T pound m TJIZa

DETERMINATION IN FORWARD MARKET

XCHANGE RATE
equal to the spot rate. The of forward
size
normally not
orward exchange rate is current expectation of future
events
mainly on the
PTemlum_or discount depends future'spot rate
towards appreciation
trend of the
uca
e X p e c t a t i o n s determine the
forward rate that is equal to,
or
close
and thereby determine the
or depreciatioD
 Mechanism 87
Chapter 4 Exchange Rate

to, the future spot rate. Suppose, the dollar is expected to depreciate, then i
ot dollars will start selling forward. the forward rae
These actions will
help depress
oT the dollar. On the contrary, when the dollar is expected to appreciate, he
holders will buy it forward and
the forward rate will
The determination of
improve
exchange rate in a forward márket finds
Interest Rate Parity (IRP). It is, therefore, relevant important
an
place in the theory of
this theory and how it helps in exchange rate determination in a forward explain
to

arbitrageurs behave when the forward rate differential is not market

and how the
the interest rate equal to
differential.
Determinatr ou tx uauge Rate
Interest Rate Parity Theory f o n wald Mauke heorysugt that forward rate
The RP theery statee-that equilibrium is achieved when the differential is
differential is approximate+y equal to the forward rateapproximately equal
other words, forward rate differs from interest rate differential. In to the interest rate
the spot rate by an amount that differential. It thus
represents the interest rate differential. In this process, the
a country with lower interest rate should be at a
currency of helps determine
forward exchange
relation to the currency of a forward premium in rate.
country with higher interest rate."
Equating forward rate differential as per Eq. (4.2) with interest rate differential
as shown in Eq. (4.8), we find that
A
x(n-day F-SVS =1+rA1 + rg) -

1 (4.10)

Determination of Forward Exchange Rate

On the basis of the IRP theory, the forward exchange rate can easily be determined.
One has simply to find out the value of forward rate (F) in
Eq. (4.10). The equation can be re-written as

F A -1s (4.11)
Suppose interest rates in India and the USA are respectively 10 per cent and 7 per
cent. The spot rate is Rs. 40/US $. The 90-day forward rate can'be calculated thus,

F 40/4 {(1.10/1.07) 1}+ 40

or F Rs. 40.28/US $
This means that the higher interest rate in India will push down the forward
value of the rupee from 40 to 40.28 a dollar.

PROBLEM 4.18
Calculate the 3-month forward rate, if spot rate is Rs. 46/US $; interest rate in
India and the USA is respectively 6 per cent and 3 per cent.

Solution
Applying the interest rate parity theorem,
3-month forward rate = 46/360/90[(1.06/1.03) - 1]+ 46

Rs. 46.34/US $.
 International Financial Management
88

Covered Interest Arbitrage

Tf the forward rate differential is not equal to the interest rate differentiol
interest arbitrage will begin and it will
continue till the two ial, covered
differentials
approximately equal.}In other words, a positive interest rate become
Covered interest
arbitrage involves
in a country is offset by annualised forward discount. A negative i lifferential
rate differential by
is offset an forward premium.
annualised aterest
borrowing and
two differentials will be equal. In fact, this is the point where Finally.
lending in two ere #h,the
the forward
markets and also
rate is determined
buying spot and
selling forward
(To explain the process of covered interest arbitrage, supDose
the
the respective spot rate is Rs. 40/US $ and the three-month forward rate is Rs. 40.28
currencies so as US $ involving a forward differential of 2.8 per cent. The interest raf
to attain parity 18 per cent in India and 12 per cent in the USA involving interest r
conditions.
differential of 5.37 per ceDt. Since the two differentials are not eaua
cóvered interest arbitrage will begin. The successive steps shall be as follow
Borrowing in the USA, say, US $ 1,000 at 12 per cent interest G37
Converting the US dollar into the rupee at spot rate to get Rs. 40,000/
Investing Rs. 40,000 in India at 18 per cent interest
Selling the rupee 90-day forward at Rs. 40.28/$
After three months, liquidating the Rs. 40,000 investment which would fetch.
Rs. 41,800
Selling Rs. 41,800 for US dollars at the rate of Rs. 40.28/US $ to
get
. 0
US $ 1,038
Repaying loan in the USA which amounts to
US $ 1,030
Reaping profit: US $ 1,038 1,030 = US $ 8.
So long as inequality continues
interest rate differential, arbitrageursbetwen
the forward rate differential and
the
will profit and the process
on. But with this of
process, the differential will be wiped out for the arbitrage
will go
1. Borrowing in the
USA will raise the interest rate there.
following easons:
2. Investing in India
would increase the invested S.32
interest rate there. funds and thereby lower the
3. Buying rupees at spot rate will increase 31
4. Selling rupees forward will depress the spot rate of the rupee.
forward rate of the
The first actions narrow the interest rate
two rupee.
forward rate differential. differential, while 3 and 4 widen the

PROBLEM 4.19
Find out the amount of
profit out of covered interest
India and the USA is respectively 9 per arbitrage if interest rate in
forward and spot exchange rates are cent and 4.50 per cent and the 6-month
respectively Rs. 45.00$ and Rs.
Solution 45.20 $.
There will /be covered interest
fate differentials are not equal.arbitrage
insofar as the interest rate and forward
To start with, borrowing 1,000 in the
45.000 and investing the rupee ror sixX USA, converting it
fetch Rs. 47.025.rupee
into for
RA. 47.025 forward will fetch $ 1,046. Alter months will
Selling
for 1,022.50, the arbitrageur profits ,045 repaying dollar loan along with interest
- 1,022.50 $ 22.50
 Chapter 4 Exchange Rate Mechanism 89
o y i n g e l l

