INTEREST RATE PARITY, ECONOMIC ENVIRONMENT FOR ‎BUSINESS, ECONOMIC INDICATORS, HEDGING EXCHANGE ‎RISK, EXCHANGE RATES, USD/PKR RATES, PAKISTAN, ‎FOREIGN EXCHANGE, STATE BANK, IMF RECOMMENDS, ‎BUSINESS ADMINISTRATION, MANAGEMENT SCIENCE, ‎EDUCATION AND LEARNING, MBA, BBA,‎

1. INTEREST RATE PARITY
ECONOMIC ENVIRONMENT FOR BUSINESS (5571)
ASSIGNMENT # 2
HUMA WASEEM
ROLL # BR564185
COL MBA / MPA
SPRING SEMESTER 2018
DEPARTMENT OF BUSINESS ADMINISTRATION
ALLAMA IQBAL OPEN UNIVERSITY ISLAMABAD
HUMA MALIK
2018

2. INTEREST RATE PARITY
1. INTRODUCTION
1.1. Definitions
2. INTEREST RATE PARITY (IRP) THEORY
2.1. Implications of Interest Rate Parity Theory
2.2. Limitations of Interest Rate Parity Model
3. ECONOMIC INDICATORS THAT IMPACT IN VALUING THE CURRENCY
3.1. Basic Economic Indicators
3.1.1. Gross Domestic Product (GDP)
3.1.2. Consumer Price Index (CPI)
3.1.3. Producer Price Index (PPI)
3.1.4. Trade Deficit
3.1.5. Trade Surplus
3.1.6. Balance of Payments (BoP)
3.1.7. Unemployment Rate
3.2. Leading, Coincident and Lagging Indicators
3.2.1. Leading Indicators
3.2.2. Coincident Indicators
3.2.3. Lagging Indicators
4. ROLE / IMPORTANCE OF INTEREST RATE PARITY (IRP)
4.1. Foreign Exchange Markets
4.1.1. Exchange Rate
4.1.2. Factors Affecting Exchange Rates
4.1.2.1. Inflation Rates
4.1.2.2. Interest Rates
4.1.2.3.
4.1.2.4. Government Debt
4.1.2.5. Terms of Trade
4.1.2.6. Political Stability & Performance
4.1.2.7. Recession
4.1.2.8. Speculation
4.2. Interest Rate
4.2.1. Lenders and Borrowers
4.2.2. Determination of Interest Rates
4.2.2.1. Supply and Demand
4.2.2.2. Inflation
4.2.2.3. Government
4.3. Spot Rate
4.3.1. Execution Of Spot Exchange
4.4. Forward Rate
5. TYPES OF INTEREST RATE PARITY (IRP)
5.1. Covered Interest Rate Parity (CIRP)
5.1.1. Covered Interest Rate Arbitrage
5.2. Uncovered Interest Rate Parity (UIP)
5.3. Covered Interest Rate Vs. Uncovered Interest Rate

3. 2
6. THE INTEREST RATE PARITY RELATIONSHIP BETWEEN THE U.S. AND
CANADA
7. HEDGING EXCHANGE RISK
8. PAKISTAN CURRECY VALUE RESPECT TO US DOLLARS,
INTERNATIONAL TRADING, INTEREST RATE, ECONOMIC SITUATION,
AND FOREX RATE
8.1. USD to PKR Exchange Rates Background
8.1.1. What Affects USD/PKR Rates
8.2. State Bank of Pakistan
8.2.1. Open Market Rates
8.2.2. Inter-Bank Market Rates
8.3. IMF Recommends Devaluing Rupee and Increasing Interest Rate
9. REFERENCES

4. INTEREST RATE PARITY
1. INTRODUCTION
Interest Rate Parity (IRP) is a theory in which the differential between the interest rates of
two countries remains equal to the differential calculated by using the forward exchange rate
and the spot exchange rate techniques. Interest rate parity connects interest, spot exchange,
and foreign exchange rates. It plays a crucial role in Forex markets.
1.1 Definitions:
Some important definitions are mentioned below:
Interest Rate: paid at an
annual rate for the use of productive services that a stock of capital supplies and it
Interest Rate (of a loan): The price, calculated as a percentage of the amount
(Krugman, Wells & Graddy, 2014).
Parity: Parity refers to the condition where two (or more) things are equal to each
other. It can thus refer to two securities having equal value, such as a convertible
bond and the value of the stock if the bondholder chooses to convert into common
stock. The term "par value" for a bond is similar to parity in that it suggests the bond
is selling for its initial face value. ( , n.d.)
Interest Parity:
denominated in different currencies. May be uncovered, with returns including
expected changes in exchange rates, or covered, with returns including the forward
(Brian, Ed., 2009)
Exchange Rate: The price at which currencies trade, determined by the foreign
exchange market. (Krugman, Wells & Graddy, 2014).
Exchange Rate: The price of one currency in terms of another. (Cleaver, 2011).
Spot Rate: The exchange rate on the spot market. Also called the spot exchange
rate. (Brian, Ed., 2009)
Spot Market: A market for exchange (of currencies, in the case of the exchange
market) in the present (as Opposed to a forward or futures market in which the
exchange takes place in the future)
Forward Market: of currencies in the future. Participants
in a forward market enter into a contract to exchange currencies, not today, but at a
specified date in the future, typically 30, 60 or 90 days from now and at a price
(forward exchange rate) that is agreed upon to (Brian, Ed., 2009).

