Question

Required:

What are some reasons why interest rate parity may not hold in spite of the economic forces that should ensure the equilibrium relationship? Please write at least 200 words. Thank you.

Answer 1

Intrest rate parity theory governs the relationship between the intrest rate and exchange rates of the two countries, the basic crux of this theory is that the return from all the countries shall be same at all levels of interest rate, because as per parity theory such difference will offset with the difference in exchange rates of the two countries. The arbitrage opportunities are traced by the investors using this theory.

The reason it does not hold true inspite of the economic forces being in equilibrium is that it is based on assumption that there is unlimited availability of funds in both the economies. Thus, when future or forward contracts are not available for hedge then the uncovered risk parity theory is reached.