Interest Parity
Interest rate parity is a theory that attempts to explain the development in exchange rates with respect to the relative interest rates between countries.
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theory includes both covered and uncovered interest parity, and said that interest rates in two countries and exchange between the two countries' currencies will eventually adjusted to effect changes in relative interest rates offset by changes in the exchange rate. It will not be possible to make risk-free investments in foreign currency (arbitrage). A change in the relative level of interest rates in foreign countries will lead to appreciation or depreciation of the domestic currency.
Interest Parity Example
If the risk-free interest rate in euro is reduced relative to interest rates in the euro area, then (if all else being equal) the euro currency, according to the idea of interest rate parity depreciate (depreciate) so that it does not pay to take out loans in euro, which may place without risk to a higher rate in the euro area.
Uncovered interest rate parity
Uncovered interest rate parity describes the relationship between the spot price and forward price of foreign currency. Spot exchange rate is the price of immediate delivery of foreign currency (and is the one usually refers to the. Forward exchange rates, the price of future delivery of foreign currency (from three days and up). Equation for uncovered interest parity can be set up as TP = ih-iu = (FS) / S, where TP is the forward premium (the difference between the spot rate and the forward rate), F is the forward rate and S is the spot rate.
It has not been shown that interest rate parity has been in effect for 1990. Contrary to the theory of interest rate parity says, have currencies with high interest rates typically appreciated rather than depreciated, possibly as a result of subdued inflation and as a result of a currency that offers higher interest rates appear to be more attractive.
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