Question

What are the two primary theories from international finance that try to predict FX rate changes from interest rate? How are they different?

Answer 1

Interest Rate Parity is the theory that considers the relationship between interest rates and currency exchange rates. It narrates that interest rates doesn't effect the hedged return from investing in different currencies as hedged returns are considered to be the same.

The two versions of interest rate parity are:

1) Covered Interest Rate Parity

2) Uncovered Interest Rate Parity

1) Covered Interest Rate Parity: In this forward exchange rate is used to bridge the gap between the interest rates of two currencies. In this investors borrows from a low-interest rate currencies and investing it in a high interest rate currencies by hedging through forward rates. There is no role of interest rate advantage.

2) Uncovered Interest Rate Parity: In this expected change in exchange rates are considered to be the same as interest rate difference. If there is a 2% difference in the interest rates of two countries, then expected change are likely to be 2% in the exchange rate. Thus, parity exists.

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