Question

what does the nominal interest rate parity state? Would the condition be violated if nominal interest rates in the domestic and foreign country were different on two securities that were identical in all aspects? A currency premium would lead to a modification of the nominal interest rate parity condition. Why?

Answer 1

Interest rate parity (IRP) plays an essential role in foreign exchange markets connecting interest rates, spot exchange rates, and foreign exchange rates. Interest rate parity (IRP) is a theory according to which the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate.

If there were to be no expected changes in exchange rates then the interest rates in different countries would be equivalent to one another. If this were not the case then there would be arbitrage opportunities. Where we allow for changes in the exchange rate, covered interest rate parity condition describes a no-arbitrage relationship between spot and forward exchange rates and the two nominal interest rates associated with these currencies. This implies that forward premiums and discounts in the foreign exchange market offset interest differentials to eliminate possible arbitrage that would arise from borrowing at the low-interest rate currency and lending at the high-interest-rate currency, while covering for the foreign exchange risk.

Interest rate parity is a critical equilibrium relationship in international finance. However, it does not always hold perfectly, as we will see. The availability of borrowing and lending opportunities in different currencies allows firms to hedge transaction foreign exchange risk with money market hedges. We demonstrate that when interest rate parity is satisfied, money market hedges are equivalent to the forward market hedges of transaction exchange risk. Moreover, we can use interest rate parity to derive long-term forward exchange rates. Knowledge of long-term forward rates is useful in developing multiyear forecasts of future exchange rates, which are an important tool in the valuation of foreign projects.¹

If an investor chooses not to cover (or hedge) the exchange risk on a foreign money market investment, the return is uncertain and will be high if the foreign currency appreciates or low if the foreign currency depreciates. Our discussion of uncovered interest rate parity condition in the foreign money market uses some basic statistical methods that are commonly used to explain empirical evidence about investment returns in all asset markets.