Interest Rate Parity (IRP): Meaning and How Price of Currency Future is Determined

In the previous chapter, we went deep into the exciting world of Forward and Futures Contracts, where we discussed what they are, why they are useful, and what risks they may have. These are essential tools that are fundamental in market volatility hedging, speculative activities engagement, and price stability for a broad line of either commodities or financial assets. In this chapter, we’ll go through the ideas of Interest Rate Parity (IRP) and determination of currency futures prices. 

Interest Rate Parity constitutes the cornerstone of currency markets in that it is the interconnection between the rate of interest and the currencies. It provides a theoretical framework for explaining how the disparity in the interest rates between two countries will affect the exchange rate and further price fluctuations of the countries’ currencies.

Without further ado, let’s get started with getting a better understanding of Interest Rate Parity!

Interest Rate Parity (IRP)

The Interest Rate Parity concept serves as a basic principle for international finance, recognising the correlation between exchange rates and interest rates across the world. Essentially, IRP argues that given interest rates of the two countries are different, it implies that the expected change in exchange rates between their currencies is different as well. This rule implies that the market will not allow arbitrage opportunities to exist, as it ensures the financial market is balanced and no one can profit from currency and interest rate differences by playing on them.

Picture yourself as a financial flaneur seeking to amass treasure troves of risk-free profits without making basic pillars of life while popping the balloons. First, you have two countries, Atlantis and El Dorado, wherein in the former country, you can obtain a 5% interest rate, and in the latter country, you can acquire a 7% interest rate. You'd have a consequent reaction that you'd like to lend money in Atlantis (e.g., a higher interest rate) and invest in El Dorado (where a higher interest rate works to your advantage). 

What IRP does is that it ensures that it speaks on behalf of the market and keeps balance in the financial world. This puts pressure on the currency value of El Dorado to lose by around 2% against the currency of Atlantis within the given investment period and turns the profit you projected from this interest rate gap into a loss.

Interest Rate Parity can be divided into two types: Covered and Uncovered. Let’s look at these types in more detail now! 

But before that, in order to make IRP more relatable, imagine shopping for the same product in two different online stores. One store offers a lower price but adds a shipping fee, while the other offers a higher price with free shipping. Initially, the options might seem different in value.

 However, after accounting for all costs, the total expenditure might be the same. IRP functions similarly by balancing the "costs" (interest rates and exchange rates) to ensure that no matter where you invest, the real return, after considering currency fluctuations, remains consistent.

Now that we have the basics of Interest Rate Parity in control let’s take a step ahead and talk about covered and uncovered IRPs. 

Covered Interest Rate Parity (CIRP)

CIRP is an extension of the Interest Rate Parity (IRP), a financial principle that includes the use of a forward contract to cover the exchange rate risk. According to the covered interest rate parity theory (CIRP), the difference between the interest rates of two countries is equal to the difference between the spot exchange rate and the forward one. Such a connection makes it possible to eliminate arbitrage opportunities, which derive from the differences in the interest rates and exchange rates when the prices of the currencies are adjusted for all the risks they carry.

Let's contemplate the case of a multinational company's corporate treasurer to improve how cash is managed across multiple currencies. The company holds a large sum of euros, which they need to exchange for US dollars before incurring their expenditures in the USA. If the treasurer is looking at charging high-interest rates in the USA, he/she might as well convert euros into dollars to enjoy the prevailing high US interest rates. 

Although such a strategy would have effectively overcome the problem of the euro being overvalued against the dollar, the treasurer uses a forward contract to fix the future exchange rate. With the assistance of CIRP, the company makes the necessary adjustments to its return and thus ensures that its risk management policy is in line with its overall risk management plan.

The CIRP can be defined as an entity that facilitates international investment and financial decisions on the stock markets through its presence. This helps mitigate uncertainty and allows investors and financial managers to manage and appreciate the real exchange risk, which ensures that capital flows are driven by the differences in real interest rates rather than nominal ones. Partially eating away the factor of risk-free profit with the inexistence of covered arbitrage, CIRP enhances the efficacy and stability of the global financial system.

Uncovered Interest Rate Parity (UIRP)

Uncovered interest rate parity (UIRP) puts the topic of interest rates in light of exchange rates a step further by doing away with the insurance provided by hedging strategies such as forward contracts. Different from CIRP, the UIRP is based on the hypothesis that the spot effect will adjust the market to level the interest rate differential between two countries instead of the actual use of financial derivatives in order to protect the country against the exchange risk.

The UIRP sheds light on the fact that a person who is planning to exploit the interest rate differential between two countries will be able to tell that the currency in the country with the higher interest rate will depreciate against the currency in the country with the lower rate of interest. This is expected to be just like the interest rate differential that will occur in the long term and, therefore, eliminate any gain from the currency arbitrage since the investment period ends.

