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How to use the Interest Rate Parity to Trade Forex

In the financial market, interest rates will include the key basic determinants of movements. The interest rate decision by Federal Reserve this year, has been the most critical discussions by financial professionals across the world. Janet Yellen, the fed chair, has made her intentions clear in regard to increasing the interest rates based upon the information which is being released. It has caused the increased strengthening of the U.S. dollar against all global currencies. Also, it has led to fears within the global community that this tightening might produce a financial recession. The IMF (International Monetary Fund) urged the fed to delay that tightening.

As the debate on rate increases rages on, smart investors, as well as market makers are going to be allocating their money to take advantage of the IRP (interest rate parity). Basically, IRP (interest rate parity) is the fundamental equation which exists or governs the correlation between a country’s currency exchange rate and interest rates. Using IRP (interest rate parity), the premise is that hedged returns from a variety of currencies should be similar irrespective of the level of interest rate.

1. Utilizing Interest Rate Parity to Trade Forex

In utilizing this strategy, it’s extremely important that you calculate the forward exchange rates. Forward exchange rates is going to refer to the exchange rates of the currencies during a future span of time. The spot exchange rates, on the other hand, is going to refer to the present rates. The formula below was suggested in order to calculate the forward rate as the U.S.D. is the base currency.

Forward Rate = Spot Rate X (1 + Oversea country’s interest rate)

(1 + Domestic country’s interest rate)

In order to get your forward rates, an individual may obtain them from a local bank and a trading broker within a period of under a week and beyond. In a spot currency, forwards usually are quoted with a bid-ask spread.

One great example in utilizing this trading strategy may be discovered by considering Canada and the United States, the largest trading partners within the world. Consider this USDCAD couple is priced at 1.0650. And at the same time, the U.S.D. interest rate is 3.15 percent, whereby the Canadian dollar is 3.6 percent.

Thereby, the forward exchange rate is going to be:

1 U.S. Dollar = 1.0650 X (1 + 3.64 percent) = 1.0700 Canadian Dollar

(1 + 3.15 percent)



2. Swap Point

 

In order to explain what this calculation means, the swap point—that’s the difference between a spot rate and forward rate is extremely important. If a swap is positive, it’s well-known as a forward premium and as it’s negative, it’s referred to as a forward discount. Additionally, a currency which has a low interest rate will typically trade at a forward premium against a currency that has a high interest rate. Utilizing this example, the U.S.D is at a forward premium against the CAD.

As a trader, having knowledge of how you can calculate the swaps and forward exchange rates is highly important. The following thing to keep in mind is on the two kinds of interest rate parity that are uncovered and covered interest rate parity.

A trader who uses the covered interest rate parity has to bear in mind that the forward exchange rates always ought to integrate the interest rates of the two countries. It will mean that a trader has to avoid borrowing funds at a country that has low interest rates to invest within a country that has high interest rates. An alternative strategy includes borrowing funds within a low interest rate country then invest in assets which have better returns.

The uncovered IRP principle, on the other hand, is going to imply that the difference in between the interest rates between the two countries is going to be the same as the expected change within exchange rates in between the two said countries. For example, if the interest rate difference in between the two countries is 3 percent, the currency that has the high interest rate is going to decline with 3 percent.

The challenge for the ordinary trader is how to utilize this strategy to day trade. But, it isn’t as challenging as it may seem. The trader has to major in as few currencies as he or she can. It is recommended to use currencies of countries like Japan, Canada, the United States, and Euro dominated countries. It’s because it’s possible to obtain the data from those countries. After obtaining the data, you ought to calculate the forward rates then determine the best currency in order to trade with. With a couple of countries in place, you’ll be at an excellent position to fully research them prior to making a final decision in regard to how to hedge the investment.

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