5. 2
Forward Rate: Also called the forward exchange rate, this is the exchange rate on
a forward market transaction. (Brian, Ed., 2009)
Uncovered Interest Parity: Equality of expected returns on otherwise comparable
financial assets denominated in two currencies, without any cover against exchange
risk. Uncovered interest parity requires approximately that i = i* + a where i is the
domestic interest rate, i* the foreign interest rate and a the expected appreciation of
foreign currency at an annualised percentage rate. (Brian, Ed., 2009)
Hedge: To offset risk. In the foreign exchange market, hedgers use the forward
market to cover a transaction or open position and thereby reduce exchange risk.
The term applies most commonly to trade. (Brian, Ed., 2009)
Forex Market:
exchange, and speculate on currencies. The forex market is made up of banks,
commercial companies, central banks, investment management firms, hedge funds,
and retail forex brokers (Forex market)

6. 3
2. INTEREST RATE PARITY (IRP) THEORY
Interest rate parity (IPR) is a theory in which the interest rate differential between two
countries is equal to the differential between the forward exchange rate and the spot
exchange rate. It is a theory proposing a relationship between the interest rates of two given
currencies and the spot and forward exchange rates between the currencies. The spot rate is
the current exchange rate, while the forward rate refers to the rate that a bank agrees to
exchange one currency for another in the future.
The interest rate differential (IRD) weighs the contrast in interest rates between two similar
interest-bearing assets. Traders in the foreign exchange market use interest rate differentials
(IRD) when pricing forward exchange rates. Based on the interest rate parity, a trader can
create an expectation of the future exchange rate between two currencies and set the
premium, or discount, on the current market exchange rate futures contracts.
Interest rate parity theory is based on assumption that no arbitrage opportunities exist in
foreign exchange markets meaning that investors will be indifferent between varying rate of
returns on deposits in different currencies because any excess return on deposits in a given
currency will be offset by devaluation of that currency and any reduced return on deposits in
another currency will be offset by appreciation of that currency.
If one country offers a higher risk-free rate of return in one currency than that of another, the
country that offers the higher risk-free rate of return will be exchanged at a more expensive
future price than the current spot price. In other words, the interest rate parity presents an
idea that there is no arbitrage in the foreign exchange markets. Investors cannot lock in the
current exchange rate in one currency for a lower price and then purchase another currency
from a country offering a higher interest rate.
The economic indicators of any country have huge impact in valuing their currency
relatively to international economy to be traded in international market. Currency pairs
fluctuate all the time due to various economic factors, including supply/demand, various
economic indicators, commercial/hedging activity, and hedge fund/financial trading.
(Interest Rate Parity

7. 4
Interest Rate Parity Flowchart
Examples
For illustration purpose consider example in USA, We'll
consider two investment cases viz:
Case I: Domestic Investment
So exchange of Euro
Now invest $1224.50 @ 3.0% for 1 year which yields $1261.79 at the end of the
year.
Case II: Foreign Investment
year. But we buy forward 1 year to lock in the future exchange rate at
Dollar.
1051.27 @ $1.20025 = $1261.79
Thus, in the absence of arbitrage, the Return on Investment (RoI) is same regardless
of our choice of investment method.
(Interest Rate Parity

8. 5
2.1. Implications of Interest Rate Parity Theory
If IRP theory holds then arbitrage in not possible. No matter whether an investor invests in
domestic country or foreign country, the rate of return will be the same as if an investor
invested in the home country when measured in domestic currency.
If domestic interest rates are less than foreign interest rates, foreign currency must trade at
a forward discount to offset any benefit of higher interest rates in foreign country to
prevent arbitrage.
If foreign currency does not trade at a forward discount, or if the forward discount is not
large enough to offset the interest rate advantage of foreign country, arbitrage opportunity
exists for domestic investors. So, domestic investors can benefit by investing in the
foreign market.
If domestic interest rates are more than foreign interest rates, foreign currency must trade
at a forward premium to offset any benefit of higher interest rates in domestic country to
prevent arbitrage.
If foreign currency does not trade at a forward premium, or if the forward premium is not
large enough to offset the interest rate advantage of domestic country, arbitrage
opportunity exists for foreign investors. So, foreign investors can benefit by investing in
the domestic market. (Interest Rate Parity
2.2. Limitations of Interest Rate Parity Model
In recent years the interest rate parity model has shown little proof of working. In many
cases, countries with higher interest rates often experience it's currency appreciate due to
higher demands and higher yields and has nothing to do with risk-less arbitrage. (Interest
Rate Parity
3. ECONOMIC INDICATORS THAT IMPACT IN VALUING
THE CURRENCY
3.1 Basic Economic Indicators
Following basic economic indicators have impact in valuing the currency that plays a role to
define interest rates, international exchange rates and trading rates.
Gross Domestic Product (GDP) - this is the total amount of all goods and services
produced in the country. This includes consumer spending, government spending,
and business inventories. Real GDP is a variant that takes out the impact of inflation,

9. 6
so that GDP can be compared over time. Real GDP is the basic measure of business
activity and tracks the business cycle.
Consumer Price Index (CPI) - this is a measure of the price of a basket of goods
and services; increases to this index indicate an increase in inflation.
Producer Price Index (PPI) - this is a measure of the price of commercial items
such as farm products and industrial commodities. It indicates the cost to produce
items and is the leading indicator of inflation.
Trade deficit - this results when a country's imports exceed its exports.
The U.S. usually has a trade deficit.
Trade surplus - this results when a country's exports exceed its imports.
Balance of payments (BoP) - this is the amount of foreign currency taken in minus
the amount of domestic currency paid out; the U.S. usually has a balance of
payments deficit.
Unemployment rate - the Bureau of Labor Statistics releases employment statistics
each month that note the number of employed and unemployed people in the U.S.,
as well as the percentage of unemployed. Increases in the unemployment rate tend to
occur when the economy declines, and vice versa.
3.2 Leading, Coincident and Lagging Indicators
Leading indicators preview signs of improvement or decline in economic
conditions. Some of these leading indicators include orders for plants and
equipment, money supply, stock prices, consumer expectations, average work week
for production workers and average weekly claims for unemployment insurance.
Coincident indicators coincide with current economic activity. Examples include
nonfarm employment, industrial production, manufacturing and trade sales, and
personal income minus transfer payments such as Social Security, disability benefits
and unemployment compensation.
Lagging indicators are signs that do not emerge until after a change in economic
conditions. They include the unemployment rate, business spending, labor costs,
bank loans outstanding and bank interest rates.
(Economic Indicators, n.d.)
4. ROLE / IMPORTANCE OF INTEREST RATE PARITY (IRP)
Interest rate parity plays an essential role in foreign exchange markets, foreign exchange
rates, connecting interest rates, and spot exchange rates. Interest rate parity is fundamental
knowledge for traders of foreign currencies.
4.1. FOREIGN EXCHANGE MARKETS

