Interest Rate Parity, Forward Foreign Exchange Market And Forward Exchange Rates

Thoughts of interest rate panty appeared long tine ago, but it was not untill 1890 that the theory of forward foreign exchange came into being. On 192~ Keynes established the classic theory of interest rate parity first time in history. He generalized the relationship between forward exchange rate and interest rate, and pointed out that forward exchange rates were decided by differences of interest rate. Keynes theory of interest rate parity was static. And on his basis Einsig developed dynamic theory of interest rate parity~ setting up the Theory of the Reciprocity in the dynamic theory of interest rate parity. Main concerns of The Theory of the Reciprocity were that on one hand forward exchange rates were determined by interest rate parity through arbitrage, on the other hand interest rate parity was affected by arbitrage. It includes forms and causes of disparity of CIP, and effects of forward exchange rate on interest rate. It also includes the relationship between forward exchange rate decided by interest rate parity and spot exchange rate decided by purchase power parity, between spot and forward exchange rate, between long term and short term forward exchange rate, and cause of disparity between long term and short term forward exchange rate. The modern theory of interest rate parity is discussed in following aspects. l.Covered interest rate parity (CIP). The essential of CJP is that the return of assets in different country is same. If it different, then arbitrage will push it back to balance. Formula of cip is (l+it*)1~+&(l+it)it can be F,-S, i,1t* changed into ~ + ,, * t for time, i~ for domestic nominal interest rate, i~7 for foreign country nominal interest rate, F~ for forward exchange rate , St for spot exchange rate. 2. Relationship between CIP and foreign exchange swap. Swap exchange rate can be obtained through CIP. Its formula is F13,s,(l:if 1)S(~L?*) 1+1, 3. ClPwith askid spread. 4. ClPwith asymmetric of tax. 5. Test of CIP. Early study in 1960 and 1970 affirmed that disparity of CIP was frequent, sometimes even continuous. Possible reasons were cost of transaction, capital control and political risk. However, when comparing forward exchange rate decided by CIP with bidsk spread in Europe money market and by general CJP between two domestic financial centers (New York and London) with market forward exchange rate, we could see that CIP with bidsk spread keep in Europe money market. 6. International Fisher Effect. Under PCM assumption, another result of arbitrage is international Fi~~her Effect. That real interest rate is all the same around the word is the assumption under international Fisher Effect. This assumption often does not keep, and thus international Fisher Effect~usually does not keep balance. A basic problem of IRP is that it ignores the partner of arbitrageur in forward dealing. ffodern theory of forward exchange rate corrects this problem by considering arbitrageur, foreign exchange dealer, hedger and speculator at the same time. These theories provide function about forward foreign exchange selling (or buying) and forward exchange rate for all parts participating in forward market. 1. Function for arbitrageur Ka~ = C ?[F3, ?90) F3, ?9O) ] , C >0 2. Function for speculator...