Question

Explain the relevance of Interest Rate Parity in cross border capital budgeting and cross border acquisitions. How do project selection rules change if Interest Rate Parity conditions are not met due to market imperfections or private exchange rate forecasts?

Answer 1

Interest rate parity is connected with Interest Rate and Exchange Rate. It form a relationship between these two and explain the relationship between current exchange rate and forward exchange rate. According to Interest rate parity difference between current exchange rate and forward exchange rate is interest rate between these two country.

All cross border fund raising activities or cross border acquisitions are well planned in advance and have some associated fund flows to plan. In order to plan future fund inflows and outflows companies consider the prevailing interest rates among countries and spot and forward rates. In case of any change in interest rate increases the currency fluctuation risk for the organization and affect their planned fund flows. So using interest rate parity companies hedge their positions to eliminate interest rate or currency exchange risk.

If the interest rate parity does not exist due to market imperfections or private exchange rate then it will create arbitrage opportunity for traders to get some a riskfree profit using the currency exchange transactions.