10. 7
The foreign exchange market is the market in which participants are able to buy, sell,
exchange and speculate on currencies. Foreign exchange markets are made up of banks,
commercial companies, central banks, investment management firms, hedge funds, and retail
forex brokers and investors. The foreign exchange market also called forex, FX, or
currency market trades currencies. It is considered to be the largest financial market in the
world. Aside from providing a floor for the buying, selling, exchanging and speculation of
currencies, the forex market also enables currency conversion for international trade and
investments.
There are some key factors that differentiate the forex market from others like the stock
market. There are fewer rules, which means investors aren't held to strict standards or
regulations as those in other markets. There are no clearing houses and no central bodies that
oversee the forex market. Most investors won't have to pay the traditional
fees or commissions that you would on another market. Because the market is open 24 hours
a day, you can trade at any time of day, which means there's no cut off time to be able to
participate in the market. (Foreign Exchange Market, n.d.).
4.1.1. Exchange Rate
Currencies values are always relative to one another. U.S. dollar and euro are the two
most commonly quoted currencies given their status as a reserve currency at many
global central banks. The most popular currency pair is the EUR/USD, which is the
number of dollars needed to purchase one euro. Considering the example of US Dollars
and European Euros, when the U.S. dollar is strong, can buy more Euro currency, and
when the U.S. dollar is weak, will cost more to buy Euro currency. Foreign currency
exchange rate shows a chart revealing whether the dollar is strengthening or weakening
along with other currencies and vice versa. Rates are usually pegged to the U.S. Dollar,
European Euro, Great British Pound, Japanese Yen.
These currency pairs fluctuate all the time due to various economic factors, including
supply/demand, various economic indicators, commercial/hedging activity, and hedge
fund/financial trading. While these fluctuations happen all the time, the changes amount
to just fractions of a currency's value, known as "pips" by those trading currencies.
Exchange rates tell how much one currency is worth in another foreign currency. The
price is being charged in one currency to purchase another currency with certain
rates. Foreign exchange traders decide the exchange rate for most currencies. They trade
the currencies 24 hours a day, seven days a week. Prices change constantly for the
currencies that Americans are most likely to use. They include Mexican pesos, Canadian
dollars, European Euros, British pounds, and Japanese yen. These countries use flexible
exchange rates. The government and central bank don't actively intervene to keep
the exchange rate fixed. Their policies can influence rates over the long term. For most
countries, the government can only influence the exchange rate but

11. 8
For any other currency of any other country, their central banks reserves in foreign
currency to control how much their currency is worth. To keep the exchange rate fixed,
the central bank holds U.S. dollars. If the value of the local currency falls, the bank sells
its dollars for local currency. That reduces the supply in the marketplace, boosting its
currency's value. It also increases the supply of dollars, sending its value down.
If demand for its currency rises, it does the opposite.
The Chinese Yuan used to be a fixed currency. Now the government is slowly
transitioning to a flexible exchange rate. That means it changes less frequently than a
flexible exchange rate, but more frequently than a fixed exchange rate.
4.1.2. Factors Affecting Exchange Rates
Foreign Exchange rate (Forex rate) is one of the most important means through which a
Following are some of the
leading factors that influence the variations and fluctuations in exchange rates
4.1.2.1. Inflation Rates
Changes in market inflation cause changes in currency exchange rates. A country
with a lower inflation rate than another's will see an appreciation in the value of its
currency. The prices of goods and services increase at a slower rate where the
inflation is low. A country with a consistently lower inflation rate exhibits a rising
currency value while a country with higher inflation typically sees depreciation in its
currency and is usually accompanied by higher interest rates.
4.1.2.2. Interest Rates
Changes in interest rate affect currency value and dollar exchange rate. Forex rates,
interest rates, and inflation are all correlated. Increases in interest rates cause a
country's currency to appreciate because higher interest rates provide higher rates to
lenders, thereby attracting more foreign capital, which causes a rise in exchange
rates
4.1.2.3.
investment. It consists of total number of transactions including its exports, imports,
debt, etc. A deficit in current account due to spending more of its currency on
importing products than it is earning through sale of exports causes depreciation.
Balance of payments fluctuates exchange rate of its domestic currency.
4.1.2.4. Government Debt
Government debt is public debt or national debt owned by the central government. A
country with government debt is less likely to acquire foreign capital, leading to
inflation. Foreign investors will sell their bonds in the open market if the market

12. 9
predicts government debt within a certain country. As a result, a decrease in the
value of its exchange rate will follow.
4.1.2.5. Terms of Trade
Related to current accounts and balance of payments, the terms of trade is the ratio
of export prices to import prices. A country's terms of trade improves if its exports
prices rise at a greater rate than its imports prices. This results in higher revenue,
which causes a higher demand for the country's currency and an increase in its
currency's value. This results in an appreciation of exchange rate.
4.1.2.6. Political Stability & Performance
A country's political state and economic performance can affect its currency
strength. A country with less risk for political turmoil is more attractive to foreign
investors, as a result, drawing investment away from other countries with more
political and economic stability. Increase in foreign capital, in turn, leads to an
appreciation in the value of its domestic currency. A country with sound financial
and trade policy does not give any room for uncertainty in value of its currency. But,
a country prone to political confusions may see a depreciation in exchange rates.
4.1.2.7. Recession
When a country experiences a recession, its interest rates are likely to fall,
decreasing its chances to acquire foreign capital. As a result, its currency weakens in
comparison to that of other countries, therefore lowering the exchange rate.

