Interest Rate Parity & Arbitrage

• Arbitrage involves exploiting price differences of the same product in different markets by buying in the lower-priced market and selling in the higher-priced market to profit
• This activity is prevalent in financial markets, particularly with foreign currencies
• Arbitrage tends to equalize product prices across various markets due to increased demand in lower-price markets, which raises prices until equilibrium is achieved

Conditions for Interest Rate Parity

• Cross-country interest rate arbitrage may not always be effective due to several conditions
• Perfect Capital Mobility (PCM) is essential, where investors view foreign financial assets as perfect substitutes for domestic assets, without which arbitrage is hindered
• Fixed exchange rate systems prevent exchange rates from adjusting to interest rate differentials, with international reserves bearing the adjustment burden
• The size of an economy matters, as interest rate differentials in small countries are more likely to influence exchange rates compared to large countries

Exchange Rate and Interest Rate Arbitrage

• Return on investment, also known as yield, is denoted as 'i'
• Investors seek the highest interest rate (i)
• If iA > iB investors will move capital from country B (selling €) to country A (buying $)
• This capital flow leads to the appreciation of the dollar (e $/€) and depreciation of the euro (e €/$)
• The appreciation of the dollar lessens the attractiveness of higher dollar interest rates, as converting euros to dollars yields fewer dollars for investment

Implications of Interest Rate Parity (I)

• The interest rate differential between two countries reflects the expected change in their exchange rates
• If if – id = expected change in the domestic exchange rate, where if is the foreign interest rate and id is the domestic interest rate
• If if > id, investors anticipate appreciation of the domestic currency (and depreciation of the foreign currency)
• If if < id, investors anticipate depreciation of the domestic currency (and appreciation of the foreign currency)

Implications I

• A scenario where iA > iB can persist if investors expect currency A to depreciate in the near future (or currency B to appreciate)
• Even with lower interest rates, investors might stay in a country if they expect its currency to appreciate, thus enabling them to invest more capital in a foreign currency later

Implications of Interest Rate Parity (II)

• Given an interest rate differential between countries, raising interest rates in one country will appreciate its exchange rate, and vice versa
• Considering if – id, an increase in domestic interest rates (monetary tightening) causes capital inflow, appreciating the domestic currency, all else being constant
• A decrease in domestic interest rates (monetary loosening) leads to capital outflow, depreciating the domestic currency, all else being constant