The Interest Rate Parity, Covered Interest Arbitrage and Speculation under Market Imperfection

Abstract

The interest rate parity is important in international finance for at least two reasons. It explains covered interest arbitrage, and it specifies conditions for speculation in currency markets (see Ghosh, 1991; 1992; Niehans, 1984). It was Keynes (1923) who had initiated via interest rate parity the discussion on short-term capital flows, and later, Spraos (1953), Tsiang (1959), Branson (1969), Aliber (1973), and others have extended it and/or reinterpreted it. The idea of interest rate parity is simple in perfect market conditions. Consider an investor who has the opportunity to borrow and invest at home and abroad. Under this situation, he will invest abroad if the amount earned there exceeds the dollar amount earned at home; in an opposite situation, he will invest at home, and in the event the two alternative choices yield exactly the same rate of return – which is the case of interest rate parity – he will be indifferent. Let 5 be the current spot rate of exchange (in direct quote), F the one-year forward rate, r and r* the domestic and the foreign rates of interest, respectively. Then, if he invests his investible funds, say $S, in the domestic market, his rate of return is r; but if he converts his $S for 1 British Pound (£1), and then invests £1 at r*, he turns it into £1(1 + r*) at the end of one year.