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Interest rate parity
is a relationship that must hold between the
spot interest rates of two
currencies if there are to be no arbitrage
opportunities. The relationship depends upon spot
and forward exchange rates between the
currencies. It is
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[1] |
where
 s is the spot exchange rate, expressed as the price in
currency a of a unit of currency b;
f is the corresponding forward exchange rate;
ra and rb are the interest rates
for the respective currencies; and
m is the common maturity in years for the forward rate and
the two interest rates.
In formula [1], the interest rates are assumed to be
annually compounded commercial rates, such as Libor
rates. If they are continuously compounded, formula [1]
becomes:
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[2] |
where
and
are continuously compounded rates, and e is the natural log base
(2.718281828...).
Interest rate parity plays a fundamental role in foreign
exchange markets, enforcing an essential link between short-term interest
rates, spot exchange rates and forward exchange rates.
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 arbitrage-free pricing
The approach to pricing instruments that underlies essentially all of financial
engineering.
compound interest
Any of several methods of crediting interest in which interest is earned on interest.
currency
swap A swap for the exchange of cash flow streams in two
different currencies.
fixed income
term structure Refers collectively to a spot curve, forward curve,
discount curve, yield curve or any other curve that describes the time value of
money at a particulate point in time.
Libor
London interbank offered rate.
put-call
parity
A relationship between the prices of European put and call options on
the same underlier.
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http://www.riskglossary.com
copyright © Glyn A. Holton,
2004
Although the information in
this website has been presented with care and obtained from sources the author believes to be reliable, there is no guarantee that it is
accurate. Such information may be incomplete, condensed, outdated or presented with
errors. The content of the website is for information purposes only. It is
provided gratuitously, so the author shall not be liable under any
theory for any damages suffered by any user. The author does not
provide investment advice, and this website is not a vehicle for communicating
investment advice. |
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