1. Compare and contrast interest rate parity and purchasing power parity.

Expert Solution

Interest Rate Parity: It focuses on why the forward rate differs from the spot rate and on the degrees of difference that should exist. This relate to specific point of time.

-Key Variables: Forward rate premium

-Basis: Interest rate differential

-Summary: The forward rate of one currency will content a premium (or discount) that is determined by the differential in interest rates between the two countries. As a result, covered interest result arbitrage will provide a return that is no higher than a domestic return.

Purchasing Power Parity: It focuses on how a currency’s spot rate will change over time. The theory suggests that the spot rate will change in accordance with inflation differentials.

-Key Variables: Percent change in spot exchange rate

-Basis: Inflation rate differential

-Summary: The spot rate of one currency with respect to another will change in reaction to the differential in inflation rates between two countries. Consequently, the purchasing power for consumers when purchasing goods in their own country will be similar to their purchasing power when importing goods from foreign country.

jeff jeffy answered 2 years ago

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