if there is any difference in interest rates, it is due to expected appreciation or depreciation in the foreign or domestic currencies.
For example, if the domestic interest is 8% and foreign interest rate is 5%, this means that the market expects the foreign currency to appreciate by 3% or conversely investors expect the domestic currency to depreciate by 3%. Understanding interest rate parity meaning is important if you are trading in currencies.
How to calculate interest parity?
Interest rate parity is used to calculate the forward exchange rate.
The current exchange rate of a currency pair (e.g. INR/USD) is called the spot exchange rate. The forward exchange rate is a projection of the two currencies in a predetermined date in the future. A currency is considered to be trading at a forward premium if the difference between the forward rate and spot rate (forward rate – spot rate) is positive. If the difference is negative, then the currency is trading at a forward discount. In the above formula, country A is the foreign currency and country B is the domestic currency.
Why is interest rate parity important?
For currency traders and other market participants, understanding the interest rate parity meaning is important because it helps them analyse the direction of currency rates. Interest parity is based on the premise that money will flow to the country with the higher interest rate and cause the currency to appreciate in value.
If you are a currency trader, learning about interest rate parity is one of the fundamental steps to evolving a trading strategy. However, to understand this concept fully, you must first learn basic concepts such as hedging, forward exchange rates, spot exchange rates, interest rates, etc.
Once you are armed with this knowledge, you can use changes and differences in interest rates of two countries or currency pairs to your advantage.
Though interest parity is an effective tool for traders, the concept itself has some limitations since it is based on the assumption that capital can move freely across countries. It may not always be true because there are factors such as taxation, costs, and political and liquidity risks at play.
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