The relationships between the currencies of different countries may be discussed in a variety of ways regarding the existing theories and formulas. Interest rate parity (IRP) theory is one of the methods that can be appropriate for the evaluation of the interest rates and exchange rates (Eun & Resnick, 2015; Piros & Pinto, 2013). However, the choice of theories usually depends on the situations that have to be investigated. In this paper, the task is to evaluate the forward exchange rate between Brazilian Real and British Pounds one year from now regarding such data as the current exchange rate between the currencies is 1 British Pound equals 4.5 Brazilian Real, the annual interest rate in the UK is 1%, and the annual interest rate in Brazil is 8%.
The calculation of the forward exchange rate has to be developed in several steps:
- The domestic country is Brazil;
- A foreign country is the United Kingdom;
- The solution is for Brazil;
- Annual domestic interest rate is 8%;
- Annual foreign interest rate is 1%;
- The spot exchange rate is 1 British Pound = 4.5 Brazilian Real;
- Interest rate differentials = domestic interest rate – foreign interest rate = 8%-1% = 7%
- Forward exchange rate = spot exchange rate x (100% – Interest rate difference) = 4.5 x (100% – 7%) = 4.5 x 93% = 4.185 Brazilian Real (1 British Pound will be equal 4.185 Brazilian Real).
Regarding the information given about the interest rates of both countries, the decision to use Brazil as a domestic country is made. The United Kingdom is identified as a foreign country. The expectations of the forward exchange rate have to be given from the point of view of Brazilian investors. There is a certain formula according to which the forward exchange rate can be identified. As the task is to make predictions in one year, no dates have to be added to the formula. The only requirement that has to be met is the identification of the difference between the interest rates of the two currencies for one year. In this case, this difference equals 7%.
The next step is the necessity to identify the possible development of the interest rate. To meet this goal, it is expected to calculate the forward exchange rate in regard to the rate difference in the countries using the current spot exchange rate. The result is that the forward exchange rate will be 4.185 Brazil Real per British Pounds in one year. It is lower than the already known current spot exchange rate of 4.5 Brazilian Real. Taking these numbers and the fact that Brazil is used as the domestic country into consideration, it is possible to come to the conclusion that a discount may exist only when the forward exchange rate is lower than the rate at the moment of operation, meaning the spot exchange rate. Therefore, the investors from the United Kingdom are able to gain profits in case there are no changes in the interest rates in the domestic country and the foreign country.
In general, the IRP theory is a helpful tool to understand the financial aspect of the relationships between two different countries in case only several variables are given and have to be used to make predictions in one year.
References
Eun, C., & Resnick, B.G. (2015). International financial management (8th ed.). New York, NY: McGraw Hill Higher Education.
Piros, C.D., & Pinto, J.E. (2013). Economics for investment decision makers: Micro, macro, and international economics. Hoboken, NJ: John Wiley & Sons.