INTEREST RATE PARITY THEORY AND THE RELATIONSHIP BETWEEN THE

FORWARD RATE AND THE FUTURE SPOT RATE

Two important theories show that a relationship exists between the spot market and the forward market.
In particular, the theory of the unbiased forward rate states that the forward rate will equal the expected
future spot rate. Both rates normally move in tandem which is caused by differences in the interest rates
of the two countries of concern. According to the theory of interest rate parity, the forward differential
should be approximately equal to the interest rate differential. If this relationship does not hold, funds are
moved between the two currencies to take advantage of this arbitrage opportunity.

A relationship exists between the spot market and the forward market.
If the forward rate is unbiased, then it should reflect the expected future spot rate at maturity.
The unbiased nature of the forward rate (UFR) is stated as
ft = e-t.
Based on empirical evidence, forward rates tend to be unbiased, though inaccurate, predictors of future
spot rates.

Spot rates and forward rates generally move in the same direction which is caused by differences in
interest rates between two currencies.
The theory of interest rate parity states that the forward rate differs from the spot rate by a sufficient
amount to offset the interest rate differential between two currencies.
1. In equilibrium, the forward differential will be approximately equal to the difference in the interest
rates of two countries.
2. The premium (discount) on the forward rate of the currency with the lower (higher) interest rate will
equal the interest
differential. 1:84
3. Interest rate parity is simplified in an approximated form as follows:
rh – rf = (fl – e0) / e0.
4. For example, if the interest rate on the German mark is 13% and the interest rate on the U.S. dollar is
15%, then the forward mark should be at a premium of approximately 2% (15% – 13%).
5. If this relationship between the forward differential and the interest differential does not hold, there is
an incentive to profit from covered interest arbitrage.
The interest parity relationship results from the arbitrage activities of profit-seeking speculators,
specifically covered interest arbitrage.
1. Covered interest arbitrage takes place when someone can profit from borrowing in one currency and
investing in another with a cover in the forward market.
2. As the amounts of funds being moved between two currencies increases, pressures will develop in the
foreign exchange market and in the money markets.
3. In equilibrium, the returns on a covered basis on the currencies of concern will be the same so that no
more profits can be realized.
4. In such a case, it is said that interest parity exists.
5. This no covered arbitrage condition is stated as follows:
(l + rh)/(l + rf) = fl/eo.
Interest rate parity among currencies holds only if interest rates are
net of costs, such as taxes, exchange controls, transactions costs, etc.
Since financial markets are usually not completely free, deviations
from interest rate parity do occur.
While the parity conditions can be used to forecast exchange rates, a
variety of currently forecasting models are used by analysts trying to
outguess the foreign exchange market.

Successful currency forecasting is most likely when governments refrain entirely from intervening in
the foreign exchange market.
1. Market-based forecasts are derived from market indicators, such as forward rates and interest rates.
a. The current forward rate contains implicit information about exchange rate changes for one year.
b. Interest rate differentials can be used to predict exchange rates beyond one year.
2. Model-based forecasts to currency prediction include fundamental analysis and technical analysis.
a. Fundamental analysis relies on examining key macroeconomic variables and policies which most
likely will affect currency movements. These include inflation rates, growth in national income, and
changes in the money supply.

b. Technical analysis involves use of historical price and volume data to forecast currency values. The
two primary methods of technical forecasting include charting and trend analysis.
Currency forecasters will not be able to consistently earn profits in an efficient foreign exchange market.
In a controlled environment, interest and forward differentials offer little information about exchange rate
changes. In this situation, the black-market rate can be used as an indicator of future changes in the
controlled currency.