Currency Forecast Interest Rate Parity

Interest Rate Parity

Interest rate parity theory holds that if two different currencies have different interest rates, then in order to prevent risk-free arbitrage, the difference in interest rates will be reflected as a premium or discount on the forward exchange rate.

For example, if the US interest rate is 3% and Japan's is 1%, the dollar should depreciate by 2% against the yen to prevent risk-free arbitrage. The forward rate announced that day reflects future exchange rates. In our example, the forward rate of the dollar is called "discount"IEXSforeign exchangeThe reason is that the forward exchange rate can only buy less yen than the spot exchange rate. In contrast, the yen is called "premium".

In recent years, the theory of interest rate parity has proved to be of little use. Generally, currencies with higher interest rates rise because central banks decide to raise interest rates to slow down a fast-growing economy. This has nothing to do with risk-free arbitrage.