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+ Arbitrage condition that must hold when international financial markets are in equilibrium.

+ Provides a linkage between interest rates in two different countries.

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When IRP doesn’t hold, the situation also gives rise to covered interest arbitrage

opportunities.

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Being an arbitrage equilibrium condition involving the (spot) exchange rate, IRP has an immediate implication for exchange rate determination.

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Governments sometimes restrict import and export of money through taxes or outright bans.

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Reasons for Deviations from Interest Rate Parity

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Reasons for Deviations from Interest Rate Parity

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Theory of purchasing power parity (PPP): The exchange rate between two currencies should equal the ratio of the countries’ price levels

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PPP Deviations and the Real Exchange Rate

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PPP Deviations and the Real Exchange Rate

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The Fisher effect holds that an increase (decrease) in the expected inflation rate in a country will cause a proportionate increase (decrease) in the interest rate in the country.

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If the Fisher effect holds in the U.S.

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the Fisher effect holds in U.K,

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if the real rates are the same in each country

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the International Fisher Effect (IFE): suggests that the nominal interest rate differential reflects the expected change in exchange rate.

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IFE combine with IRP

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Financial Markets are efficient if prices reflect all available and relevant information.

If this is so, exchange rates will only change when new information arrives,

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random walk hypothesis

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s = natural logarithm of the spot exchange rate.

m − m* = natural logarithm of domestic/foreign money supply.

v − v* = natural logarithm of domestic/foreign velocity of money.

y* − y = natural logarithm of foreign/domestic output.

u = random error term, with mean zero.

α, β’s = model parameters.

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Technical analysis first analyzes the past behavior of exchange rates for the purpose of identifying “patterns” and then projects them into the future to generate forecasts.

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forecasters cannot do a better job of forecasting future exchange rates than the forward rate.