13. 10
4.1.2.8. Speculation
If a country's currency value is expected to rise, investors will demand more of that
currency in order to make a profit in the near future. As a result, the value of the
currency will rise due to the increase in demand. With this increase in currency
value comes a rise in the exchange rate as well. (Key Factors that n.d.).
4.2. INTEREST RATE
Some of the most important influences that drive movements in forex are the interest
rate changes from eight of the world's most important central banks. Interest rate shifts
represent a monetary, policy-based response as a result of economic indicators that assess
the health of an economy. Most importantly, they possess the power to move the market
immediately as one aspect of a country's fundamentals have now suddenly changed.
Moreover, surprise rate changes may often make the biggest impact because these volatile
moves can lead to quicker responses and higher profit levels.
Interest rates impact currencies in the following manner: the greater the rate of return, the
greater the interest accrued on currency invested and the higher the profit. As a result,
relatively high interest rates compared to others around the world leads to major shifts in
capital as investors seek return. The task of forex investors is to try and predict changes in
interest rates by analyzing factors such as news, economic reports, charts etc.
Each central bank's board of directors controls the monetary policy of its country and the
short-term prime interest rate that banks use to borrow from each other. When the economy
is doing well, interest rates are hiked in order to curb inflation and when times are tough, cut
rates to encourage lending and inject money into the economy.
An interest rate is the cost of borrowing money. It is the compensation for the service and
risk of lending money. It keeps the economy moving by encouraging people to borrow, to
lend and to spend. But prevailing interest rates are always changing, and different types of
loans offer different interest rates. (Murphy, n.d.).
4.2.1. Lenders and Borrowers
The money lender takes a risk that the borrower may not pay back the loan. Interest
provides a certain compensation for bearing risk. Coupled with the risk of default is the
risk of inflation. When you lend money now, the prices of goods and services may go up
by the time you are paid back, so your money's original purchasing power would
decrease. Thus, interest protects against future rises in inflation. A lender such as a bank
uses the interest to process account costs as well.
Borrowers pay interest because they must pay a price for gaining the ability to spend
now, instead of having to wait years to save up enough money. Businesses also borrow
for future profit. They may borrow now to buy equipment so they can begin earning

14. 11
those revenues today. Banks borrow to increase their activities, whether lending or
investing and pay interest to clients for this service. Interest can thus be considered a
cost for one entity and income for another. It can represent the lost opportunity
or opportunity cost of keeping your money as cash under your mattress as opposed to
lending it.
4.2.2. Determination of Interest Rates
Following are the determinants of Interest rates:
4.2.2.1. Supply and Demand
Interest rate levels are a factor of the supply and demand of credit: an increase in the
demand for money or credit will raise interest rates, while a decrease in the demand
for credit will decrease them. Conversely, an increase in the supply of credit will
reduce interest rates while a decrease in the supply of credit will increase them. The
supply of credit is increased by an increase in the amount of money made available
to borrowers. When we open a bank account, we are actually lending money to the
bank. Depending on the kind of account we open (a certificate of deposit will render
a higher interest rate than a checking account, with which we have the ability to
access the funds at any time), the bank can use that money for its business and
investment activities. Bank can lend out that money to other customers. The more
banks can lend, the more credit is available to the economy that increases the supply
of credit and the price of borrowing (interest) decreases.
Credit available to the economy is decreased as lenders decide to defer the
repayment of their loans. For instance, when you decide to postpone paying this
month's credit card bill until next month or even later, you are not only increasing
the amount of interest you will have to pay but also decreasing the amount of credit
available in the market. This, in turn, will increase the interest rates in the economy.
4.2.2.2. Inflation
Inflation also affects interest rate levels. The higher the inflation rate, the more
interest rates are likely to rise. This occurs because lenders will demand higher
interest rates as compensation for the decrease in purchasing power of the money
they will be repaid in the future.
4.2.2.3. Government
The government say in how interest rates are affected based on monetary policy.
The federal funds rate, or the rate that institutions charge each other for extremely
short-term loans, affects the interest rate that banks set on the money they lend.
That rate then eventually trickles down into other short-term lending rates. When the
government buys more securities, banks are injected with more money than they can
use for lending, and the interest rates decrease. When the government sells

15. 12
securities; money from the banks drains for the transaction results in rendering fewer
funds at the banks' disposal for lending that forces a rise in interest rates.
4.3. SPOT RATE
A spot exchange rate is the price to exchange one currency for another for delivery on the
earliest possible value date. The standard settlement date for most spot transactions is two
business days after the transaction date. The foreign exchange spot market can be very
volatile. In the short term, rates are often driven by rumor, speculation and technical trading.
In the long term, rates are generally driven by a combination of economic growth
and interest rate differentials. Central banks sometimes intervene to smooth the market,
either by buying or selling the local currency or by adjusting interest rates.
On the transaction date, the two parties involved in the transaction agree on the price, which
is the number of units of currency A that will be exchanged for currency B. The parties also
agree on the value of the transaction in both currencies and the settlement date. If both
currencies are to be delivered, the parties also exchange bank information. Speculators often
buy and sell multiple times for the same settlement date, in which case the transactions are
netted and only the gain or loss is settled.
4.3.1. Execution of Spot Exchange
There are a number of different ways in which traders can execute a spot exchange,
especially with the advent of online trading systems. The exchange can be made directly
between two parties, eliminating the need for a third party. Electronic broking systems
may also be used, where dealers can make their trades through an automated order
matching system. Traders can also use electronic trading systems through a single or
multibank dealing system. Finally, trades can be made through a voice broker or over the
phone with a foreign exchange broker.
Trading takes place electronically around the world between large, multinational banks.
Other active market participants include corporations, mutual funds, hedge funds,
insurance companies and government entities. Transactions are for a wide range of
purposes, including import and export payments, short- and long-term investments,
loans and speculation. Some currencies, especially in developing economies, are
controlled by the government that sets the spot exchange rate.
4.4. FORWARD RATE
A forward rate is an interest rate applicable to a financial transaction that will take place in
the future. Forward rates are calculated from the spot rate and are adjusted for the cost of
carry to determine the future interest rate that equates the total return of a longer-term

