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Interest Rate on Forex Money
Forex Interest Rate Parity
Let's say that a U.S. engineering corporation purchases new road-building equipment from a manufacturer located in an FC country. The manufacturer sells the equipment for 1,000,000 FC, with payment due one year from the date of sale. The corporate treasurer now has an FC payable on books and is concerned about the exposure. He decides to hedge this myth, and looks at two options (assume FC futures Forex trade on a change and the current FC/$ spot rate is 1.00):
USD
1. The treasurer can immediately exchange $1,000,000 for 1,000,000 FC and invest the foreign currency. (To eliminate extraneous risk factors, let's say he invests in a money market instrument comparable to a U.S. treasury bill.) The FC payment is due when the instrument matures.
2. He can purchase FC one-year forward or futures contracts, take delivery when the contracts mature, and make the payment. (Alternatively, of course, he can liquidate the contract, take the gain or loss, and apply it toward the purchase of spot FC.) Note that a third alternative, borrowing FC and investing it for one year, doesn't work in this instance because it merely substitutes one FC liability for another.
The treasurer looks for the most economical option and discovers that all are virtually equal in cost, as shown by the following:
Value Date of FC Exchange Rate ($/FC) Interest Rate (one-year)
Spot 1.00 ($1.00 = 1.00 FC)$ = 10% One-year forward
1.05 ($1.05 = 1.00 FC) FC = 5%
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Base Currency
 Base currency is the currency in which an investor or issuer maintains its book of accounts. In the FX markets, the US Dollar is normally considered the 'base' currency for quotes.
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Technical Analysis
 An effort to forecast prices by analyzing market data, i.e. historical price trends and averages, volumes, open interest, etc. |
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It's normally condensed as the dollar sign, $. The U.S. dollar is divided into 100 cents.
The euro is the currency of 13 European Union countries.
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With the first option, the treasurer foregoes the interest for one year on dollars (10%), and earns one year of interest on forex (5%). This represents a net cost equal to 5% of $1,000,000. With the second option, he earns 10% on $1,000,000 for the year because he doesn't trade it for FC; however, he pays a premium for the one-year futures, which costs 5% in dollar terms. Again, the net cost is 5% of $1,000,000.
This "one is the same as the other" result applies in every case. This correlation is known as interest rate parity. The correlation works in both directions. If the interest rate were 10% for FC and 5% for dollars, the futures would be discounted from the spot, rather than priced at a premium. Let's look at this scenario:
Now, the cost becomes a gain, but again, the amount is the same, regardless of which option is chosen. With the first option, the treasurer can gain 5% by converting dollars to FC and investing it at 10% for a year, foregoing a 5% earning on dollars, or he can gain the same 5% by purchasing forwards or futures at a discount.
Legal Responsibility
Does the company actually realize a gain by hedging in discount currencies? Probably not. Remember that the treasurer starts out with an FC liability. He is seeking to eliminate the exchange risk strategy it represents by acquiring an FC asset in one form or another. The discounted purchasing price of the futures (the asset) more than likely will be offset by the higher interest cost factored into the payable. By the same token, the 5% "cost" in the first example is offset by the lower interest rate charged for the liability.
The terms premium currency (futures priced at a premium to spot) and discount currency (futures priced at a discount to spot) are used to identify which currency has the higher or lower yield. By knowing either the futures price or the interest rate, the other can be approximated out to about a year distant. The calculations are less exact as the time frame gets longer than that because other risks come into play. Even so, forward contracts out as far as twenty years are not unknown.
An underlying assumption of the Interest Rate Parity theory is that the foreign currency interest rate is 0%. Obviously, this is never the case in a world of fiat currencies; however, the theory is still widely discussed. For those with a mathematical bent, calculation of market Interest Rate Parity. |
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