Learning Outcomes
After reading this article, you will be able to explain the interest rate parity (IRP) theory and its importance in forecasting forward exchange rates for ACCA FM. You will learn to apply the IRP formula, understand the link between interest rates and forward exchange rates, distinguish between covered and uncovered IRP, and perform relevant calculations. You will recognise how IRP is examined and its practical implications in risk management.
ACCA Financial Management (FM) Syllabus
For ACCA Financial Management (FM), you are required to understand the application of parity conditions for exchange rate forecasting and risk management. In particular, you should be confident with:
- Explaining the causes of exchange rate fluctuations, including interest rate parity (IRP) theory
- Calculating and interpreting forward exchange rates using IRP
- Forecasting future exchange rates based on interest rate differentials
- Understanding covered and uncovered interest rate parity
- Distinguishing between spot and forward exchange rates
- Applying IRP within scenario-based exam questions, including common calculations
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- If the domestic annual interest rate is 5% and the foreign annual rate is 3%, with a spot rate of $1.5000 = £1, what is the one-year forward rate according to IRP?
- Which theory claims that differences in interest rates between two countries determine the forward rate between their currencies?
a) Purchasing power parity
b) Interest rate parity
c) Expectations theory
d) Fisher effect - Define "covered interest rate parity" and explain its significance for forward exchange rate contracts.
- What is typically the impact on the forward rate of a currency if its domestic interest rate is higher than the foreign interest rate?
Introduction
Interest rate parity (IRP) forms a core part of exchange rate forecasting and risk management. It underpins how forward exchange rates are set in practice and is frequently assessed in the ACCA FM exam. Understanding IRP links the cost of borrowing or investing across countries and ensures there are no arbitrage profits between money and currency markets.
Predicting future exchange rates is essential for multinational organisations managing foreign currency risk. The IRP theory guides the pricing of forward contracts, which are widely used to lock in future exchange rates and hedge exposure.
Key Term: interest rate parity (IRP)
A theory that states the forward exchange rate between two currencies should reflect the interest rate differential between those currencies over the contract period.
THE INTEREST RATE PARITY THEORY
What is Interest Rate Parity?
Interest rate parity states that the difference between the spot exchange rate and the forward exchange rate for two currencies equals the difference between the respective interest rates. In simple terms, any advantage in investing in one currency due to higher interest rates is offset by an expected depreciation of that currency in the forward market.
There are two main forms of IRP:
Key Term: covered interest rate parity
The situation where the use of forward contracts eliminates any interest rate arbitrage profits, so the forward rate adjusts to offset interest differentials.Key Term: uncovered interest rate parity
The expected future spot rate is forecast to adjust so that investors are indifferent between domestic and foreign interest-bearing investments, without using a forward contract.
The Interest Rate Parity Formula
In ACCA FM exams, you must know the IRP formula for forward rate determination:
Where:
- = forward rate (foreign/domestic)
- = current spot rate (foreign/domestic)
- = interest rate in the foreign country
- = interest rate in the domestic country
The formula ensures parity by equalising returns from investing in either currency with forward hedging.
Key Term: forward rate
The agreed exchange rate today for exchanging currencies at a specified future date, set according to IRP.
Parity and Arbitrage
If the forward rate does not reflect the interest rate differential, investors could exploit arbitrage: borrowing in one currency, converting at the spot rate, investing in the other currency, and using a forward contract to lock in risk-free profit. IRP theory claims such opportunities are quickly eliminated by market forces.
Covered vs. Uncovered IRP
- Covered IRP: Involves the use of a forward contract to fix the future exchange rate; no risk of exchange rate movement remains.
- Uncovered IRP: No forward contract is used; exchange risk remains, and only expected returns are balanced through anticipated spot rate movements.
Key Term: arbitrage
The opportunity to earn risk-free profit by exploiting differences in interest rates and exchange rates, which IRP theory states should be eliminated in efficient markets.