16. 13
investment with a strategy of rolling over a shorter-term investment. It may also refer to the
rate fixed for a future financial obligation, such as the interest rate on a loan payment.
In forex, the forward rate specified in an agreement is a contractual obligation that must be
honored by the parties involved. For example, consider an American exporter with a large
export order pending for Europe, and the exporter undertakes to sell 10 million euros in
exchange for dollars at a forward rate of 1.35 euros per U.S. dollar in six months' time. The
exporter is obligated to deliver 10 million euros at the specified forward rate on the specified
date, regardless of the status of the export order or the exchange rate prevailing in the spot
market at that time. For this reason, forward rates are widely used for hedging purposes in
the currency markets, since currency forwards can be tailored for specific requirements,
unlike futures, which have fixed contract sizes and expiry dates and therefore cannot be
customized.
In the context of bonds, forward rates are calculated to determine future values. For example,
an investor can purchase a one-year Treasury bill or buy a six-month bill and roll it into
another six-month bill once it matures. The investor will be indifferent if both investments
produce the same total return. The investor will know the spot rate for the six-month bill and
will also know the rate of one-year bond at the initiation of the investment, but he or she will
not know the value of a six-month bill that is to be purchased six months from now.
To mitigate re-investment risk, the investor could enter into a contractual agreement that
would allow him or her to invest funds six months from now at the current forward rate. Fast
forward six months. If the market spot rate for a new six-month investment is lower, then the
investor could use the forward rate agreement to invest the funds from the matured t-bill at
the more favorable forward rate. If the spot rate is high enough, the investor could cancel the
forward rate agreement and invest the funds at the prevailing market rate of interest on a new
six-month investment. (Forward Rate, n.d.).
So, the forward exchange rate is just a function of the relative interest rates of two
currencies. In fact, forward rates can be calculated from spot rates and interest rates using
the formula
Forward Rate = Spot Rate x
1 + Domestic Interest Rate
1 + Foreign Interest Rate
where the 'Spot' is expressed as a direct rate (i.e. as the number of domestic currency units
one unit of the foreign currency can buy).
In other words, if S is the spot rate and F the forward rate, and rf and rd are foreign currency
interest rates and domestic currency interest rates respectively, then:

17. 14
Forward rates are available from banks and currency dealers for periods ranging from less
than a week to as far out as five years and beyond. As with spot currency quotations,
forwards are quoted with a bid-ask spread.
Example: If the spot CAD/USD rate is 1.1239 and the three month interest rates on CAD and
USD are 0.75% and 0.4% annually respectively, then calculate the 3 month CAD/USD
forward rate. In this case the forward rate will be
It can be confusing to determine which interest rate should be considered 'domestic', and
which 'foreign' for this formula. For that, look at the spot rate. Think of the spot rate as
being x units of one currency equal to 1 unit of the other currency. In this case, think of the
spot rate 1.1239 as "CAD 1.1239 = USD 1". The currency that has the "1" in it is the
'foreign' and the other one is 'domestic'.
It is also important to remember how exchange rates are generally quoted. Most exchange
rates are quoted in terms of how many foreign currencies does USD 1 buy. Therefore, a rate
of 99 for the JPY means that USD 1 is equal to JPY 99. These are called 'direct rates'.
However, there are four major world currencies where the rate quote convention is the other
way round - these are EUR, GBP, AUD and NZD. For these currencies, the FX quote
implies how many US dollars can one unit of these currencies buy. So a quote of ""1.1023""
for the Euro means EUR 1 is equal to USD 1.1023 and not the other way round. (Pareek,
2009).
5. TYPES OF INTEREST RATE PARITY (IRP)
There are two types of Interest Rate Parity (IRP)
Covered Interest Rate Parity (CIRP)
Uncovered Interest Rate Parity (UIP)
5.1 Covered Interest Rate Parity (CIRP)
Covered Interest Rate theory states that exchange rate forward premiums (discounts) offset
interest rate differentials between two sovereigns. In another words, covered interest rate
theory holds that interest rate differentials between two countries are offset by the
spot/forward currency premiums as otherwise investors could earn a pure arbitrage profit.

18. 15
With covered interest rate parity, forward exchange rates should incorporate the difference in
interest rates between two countries; otherwise, an arbitrage opportunity would exist. In
other words, there is no interest rate advantage if an investor borrows in a low-interest rate
currency to invest in a currency offering a higher interest rate. Typically, the investor would
take the following steps:
1. Borrow an amount in a currency with a lower interest rate.
2. Convert the borrowed amount into a currency with a higher interest rate.
3. Invest the proceeds in an interest-bearing instrument in this higher-interest-
rate currency.
4. Simultaneously hedge exchange risk by buying a forward contract to convert the
investment proceeds into the first (lower interest rate) currency.
The returns in this case would be the same as those obtained from investing in interest-
bearing instruments in the lower interest rate currency. Under the covered interest rate parity
condition, the cost of hedging exchange risk negates the higher returns that would accrue
from investing in a currency that offers a higher interest rate.
Covered Interest Rate Examples
Assume Google Inc., the U.S. based multi-national company, needs to pay it's European
employees in Euro in a month's time.
Google Inc. can achieve this in several ways viz:
Buy Euro forward 30 days to lock in the exchange rate. Then Google can invest in
dollars for 30 days until it must convert dollars to Euro in a month. This is called
covering because now Google Inc. has no exchange rate fluctuation risk.
Convert dollars to Euro today at spot exchange rate. Invest Euro in a European bond
(in Euro) for 30 days (equivalently loan out Euro for 30 days) then pay it's obligation
in Euro at the end of the month.
Under this model Google Inc. is sure of the interest rate that it will earn, so it may convert
fewer dollars to Euro today as it's Euro will grow via interest earned. This is also called
covering because by converting dollars to Euro at the spot, the risk of exchange rate
fluctuation is eliminated.
The following equation represents covered interest rate parity.
where Ft is the forward exchange rate at time t. The dollar return on dollar deposits,
1 + $ , is shown to be equal to the dollar return on euro deposits,

