After the U.S. abandoned the gold standard in 1973 when all the currencies were pegged to the dollar and thereby had a fixed value in terms of gold, the foreign exchange rates began to be determined based on market conditions according to the law of supply and demand, and also according to other principal laws, among which three basic ones can be distinguished:
Each of these laws affects a foreign exchange rate simultaneously, but unevenly, and depends on market conditions. However, the Interest Rate Parity law is the first and the main law that has the greatest impact on exchange rates.
Money has a positive time advantage. Differently put, any economic entity that has money prefers to spend it here and now. That is what the fee that the borrower pays the lender is based on. At the same time, money is the universal equivalent of value, and the borrowing interest rate measures the values of money. Pursuing a monetary policy, a central bank sets the minimum value of money (interest rate) for commercial banks, it is usually the cost of borrowing for a short-term period, for example, one day or two weeks.
As you already know, the value of any Forex currency is determined in comparison to the US dollar, that is why the federal funds rate is an important benchmark in financial markets.
When we talk about currency quotation, we mean a currency pair that includes two currencies. It is usually the US dollar and some other currency, for example, EUR/USD, GBP/USD, AUD/USD or USD/JPY, USD/CAD, USD/CNY.
There are more seldom the quotations like EUR/JPY, GBP/JPY, EUR/GBP, AUD/JPY, and so on, which are called cross currency rates but they are special cases for which the same principles are applied as for currency pairs formed with the US dollar, with the exception that, in fact, the volume of operations in the cross-currency rates may be small, and the central bank will calculate the quotes of these currency pairs in terms of the dollar, which is artificial.
If you try to express the currency pairs in terms of central banks, it will look like this: European Central Bank/Federal Reserve system; Bank of England/ Federal Reserve system or Federal Reserve system/ Bank of Japan; Federal Reserve system/Bank of Canada; Federal Reserve system/People’s Bank of China. In general, the higher is the interest rate (annual percentage rate apr), set by the bank, the more expensive is the currency issued by this bank, the greater is the difference between the interest rates of the central banks, the higher or the lower the exchange rate.
Let try to see how it works. Suppose that a nominal interest rate for an instrument with a particular execution term in country X is higher than the nominal interest rate for the same instrument with the same execution term and a similar risk level in country Y.
Besides, we also assume that the spot rate (cash rate) and the forward rate (future rate) are currently equal. If so, investors who have spare funds in country Y will invest their local currency “y” in the high-yielding currency “x”, and invest the currency in country X at high-interest rates, set in country X.
Based on the Interest Rate Parity irp formula, we can calculate the relationship between the spot rate and interest rates differential (fig. 2).
Let us analyze the situation using an ideal example of uncovered interest rate parity using the government Treasury bills and bonds of the United States and Great Britain, with a maturity term of 1 year, assuming that the cash and futures rates of GBP / USD are equal in this situation. As of May 22, annual 1-year UK bonds have a yield of 0.729%, and 1-year US Treasury bonds have a yield of 2.362%.
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The US Treasury yield is 1.633% higher than the UK bond yield. Both bonds have the same term of maturity and the same credit rating, i.e. the same minimal risk level. These are so-called risk-free assets, having the highest degree of credibility. Let us see how carry trades work.
It is obvious that, having an opportunity to receive funding in pounds at lower interest rates, an international investor will exchange the pounds for the dollars and place them in the USA at a higher interest rate. The yield of this operation of one million GBP will be 1.633%. Based on the supply and demand law, when converting the pounds into the US dollars, the investor will reduce the pound rate and set the higher price for the dollar.
That is how it looks in theory. This example describes an ideal situation that can’t be implemented in practice because of the difference between the spot rate and the forward rate. The matter is that when receiving funding in pounds and buying the US dollars for the GBP, the investor acquires an undesirable short position in pounds, that is, it has an uninsurable currency risk, which can lead to significant losses, exceeding the investor's profit.
In order to avoid the risk of currency fluctuations, covered interest rate parity should be applied. It means that the investor must acquire the British pounds in the forward or futures market with a delivery term of one year, that is, make a reverse conversion, thus insuring the short position.
In this case, the investor will buy the pound in the futures market, increase its value in the future, and sell the dollar lowering its rate on the delivery date. It is a very important condition allowing one to identify the direction of the money flows. Carry trades involve a kind of influence on the money flows. If the currency forward rate is higher than its spot rate, the money flow is directed to the advantage of the quote currency.
If the forward rate is lower than the spot rate, the money is invested in the base currency. The difference between the spot rate and the forward rate is called the “forward point”. This difference doesn’t allow investors to use the risk-free Forex arbitrage opportunities. Continue reading with Litefinance.com...
