Question

1. Describe a situation from practice when the interest rate parity was an outstanding success and another situation where it led to poor results from faulty execution or naive application.

Answer 1

Interest rate parity explains the relationship between the interest rates and the relationship between the interest rates and the currency exchange rate. There is covered interest rate parity and uncovered interest rate parity. Now interest rate parity can be used to take positions in currency trade let’s say that there is difference in interest rates in India and US interest rate and the currency is not in line with dollar to rupee and according to interest rate parity rupee should appreciate vis a vis dollar. Now everything goes well you take a position in USD/INR and INR appreciates and you gain on your position in the next six months. Take the same situation but now add another factor. Suddenly because of the trade war between US and China the export of India is affected negatively and there is also market turbulence going on in the Indian stock market, now instead of INR appreciating the INR might depreciate you will have to incur loss on your position. So, interest rate parity does work but it works in the long term and it is also very difficult to define if that long-term duration will be 5 years or 10 years or more than that.