Using Interest Rate Parity To Trade Forex

The basic premise of interest rate parity is that hedged returns from investing in different currencies should be the same, regardless of the level of their interest rates.
SEE: The Forex Walkthrough
There are two versions of interest rate parity:
1. Covered Interest Rate Parity 2. Uncovered Interest Rate Parity
Read on to learn about what determines interest rate parity and how to use it to trade the forex market.
Calculating Forward RatesForward exchange rates for currencies refers to exchange rates at a future point in time, as opposed to spot exchange rates, which refers to current rates. An understanding of forward rates is fundamental to interest rate parity, especially as it pertains to arbitrage. The basic equation for calculating forward rates with the U.S. dollar as the base currency is:

Forward Rate = Spot Rate X (1 + Interest Rate of Overseas country) (1 + Interest Rate of Domestic country)

 
Forward rates are available from banks and currency dealers for periods ranging from less than a week to as far out as five years and beyond. As with spot currency quotations, forwards are quoted with a bid-ask spread.
SEE: The Basics Of The Bid-Ask Spread
Consider U.S. and Canadian rates as an illustration. Suppose that the spot rate for the Canadian dollar is presently 1 USD = 1.0650 CAD (ignoring bid-ask spreads for the moment). One-year interest rates (priced off the zero-coupon yield curve) are at 3.15% for the U.S. dollar and 3.64% for the Canadian dollar. Using the above formula, the one-year forward rate is computed as follows:

1 USD = 1.0650 X (1 + 3.64%) = 1.0700 CAD(1 + 3.15%)

The difference between the forward rate and spot rate is known as swap points. In the above example, the swap points amount to 50. If this difference (forward rate – spot rate) is positive, it is known as a forward premium; a negative difference is termed a forward discount.
A currency with lower interest rates will trade at a forward premium in relation to a currency with a higher interest rate. In the example shown above, the U.S. dollar trades at a forward premium against the Canadian dollar; conversely, the Canadian dollar trades at a forward discount versus the U.S. dollar.
Can forward rates be used to predict future spot rates or interest rates? On both counts, the answer is no. A number of studies have confirmed that forward rates are notoriously poor predictors of future spot rates. Given that forward rates are merely exchange rates adjusted for interest rate differentials, they also have little predictive power in terms of forecasting future interest rates. Covered Interest Rate Parity According to covered interest rate parity, forward exchange rates should incorporate the difference in interest rates between two countries; otherwise, an arbitrage opportunity would exist. In other words, there is no interest rate advantage if an investor borrows in a low-interest rate currency to invest in a currency offering a higher interest rate. Typically, the investor would take the following steps: 1. Borrow an amount in a currency with a lower interest rate.

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