Interest Rate Parity
Candlefocus EditorThe basic principle of interest rate parity is that when investing in different currencies, the return should be the same, regardless of the interest rate. The interest rate parity equation states that the return on a currency investment should be equal to the difference between the current exchange rate and the expected change in that exchange rate over the period of the investment, as a result of the interest rate differential.
For example, assume that a dollar-denominated asset is expected to pay a 4 percent return over a twelve month period, while a euro-denominated asset is expected to pay a 6 percent return over the same period. According to the interest rate parity equation, the net return on the dollar-denominated asset should be equal to the return on the euro-denominated asset, minus the expected change in the euro-dollar exchange rate over the twelve months.
This equation has implications for investors and forex traders alike. For investors, it serves as a reminder that when investing in different currencies, the return should be the same regardless of the interest rate. This means that investors should not assume that higher interest rates will automatically generate higher returns.
For forex traders, this equation can help them identify arbitrage opportunities. If the equation is not satisfied, then there is an arbitrage opportunity - meaning that one currency is undervalued relative to the other, and has the potential to generate more return that expected.
Overall, interest rate parity is an important concept to understand for anyone involved in currency trading, or investing in different currencies. It serves as a reminder that the return on investments should be the same regardless of the currency, and it can also be used to identify potential arbitrage opportunities.