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Forex Fundamental Analysis What is Interest Rate Parity (IRP)


Interest East forex cashback parity provides that the appreciation (depreciation) of one currency aga cashbackforexbtcst another must be offset by changes in interest rate differences For example, suppose you are an investor in forexcashbackcalculator A and have a free hand to move in and out of the financial markets of your country and country B. Assuming that there are no restrictions and transaction costs on the international movement of funds, there Eastforexcashback a choice of which countrys financial market to invest in. When making the choice, if other conditions remain unchanged, it is obvious to see which countrys return is higher assume that the one-year interest rate in country A is i, the same period interest rate in country B is i^*, the spot cashback forex rate is e (direct markup method) if invested in the domestic financial market, then each unit of domestic currency can be appreciated to maturity: 1 × (1 + i) = 1 + i if invested in the financial market of country B, it can be divided into three steps: in the domestic foreign exchange market into the currency of country B, in country B, in country B, in the foreign exchange market, in country B, in country B, in country B, in country B, in country B. If we invest in the financial market of country B, we can convert the currency into the currency of country B, make a deposit in the financial market of country B for a period of one year, and then convert the deposit into the national currency after maturity, but there is an exchange rate problem. investment depends on the high or low rate of return of these two ways if 1+i>f(1+i^*)/e, then we will invest in the domestic financial market; if 1+i<f(1+i^*)/e, then we will invest in the financial market of country B; if 1+i=f(1+i^*)/e, then investing in the financial market of both countries can be in the market of other investors also face The same decision choice therefore, if 1+i<f(1+i^*)/e, then many investors will invest their money in the financial market of country B, which leads to the foreign exchange market on the spot purchase of the currency of country B as well as the forward sale of the currency of country B behavior, so that the depreciation of the local currency (e increases), forward appreciation (f decreases), the rate of return on investment in the financial market of country B decreases only when the two types of investment The market is in equilibrium only when the yields of these two forms of investment are identical. Therefore, when investors take the hedge transaction of holding forward contracts, the market will eventually make the following relationship between interest rates and exchange rates: 1+i=f(1+i^*)/e Collation gives: f/e=(1+i)/(1+i^*) We note that the rate of appreciation (discount) between spot and forward exchange rates is ρ, that is, ρ=(f-e)/ e Combining the above two equations yields: ρ=(f-e)/e=(1+i-(1+i^*))/(1+i^*)=(i-i^*)/(1+i^*) i.e.: ρ+ρi^*=i-i^* Since both ρ and i^* are very small values, their product ρi^* can be omitted, i.e.: ρ=i-i^* The above equation is the general form of the interest rate parity of the hedge its The economic implication is that the forward rate of appreciation and discount of the exchange rate is equal to the difference between the interest rates of the two currencies If the home rate is higher than the foreign rate, the local currency will depreciate in the forward; if the home rate is lower than the foreign rate, the local currency will appreciate in the forward That is, the movement of the exchange rate will offset the difference in interest rates between the two countries, so that the financial market is in equilibrium Interest rate parity theory is proposed by Keynes and Einziger forward exchange rate determination The theory they believe that the equilibrium exchange rate is formed by foreign exchange transactions caused by international arbitrage in the case of differences in interest rates between the two countries, capital will flow from the low interest rate country to the high interest rate country to make profits but arbitrageurs in comparing the rate of return on financial assets, not only consider the rate of return provided by the interest rate of the two assets, but also consider the change in the return of the two assets due to changes in the exchange rate, that is, foreign exchange risk arbitrageurs often combine arbitrage with swap business to avoid exchange rate risk and ensure no risk of loss a large number of swap foreign exchange transactions are the result of the low interest rate country currency spot exchange rate down, the term exchange rate up; high interest rate country currency spot exchange rate up, the term exchange rate down forward spread for the difference between the term exchange rate and the spot exchange rate, thus the low interest rate country currency will appear forward appreciation, the high interest rate country currency will appear forward With the continuous carry out of the throwback arbitrage, the forward spread will continue to increase until the two assets provide exactly the same rate of return, then the throwback arbitrage activity will stop, the forward spread is exactly equal to the interest rate differential between the two countries, that is, interest rate parity is established so we can summarize the basic point of interest rate evaluation: the forward spread is determined by the difference between the two countries interest rates, and the high interest rate country currency in the forward exchange market must be However, transaction costs are a very important factor. If all kinds of transactions are too high, it will affect the arbitrage income, thus affecting the relationship between exchange rates and interest rates. 2. Interest rate parity assumes that there are no barriers to capital flows and that funds can flow smoothly and without restrictions between countries, but in reality, the flow of funds between countries is hampered by exchange controls and underdeveloped foreign exchange markets, etc. At present, only in a few international financial centers there is a well-developed futures market, and the flow of funds is less restricted. The scale of arbitrage is infinite, so arbitrageurs can continue to cover arbitrage until interest rate parity is established