Question

Can someone please explain interest rate parity step by step? Thanks

Answer 1

Interest rate parity :

It is a theory where the difference in interest rate between two countries is equal to the difference between forward and spot exchange rate . It is an important variable in foreign exchange markets . The interest rate parity says 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 . There are two kinds of interest rate parity : covered and uncovered .

Interest rate parity gives us the break even condition where the return on a domestic currency investment is identical with the return on a foreign currency investment covered against exchange risk .