Interest Rate parity theory - Foreign Exchange

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Interest Rate parity theory

Interest Rate parity theory states that foreign exchange rate between currencies are directly dependent on their interest rate differential.

As per this theory, in a free and efficient market, interest arbitrage is not possible.

If interest rate of a currency is higher, the currency will be at discount in future, the gain of higher interest rate will be set-off by loss on account of discount in currency value and vice-versa.

Let " X " and " Y " be two currency.

According to Interest Rate parity theory, whether you invest in " X " and " Y " , on maturity your relative wealth will be same.

According to Interest Rate parity theory, the rate of Discount/Premium of currency " X " (in comparison with currency " Y " = ( Ry - Rx ) / ( 1 + Rx )

Where,

Rx and Ry is Real Rate of Interest of currency " X " and " Y " respectively.

Real Rate of Interest (The Fisher Effect)

According to Prof. Fisher, the expected inflation rate of a country has an important effect on money- interest rate ( also known as Nominal-Interest rate) in the country.

Nominal-Interest rate is effected by Inflation rate.

The Fisher principal of interest rate is -

( 1 + Real Interest rate ) X ( 1 + Inflation rate ) = ( 1 + Nominal-Interest rate )

Example

If real rate of interest is 10%, inflation rate is 20% then,

Nominal-Interest rate=(1 + 0.10) X ( 1+0.20)

=> Nominal-Interest rate = 1.32

=> Nominal-Interest rate is 32%.

Thank you for reading.

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