The Interest Rate Parity theory is a hypothesis that suggests that the difference between the spot rate and forward exchange rate of two currencies is equal to the differential of the interest rates of two countries.
According to the theory, the interest rate differences in the two countries are offset by the difference in the spot exchange rate and forward exchange rate differences of the currencies of these countries over a period of time.
Spot exchange rate is the exchange rate between two currencies at the present time in the forex market. This exchange rate can be obtained from financial institutions such as banks.
Forward exchange rates are predicted exchange rates between two currencies at a future point in time. This rate is predicted for major currencies in the world and can be obtained from financial institutions. The forward exchange rate can also be calculated using different models.
This theory makes some assumptions which must be true to obtain an accurate forward exchange rate. It assumes that the transactions are taking in a perfect market with capital mobility.
This means there are no restrictions on borrowing funds and moving funds to other countries. Furthermore, this theory assumes perfect asset substitutability. This means that assets in both countries will be the same class and have the same risks associated with them.
The interest rate parity theory has some advantages when used properly. These advantages are as below:
1) Used to Predict Forward Exchange Rates
The main advantage of the interest rate parity theory is that it can be used to calculate the forward exchange rates of currencies. The information to calculate the forward exchange rates of currencies can be readily obtained from the market or financial institutions of countries.
The formula to calculate the forward exchange rate of a currency using the interest rate parity theory is as follows:
F = S x (1 + ia / 1 + ib)
Where F0 represents the forward exchange rate of a currency at a future point in time. S0 represents the spot exchange rate of a currency at the current point in time. While ia and ib represent the interest rate in two countries.
The interest rate parity theory represents a no-arbitrage state of foreign exchange rates. Arbitrage is the idea that entities can benefit from the difference in market values of identical items in different markets.
For example, an investor buys a share for $10 in one market and at the same time sells the same share in another market for $11. This happens due to the lack of information between the two markets. This lack of information can be exploited by entities to make profits.
When the interest rate parity theory is true, entities cannot profit using arbitrage in different countries. For example, if an investor borrows money in one country with an interest rate of 5% and invests it in a country with an interest rate of 8%, they cannot profit from it.
This is because, according to the theory, this difference in interest rates is effectively offset by the difference in the exchange rates of the currencies of the two countries over time. This difference in exchange rates over time is due to interest rate differences of the two countries.
3) Describes Relationship Between Interest Rate and Exchange Rates
The interest rate parity theory can be used to describe the relationship between the exchange rates of currencies and the interest rates of countries. According to this theory, a country with a higher interest rate as compared to another country will have the value of its currency fall against the currency of the country with lower interest rates.
For example, if Country A has an interest rate of 10% and Country B has an interest rate of 8%, by the end of a period, the currency of Country A will devalue against the currency of Country B. According to the theory, this fall in the value of the currency will be in line with the difference between the interest rates of the two countries, i.e. 2%.
The interest rate parity theory is a theory that suggests a strong relationship between the stock exchange rate and forward exchange rate of currencies of two countries and the interest rates that are prevalent in those countries.
Using the interest rate parity can have many advantages because it can be used to predict the forward exchange rate of currencies, can be used to represent no-arbitrage state, and can also be used to describe the relationship between interest rates and exchanges rates of two countries.