Interest rate parity

Interest rate parity is the difference between two countries, is equal to the
percentage difference between a forward exchange rate and a spot exchange
rate. Interest rate parity plays an essential role in foreign exchange markets,
connecting interest rates, spot exchange rates and foreign exchange rates.
Relates interest rate differentials between home country and foreign country to
the forward premium/discount on the foreign currency The size of the forward
premium or discount on a currency should be equal to the interest rate
differential between the countries of concern. If nominal interest rates are
higher in country A than country B, the forward rate for country Bs currency
should be at a premium sufficient to prevent arbitrage
IRP: F/S = (1+rd)/(1+rf)
If domestic interest rates are less than foreign interest rates, foreign currency
must trade at a forward discount to offset any benefit of higher interest rates in
foreign country to prevent arbitrage.
Interest Rate Parity Condition
Interest rate parity refers to a condition of equality between the rates of return
on comparable assets between two countries. The term is somewhat of a
misnomer on the basis of how it is being described here, as it should really be
called rate of return parity. The term developed in an era when the world was in
a system of fixed exchange rates. Under those circumstances, and as will be
demonstrated in a later chapter, rate of return parity did mean the equalization
of interest rates. However, when exchange rates can fluctuate, interest rate
parity becomes rate of return parity, but the name was never changed.
International Fisher effect
States that nominal interest rates (r) are a function of the real interest rate (a)
and a premium (i) for inflation expectations
R=a+i

The generalized version of the Fisher effect says that real returns are equalized
across countries through arbitrage. According to the generalized International
Fisher Theory, the real interest rates should be same across the borders. But
the validity of generalized Fisher theory largely depends on the integration of
the capital market. That is, the capital in the market needs to be free to flow
across borders. Usually the capital markets of the developed countries are
integrated in nature. It has been seen that in the underdeveloped countries the
currency flow is restricted.
Real Rates of Interest
Should

tend

toward

equality

everywhere

through

arbitrage,

with

no

government interference nominal rates vary by inflation differential or

rh - rf = ih - if
If expected real returns are higher in one country than another, capital will flow
from country with lower real returns to a country with higher real returns. This
process will continue until returns are equalized across countries.
IFE STATES:
The spot rate adjusts to the interest rate differential between two countries.
IFE = PPP + FE
The International Fisher Theory observation holds that a country with higher
interest rate will also be inclined to have a higher inflation rate. The
International Fisher Theory also estimates the future exchange rates based on
the nominal interest rate relationships.