does interest rate parity hold good between usd/inr?

ISSN: 2319-7943

Impact Factor : 2.1632(UIF)

Volume - 4 | Issue - 4 | Jan - 2016

Sudindra V. R.

DOES INTEREST RATE PARITY HOLD GOOD BETWEEN USD/INR? A CASE STUDY Sudindra V. R. Assistant Professor

ABSTRACT It is often believed that interest rate parity governs exchange rates between currencies of various countries. If interest rate parity does not exist there is anopportunityfor covered interest rate arbitrage. This paper demonstrates that in what way one can produce riskless profit using a covered interest rate arbitrage process. The objective of the study is to examine the possibility of arbitrage profit between USD/INR,and conclude if the interest rate parity holds. For the purpose of study USD/INR spot exchange rate, 3 months forward exchange rate and annualized interest rate between two countries considered. Based on the study we find that there is a covered interest arbitrage is possible, thus, we fail to accept the null hypothesis and infer that interest rate parity does not hold between USD/INR. KEY WORD: Covered interest rate arbitrage, Interest rate parity, USD/INR INTRODUCTION Interest rate parity is a no arbitrage condition depicts an equilibrium state under which investors will be indifferent to interest rate available on investment in two counties. This condition constantlymay not hold and provides opportunities to earn risk less profit. Twokey assumption to interest rate parity are capital mobility and perfect substitutability of domestic and foreign assets. Interest rate parity condition states the expected return on domestic asset will equal the exchange rate- adjusted expected return on foreign currency assets. Investors then cannot earn arbitrage profit Available online at www.lsrj.in

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DOES INTEREST RATE PARITY HOLD GOOD BETWEEN USD/INR? A CASE STUDY

by borrowing in a country with a lower interest rate, exchanging for foreign currency, and investing in a foreign country with a higher interest rate, due to gains or losses from exchanging back to their domestic currency at maturity. There are two distinctive form of interest rate parity uncovered interest rate parity refers to the parity condition in which exposure to foreign exchange risk (unanticipated changes in exchange rates) is uninhibited, whereas covered interest rate parity refers to the condition in which a forward contract has been used to cover (eliminate exposure to) exchange rate risk. While the spot and forward exchange rates are not at equilibrium and interest rate parity does not persistently hold, there is aprospect to earn riskless profit from covered interest rate arbitrage. Usually interest arbitrage covers short term funds of investors abroad, who want to avoid the foreign exchange risk. It provides a link between foreign exchange markets and money markets in different currencies. 2. REVIEW OF LITERATURE: Daniel Po-Ming Chan (2005), suggested that arbitrage profit exist in Hong Kong market and there is overwhelming evidence on the validity of the relationship in the Hong Kong foreign exchange market.Alex Luiz Ferreira (2003), analyzed real interest parity hypothesis and reveals a high degree of market integration for developed countries.Ashraful Haque, concludes interest rate differential between USA and emerging Asian market gives positive excess return and US investors can earn an excess return by investing in the emerging markets of Asia instead of investing in other industrialized countries.Ted Juhl eta (2004), indicate that Covered interest differentials for the US-UK rate were generally large during the classical gold standard than any period hence.Niall Coffey eta (2009), indicates a breakdown of arbitrage due to lack of funding and heightened counterparty credit risk. 3. OBJECTIVES OF STUDY m To analyze the possibility of arbitrage profit between USD/INR m To determine if interest rate parity holds good between USD/INR 4. RESEARCH METHODOLOGY The study is descriptive, case study and analyticalin nature. For the purpose of study spot exchange rate between USD/INR considered from Reserve bank of India website and 3 months forward exchange rate from www.markets.inwebsite. Annualized interest rate of USA and India considered from www.tradingeconomics.comwebsite. The mechanism of covered interest rate arbitrage is based on certain assumptions, which includes: m Various assets which will be having different characteristics. m The frequency of time series data varies. m Where there is no transaction cost and tax associated with arbitrage strategy. m The investors borrow and invest money at the prevailing interest rate of RBI and Federal Reserve of USA. m Mechanism is based on assumption of ceteris paribus. Thus, essentially we will be testing the below research hypotheses: H0: Interest Rate Parity holds between USD/INR H1: Interest Rate Parity does not hold between USD/INR

