Question

If the US interest rate is close to zero, while the interest rate of Russia is very high, what would interest rate parity suggest about the forward rate of the Russian ruble? Explain.

Answer 1

Interest Rate Parity (IRP) suggests that the difference in the interest rates of two countries shall be equal to the difference in the forward exchange rate and spot exchange rate.

The forward exchange rate stated by IRP is given below:

F_o = S_o * (1 + i_a) / (1 + i_b) where,

F_o = Forward exchange rare

S_o = Spot Exchange Rate

i_a = Interest Rate of quoted currency

i_b = Interest Rate of Base Currency

So now, let us understand the USD and Ruble case by example.

Let us assume current spot rate of USD/RUB = 64 = S_o

Interest Rate of Ruble (Quoted Currency) = i_a = 8.0%

Interest Rate of USD (Base Currency) = i_b = 0.5%

Hence, using the IRP formula stated above, the Forward Exchange Rate for USD/RUB should be:

F_o = 64 * (1+8%) / (1+0.5%)

F_o = 68.77

As observed here, the key takeaway is:

"The currency whose interest rate is higher shall depreciate going forward and vice versa. The currency whose interest rate is lower shall appreciate".

As seen here, since the interest rate of Russian Rouble was higher, the currency depreciated; the futures prices of USD/RUB (@68.77) was higher than the spot price (@64)

Specific asnwer to the question: Interest Rate parity suggests that since the interest rate of rouble is higher; the rouble will depreciate.