Question

9. Would the currency of a smaller developing country with capital controls and tariffs/taxes result in Covered Interest Rate Parity (IRP) holding with respect to larger developed countries? Why or why not?

Answer 1

Covered interest rate parity (CIRP) shows the relation between interest rate and spot and forward currency values of two countries.
CIRP; (1+id) = F/S (1+if)
Where; id is the domestic interest rate, if is the foreign interest rate, S is the current spot exchange rate and F is the forward exchange rate.
Covered interest rate parity is a non arbitrage condition. For a small developing country with capital control and tax rates, will have low level relation with the foreign market. So they will not prefer to do any kind of interest parity agreements. This CIRP used for the forward contracts to cover exchange rate. Country having strict measures on the foreign relations will not try to do this. They have high level of tax on export. They give low preference and interest towards trade. Under this situation, there is an avoidance of foreign risk in the market.
On the other hand, the consideration towards the low level capital mobility with other country, the investors in the domestic country should be secure from the exchange rate risks. Under CIRP the investors are indifferent towards the interest rate. The domestic country tried to make a forward agreement to avoid the risks in the foreign market. So the low level export countries will not bothered about the risks and unnecessary occurrence in the market.