UNIT 5: INTEREST RATE PARITY

1. Answer the following questions about discounting and interest rates.

(a) You win $10,000,000 in the lottery. The organizers are offering you to exchange the prize
for an annual income of $333,333.33 each and every year for 30 years. If the interest rate is 8%
p.a., should you accept this offer?

R= The present value of 30 annual payments of $333,333.33 when discounted at 8% is

$3,752,594.41. This value can be found in Excel by using the function NPV(rate, cashflows),
where rate = 8% and cashflows refers to a sequence of 30 cells that all have the value
$333,333.33.

(b) Suppose that there is a 0.5% probability that the government of Argentina will nationalize
its banking system and freeze all foreign de- posits indefinitely during the next year. If the dollar
deposit interest rate in the United States is 5%, what dollar interest would Argentine banks have
to offer in order to attract deposits from foreign investors?

R= If the freezing of deposits is an idiosyncratic event, then the expected value of the return
should equal the risk free return of 5%. If investors effectively get a return of zero with 0.5%
probability, they must get a return of (1 + X%) with 99.5% probability, such that [(1 + X%) 
0.995] + [0  0.005] = 1.05 When we solve this equation for X%, we find X% = 5.53%. Of course,
the more that you eventually recover in the event of a freeze of deposits, the smaller the interest
rate can be.

(c) If the market price of a 20-year pure discount bond with a face value of $1,000 is $214.55,
what is the spot interest rate for the 20-year maturity expressed in percentage per annum?

R= We know that the relationship between the price of a pure discount bond and the spot
interest rate at the 20-year maturity satisfies P(t)= ($1,000)/(1+i(t,20)) ¨20. Substituting the price
of $214.55 and solving for i(t,20), we find i(t,20) = ($1.000)/ ($214.55)¨(1/20)- 1 = 0.08.
Therefore, the spot interest rate for the 20-year maturity expressed in percentage per annum is
8%.

(d) Consider a 2-year euro-denominated bond that has a current market price of €970, a face
value of €1,000, and an annual coupon of 5%. If the 1-year spot interest rate is 5.5%, what is the 2-
year spot interest rate?

R= The present value of a coupon paying bond is found by discounting each annual coupon and
the final principal payment at the appropriate spot interest rates for those maturities. Thus, to
find the 2-year euro-denominated spot interest rate we must solve for the two-period spot
interest rate in the following equation: €970= (€50)/(1.055) +(€1050)/(1+i(t,2))¨2. The answer is
i(t,2) = 6.68%.
2. Answer the following questions about the IRP:

(a) Suppose the 5-year interest rate on a dollar-denominated pure dis- count bond is 4.5% p.a.
and the interest rate on a similar pure discount euro-denominated bond is 7.5% p.a. If the current
spot rate is $1.08/€, what forward exchange rate prevents covered interest arbitrage?

R= We know that the 5-year forward rate must satisfy 1+i(t,5,$) 1.045 F(t,5,$/€) = S(t,$/€)× =
$1.08/€ × = $0.9375

(b) If the 30-day yen interest rate is 3% p.a., and the 30-day euro interest rate is 5% p.a. What
is the magnitude of the forward premium or discount on the yen?

R= We know that the high interest rate currency must sell at a forward discount when priced in
the low interest rate currency to prevent a covered interest arbitrage. Therefore the euro is at a
discount in the forward market. To determine the magnitude of the discount, recognize that
interest rate parity requires equality of the return to investing in yen versus converting the yen
principal into euros, investing the euros, and selling the euro principal plus interest in the
forward market for yen. The de-annualized interest rates are 0.0025 = (3/100)  (30/360) for the
yen and 0.004167 = (5/100)  (30/360) for the euro. The right-hand side of the above expression
is therefore -0.00166. The annualized value is -0.00166  (100)  (360/30) = -1.99%. We
therefore say that the euro sells at an annualized discount of 1.99%.

(c) Suppose the spot rate is CHF1.4706/$, and the 180-day forward rate is CHF1.4295/$. If the
180-day dollar interest rate is 7% p.a., what is the annualized 180-day interest rate on Swiss francs
that would prevent arbitrage?

