Saturday, September 5, 2009

The principle of interest-rate parity(1)

The foregoing example suggests an important rule regarding international capital flows and foreign-exchange rates: the rate of return to the investor from any foreign investment is equal to the interest earned plus or minus the premium or discount on the price of the foreign currency involved in the transaction. The theory of forward exchange states that, under normal conditions, the forward discount or premium on one currency relative to another is directly related to the difference in interest rates between the two countries involved. More specifically, the currency of the nation experiencing higher interest rates normally will sell at a forward discount in terms of the currency issued by the nation with lower interest rates. And the currency of the nation with relatively low interest rates normally will sell at a premium forward relative to that of the high-rate country. A condition Known as interest-rate parity exists when the interest-rate differential between two nations is exactly equal to the forward discount or premium on their two currencies.
When parity exists, the currency markets are in equilibrium, and capital funds will not flow from one country to another. This is due to the fact that the gain from investing abroad at higher interest rates is fully offset by the cost of covering currency risk in the forward exchange market.

No comments: