Interest Rate Parity

Definition

Interest rate parity is an economic theory that states the difference in interest rates between two countries should be equal to the difference in the forward exchange rate and the spot exchange rate between their currencies. It is a fundamental concept in understanding foreign exchange rates and the relationship between interest rates and currency values.

5 Must Know Facts For Your Next Test

1. Interest rate parity suggests that higher interest rates in one country should be offset by an expected depreciation in that country's currency.
2. The theory assumes that there are no barriers to capital flows and that investors can borrow and lend freely in both countries.
3. Interest rate parity is a key concept in understanding the relationship between exchange rates and interest rates, as it helps explain how these variables are related.
4. Deviations from interest rate parity can create opportunities for arbitrage, where investors can profit from the difference between the actual and theoretical exchange rate.
5. Interest rate parity is an important consideration for multinational corporations and international investors when making decisions about capital allocation and risk management.

Review Questions

• Explain how interest rate parity relates to the determination of foreign exchange rates.
  • According to the interest rate parity theory, the difference in interest rates between two countries should be equal to the difference in the forward exchange rate and the spot exchange rate between their currencies. This relationship suggests that higher interest rates in one country should be offset by an expected depreciation in that country's currency, as investors seek to equalize the returns from investing in the two countries. By understanding this connection, we can better predict how changes in interest rates will impact foreign exchange rates and make more informed decisions about international investments and capital flows.
• Describe the role of interest rate parity in the context of exchange rate risk and international investing.
  • Interest rate parity is a crucial concept for understanding exchange rate risk and its implications for international investing. The theory suggests that investors should be indifferent between investing in two countries with different interest rates, as the difference in rates should be offset by the expected change in the exchange rate. This means that deviations from interest rate parity can create opportunities for arbitrage, where investors can profit from the difference between the actual and theoretical exchange rate. Consequently, understanding interest rate parity is essential for multinational corporations and international investors when making decisions about capital allocation, risk management, and hedging strategies to mitigate exchange rate fluctuations.
• Analyze how violations of interest rate parity can impact the global financial system and the behavior of international investors.
  • Significant and persistent violations of interest rate parity can have far-reaching implications for the global financial system and the behavior of international investors. When the actual exchange rate deviates from the rate implied by interest rate parity, it can create incentives for speculative capital flows as investors seek to capitalize on the arbitrage opportunities. This can lead to increased volatility in foreign exchange markets, disrupt international trade and investment flows, and potentially destabilize national economies. Furthermore, violations of interest rate parity can undermine the efficiency of global capital markets, as investors may not be able to rely on the assumed relationship between interest rates and exchange rates when making investment decisions. Addressing these violations and maintaining interest rate parity is therefore crucial for promoting financial stability and facilitating the smooth functioning of the international monetary system.

Related terms

Spot Exchange Rate:

The current market price at which one currency can be exchanged for another for immediate delivery.

Forward Exchange Rate: The exchange rate at which a currency can be bought or sold for delivery and payment at a future date.

Covered Interest Rate Parity: A condition where the difference in interest rates between two countries is offset by the forward premium or discount on the currency, eliminating any arbitrage opportunities.