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5. MECHANISM OF COVERED INTERST RATE ARBITRAGE To create riskless profit from interest rate differentials in two countries with forward market, various steps can be followed such as: Recognize the spot exchange rate and forward exchange rate between two countriesand the m interest rate of two countries. Find the interest rate differential between two countries and forward rate differentials between m two counties (whileforward rate >spot rate, forward premium exists and while forward rate < spot rate forward discount exists). Equate the interest rate differential (IRD) with forward differentials (FRD),(Assessment rule: IRD > FRD, capitalize in the country where interest rate is higher and if IRD < FRD, capitalize in the country where interest rate is lower). Arbitrage process: Borrow money from one country at the prevailing interest rate and convert into another country m currency at the prevailing spot exchange rate. Invest the proceeds of money to obtainthe assets, at the end of the period the investment will be m giving the interest on purchased assets. Convert the principal and interest amount in forward rate. m Repay the borrowed amount along with the interest at the end of the period. m Compare the arbitrage proceed with the repayment of borrowed money along with the interest. m The differences between the arbitrage proceeds to repayment of borrowed money gives gain/loss m from the arbitrage process 6. DATA ANALYSIS If the spot exchange rate between USD/INR is INR.66.7905/$, 3 months forward rate available at INR 67.6450/$. Interest rate in India 6.75% and interest rate in USA is 0.25% (annualized) How can the investors dothe arbitrage? Interest rate differentials between India and US is (6.75-0.25) = 6.5% m Forward rate differentials between spot and forward market is ((67.6450-66.7905)/66.7905 m *100*12/3)= 5.11% IRD 6.5%> FRD 5.11%, hence arbitrage opportunity exist in the India where interest rate is higher. m Arbitrager can borrow amount in US dollar and invest in India. m Assume arbitragers borrow money of $ 1000 at the prevailing interest rate of 0.25% for 3 months. m Convert $1000 into Indian rupee at the prevailing spot price 66.7905 =INR. 66,790.50 m Invest the amount of INR. 66,790.50 in India at the interest rate of 6.75%, at the end of the period m the amount becomes (66,790.50+ 66,790.50*6.75%*3/12) =INR. 67,917.59 Convert the above amount in dollar at the forward rate INR. 67,917.59/67.6450 is $ 1004.03 m Repay the borrowed amount with interest ( 1000+1000*.25%*3/12)= $ 1000.625 m The differences between the arbitrage amount and repayment amount is the gain from arbitrage. m (1004.03-1000.625) = $3.4047 7. CONCLUSION Based on the study we find that there is a covered interest arbitrage is possible, thus, we fail to


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accept the null hypothesis and infer thatinterest rate parity does not hold between USD/INR. Investors can make riskless profit of $ 3.4047 by borrowing (assume $1000)money from United States and invest in Indian market, as the interest rate differential is higher than forward differentials. If the interest rate differentials are less than forward differentials, investors can invest in United States by borrowing money from India to gain riskless profit. 8. SCOPE FOR FURTHER STUDY: The study can be further extend to other country currencies. The study limited only to 3 month time horizon and it can be extend to other time horizons. 9. REFERENCES 1. Does the Real Interest Parity Hypothesis Hold? Evidence for Developed and Emerging Markets, Alex Luiz Ferreira, Department of Economics, University of Kent, August 2003. 2. Covered interest arbitrage under the linked exchange rate: does it exist? an evidence from the HongKong foreign exchange market, Daniel Po-Ming Chan, ISSN 1035-4581 3. Covered Interest Arbitrage: A Comparative Study of Industrialized Countries and Selected Developing Countries, Ashraful Haque Mohammed, Journal of International Business Research. 4. Capital Constraints, Counterparty Risk, and Deviations from CoveredInterestRate Parity, Niall Coffey, Warren B. Hrung, Asani Sarkar, FRB of New York Staff Report No. 393, October 2009. 5. CoveredInterestArbitrage: Then vs. Now, Ted Juhl,William Miles, NBER Working Paper No. w10961, December 2004 6. Madhu Vij (2011), International financial Management: 3rd Edition, Excel Books, ISBN 978-81-7446821-5 7. Madura, Jeff (2007). International Financial Management: Abridged 8th Edition. Mason, OH: Thomson South-Western. ISBN 0-324-36563-2.


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