Concept of Interest Rate Parity

Concept of Interest Rate Parity

Interest rate parity explains the relationship between interest rate and exchange rate. If domestic country offers high interest rate as compared to foreign currency then domestic currency will depreciate as compared to foreign currency because high interest rate will result in more supply of domestic currency.

Similarly if domestic currency interest rate is lower than foreign currency then it will appreciate the domestic currency as compared to foreign currency. This theory is very similar to purchase parity theory.

Example of Interest Parity

$/Pound	1.8000
US Interest Rate	8%
UK Interest Rate	5%

Solution

1.       First Currency & 2^nd Currency

First currency is USD and 2^nd Currency is pound.

Formula for future Exchange Rate = Spot Rate x (1+ Interest first Currency)

                                                                                        (1+ interest rate 2^nd Currency)

= 1.8000 x (1.08)/ (1.05)

= 1.8000 x (1.0285)

=1.8513

Above example clearly indicate that high interest rate in the country will create pressure on the currency and will result in its devaluation as compared to foreign currency.