Question

critical evaluation of interest rate parity

Answer 1

Interest rate parity theory states that

Interest rate differencial between two countries = differencial between forward exchange rate and spot exchange rate.

It plays an important role in foreign exchange market, connecting spot rate, interest rate and forward rate. Formula of it is

F/s = (1+r)/(1+r)

F= forward rate

S= Spot rate

If one country offers a higher risk-free rate of return in one currency than that of another, the country that offers the higher risk-free rate of return will be exchanged at a more expensive future price than the current spot price. In other words, the interest rate parity presents an idea that there is no arbitrage in the foreign exchange markets. Investors cannot lock in the current exchange rate in one currency for a lower price and then purchase another currency from a country offering a higher interest rate.

The interest rate parity is said to be covered when the no-arbitrage condition could be satisfied through the use of forward contracts in an attempt to hedge against foreign exchange risk. Conversely, the interest rate parity is said to be uncovered when the no-arbitrage condition could be satisfied without the use of forward contracts to hedge against foreign exchange risk.