What is the parity of interest rates?
Interest rate parity is an economic theory involving interest rates in two countries and a exchange rate between their currencies. The theory says that the difference in exchange courses will be proportionally the same as the difference between the exchange rate now and the exchange rate for trades that are now agreed, but later. If the theory is correct, it means that there may be an opportunity to earn money when these proportions differ. Some economic theories question that there is a parity of interest rates.
There are three key variables in the parity of interest rate theory. One of them is the risk -free interest rate in each country. Since the risk -free rate is hypothetical, the calculations can work either with a credit rate of the central bank or the rates offered on government bonds. Both should be close enough to the guaranteed interest payment for a guaranteed rate for theory purposes.
The second variable is the shift exchange rate. This is the current -purpose exchange rate between the currencies of both countries. The third variable is the future rate.It is a predominant market rate for monetary futures contractions, which two investors agree to replace the currency in the future date at a fixed price. This rate will vary depending on how both investors predict that the rate of spot will change over time.
The theory of interest rate parity is that the proportional difference between interest rates will be equal to the proportional difference between the spot rate and the future rate. In most cases, the calculation will be based on interest rates in the next 12 months and the future exchanges that will be completed in 12 months. However, if the theory is correct, the parity applies to any period: the interest rate must be easily adjusted to cover the time. For example, if the future rate is in six months, Calculation performs half the annual interest rate of each country.
Although there are complicated explanations of how interest the interest rate works is generalThe principle that investors' behavior ensures that it exists. This is because usually, if there is a parity of interest rates, the investor gets the same yield of two different strategies: investing in country A now when establishing an agreement to convert money into Earth's currency after a certain period or converting into currency B and investing in the same period in country B. rates.