Due to interconnected markets across the world, economic fluctuations in one region affect investors across the world. Factors like interest rate, inflation, international commodity prices, etc., play as big a role in influencing returns as do domestic factors.
Interest rate parity is one such parameter. It assumes that investors in different countries would be indifferent to the interest rate differential between bank deposits in their countries owing to exchange rate dynamics. Let us see how interest rate parity affects those who invest in foreign markets.
Importance of interest rate
People who invest in foreign markets convert their domestic currency to foreign currency, invest in the foreign market, earn returns, convert it back to the domestic currency, and measure the returns as denominated in domestic currency.
In this whole cycle, interest rate between different markets and nations plays a vital role. Interest rate parity assumes significance here because it causes an equilibrium to exist between interest rate differentials and exchange rate differentials between the two countries in question.
Domestic investors in foreign market
Consider a scenario where you have R1 lakh to invest in the US market and the dollar-rupee exchange rate is R50 for 1 dollar. First, you would convert R1,00,000 into $2,000 and invest this money in the US market. After one year, you liquidate your investment and receive $2,100. The nominal return in absolute dollar terms is 5% in a year. Now, you have to convert the US dollar into rupees. Suppose the exchange rate now is R52 for $1. Hence, you get 2,100 * 52 = R1,09,200. Ignoring the transaction charges, your net return for the year is 9.2%. Suppose you can get similar returns from investments in the Indian market itself, would you have enough reason to go for the foreign investment?
Determining forward exchange rate
The forward exchange rate is determined by what is called the interest rate parity relationship. Consider the following scenario. Current (or spot) exchange rate is R50 per dollar, while forward exchange rate (three months) is R50.30 per dollar.
Suppose you take a loan of $2,000 from a US bank at an annual rate of 4%. At the end of three months, you have to return $2,020 (2,000 * (1 + 4% / 4)). Now, you convert this $2,000 into R1,00,000 at the spot exchange rate and deposit the sum in Indian banks at an annual rate of 8%. At the end of three months, you receive R1,02,000 (1,00,000 * (1 + 8% / 4)). Since you have to pay $2,020 to the US bank, you convert R1,02,000 into dollars at the rate of R50.30 per dollar and receive $2,027.83. Out of this, you return $2,020 to repay your dollar loan. The remaining $7.83 is your profit. This is risk-free profit because all this data is available to you at the time of
In such scenarios, interest rate parity principle works to erase this type of risk-free profit.
Hence, in the above example, the exchange rate between the US and India would move in such a way that the returns achieved would not give more than $2,020 at the end of three months. The forward exchange rate would then be R50.50 per dollar (i.e., 1,02,000 / 2,020).
Thus, knowing which way the forward and spot exchange rates are moving with respect to major currencies can give an investor an idea as to whether he is earning optimum returns or not on his domestic investments, although exchange rate movements are just one of the several ways to determine that.
In the real world, exchange rates and interest rate parity do not work as linearly as outlined above due to political compulsions, monetary policy interventions, and interdependence and volatility in different markets. Other factors, such as property market, consumer spending, general inflation, economic growth rate, and domestic compulsion, play their part in deciding the interest rates.
The writer is CEO, BankBazaar.com