The interest rate parity is a theory that suggests a link between the interest rates in two countries and the difference between the spot rate and forward rate of the currencies of the two countries.
It suggests that the difference between the forward exchange rate and spot exchange rates of two countries after a specific amount of time depends on the interest rates in the two countries.
According to the theory, after a certain period of time, often taken as 1 year, the difference between the spot rate and the forward exchange rate is offset by the difference between the interest rate in two countries.
The interest rate parity is a no-arbitrage theory. Arbitrage is the process when entities try to take advantage of difference in market prices of different commodities to make a profit.
For example, if the interest rate in one country is higher than that of another country, entities can simply take a loan in the country with a lower interest rate and invest it in the country with a higher interest rate and make a profit.
This means the entity has to pay a lower rate in the country it has borrowed from and receive a higher rate in the country it has invested in.
Interest rate parity theory suggests that while the entity can make a profit through interest income in the country with a higher interest rate, this interest income is offset by the loss the entity makes due to loss of value of the currency of the country with higher interest rate.
This is the main idea of the interest rate parity; however, this theory is not always effective and is limited by some assumptions that the theory makes.
The limitations of the interest rate parity theory are as below:
1) Assumes Perfect Market
The interest rate parity assumes a perfect market. A perfect market is a market where all information is readily available to the market participants.
Perfect markets are also characterized by a high number of transactions, homogenous products, no barriers to entry, and no transaction costs. The perfect market is a theoretical market and does not exist in the real world.
When interest rate parity suggests an offset between interest rates and spot and forward exchange rates of currencies of two countries, it assumes a perfect market exists.
This means that the interest rate parity theory assumes that the only factor that affects the difference between forward and spot exchange rates is the interest rates of the two countries.
However, in the real world, due to market imperfectness, there may be more than these reasons that dictate the differences between the two rates.
2) Assumes Capital Mobility
Another limitation of the interest rate parity theory is that it assumes capital is freely mobile. It means that the theory assumes that entities can easily move the capital from one country to another.
This also relates to perfect markets as it also assumes that there are no transaction costs in moving the capital from one country to another.
In real world, capital is not freely mobile. To transfer capital from one country to another, entities must bear different type of costs.
These costs can be in different forms such as taxes and tariffs on the transfer of capital. Some countries may even limit the amount of capital that can be transferred from or to it.
Furthermore, there are different rules and regulations both national and international that must be considered when moving the capital from one country to another.
3) Assumes Perfect Asset Interchangeability
The interest rate parity theory also assumes that assets are perfectly interchangeable in two countries.
It assumes that entities looking to borrow in one country and invest it in another country can find instruments of the same class and risk in both countries.
This is not true in the real-world as different countries do not have the same class of assets with similar risks.
4) Assumes No-arbitrage
As mentioned, the interest rate parity assumes arbitrage does not exist. This is mainly due to the other assumptions that the theory makes. In the real world, entities exploit market conditions in many ways to achieve arbitrage.
No-arbitrage only exists inefficient markets, however, as demonstrated above, efficient markets do not exist due to different types of market deficiencies.
The interest rate parity theory suggests the difference in the spot exchange rate and forward exchange rate of two currencies after a period in time depends on the differential of the interest rates in the two countries.
This theory may be useful to determine the forward exchange rate of a currency but it has some limitations due to the assumptions it makes.
These assumptions are assumptions of a perfect market, assumption of capital mobility, assumption of asset interchangeability, and assumption of no-arbitrage.