Interest Rate Parity

Definition

Interest rate parity is an economic theory that establishes a relationship between interest rates and exchange rates of two currencies, indicating that the difference in interest rates between two countries is equal to the expected change in exchange rates over time. This concept helps explain how capital flows between countries, as investors seek to maximize their returns by considering both interest rates and currency value fluctuations. It highlights the interconnectedness of financial markets and serves as a foundation for understanding how exchange rates adjust to maintain equilibrium.

5 Must Know Facts For Your Next Test

1. Interest rate parity comes in two forms: covered interest parity and uncovered interest parity, each addressing different levels of risk related to exchange rate fluctuations.
2. Covered interest parity states that the difference in interest rates should equal the difference between the forward exchange rate and the spot exchange rate.
3. Uncovered interest parity relies on expectations of future exchange rates, assuming investors will be compensated for the risk of currency fluctuations with higher returns.
4. When interest rate parity holds true, there are no arbitrage opportunities available; otherwise, capital will flow until equilibrium is reached.
5. Interest rate parity is essential for understanding international finance, as it influences investment decisions and currency speculation.

Review Questions

• How does interest rate parity impact international investment decisions?
  • Interest rate parity significantly influences international investment decisions by providing a framework for comparing potential returns across different currencies. Investors look at both the interest rates offered by various countries and the expected changes in currency values due to exchange rates. When making investment choices, they consider whether the return from higher interest rates justifies the risks posed by possible currency depreciation or appreciation, thus shaping their allocation of capital across borders.
• Discuss the relationship between covered interest parity and forward contracts in maintaining equilibrium in foreign exchange markets.
  • Covered interest parity is maintained through the use of forward contracts, which allow investors to lock in an exchange rate for a future transaction. This eliminates exchange rate risk and ensures that any differences in interest rates between two countries will reflect accurately in the forward exchange rates. When covered interest parity holds, there are no arbitrage opportunities, meaning that capital flows will stabilize until any discrepancies are resolved, thus ensuring equilibrium in foreign exchange markets.
• Evaluate the implications of a breakdown in interest rate parity on global financial markets and capital flows.
  • A breakdown in interest rate parity can have significant implications for global financial markets and capital flows. When the expected relationship between interest rates and exchange rates fails to hold, it creates opportunities for arbitrage, which can lead to volatile capital movements as investors quickly seek to exploit these discrepancies. This can destabilize currency values and create uncertainty in international trade and investment. Furthermore, persistent deviations from interest rate parity may signal underlying economic issues in one or more countries, prompting further scrutiny from policymakers and investors alike.

Related terms

Forward Exchange Rate: The predetermined exchange rate at which two currencies will be exchanged at a specified future date, used to hedge against currency risk.

Covered Interest Arbitrage: A trading strategy that involves exploiting differences in interest rates between two countries while using forward contracts to eliminate exchange rate risk.

Uncovered Interest Arbitrage: A trading strategy where investors capitalize on interest rate differentials without using forward contracts, exposing them to potential exchange rate fluctuations.