185 spring 2004

Interest Rate Parity

We begin our discussion of exchange rates by introducing the notion of interest rate parity (IRP). The idea is to establish a link between bond markets in two countries.

If the interest rate is 5% in both countries and the exchange rate stays constant, there are no arbitrage profits.

If the interest rate in Europe changes to 3%, an arbitrage profit opportunity opens up. If the current exchange rate makes the euro worth only 1.2164 dollars, then the arbitrage profit opportunity goes away.

Here is how you secure those arbitrage profits either now or next year.

We have an equation the expresses the math involved. Here is now you calculate the exchange rate that shuts off the arbitrage profits.