Interest Rate Parity
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Interest rate parity is an economic concept, expressed as a basic algebraic identity that relates interest rates and exchange rates. The identity is theoretical, and usually follows from assumptions imposed in economic models. There is evidence to support as well as to refute the concept.
Interest rate parity is a non-arbitrage condition which says that the returns from borrowing in one currency, exchanging that currency for another currency and investing in interest-bearing instruments of the second currency, while simultaneously purchasing futures contracts to convert the currency back at the end of the holding period, should be equal to the returns from purchasing and holding similar interest-bearing instruments of the first currency. If the returns are different, an arbitrage transaction could, in theory, produce a risk-free return.
Looked at differently, interest rate parity says that the spot price and the forward, or futures price, of a currency incorporate any interest rate differentials between the two currencies assuming there are no transaction costs or taxes.
Two versions of the identity are commonly presented in academic literature: covered interest rate parity and uncovered interest rate parity.
Covered Interest Rate Parity
Covered Interest Rate Parity is also known as Interest Parity Condition. It assumes that the ‘interest rate return from different currencies will be the same if one covers against currency changes.’ That is, the returns will be the same when you invest USD in US deposits and the same dollar amount in a foreign currency, and protect that investment using a forward on the foreign currency.
Uncovered Interest Rate Parity
Uncovered Interest Rate Parity is a condition that assumes that ‘the difference between the interest rate of two currencies will be equal to the expected depreciation of a currency.’ That is, a 10% depreciation of the USD against any foreign currency is to be compensated by a 10% rise in the interest rate of the dollar.