Chapter 15
Exchange Rates,
Interest Rates,
and Interest Parity
Topics to be Covered
• Interest Rate Parity
• Nominal Interest Rate
• Real Interest Rate
• Fisher Equation
• Exchange Rates, Interest Rates,
and Inflation
• Expected Exchange Rates and the Term
Structure of Interest Rates
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Interest Parity
• The interest parity relationship is a result
of profit-seeking arbitrage activity called
covered interest arbitrage.
• A U.S. investor deciding between
investing in the U.S. or in the U.K.
must consider:



The interest rates, i$ and i£
The spot exchange rate, E , (in $/ £)
The forward exchange rate, F, (in $/ £)
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Interest Parity (cont.)
• By investing $1 at home, the U.S. investor
can earn 1 + i$ for one period.
• Or, since $1 = 1/E pounds, the U.S. investor
can invest in the U.K. and earn (1 + i£)/E.
• Since future spot rates are unknown, the
investor can eliminate the uncertainty over the
future dollar value of the investment with a
forward exchange contract.
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Covered Return
• Covered return is the domestic currency
value of a foreign investment when the
foreign currency proceeds are sold in the
forward market.
• In our example, the covered return is equal to
(1 + i£)F/E dollars. Arbitrage between the two
investment opportunities results in:
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Interest Rate Parity
• Interest rate parity states that the
forward premium (or discount) is equal
to the interest differential. This parity is
approximated by the equation:
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Effective Return
• The effective return on a foreign
investment is given by the interest
rate plus the expected change in the
exchange rate.
• Using our example, the effective
return is:
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Reasons Why Interest Rate Parity
May Not Hold
• Buying and selling foreign exchange and international
securities involve transaction costs.
• Taxes may differ according to an investor’s residence.
• Government controls on financial capital flows
may exist.
• There may be political risks.
• There are time lags between observing the profit
opportunity and actually trading to realize the profit.
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Interest Rates and Inflation
• Nominal Interest Rate—the interest
rate actually observed in the market.
• Real Interest Rate—the nominal interest
rate minus or adjusted for inflation.
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Fisher Equation
• The relationship between interest
rates and inflation is given by the
Fisher equation:
where i is the nominal interest rate, r is
the real interest rate, and π is the
expected rate of inflation.
• Refer to Table 15.1
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15-10
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Exchange Rates,
Interest Rates, and Inflation
• Real interest rates are equalized across
countries when the Fisher equation, interest
rate parity, and relative purchasing power
parity all hold.
• Given our U.S. and U.K. investment example:
• Interest rates, inflationary expectations, and
exchange rates are all jointly determined and
affected by government policy changes and
other news.
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Term Structure of Interest Rates
• There is no such thing as the interest
rate for a country.
• Term structure of interest rates—the
pattern of interest rates over different
terms of maturity.
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Expected Exchange Rates
and Term Structure of Interest Rates
• Refer to Figure 15.1 Eurocurrency
Interest Rates
• If the term structure lines for two countries are:

Parallel, then exchange rate changes are expected
to be constant

Diverging, then the high-interest-rate currency
is expected to depreciate at an increasing rate
over time

Converging, then the high-interest-rate currency is
expected to depreciate at a declining rate relative to
the low-interest-rate currency
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