Interest Rate Parity

Definition

Interest rate parity is a fundamental financial theory that states the relationship between interest rates and exchange rates for two currencies, suggesting that the difference in interest rates between two countries will be offset by the expected change in exchange rates over time. This concept ensures that arbitrage opportunities are eliminated, leading to equilibrium in currency markets. The theory is crucial in understanding how exchange rates are influenced by interest rate differentials and plays a vital role in currency policies.

5 Must Know Facts For Your Next Test

1. Interest rate parity helps explain why higher interest rates in one country can lead to depreciation of that country's currency compared to another with lower interest rates.
2. There are two forms of interest rate parity: covered and uncovered, with covered interest rate parity involving the use of forward contracts to hedge against exchange rate risk.
3. The concept relies on the assumption of no transaction costs and capital mobility, meaning investors can move money freely across borders without restrictions.
4. If interest rate parity holds, investors should not be able to earn arbitrage profits through discrepancies in interest rates and exchange rates across different markets.
5. Changes in domestic and foreign economic conditions can lead to shifts in interest rates, which in turn affect exchange rates according to the principles of interest rate parity.

Review Questions

• How does interest rate parity contribute to the understanding of exchange rate movements between two countries?
  • Interest rate parity establishes a clear connection between interest rates and exchange rates, illustrating how differences in interest rates will influence currency values over time. If one country has higher interest rates than another, its currency is expected to depreciate relative to the lower interest rate country. This theory helps investors predict exchange rate movements based on prevailing interest rates and prevents arbitrage opportunities from arising.
• Analyze how covered interest arbitrage can be utilized by investors when there are discrepancies between domestic and foreign interest rates.
  • Covered interest arbitrage allows investors to capitalize on differences in interest rates while eliminating exchange rate risk through forward contracts. By borrowing funds in a country with low-interest rates, converting them into a foreign currency with higher returns, and securing the future exchange rate using a forward contract, investors can ensure profit without exposure to currency fluctuations. This mechanism reinforces the concept of interest rate parity by aligning returns across markets.
• Evaluate the implications of failing to achieve interest rate parity for global financial markets and international trade.
  • When interest rate parity does not hold, it creates potential arbitrage opportunities that can lead to significant volatility in global financial markets. Investors may rush to take advantage of these discrepancies, causing rapid changes in currency values that can disrupt international trade by affecting import and export costs. Furthermore, persistent deviations from interest rate parity might signal underlying economic issues, influencing investor confidence and altering capital flows between nations, which can destabilize economies.

Related terms

Arbitrage: The practice of taking advantage of price differences in different markets to generate a profit without any risk.

Forward Exchange Rate: The agreed-upon exchange rate for a currency pair for a transaction that will occur at a future date, used in hedging against currency risk.

Covered Interest Arbitrage: A strategy that involves borrowing in one currency, converting it into another, investing at the higher interest rate, and using a forward contract to hedge against exchange rate fluctuations.