Suppose an investor from Country X faces the home interest rate which is at 2%, and considering investing in Country Y with a 6% rate. The attraction of higher returns is already clear, but UIRP supports its position that County Y's currency will depreciate against County X's currency by approximately 4% over the investment period. With a possible depreciation of currency predicted, the investor’s nominal return for the investment in Country Y would be equal to the amount that the investor would lose from the depreciation when they convert the investment from Country Y back to their currency from Country X.

The question of how UIRP will survive if there are mistakes in forecasting future exchange rate movements is one of the problems connected with it. The fluctuations of the Forex market are influenced by various factors such as political events, economic signals as well as general market sentiment; thus, accurate forecasting becomes a difficult task. Nevertheless, the UIRP provides a theory that explains and predicts currency valuations as they take into consideration the divergence of interest rates.

Here’s a quick table that summarises the key points of difference between CIRPs and UIRPs. 

Feature	Covered Interest Rate Parity (CIRP)	Uncovered Interest Rate Parity (UIRP)
Definition	The relationship between interest rates and forward exchange rates eliminates arbitrage opportunities.	The expected relationship between interest rates and future spot exchange rates, without hedging.
Hedging	Involves hedging against exchange rate risk using forward contracts.	Does not involve hedging; it's based on expectations of future exchange rates.
Exchange Rate Risk	Eliminated through the use of forward contracts.	Remains, as it depends on the accuracy of future exchange rate expectations.
Investor Action	Investors can lock in exchange rates for risk-free returns, equalising the interest differential.	Investors rely on expected changes in exchange rates to seek returns, accepting the risk of currency fluctuations.
Use in Financial Markets	Commonly used by corporations and investors for hedging against currency risk in international transactions.	Utilised by investors and economists to forecast currency movements and assess investment risk.
Predictability	Provides a clear mechanism for calculating returns by using forward rates.	Involves speculation on future exchange rates, introducing uncertainty.
Focus	On ensuring no arbitrage opportunities between different currencies by locking in prices.	On the expectation that currency values will adjust to reflect interest rate differentials without guarantee.

Now, let’s try to understand how the prices of currency futures are determined. 

Determination of Currency Futures Prices 

Here are some core elements that go into determining currency futures prices: 

• Interest Rate Differentials

Among the main pricing principles of the currency futures market, the differential of interest rates between two currencies is one of the principal concepts. These variations reveal the gap between the interest rates that are being charged by the banks of the countries issuing these currencies. Essentially, suppose one currency offers a higher interest rate than another. In that case, the higher-yielding currency tends to depreciate in the futures market to offset the advantage of the higher interest yield.

• Cost of Carry Model

The Cost of Carry Model is an integral model for a basis of pricing for currency futures. It may be taken to signify the costs incurred in storing value in a currency. This can be in the form of interest payments or receipts. This model prescribes that in a perfect market, the futures price would equal the spot price plus the cost of carrying money to the contract's expiry date paired with dividends (dividend income, in particular, is related to outflows of interest rates). This is the interest rate that is paid for currency when it is borrowed, adding to the total interest rate a central bank pays or receives. It is also referred to as the state of no depreciation between one currency and another.

• Time to Maturity

Both maturity and risk aversion have key roles in the pricing of currency futures. Once the expiry day of the futures contract is getting closer, the price of it at that moment on the market becomes similar to the spot price of the currency. This merger takes place due to the vanishing period and the reduced compatibility situations that underlying spot price and futures price can be far from the normal level. The longer a forward rate expires, the more the uncertainty is, hence the greater the possibility of divergence between the futures rates and the current rate.

• Arbitrage and Market Efficiency

In situations where the contract term is longer than the expected interest rate differentials, a price discrepancy between the futures contract and the future spot price occurs, giving rise to arbitrage opportunities. Skilled traders often capitalise on this arbitrage to make risk-free profits, concurrently purchasing cheap assets on the one hand and selling the same higher on the other side. Thus, the yield curve for arbitrage adds greatly to the market efficiency because futures prices are matched to expected future spot prices based on this process. 

This efficient market hypothesis suggests that in actual time, no information that is operated upon by everyone or any expectation regarding future movements is fully reflected by prices. Above all, arbitrage is strategically important because it leads to future currency prices that fairly reflect investors’ outlook, promoting a certain market's efficiency.

In navigating the complexities of Interest Rate Parity (IRP) and determining currency futures prices, we've journeyed through the core principles that shape the global financial markets. In the next chapter, we’ll take the next step in this discussion and explore the core ideas behind foreign exchange rates!