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 .

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Covered Interest Parity
Show how the equation in covered interest parity is derived.
Explain the theory.
Assume the current $/Euro exchange rate on the $/Euro exchange
rate on the FORWARD market is 1.05 dollars per Euro. If the US
interest rate is 6% and the EU interest rate is 10%, show what the
current $/Euro SPOT market exchange would be under the theory of
covered interest rate parity.

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can
i use expected return rate instead of interest rate when
calculating uncovered interest parity

Explain why, in order to preserve the interest rate parity
(IRP), a country with a higher nominal interest rate should have
its currency's forward exchange rate reflect expected depreciation
against currencies of countries with lower interest rates.

12. Explain. why., in. order. to preserve. the interest. rate.
parity. (IRP), a country. with a higher nominal interest rate
should have its currency's forward exchange rate reflect expected
depreciation against currencies of countries with lower interest
rates.

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