19. 16
5.1.1 Covered Interest Rate Arbitrage
Arbitrage occurs when a security is purchased in one market and simultaneously sold in
another market at a higher price, thus considered to be risk-free profit for the trader.
Arbitrage provides a mechanism to ensure prices do not deviate substantially from fair
value for long periods of time.
For example, assume that the interest rate for borrowing funds for a one-year period in
Country A is 3% per annum, and that the one-year deposit rate in Country B is 5%.
Further, assume that the currencies of the two countries are trading at par in the spot
market (i.e., Currency A = Currency B). An investor does the following:
Borrows in Currency A at 3%
Converts the borrowed amount into Currency B at the spot rate
Invests these proceeds in a deposit denominated in Currency B and
paying 5% per annum
The investor can use the one-year forward rate to eliminate the exchange risk implicit
in this transaction, which arises because the investor is now holding Currency B, but
has to repay the funds borrowed in Currency A.
Market forces ensure that forward exchange rates are based on the interest rate
differential between two currencies, otherwise arbitrageurs would step in to take
advantage of the opportunity for arbitrage profits.
5.2 Uncovered Interest Rate Parity (UIP)
Uncovered Interest Rate theory states that expected appreciation (depreciation) of a currency
is offset by lower (higher) interest.
Uncovered Interest Rate Example
For example, Google Inc. can implement the other method, that is:
Google Inc. can also invest the money in dollars today and change it for Euro at the end of
the month. This method is uncovered because the exchange rate risks persist in this
transaction. The following equation represents uncovered interest rate parity.
Where,
Et(St+k) is the expected future spot exchange rate at time t + k
k is the number of periods into the future from time t
St is the current spot exchange rate at time t

20. 17
i$ is the interest rate in one country (for example, the United States)
ic is the interest rate in another country or currency area (for example, the Eurozone)
The dollar return on dollar deposits, 1 + $ , is shown to be equal to the dollar return
on euro deposits,
5.3 Covered Interest Rate Vs. Uncovered Interest Rate
Recent empirical research has identified that uncovered interest rate parity does not hold,
although violations are not as large as previously thought and seems to be currency rather
than time horizon dependent.
In contrast, covered interest rate parity is well established in recent decades amongst the
OECD economies for short-term instruments. Any apparent deviations are credited to
transaction costs.
6. THE INTEREST RATE PARITY RELATIONSHIP BETWEEN
THE U.S. AND CANADA
The historical relationship between interest rates and exchange rates for the United States
been exceptionally
volatile since the year 2000. After reaching a record low of US61.79 cents in January 2002,
it rebounded close to 80% in the following years, reaching a modern-day high of more than
US$1.10 in November 2007.
Looking at long-term cycles, the Canadian dollar depreciated against the U.S. dollar from
1980 to 1985. It appreciated against the U.S. dollar from 1986 to 1991 and commenced a
lengthy slide in 1992, culminating in its January 2002 record low. From that low, it then
appreciated steadily against the U.S. dollar for the next five and a half years.
Prime rates (the rates charged by commercial banks to their best customers) are used to test
the UIP condition between the U.S. dollar and Canadian dollar from 1988 to 2008.
Based on prime rates, UIP held during some points of this period, but did not hold at others,
as shown in the following examples:
The Canadian prime rate was higher than the U.S. prime rate from September 1988
to March 1993. During most of this period, the Canadian dollar appreciated against
its U.S. counterpart, which is contrary to the UIP relationship.

21. 18
The Canadian prime rate was lower than the U.S. prime rate for most of the time
from mid-1995 to the beginning of 2002. As a result, the Canadian dollar traded at a
forward premium to the U.S. dollar for much of this period. However, the Canadian
dollar depreciated 15% against the U.S. dollar, implying that UIP did not hold
during this period as well.
The UIP condition held for most of the period from 2002, when the Canadian dollar
commenced its commodity-fueled rally, until late 2007, when it reached its peak.
The Canadian prime rate was generally below the U.S. prime rate for much of this
period, except for an 18-month span from October 2002 to March 2004. (Picardo,
2018).
7. HEDGING EXCHANGE RISK
A hedge is an investment to reduce the risk of adverse price movements in an asset.
Normally, a hedge consists of taking an offsetting position in a related security, such as
a futures contract. (Hedge, n.d)
Forward rates can be very useful as a tool for hedging exchange risk. The caveat is that a
forward contract is highly inflexible, because it is a binding contract that the buyer and seller
are obligated to execute at the agreed-upon rate.
A foreign exchange hedge (also called a FOREX hedge) is a method used by companies to
eliminate or "hedge" their foreign exchange risk resulting from transactions in foreign
currencies. This is done using either the cash flow hedge or the fair value method. The
accounting rules for this are addressed by both the International Financial Reporting
Standards (IFRS) and by the US Generally Accepted Accounting Principles (US GAAP) as
well as other national accounting standards.
A foreign exchange hedge transfers the foreign exchange risk from the trading or investing
company to a business that carries the risk, such as a bank. There is cost to the company for
setting up a hedge. By setting up a hedge, the company also forgoes any profit if the
movement in the exchange rate would be favourable to it.
When companies conduct business across borders, they must deal in foreign currencies.
Companies must exchange foreign currencies for home currencies when dealing with
receivables, and vice versa for payables. This is done at the current exchange rate between
the two countries. Foreign exchange risk is the risk that the exchange rate will change
unfavorably before payment is made or received in the currency. For example, if a United
States Company doing business in Japan is compensated in yen, that company has risk
associated with fluctuations in the value of the yen versus the United States dollar. (Foreign
Exchange , n.d.)

