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Foreign exchange risk

4.2 Interest rate parity theory (IRPT)

IRPT claims that the difference between the spot and the forward
exchange rates is equal to the differential between interest rates
available in the two countries.

The forward rate is a future exchange rate, agreed now, for buying or
selling an amount of currency on an agreed future date.

 the country with the higher interest rate see the forward rate for its
currency subject to a depreciation.

Formula to estimate forward rates:

(1 + i c)

F 0 = S 0 × ––––––
(1 + i b)

Limitations:

 government controls on capital markets

 controls on currency trading

 intervention in foreign exchange markets

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