APPLICATION: FORWARD RATE CALCULATIONS
Calculating the Forward Rate
To apply IRP, you must:
- Identify the spot rate and both countries' interest rates for the period.
- Insert values into the IRP formula.
- Calculate the resulting forward rate.
Forward rates quoted as "currency per base currency" should be aligned with the input spot rate.
Worked Example 1.1
A UK company expects to pay EUR 1,200,000 in 6 months. The spot rate is €1.2000 = £1. UK 6-month interest rate is 2% (annualised), Eurozone 6-month rate is 1% (annualised). What is the 6-month forward rate, and will the euro trade at a forward premium or discount?
Answer:
To apply IRP, convert annual rates to 6-month rates:
UK: 2% ÷ 2 = 1.0%
Eurozone: 1% ÷ 2 = 0.5%Forward rate = €1.2000 × (1 + 0.005) / (1 + 0.01)
= €1.2000 × 1.005 / 1.01
= €1.1941 = £1 (rounded)Forward rate is lower than the spot, so the euro trades at a forward discount against sterling.
Worked Example 1.2
The Japanese 1-year interest rate is 0.5%. The UK 1-year rate is 3%. The current spot rate is ¥150 = £1. Find the 1-year forward rate.
Answer:
Forward rate = ¥150 × (1 + 0.005) / (1 + 0.03)
= ¥150 × 1.005 / 1.03
= ¥146.60 = £1
The pound is forecast to strengthen in the forward market due to higher UK rates.
Exam Warning
In exam questions, always clarify which currency is the "base" and which is the "counter". Adjust the formula to match the quote's format and use the correct time base for quoted interest rates (e.g., if rates are annual but the period is 6 months, divide by 2).
PRACTICAL IMPLICATIONS AND FORECASTING
IRP provides the theoretical basis for forward pricing in currency contracts. The forward rate calculated using IRP is the market's unbiased forecast, under the assumption of no arbitrage and efficient markets.
However, due to transaction costs, market imperfections, or capital controls, actual market rates may deviate slightly from theoretical IRP. In addition, IRP assumes risk-free conditions. In practice, uncovered IRP is less reliable for forecasting actual future spot rates because exchange rates are affected by factors beyond interest differentials.
Forward contracts are primarily used for hedging, not speculation. Businesses use forward pricing to manage currency risk in known future transactions, not to "beat the market" on exchange rate movements.
Worked Example 1.3
A Canadian exporter will receive US$100,000 in three months. The spot rate is C$1.3500 = US$1. The 3-month US dollar interest rate is 1% (quarterly), Canadian 3-month dollar rate is 1.5% (quarterly). What is the 3-month forward rate for hedging?
Answer:
US: 1%
Canada: 1.5%
Forward rate = C$1.3500 × (1 + 0.01) / (1 + 0.015)
= C$1.3500 × 1.01 / 1.015
= C$1.3446 = US$1
The exporter can lock in this forward rate for their receipt.
Revision Tip
Practise IRP calculations under both annual and non-annual periods. Convert all rates to the correct time basis: for n months, use (annual rate × n/12).
Summary
Interest rate parity is the key link between interest rate differentials and forward exchange rates. The absence of arbitrage ensures the forward rate adjusts to eliminate any profit opportunity from borrowing in one currency, converting, and investing in another. IRP is central to ACCA FM for both theory and calculation questions, especially where forward contracts and currency risk management are tested.
Key Point Checklist
This article has covered the following key knowledge points:
- Explain interest rate parity (IRP) theory and why forward rates depend on interest differentials
- Apply the IRP formula to calculate forward exchange rates
- Distinguish between covered and uncovered IRP (and their exam relevance)
- Recognise how IRP prevents arbitrage between money and currency markets
- Carry out forward rate calculations using appropriate periods and bases for interest rates
Key Terms and Concepts
- interest rate parity (IRP)
- covered interest rate parity
- uncovered interest rate parity
- forward rate
- arbitrage