Using Interest Rate Parity to Trade Forex

Using Interest Rate Parity to Trade Forex

Interest rates are they key fundamental determinants of movements in the financial market. This year, the interest rate decision by the Federal Reserve has been the most important discussions by financial experts around the world. The fed chair, Janet Yellen has indicated her intentions of raising the interest rates based on the data that is being released. This has led to the increased strengthening of the dollar against the global currencies. It has also led to fears in the global community that the tightening could lead to a financial recession. The International Monetary Fund (IMF) has urged the fed to delay the tightening.

As the debate on rate hike rages on, wise investors and market makers are allocating their funds to take advantage of the Interest rate parity. Interest rate parity (IRP) is basically the fundamental equation that exists or governs the relationship between a country’s interest rates and the currency exchange rates. Using IRP, the premise is that hedged returns from different currencies ought to be similar regardless of the interest rate level.

In using this strategy, it is very important to calculate the forward exchange rates. The forward exchange rates refers to the exchange rates of the currencies at a future period of time. On the other hand, the spot exchange rates refers to the current rates. The following formula has been suggested to calculate the forward rate when the United States dollar is the base currency.

Forward Rate = Spot Rate X (1 + Interest Rate of Overseas country)
(1 + Interest Rate of Domestic country)

To get the forward rates, one can get them from local banks and trading brokers with a period of less than a week and beyond. In spot currencies, forwards are usually quoted with a bid-ask spread.

A good example in using this strategy in trading can be found by considering the United States and Canada, the biggest trading partners in the world. Consider that USDCAD pair is priced at 1.0650. At the same time, the U.S dollar interest rate is 3.15% while the Canadian dollar is 3.6%.

Therefore, the forward exchange rate will be:

1 USD = 1.0650 X (1 + 3.64%) = 1.0700 CAD
(1 + 3.15%)

To explain what the calculation means, the swap point which is the difference between the forward and spot rate is very important. If the swap is positive, it is known as a forward premium and when it is negative, it is known as a forward discount. In addition, a currency that has low interest rates usually trades at forward premium against the currency with a high interest rate. Using this example, the United States dollar is at a forward premium against the Canadian dollar.

As a trader, understanding how to calculate the forward exchange rates and swaps is very important. The next thing to understand is on the two types of interest rate parity which are covered and uncovered interest rate parity.

A trader using the covered interest rate parity needs to understand that the forward exchange rates should always incorporate the interest rates of the two countries. This means that the trader needs to avoid borrowing money at a country with low interest rates to invest in a country with high interest rates. An alternative strategy is to borrow money in a low interest rate country and then invest in assets that have better returns.

On the other hand, the uncovered interest rate parity principle implies that the difference between the interest rates between two countries is the same as the expected change in exchange rates between the two countries. For instance, if the interest rate difference between the two countries is 3%, then the currency with the high interest rate will decline with 3%.

The challenge for an ordinary trader is how to use this strategy for day trading. However, it is not as difficult as it seems. A trader needs to major in as few currencies as possible. I recommend using currencies of countries such as the United States, Canada, Japan, and the Euro dominated countries. This is because it is possible to get the information from these countries. After getting the information, you should calculate the forward rates and then decide the best currency to trade with. With few countries in place, you will be at a good position to research them fully before making the final decision on how to hedge your investment.