Interest Rate Parity

Definition

Interest rate parity is a financial theory that establishes a relationship between the interest rates of two countries and their exchange rates. It asserts that the difference in interest rates between two countries is equal to the expected change in exchange rates between their currencies, ensuring that arbitrage opportunities are eliminated. This concept is crucial in understanding how exchange rate systems operate, making investment decisions, and determining currency value in foreign exchange markets.

5 Must Know Facts For Your Next Test

1. Interest rate parity comes in two forms: covered interest parity, which involves hedging against exchange rate risk, and uncovered interest parity, which does not.
2. The theory assumes that investors are rational and markets are efficient, meaning that any potential arbitrage opportunities will be quickly exploited and eliminated.
3. Interest rate parity helps explain why countries with higher interest rates tend to have weaker currencies, as capital flows to where returns are higher.
4. This concept is vital for multinational corporations when making global investment decisions, as it impacts the cost of capital across different currencies.
5. Changes in monetary policy by central banks can directly affect interest rates and consequently influence exchange rates through the lens of interest rate parity.

Review Questions

• How does interest rate parity relate to the concept of arbitrage in foreign exchange markets?
  • Interest rate parity is fundamentally tied to arbitrage because it prevents discrepancies between interest rates and exchange rates from existing. When there's a difference in interest rates between two countries, arbitrageurs will exploit that difference by borrowing in the country with the lower rate and investing in the country with the higher rate. This activity creates pressure on exchange rates until they align with what interest rate parity predicts, thus eliminating any arbitrage opportunities.
• Discuss how covered interest arbitrage functions as a practical application of interest rate parity and its significance for investors.
  • Covered interest arbitrage utilizes forward contracts to mitigate exchange rate risk while exploiting differences in interest rates between two currencies. By locking in the future exchange rate, investors can ensure a guaranteed profit from investing in higher-yielding currencies without exposure to currency fluctuations. This application reinforces the principle of interest rate parity by demonstrating how investors can achieve equilibrium through hedging strategies.
• Evaluate the implications of interest rate parity on global capital budgeting decisions for multinational corporations.
  • Interest rate parity significantly influences global capital budgeting decisions by affecting how multinational corporations assess investment opportunities across different countries. When evaluating projects, firms must consider local interest rates and expected currency movements, as these factors impact their overall cost of capital and potential returns. By understanding and applying the principles of interest rate parity, corporations can make informed decisions about where to allocate resources to maximize profitability while minimizing risks associated with fluctuating currencies.

Related terms

Arbitrage: The practice of taking advantage of price differences in different markets to earn a profit, often involving simultaneous buying and selling.

Forward Exchange Rate: The agreed-upon exchange rate for a currency transaction that will occur at a specified date in the future, often used to hedge against currency fluctuations.

Covered Interest Arbitrage: A strategy that involves borrowing in one currency at a lower interest rate and investing in another currency at a higher interest rate, while simultaneously using forward contracts to lock in exchange rates.