Interest Rate Parity

Definition

Interest rate parity is a financial theory that states the relationship between interest rates and exchange rates should be equal across countries to prevent arbitrage opportunities. It highlights that the difference in interest rates between two countries is equal to the expected change in their exchange rates over time. This concept is crucial for understanding how foreign exchange markets operate and the risks associated with currency fluctuations.

5 Must Know Facts For Your Next Test

1. Interest rate parity assumes that capital is perfectly mobile across borders, meaning investors can freely move money to take advantage of interest rate differences.
2. There are two forms of interest rate parity: covered interest rate parity (CIRP), which involves using forward contracts, and uncovered interest rate parity (UIRP), which does not.
3. If interest rate parity holds, investors should expect no arbitrage profits from differences in interest rates and foreign exchange rates.
4. Interest rate parity can help explain movements in exchange rates as it connects interest rates directly with currency values.
5. Deviations from interest rate parity can indicate potential profit opportunities, leading traders to execute arbitrage strategies until equilibrium is restored.

Review Questions

• How does interest rate parity relate to the concept of arbitrage in foreign exchange markets?
  • Interest rate parity directly links to arbitrage because it explains how discrepancies in interest rates between two countries lead to equalization through currency exchange rates. When investors spot differences that violate this parity, they can engage in arbitrage by borrowing in one currency with a lower interest rate and investing in another currency with a higher interest rate. This activity continues until the market corrects itself, reflecting the concept that interest rates and exchange rates must align.
• Discuss the implications of covered versus uncovered interest rate parity for international investors.
  • Covered interest rate parity involves hedging against currency risk using forward contracts, which guarantees a specific future exchange rate and removes uncertainty about future cash flows. Uncovered interest rate parity, on the other hand, does not involve such hedging and exposes investors to potential currency fluctuations, leading to risk. Understanding these two forms allows international investors to make informed decisions based on their risk tolerance and market outlook.
• Evaluate how shifts in domestic and foreign interest rates impact the stability of exchange rates under the theory of interest rate parity.
  • Shifts in domestic and foreign interest rates can significantly impact exchange rates by altering expectations of currency value based on the principle of interest rate parity. For example, if a country's interest rates increase compared to another, it may attract foreign investment, leading to an appreciation of its currency. Conversely, if rates decrease, capital may flow out, causing depreciation. Such shifts reflect adjustments in supply and demand dynamics for currencies as investors react to changing economic conditions, highlighting the interconnectedness of monetary policy and exchange market stability.

Related terms

Arbitrage: The simultaneous purchase and sale of an asset in different markets to profit from differing prices.

Forward Exchange Rate: The agreed-upon exchange rate for a transaction that will occur at a future date.

Currency Risk: The potential for loss due to fluctuations in the exchange rate between currencies.