Interest Rate Parity

<body onLoad="MM_checkPlugin('Shockwave Flash','','http://www.riskglossary.com/default_nofl.htm',false);return document.MM_returnValue"> <div align="left"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table1"> <tr> <td width="740"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table2"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table3"> <tr> <td width="100%" align="left" valign="top"> <p class="header_gold">Interest Rate Parity</td> <td width="45" align="right" valign="bottom"> <map name="FPMap6"> <area href="http://www.contingencyanalysis.com" shape="rect" coords="1, 0, 44, 11" target="_top"> </map> <img border="0" src="../images/home.gif" usemap="#FPMap6" width="45" height="12"></td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" cellspacing="1" id="table4"> <tr> <td width="0%" align="left" valign="top"> <p class="header2_black">Explained:<br> <img border="0" src="../images/blank_1x100.gif" width="100" height="1"></td> <td width="0%" align="left" valign="top"><p class="word_list"> <a href="#Interest rate parity">interest rate parity</a><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> <td width="100%" align="left" valign="top"><p class="word_list"> <br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="right" id="table5"> <tr> <td align="right" width="9" height="14"></td> <td width="336" height="14"> <font size="4"> </font></td> </tr> <tr> <td align="right" width="9"> </td> <td width="336"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> <p class="body"><b><a name="Interest rate parity">Interest rate parity</a></b> is a relationship that must hold between the <a href="../articles/fixed_income_term_structure.htm">spot interest rates</a> of two currencies if there are to be no <a href="../articles/arbitrage.htm">arbitrage</a> opportunities. The relationship depends upon <a href="../articles/settlement.htm">spot</a> and <a href="../articles/forward.htm">forward</a> exchange rates between the currencies. It <a name="[1]">is</a></p> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" cellpadding="0" height="36" id="table6"> <tr> <td width="100%" align="center"> <img border="0" src="../formulas/interest_rate_parity_1.gif" width="97" height="56"></td> <td width="5%" align="right">[1]</td> </tr> </table> <p class="body">where</p> <p class="body" style="margin-top: 6; margin-bottom: 6"> <img border="0" src="../images/bullet.gif" width="20" height="10"><i>s</i> is the spot exchange rate, expressed as the price in currency <i>a</i> of a unit of currency <i>b</i>;</p> <p class="body" style="margin-top: 6; margin-bottom: 6"> <img border="0" src="../images/bullet.gif" width="20" height="10"> <i>f</i> is the corresponding forward exchange rate; </p> <p class="body" style="margin-top: 6; margin-bottom: 6"> <img border="0" src="../images/bullet.gif" width="20" height="10"><i>r<sub>a</sub></i> and <i>r<sub>b</sub></i> are the interest rates for the respective currencies; and</p> <p class="body" style="margin-top: 6; margin-bottom: 6"> <img border="0" src="../images/bullet.gif" width="20" height="10"><i>m</i> is the common maturity in years for the forward rate and the two interest rates. </p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="left" id="table7"> <tr> <td width="336" height="10"><font size="2"> </font></td> <td width="9" height="10"></td> </tr> <tr> <td width="336"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> <td width="9"> </td> </tr> </table> <p class="body" style="margin-bottom: 32">In formula [<a href="#[1]">1</a>], the interest rates are assumed to be annually compounded commercial rates, such as <a href="../articles/libor.htm">Libor</a> rates. If they are continuously compounded, formula [<a href="#[1]">1</a>] becomes: </p> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" cellpadding="0" height="36" id="table8"> <tr> <td width="100%" align="center"> <img border="0" src="../formulas/st_rate_parity_.gif" width="100" height="41"></td> <td width="5%" align="right">[2]</td> </tr> </table> <p class="body" style="margin-top: 32">where <img border="0" src="../formulas/interest_rate_parity_r_a_star.gif" align="absbottom" width="14" height="16"> and <img border="0" src="../formulas/interest_rate_parity_r_b_star.gif" align="absbottom" width="13" height="16"> are continuously compounded rates, and <i>e</i> is the natural log base (2.718281828...).</p> <p class="body" style="margin-bottom: 32">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.</p> <table border="0" 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