22. 19
Understanding exchange risk is an increasingly worthwhile exercise in a world where the
best investment opportunities may lie overseas.
Consider a U.S. investor who had the foresight to invest in the Canadian equity market at the
2002 to August 2008 were 106%, or about 11.5% annually. Compare that performance with
that of the S&P 500, which has provided returns of only 26% over that period, or 3.5%
annually.
invested in the S&P/TSX at the start of 2002 would have had total returns (in terms of USD)
of 208%
U.S. dollar over that time frame turned healthy returns into spectacular ones.
At the beginning of 2002, with the Canadian dollar heading for a record low against the U.S.
dollar, some U.S. investors may have felt the need to hedge their exchange risk. In that case,
if they had been fully hedged over the period mentioned above, they would have foregone
With the benefit
of hindsight, the prudent move in this case would have been to not hedge the exchange risk.
(Picardo, 2018).

23. 20
STUDY ON
PAKISTAN CURRENCY VALUE RESPECT TO US DOLLARS,
INTERNATIONAL TRADING, INTEREST RATE, ECONOMIC
SITUATION, AND FOREX RATE

24. 21
8. PAKISTAN CURRENCY VALUE RESPECT TO US
DOLLARS, INTERNATIONAL TRADING, INTEREST RATE,
ECONOMIC SITUATION, AND FOREX RATE
8.1 USD TO PKR EXCHANGE RATES - BACKGROUND
Up until 1982, the Pakistani rupee was pegged to the British pound, after which the
government decided to turn it into a managed float. Between 1982 and 1983, the rupee
devalued by 38.5%, and devalued the same again between 1987 and 88, largely as a result of
this. With regards to the US dollar, the Pakistani rupee depreciated against the dollar up until
-account surplus increased the value of the rupee
against the dollar. The rupee was stabilized by lowering the interest rate, in order to preserve
the country's export competitiveness. (PKR, n.d.)
had a huge effect on the value of the rupee, with it losing 23% of its value since December
2007 to a record low of 79.2 against the dollar. Foreign reserves fell to $2 billion, but had
recovered to $17 billion by February 2011. From there, more than $10 billion was borrowed
money with interest applicable, helping to strengthen the rupee. By February 2016, the
Pakistani rupee was at 104.66 PKR to 1 US dollar, and as of June 2017, sits at 104.83 to 1
USD. (US dollar to
USD/PAK Rates during year 2018.
Year 2018 $ 1 = -- Rs.
1 March, 2018 115.71
1 April, 2018 115.77
1 May, 2018 115.775
1 June, 2018 121.735
1 July, 2018 124.06
1 Aug, 2018 123.50
1 Sep, 2018 123.11
1 Oct, 2018 132.97
8.1.1 What Affects USD/PKR Rates?
In the past, the Bank of Pakistan constantly interfered in the foreign exchange market to
try and stabilize the value of the Pakistani rupee. Noticeable macroeconomic
105
110
115
120
125
130
135
1-Mar 1-Apr 1-May 1-Jun 1-Jul 1-Aug 1-Sep 1-Oct
DATE
USD/PKR Exchange Rates (2018) $ 1 =

25. 22
and this caused the rupee to stabilize until late 2007. Regular remittances from
its significant reliance on imports has resulted in a growing current account deficit.
Payments made by Pakistan toward the China Pakistan Economic Corridor (CPEC)
pay around U.S. $90 billion in installments, starting from 2020. The effect that these
payments wi
depreciate even more.
government on multiple occasions. Militant attacks tend to have an impact on the
government is trying to encourage growth by going the privatization way, hoping to
attract foreign investment and reduce its current account deficit. This might work well
for the rupee.
Other factors that may have an effect on the USD/PKR currency pair include policy
changes implemented by the U.S. Federal Reserve, exports from Pakistan, and trade
relations between both countries.
While sending money from the United States to Pakistan or the other way around is
simple, it is important that you pay attention to the USD/PKR exchange rate that
applies on your transfer. To get the best deal, all you need to do is compare the top
overseas money transfer companies according to where you live.
8.2 STATE BANK OF PAKISTAN
Monetary policy only makes news when it is changing. State Bank of Pakistan (SBP) has
increased the rate by 100 basis points to 7.5% for the next two months. In January, the
central bank had increased the rate by 25 basis points, followed by an increase of 50 basis
points in May. So cumulatively, the SBP has revised up the rate by 175 basis points since
January 2018. While a rise in the rate was expected, experts differed over how much. The
100-point rise comes as inflationary pressure, along with the current account deficit, takes
(Editorial, 2018)
The SBP move is targeted at cutting imports and reducing demand for dollars to stabilize
foreign currency reserves that have been depleting rapidly in the last few months, in view
of a huge import bill, repayments to international creditors and debt servicing. Besides,
export proceeds, combined with remittances from abroad, have been unable to match the
increase in imports, widening the current account deficit to $15.96 billion in the first 11
months of the previous fiscal year. Expenditures too have swelled significantly during the
election year, with the fiscal deficit set to cross 7% of GDP. (Siddiqui, 2018, July 14).
The rupee fell modestly against the dollar, however, it gained in terms of the euro on the
money market during the week, ended on February 24, 2018. In the open market, the rupee
lost 50 paisas in terms of the dollar for buying and selling Rs 111.90 and Rs 112.20, the

