BUSF_A01.qxd

Foreign exchange

Interest rate paritycan be summarised, in this context, as saying that where nom-

inal interest rates differ from one country to the other, the spot and future rates will

not be the same. The relationship is as follows:

=

where f 1 is the future value, in the currency of the home country, of one unit of the for-

eign currency, and the other symbols are as previously specified.

The future rate will be higher than the spot rate where the interest rate in the home

country is greater than that in the foreign country. For example, assuming that UK

interest rates are higher than US ones, you would have to pay more in sterling for US

dollars if you were to take delivery of the dollars (and pay the pounds) at a date in the

future, than if it were a spot transaction. This is because you would be able to benefit

from the better UK interest rates for longer than if you were to exchange sterling for

dollars immediately. The converse would also be true.

For example, assume that the spot rate is £1 =$1.95 or $1 =£0.51. Assume also that

the rates of interest expected to prevail for the next year are 10 per cent in the USA and

5 per cent in the UK. If we convert £0.51 now, we should have $1, which we could

invest in the USA and it would grow to $1.10 by the end of the year. The person who

received our £0.51 could invest this in the UK such that it would grow to £0.54 by the

end of the year. By that time, taking account of the interest that we could each earn,

the effective rate of exchange is $1 =£0.49 (that is, 0.54/1.10). This would be the future

rate for a transaction to be carried out in one year’s time.

The above formula will give us the same result:

=

f 1 ==0.49

Here we should say that the dollar is trading at a forward discount against sterling.

Were the opposite state of affairs to apply (interest rates higher in the USA than in the

UK), sterling would trade at a forward discount against the dollar. The size of the pre-

mium or discount depends partly on how far into the future the exchange will occur,

as well as on the relative interest rates.

In practice, interest rate parity tends to follow the theoretical model very closely.

Foreign exchange markets and market efficiency

We saw in Chapter 9 that the secondary capital market, the stock exchanges of the

world, tends to be price efficient to a significant degree. This means that new informa-

tion is rapidly and rationally impounded in security prices. This leads to a situation

where it is not possible consistently to make better than average returns without hav-

ing information that is not available to investors generally.

Casual observation of the foreign exchange market might lead to the conclusion

that this too would be efficient, such that it would not be possible consistently to make

1.05 ×0.51

1.10

f 1

0.51

1 +0.05

1 +0.10

f 1

e 0

1 +rnh

1 +rnf

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