R= Interest rate parity requires equality of the return to investing in CHF versus converting the
CHF principal into dollars, investing the dollars, and selling the dollar principal plus interest in
the forward market for CHF: 1 + i(CHF) = × 1 + i($) × F(CHF/$) S(CHF/$) If we de-annualize the
dollar interest rate, we find that the 180 day interest rate is 0.035. Hence, the Swiss franc
interest rate that prevents arbitrage is 1 i(CHF) = × 1.035 × CHF1.4295/$ - 1 = 0.0061
CHF1.4706/$ Chapter 6: Interest Rate Parity ©2012 Pearson Education, Inc. 8 If we annualize
this value, we find 0.0061  (100)  (360/180) = 1.21%

3. Carla Heinz is a portfolio manager for Deutsche Bank. She is considering two alternative
investments of EUR10,000,000: 180-day euro deposits or 180-day Swiss franc (CHF) deposits. She
has decided not to bear trans- action foreign exchange risk. Suppose she has the following data:

• 180-day CHF interest rate of 8% p.a.;

• 180-day EUR interest rate of 10% p.a.;

• spot rate of EUR1.1960/CHF;

• 180-day forward rate of EUR1.2024/CHF.

R= The euro return to investing directly in euros is 5%, so the euros available in 180 days is
EUR10,000,000  1.05 = EUR10,500,000. Alternatively, the EUR10,000,000 can be converted into
Swiss francs at the spot rate of EUR1.1960/CHF. The Swiss francs purchased would equal
EUR10,000,000 / EUR1.1960/CHF = CHF8,361,204. This amount of Swiss francs can be invested to
provide a 4% of return over the next 180 days. Hence, interest plus principal on the Swiss francs
is CHF8,361,204  1.04 = CHF8,695,652. If we sell this amount of Swiss francs forward for euros
at the 180-day forward rate of EUR1.2024/CHF, we get a euro return of CHF8,695,652 
EUR1.2024/CHF = EUR10,455,652. This is less than the return from investing directly in euros.

If these were the actual market prices, you should expect investors to do covered interest
arbitrages. Investors would borrow Swiss francs, which would tend to drive the CHF interest rate
up; they would sell the Swiss francs for euros in the spot foreign exchange market, which would
tend to lower the spot rate of EUR/CHF; they would deposit euros, which would tend to drive the
EUR interest rate down; and they would contract to buy CHF with EUR in the 180-day forward
market, which would put upward pressure on the forward rate of EUR/CHF. Each of these
actions would help bring the market back to equilibrium.

4. As a trader for Goldman Sachs, you see the following prices from two different banks:

• 1-year euro depositsloans: 6.0%–6.125% p.a.

• 1-year Malaysian ringgit depositsloans: 10.5%–10.625% p.a.

• Spot exchange rates: MYR4.6602EUR–MYR4.6622EUR

• 1-year forward exchange rates: MYR4.9500EUR–MYR4.9650EUR

The interest rates are quoted on a 360-day year. Can you do a covered interest arbitrage?

R= We need to check the two inequalities that characterize the absence of covered interest
arbitrage. In the first, we will borrow euros at 6.125%, convert to ringgits in the spot market at
MYR4.6602 / EUR, invest the ringgits at 10.5%, and sell the ringgit principal plus interest
forward for euros at MYR4.9650 / EUR. We find that MYR4.6602 1 1.06125 > × 1.105 × = 1.0372
EUR MYR4.9650/EUR Thus, it is not profitable to try to arbitrage in this direction as the amount
that we would owe is greater than the amount that we would gain. Let’s try the other direction,
arbitraging out of ringgits into euros and covering the foreign exchange risk. We will borrow
ringgits at 10.625%, convert to euros in the spot market at MYR4.6622 / EUR, invest the euros at
6.0%, and sell the euro principal plus interest forward for ringgits at MYR4.9500 / EUR. We find
that 1 MYR4.9500 1.10625 < × 1.06 × = 1.1254 MYR4.6622/EUR EUR Thus, there is a possible
arbitrage opportunity because the amount that we owe from borrowing ringgits is less than the
amount that we gain by converting from ringgits to euros, investing the euros, and covering the
transaction exchange risk with a forward sale of euros for ringgits.

5. As an importer of grain into Japan from the United States, you have agreed to pay
$377,287 in 90 days after you receive your grain. You face the following exchange rates and
interest rates:

• spot rate ¥106.35$;

• 90-day forward rate ¥106.02$;

• 90-day USD interest rate 3.25% p.a.;

• 90-day JPY interest rate 1.9375% p.a. Using these data answer the following questions:
(a) Describe the nature and extent of your transaction foreign exchange risk.

R= As a Japanese grain importer, you are contractually obligated to pay $377,287 in 90 days.
Any weakening of the yen versus the dollar will increase the yen cost of your grain. The possible
loss is unbounded.

