Question

Predicts change in foreign exchange rate caused by the difference in nominal interest rates between home (h) and abroad (f): (1 + rn). Ft = forward-rate for time t, So = spot-rate at time 0, rh = home nominal rate, If = foreign nominal rate. Ft – so rh - rf (1 + r) So

What is the difference between those formula calculating the interest rate parity, please give an example if possible.

Answer 1

There is essentially no difference between the two formulas used . Infact, the 2nd formula can be derived from the 1st formula

The uses however, may be different as the first formula can be used to predict the forward exchange rate whereas the second formula can be used to estimate the forward premium/discount as a percentage of the spot rate

For example, let us assume that the spot exchange rate (S₀) of US dollar against the Euro is Euro 1= $1.1

Also, let us assume that the nominal rate in USA(home)  is 5% whereas that in Europe(foreign) is 2%

The forward rate then by the formula is

F/1.1 = (1+0.05)/(1+0.02)

=> F   = 1.1324

Which means that the Forward rate after one year shall be Euro 1 = $1.1324

If , however we use the second formula, we get

(F-1.1)/1.1 = (0.05-0.02)/1.02 = 0.029412

which means that the forward rate should quote at a premium of 2.94% of the spot rate

i.e 1.1+ 2.94% of 1.1 = 1.1324

which is the same value as obtained from the 1st formula