Interest Rate Parity

Definition

Interest rate parity is a financial theory that suggests the relationship between interest rates and currency exchange rates should lead to an equilibrium where expected returns on investments in different currencies are equal when adjusted for exchange rate risk. This concept helps explain how differences in national interest rates can affect exchange rates, which is crucial for understanding global financial markets and trading strategies.

5 Must Know Facts For Your Next Test

1. Interest rate parity assumes that capital is mobile and investors will move funds to wherever they can achieve the best return, considering the risks involved.
2. The theory relies on the idea that if interest rates are higher in one country compared to another, the currency of the higher-rate country is expected to depreciate over time, aligning returns across currencies.
3. The two main forms of interest rate parity are covered interest parity, which uses forward contracts, and uncovered interest parity, which does not.
4. Failure of interest rate parity can lead to arbitrage opportunities, where traders can exploit differences in interest and exchange rates for profit.
5. Central banks may influence interest rates through monetary policy, impacting the effectiveness of interest rate parity in predicting exchange rates.

Review Questions

• How does interest rate parity explain the relationship between national interest rates and currency values?
  • Interest rate parity explains that when a country has higher interest rates compared to another, its currency is expected to depreciate. This adjustment ensures that investors achieve similar returns on investments across different currencies after accounting for exchange rate changes. As a result, any discrepancy between interest rates prompts investors to move their funds, leading to adjustments in currency values until parity is restored.
• Discuss the implications of covered and uncovered interest arbitrage on global currency trading strategies.
  • Covered and uncovered interest arbitrage strategies rely on the principles of interest rate parity to exploit differences in interest rates between countries. Covered arbitrage uses forward contracts to lock in exchange rates, minimizing currency risk, while uncovered arbitrage takes on more risk by not using such contracts. Both strategies highlight how traders can seek profit opportunities in foreign exchange markets, but they also demonstrate varying levels of risk tolerance among investors.
• Evaluate how changes in monetary policy by central banks affect the practical application of interest rate parity in foreign exchange markets.
  • Changes in monetary policy by central banks can significantly impact interest rates and, consequently, the application of interest rate parity. For example, if a central bank raises interest rates to combat inflation, it can attract foreign investment, leading to an appreciation of its currency. However, if other countries do not adjust their policies similarly, it can create discrepancies that challenge the assumptions of interest rate parity. Traders must continuously assess these changes and their effects on exchange rates and returns when making investment decisions.

Related terms

Forward Exchange Rate: The agreed-upon exchange rate for a currency pair at a future date, used to hedge against potential fluctuations in exchange rates.

Covered Interest Arbitrage: A strategy that takes advantage of discrepancies between interest rates and exchange rates, ensuring a risk-free profit through the use of forward contracts.

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