(b) Explain two ways to hedge the risk.

R= You could hedge your risk by buying dollars forward at ¥106.02/$. Alternatively, you could
determine the present value of the dollars that you owe and buy that amount of dollars today in
the spot market. You could borrow that amount of yen to avoid having to pay today.

(c) Which of the alternatives in part b is superior?

R= If you do the forward hedge, you will have to pay ¥106.02/$  $377,287 = ¥39,999,967.74 in
90 days. If you do the money market hedge, you first need to find the present value of $377,287
at 3.25%. The de-annualized interest rate is (3.25/100)  (90/360) = 0.008125. Thus, the present
value is $377,287 / 1.008125 = $374,246.25 Purchasing this amount of dollars in the spot market
costs ¥106.35/$  $374,246.25 = ¥39,801,088.69 To compare this value to the forward hedge, we
must take its future value at 1.9375% p.a. The de-annualized interest rate is (1.9375/100) 
(90/360) = 0.00484375, and the future value is ¥39,801,088.69  (1.00484375) = ¥39,993,875.21
The cost of the money market hedge is essentially the same as the cost of the forward hedge
because interest rate parity is satisfied.

6. You are a sales manager for Google Nexus and export cellular phones from the United
States to other countries. You have just signed a deal to ship phones to a British distributor, and
you will receive £700,000 when the phones arrive in London in 180 days. Assume that you can
borrow and lend at 7% p.a. in U.S. dollars and at 10% p.a. in British pounds. Both interest rate
quotes are for a 360-day year. The spot rate is $1.4945/£, and the 180-day forward rate is
$1.4802/£.

(a) Describe the nature and extent of your transaction foreign exchange risk.

R= As a U.S. exporter, you have a contract to receive £700,000 in 180 days. Any weakening of
the pound versus the dollar will decrease the dollar value of your pounddenominated receivable.
Large losses are possible as the dollar value could go to zero, although that is highly unlikely.

(b) Describe two ways of eliminating the transaction foreign exchange risk.

R= You could hedge by selling pounds forward for dollars. Alternatively, you could do a money
market hedge in which you borrow the present value of the pounds, and convert the loan
principal to dollars in the spot market, and then use the pound receivable to pay off the interest
plus principal on the loan at maturity.

(c) Which of the alternatives in part b is superior?

R= The forward hedge gives $1.4802/£  £700,000 = $1,036,140 in 180 days. The money market
hedge requires the present value of the £700,000. The interest rate is (10/100)  (180/365) =
0.0493. Thus, the present value is £700,000 / 1.0493 = £667,111.41 The dollar value of this is
$1.4945/£  £667,111.41 = $996,998 To compare this to the forward hedge we must take its
future value at 7% p.a. The interest rate is (7/100)  (180/360) = 0.035. Therefore the future
value is $996,998  1.035 = $1,031,892.93 The forward hedge provides slightly more dollar
revenue.

(d) Assume that the dollar interest rate and the exchange rates are correct. Determine what
sterling interest rate would make your firm indifferent between the two alternative hedges.

R= We know that if interest rate parity is satisfied, the money market hedge and the forward
hedge will provide the same revenue. The pound interest rate that satisfies interest rate parity is
1 + i(£) = S($/£) × 1 + i($) × F($/£) The value of the right-hand side is $1.4945/£  1.035 /
$1.4802/£ = 1.0450. Thus the annualized pound interest rate that would make the firm
indifferent between the forward hedge and the money market hedge is 0.0450  100 
(365/180) = 9.12%.

7. Considering the following spot annual interest rates data for different time periods and
knowing that the spot exchange rate is ¥132.192/£, what should be the 2-year forward rate to
prevent arbitrage?

R= We know that if the coupon on a bond is equal to the yield to maturity on the bond, then the
bond is selling for face value. Therefore, without loss of generality, we assume that a twoyear
coupon bond has a coupon of 1.77% in the U.K. and 0.43% in Japan. Thus, in the U.K. the two-
year spot interest rate satisfies 1= (0.0177)/(1+0.01105) +(1.0177)/(1+i(2))¨2. Solving for i(2)
gives 0.01776. Doing the same for the yen, we have 1=(0.0043/(1+0.0037) + (1.0043)/(1+i(2))¨2.
Solving for i(2) gives 0.004301. Hence, the 2-year forward rate that prevents arbitrage would
satisfy f(T,2)= (¥132.192)/(£)* (1.004301¨2)/(1.01776¨2)= (¥128.719)/( £).