26. 23
rupee, however, managed to gain in relation to the euro, picking up 75 paisas for buying and
selling at Rs 136.75 and Rs 138.25.
In the inter-bank market, the rupee traded almost around Rs 110.57 and Rs 110.58 versus the
dollar. Commenting on the rising demand for dollars, some experts said that in fact, when
dollars' buying increases, the rupee dropped it's value.
Besides, they observed that import bill surged due to rise in oil prices to 11.6 billion dollars
in the first seven months of current fiscal year as a result of an increase in the global prices
of crude and grams.
State Bank of Pakistan (SBP) reserves declined to 18.8 billion dollars. The government had
held back exchange rate for long, but recently allowed around five percent adjustment in the
rupee-dollar parity. However, more flexibility is needed to move in the desired direction.
According to the market sources, number of buyers increased which helped the dollar to
move up in terms of the rupee. (The Rupee, 2018)
OPEN MARKET RATES: On Monday, the rupee gave 10 paisas in relation to the dollar
for buying and selling Rs 111.40 and Rs 111.70, they said. The rupee also shed 20 paisas
against the euro for buying and selling at Rs 137.50 and Rs 139.00, they added.
ON Tuesday, the rupee dropped by 10 paisas in relation to the dollar for buying and selling
Rs 111.50 and Rs 111.80, they said. The rupee, however, gained 70 paisas against the euro
for buying and selling at Rs 136.80 and Rs 138.30.
On Wednesday, the rupee continued slide against the dollar, losing 10 paisas more for
buying and selling Rs 111.60 and Rs 111.90. The rupee, however, inched up against the
euro, picking up five paisas for buying and selling at Rs 136.75 and Rs 138.25.
On Thursday, the rupee lost further 30 paisas against the dollar for buying and selling Rs
111.90 and Rs 112.20. The rupee, however, gained 15 paisas in terms of the euro for buying
and selling at Rs 136.60 and Rs 138.10.
On Friday, the rupee did not move any side in terms of the dollar for buying and selling Rs
111.90 and Rs 112.20. The rupee, however, lost 40 paisas in relation to the euro for buying
and selling at Rs 137.00 and Rs 138.50.
On Saturday, the rupee sustained overnight levels in terms of the dollar for buying and
selling Rs 111.90 and Rs 112.20. The rupee managed to extend overnight gains in relation to
the euro, picking up 25 paisas for buying and selling at Rs 136.75 and Rs 138.25. (The
Rupee, 2018)
INTER-BANK MARKET RATES: On February 19, the rupee moved slightly in relation
to the dollar for buying and selling at Rs 110.55 and Rs 110.56. On February 20, the rupee
moved cautiously versus the dollar for buying and selling at Rs 110.56 and Rs 110.58. On
February 21, the rupee traded within a tight range versus the dollar for buying and selling at
Rs 110.57 and Rs 110.58. On February 22, the rupee did not fluctuate sharply versus the
dollar for buying and selling at Rs 110.57 and Rs 110.58. On February 23, the rupee was

27. 24
unchanged versus the dollar for buying and selling at Rs 110.57 and Rs 110.58. (The Rupee,
2018)
The US currency has been weighed down by a variety of factors this year, including
concerns that Washington might pursue a weak dollar strategy and the perceived erosion of
its yield advantage as other countries start to scale back easy monetary policy.
8.3 IMF RECOMMENDS DEVALUING RUPEE AND
INCREASING INTEREST RATE
percent as insufficient, suggesting to raise it to double digits to fill in the gaping current
account deficit.
The IMF suggested depreciating the currency by at least 15 percent in the Fiscal Year 2018-
19. The organization deems it incumbent to stabilize the presently staggering economy.
While the State Bank is of the view that the value of money should not weaken by more than
22 percent (current value), the IMF assessed it should be devalued by 30 percent.
The suggestions have come in the staff-
for Pakistan, Herald Finger, where IMF considered the recent fiscal and monetary
adjustments insufficient.
The organization expressed concern that the authorities seemed quite satisfied and they were
s
economic viability.
The government and IMF are having differences on issues ranging from the extent of higher
As mentioned earlier, the IMF suggested a rise in the interest rate, to 11 percent. It deemed it
inevitable to contain inflation and minimize the deficit.
Another point of difference that arose in staff-level talks was the exchange rate parity. The
IMF suggested the exchange rate of Rs. 145 to a dollar. However, the government deemed
Rs. 137 to a dollar till June 2019 sufficient to deal with the challenges.
Also, IMF projects the budget deficit at 5.5 percent of the GDP while the government had
targeted it at almost half a percentage point lower than that. It needs to be mentioned here
that the recommendations of IMF are not mandatory on Pakistan to follow. (Shabbir, 2018)

28. 25
9. REFERENCES
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value/cfp4.asp
Editorial. (2018, July 16). The Express Tribune. Retrieved from
https://tribune.com.pk/story/1759076/6-rising-interest-rate/
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https://www.forexkarma.com/interest-rate-parity.html#.W8W01tczYdU
Key Factors that Affect Foreign Exchange Rates. (n.d.). In CompareRemit. Retrieved from
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currency-exchange-rates/
Essentials of Economics, 3rd
ed. NY: Worth
Publishers
Murphy, C. (n.d.). Interest Rates. In Investopedia. Retrieved from
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Nelson Brian (Ed.). (2009). A Comprehensive Dictionary of Economics. Delhi: Abhishek
Publications.
Pareek, M. (2009). Calculating forward exchange rates-covered interest parity. In
RiskPrep.com. Retrieved from https://www.riskprep.com/all-tutorials/36-exam-
22/59-calculating-forward-exchange-rates-covered-interest-parity
Parity. (n.d.). In Investopedia. Retrieved from
https://www.investopedia.com/terms/p/parity.asp
Picardo, E. (2018).Using interest rate parity to trade forex. In Investopedia. Retrieved from
https://www.investopedia.com/articles/forex/08/interes-rate-parity.asp
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ProPakistani.pk. Retrieved from https://propakistani.pk/2018/10/04/imf-
recommends-devaluing-rupee-and-increasing-interest-rate/

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Siddiqui, S. (2018, July 14). The Express Tribune. Retrieved from
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interest-rate-100-basis-points-7-5/
The Rupee: Weak Trend. (2108, February 26). Business Recorder. Retrieved from
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US dollar to Pakistani rupee exchange rates. (n.d.). Travelex Currency Services Inc.
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