RD

However, the real life

experience shows that the two differentials-interest rateu B o r B &m U

and forward rateare

equal
interest rate parity theorem only approximately and not precisely. It is because the
assumes no transaction cost, no tax rate. t a xR a

First of all, there is always transaction cost

and buying it forward. The transaction involved in selling a currency spot p
forces forward rate cost, which is manifest in the bid-ask
differential to deviate spread,
cost, which is involved also in borrowing from the expected one. The transaction
nterest and investing, influences the effective
rate and thereby the interest rate differential. Secondly, there is
in the tax rate
on interest income in different countries. Such disparityJQXRa
interest rate differential to
deviate from the expected one. Last but not
a
disparity allows the
there is least, if
o
political
unrest in the
country
investment will be greater and this will
where the funds are invested, the cost of o JI(O
influence the interest rate
differential. Coueoc. VnAep
Uncovered Interest Arbitrage
When one talks about interest arbitrage, it would be worthwhile
to note Uncovered
Athat interest arbitrage may not be only covered, it may also be uncovered.)
However, in an uncovered interest arbitrage, the nterest
does notarbitrage
involve
take advantage arbitrageur
of the forward market and does not
does not forward market
go for any forward
contract for reaping profit. Rather the decision behind transactions as
upon the expectation about the future
profit-making depends interest rate
spot rate, inasmuch as the interest-rerentia ea0s
rate differential between two countries leads to to changes in
changes in future spot future spot rate
rate
If interest-rate differential is equal to changes in the future spot rate,
uncovered
interest parity witl exist. This can be represented in the form of an equation:
(1+RA/(1 +Rg) (Se+1 - SWS =
(4.12)
where Se+1 is the expected future
spot rate, and Ra and Rß are the interest rates
in Country A and Country B.
Solong as equality is not reached, the arbitrageurs will go for uncovered
intefest arbitrage and reap profits Suppose the interest rate on the Indian treasury
bill is 7.0 per cent and that on the UK
treasury bill is 4.0 per cent and so the
interest rate differential is 2.88 per cent. If the investor
4.0 per cent in the füture spot rate of Indian
expects a depreciation of
rupee he/she will invest in the UK
treasury bill because a fixed amount of British pound will fetch greater amount of
Indian rupee at a future date. This will go on till the two
differentials are equal.
This is uncovered interest arbitrage..
PROBLEM 4.20
Interest rate in India and the USA is respectively 6 per cent and 5 per cent. Spot
exchange rate at present is Rs.42.32/US $. Because of higher interest rate,
arbitrageurs are tempted to make investment in rupee market. But by the time
their investment matures, rupee is expected to depreciate to Rs. 4520/US $. Find 43
whether there would be uncovered interest arbitrage. If there will be arbitrage,
what will be the process? 4.20-42:32x{oo 6 8

43 32 Spet
foad
Ra Rat
 International Financial Management
90

Solution
rate differential 1.06/1.05 1 = 0.95 per cent
Interest
-
=

Future spot rate differential = (45.20 42.32)/42.32 = 6.81 per nt

Since these two differentials are not equal, uncovered parity does not exict
a result, there will be uncovered interest arbitrage. .As
Again, under this type of situation, arbitrageurs will take back their invest.
out of rupee market for fear of lower return in terms of US dollar. As a w a t restmer
oflower supply of money there, Indian interest rate will ascend to achieveuncovvered
parity.

Evaluating IRP Theorem

Does the IRP theory hold good in real life or do the arbitrageurs respond to tho
interest rate differential? The study of Marston (1976) shows that the IRP theorem
held good with greater accuracy in the Euro-currency market in view of the complete
freedom firom controls and restrictions. Similar findings emerge from the work of
Giddy and Duffey (1975). However, there are studies that identify deviation from
the theorem (Oficer and Willet, 1970; Aliber, 1973; Frenkel and Levich, 1975).
The reasons for derivations are:
) Since different_rates prevail_on bank deposits, loans, treasury bills, etc.
short-term interest rate cannot be specific and the chosen rate can hardly
bethe definitive pate of the formula,
i) The marginal interest rate applicable to borrowers and
lenders differs from
the average interest rate because interest raté changes with successive
borsOwt amount of borrowing.
(ii) The investment in foreign assets is more
risky than that in domestic
assets. If greater diversification is
applied to foreign investment in order to
lower the risk element, the law of
a
diminishing returns may apply; and as
result, the arbitrageurs may not respond to the
interest rate differential
as
envisaged by the IRP theorem.
( i v ) There are also cases when interest rate
parity is disturbed owing to the
R l
play of
extraordinary forces leading to speculation. It is basically
expectation of future spot rates that influences the forward rate.the market
If market
expectations are strong enough, they can push forward rates beyond the
point which interest rate parity would dictate.

OniautorC O
(vEven the covered interest
parity. The reasons are
arbitrage does hardly help achieve
(a) There is transaction cost involved in
IRP theory does not take into
the
interest rate
arbitrage process which tne
account.
C o n t s to
l n
(by Control on capital account transactions is
Pital found
C o n t s a lo n

hinders smooth in many countries tha

a
arbitrage process.
CoP

Modern Theory
The IRP theorem explains the forward rate differentis1
terms of interest rate
differential between two countries the rolen
and emphasises
of arbitrageurs who help