May 23

Interest rate parity - 9 min. screencast

by David Harper, CFA, FRM, CIPM

Here is an illustration of interest rate parity (IRP). For FRM candidates, please note:

This is yet another variation on the cost of carry model. Start with Forward = (Spot)*EXP(rate*T). Then note what Hull says: "a foreign currency can be regarded as an investment asset paying a known yield. The yield is the risk free rate of interest in the foreign currency." So, the formula becomes Forward = (Spot)*EXP[(rate-foreign rate)*T)]. The foreign rate is subtracted, in the cost of carry model, as if it were a dividend (or convenience yield, for that matter).
The assigned Saunders text shows IRP under annual compounding; at the end, I show the difference. Conceptually, the formulas are the same.