Interest Rate Parity and Forex Trading

interest rate parity and forex tradingThe subject of using interest rate parity for the purpose of forecasting currency pair prices definitely belongs in the category of fundamental analysis, which implies that its usefulness as a price indicator is primarily geared toward longer term trading. For technical traders, it could be used to provide a long term view of the market, that when combined with one or more technical analysis techniques, could provide insights into price direction that could be valuable to devising a forex trading strategy.

The basic theory behind the concept of interest rate parity is that there is a relationship between interest rates and currency exchange rates. The term parity simply means equivalent or equal. If, for example, the USD and CAD were at 1.00, meaning that one U.S. dollar could be exchanged for one Canadian dollar, the two currencies would be said to express parity.

With regard to interest rate parity, the term parity refers to the idea that the returns from properly hedged currencies should be the same no matter the difference between their interest rates. Forex brokers and their trading platforms often contain the functionality of quoting interest rates. Just as with currency pairs, interest rates will be quoted with bid and ask prices. In order to use interest rate parity for trading forex, it is necessary to understand the concept of forward exchange rates, that is, what the rate will be in the future, as opposed to its current or spot rate.

The math can get a little complex. Forward rates can be obtained from brokers and banks without the necessity of performing the calculation. These quotes can be from short time periods of as little as a few days to over five years. Using forward rate quotes to forecast future spot rates or interest rates in generally considered as unreliable. This has been the subject of a number of studies by people that are searching for every conceivable edge in the forex market.

The strategy involved in using interest rate parity to trade forex is essentially one involving arbitrage, which is basically the tactic of trying to profit from the difference between the interest rates of two currencies. For example, a trader might sell a currency with a low interest rate while simultaneously buying one with a higher interest rate. The trader would take the resulting difference and invest it in an interest bearing financial instrument based on the currency with the higher interest rate.

Since the difference between interest rates of major currencies is typically not significant, it requires trades involving a very large number of currency units in order to offer a significant profit potential. On the other hand, arbitrage is a fairly conservative strategy that represents one of the lower risks possible with regard to currency trading.

Traders who do wish to incorporate the concept of interest rate parity into their trading strategy should focus on learning about covered and uncovered interest rate parity. Another topic that would merit study would be that of the “carry trade.” Contact a LucrorFx specialist today for a consultation.

 

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