International Finance: Analyzing Interest Rate Parity as No-Arbitrage

This essay provides an in-depth analysis of interest rate parity (IRP) as a no-arbitrage equilibrium condition in international finance. It distinguishes between uncovered and covered interest rate parity, highlighting the relationship between interest rates, spot and forward currency values. The essay emphasizes that the condition of arbitrage is fulfilled when there is no investment, no risk, and a profit condition for the firm. It uses the example of an American investor operating in the German capital market to illustrate how covered interest rate parity works, including hedging currency risk through forward contracts. The analysis concludes that investors must assess volatility and fluctuations in foreign currency risk, and the profitability should remain above the payments made, advocating for a least-cost dealing approach where currency transactions are fully hedged to minimize foreign currency fluctuation risks. Desklib provides various study tools and solved assignments for students.

Running head: INTERNATIONAL FINANCE
International Finance
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“Interest Rate Parity as no Arbitrage Equilibrium Condition”
The interest rate parity is the no arbitrage equilibrium condition where the investors are
usually indifferent with the different interest rates offered to them in two countries is almost
same where the choice of the customer is selecting the one says rational. The uncovered interest
rate parity shows the existence between the financial assets internationally and the good markets
so that the law of one price exists. However, the covered interest rate parity shows the
relationship between the interest rates and the different spot and forward currency value
determined and observed in the two countries and there values in the condition of equilibrium
stage. The investors may use the covered interest rate parity when the foreign exchange market is
used for determining the forward foreign exchange rate. The volatility and the changes in the
currency and interest rates changes susceptibly over time and should be well taken into
consideration for the same (Avdjiev et al. 2016).
The condition of arbitrage would be only fulfilled when there is no investment and no
risk and there is a profit condition for the firm. It is essential that the covered interest rate parity
must be there in any kind of financial market equilibrium conditions (Borio et al. 2016). The
investor should apply and evaluate the different ways and forward contracts where the
profitability of the investor stays well above the payment, which he will be paying. The
following theory can be better explained with the help of an example where the American
investor would perform the following steps to shows that the covered interest rate parity holds
well. The initial step would start from borrowing the initial 1 Deutsche Mark (DM) in the
German capital market for a period of 30 days. The interest and the principal would be paid to
the lender after a sum of 30 days. The possible risk included in the same is the foreign currency
exchange risk that is $/DM fluctuations (Du, Tepper and Verdelhan 2016). The investor then to

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hedge the currency risk would be entering into a foreign exchange forward contract where the
partner would be paying him a amount equal to (1+RDM) exactly after 30 days of time period.
The amount that will be payable to the partner would be around F*(1+RDM) dollars and no more
than and which should be paid to him only in the 30 day period. After the investors enters into
the forward contract, the investor would be able to deal with the different kinds of risks and the
condition of the arbitrage market will be satisfied (Chortareas, Kapetanios and Magkonis 2018).
The amount received from the partner would be repaid or refunded to the German lender in the
30 day. The amount of DM currency received would be exchanged for E$ in the spot market.
The investor would then be investing an amount of E $ in the local market for 30 days which will
yield him a E. (1+R$). The investor would be able to completely hedge the transaction by the
contract. The possible gain from our portfolio would be when the E*(1+R$) will exceed the
payment which will be paid to the German lender. The forward currency entered by the investor
will help him hedge the interest rate risk and the currency fluctuation risk suffered from the
investors. Investors should well assess the volatility and fluctuation in the foreign currency risk
and the same should be well assessed by the investor keeping the different scenarios and factors
(Pinnington and Shamloo 2016).
Hence the two criteria E. (1+R$) - E. (1+R$) both must hold good in the equilibrium
stage. Hence, there are various costs, risks and factors that should be taken into consideration
while the evaluation of the currency transaction or the investment to be done by the interest. The
investor should apply and evaluate the different ways in which the profitability of the investor
stays well above the payment, which he will be paying. The complete least cost dealing could be
applied in the above case when the currency transaction or the investment transaction to be done

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by the investor is completely hedged and the chances for the fluctuation of foreign currency is
minimized to the extent possible.
Reference
Avdjiev, S., Du, W., Koch, C. and Shin, H.S., 2016. The dollar, bank leverage and the deviation
from covered interest parity.
Borio, C.E., McCauley, R.N., McGuire, P. and Sushko, V., 2016. Covered interest parity lost:
understanding the cross-currency basis.
Chortareas, G., Kapetanios, G. and Magkonis, G., 2018. Resuscitating real interest rate parity:
new evidence from panels. The European Journal of Finance, 24(14), pp.1176-1189.
Du, W., Tepper, A. and Verdelhan, A., 2016. Covered interest rate parity deviations in the post-
crisis world. Available at SSRN 2768207.
Du, W., Tepper, A. and Verdelhan, A., 2018. Deviations from covered interest rate parity. The
Journal of Finance, 73(3), pp.915-957.
Pinnington, J. and Shamloo, M., 2016. Limits to arbitrage and deviations from covered interest
rate parity (No. 2016-4). Bank of Canada staff discussion paper.

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