Friday, December 03, 2004

Interest Rate Parity Brought Home

One of the final topics studied in most undergraduate finance courses is something called "interest rate parity." The concept is a simple one. It states that investors should earn an equal rate of interest on equal risk investments, regardless of the currency involved. In mathematical form, this means:

Forward Rate/Spot Rate = (1+kh)/(1+kf)

Where the forward rate and the spot rate are in terms of home currency per foreign currency unit, kh is the interest rate at home and kf is the interest rate in the foreign land.

Recently, exchange rates have been changing, with the dollar becoming weaker (less foreign currency is provided per dollar exchanged). To counterbalance this change, the above equation implies that interest rates at home will have to increase, since the change in currency rate is accelerating (the difference between the spot rate and the forward rate is becoming greater).

A related concept is purchase price parity. The classic example of this is the Big Mac. We assume that if a Big Mac costs $10 in the USA, then the same Big Mac must cost the equivalent of $10 in any foreign country into which it is sold. This is summarized by the equation:

Spot Rate = Price at home / Price in Foreign Land

Where the price at home would be in the home currency and the price in the foreign land would be in the foreign currency. Since the cost of a Big Mac in Europe is pretty stable, the fall of the dollar in terms of Euros purchased per Dollar implies the cost of the Big Mac will soon increase by a like amount in the United States.


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