# Examples Of Interest Rate Parity Theory

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2.1.3 Interest rate parity Interest rate parity (IRP) theory states that the difference between the interest rates of two countries is equal to the difference between the spot exchange rate and the forward exchange rate. IRP is an important factor in foreign exchange markets which assumes that there is a relationship among interest rate, spot exchange rate and forward exchange rate. There are two forms of IRP which are the covered interest rate parity and the uncovered interest rate parity. Covered interest rate parity theory states that there is equilibrium between the interest rates of two countries and their spot and forward currencies. Therefore, it is impossible for investors to make an arbitrage profit. The forward exchange rate is also…show more content…
On the other hand, uncovered interest rate parity theory states that there is equality between the difference in the interest rates of two countries and the estimated change in their exchange rates. There is the possibility for an investor to make an arbitrage profit if the parity does not exist. The uncovered interest rate parity can be expressed as follows: Where, is is the interest rate in one country; Et (St+k) is the expected future spot exchange rate at time t + k; k is the number of periods in the future from time t; St is the current spot exchange rate at time t; ic is the interest rate in another country. 2.1.4 Fisher theory The economist Irving Fisher introduced the Fisher theory in his Theory of Interest (1930) which explains the relationship that exists between inflation and the real and nominal interest rates. Mankiw’s Macroeconomics (2012) stated that “According to the Fisher equation, a 1 percent increase in the rate of inflation causes a 1 percent increase in the nominal interest rate. The one-for-one relation between the inflation rate and the nominal interest rate is called the Fisher Effect”. The Fisher Effect can be written as the following equations:…show more content…
On the other hand, if inflation rate decreases, then nominal interest rate will decrease while real interest rate will increase. Thus, there is a positive relationship between inflation rate and nominal interest rate whereas there is a negative relationship between inflation rate and real interest rate. 2.1.5 Spot exchange rate Spot exchange rate is the rate at which the transaction between two countries is done where there is an immediate exchange of their currencies. There is a delay of two days for the transaction to be settled. For example, on 18 November 2015, one British pound can be exchanged for Rs 55.01 immediately. (Source: Mauritius Rupee Exchange Rate) 2.1.6 Forward exchange rate Forward exchange rate is the rate at which a transaction can be conducted at the current exchange rate where payment and delivery are expected to be done at a later date. The relationship between spot exchange rate and inflation or interest rates in both the domestic and foreign countries determines the forward exchange rate. The main reason why countries enter into forward contracts is to protect themselves against exchange rate movements that occur between the time the transaction is made and when payment/delivery is