Financial Management: Principles and Applications, 13/e

19.2 Interest Rate and Purchasing-Power Parity

The concepts of interest rate and purchasing-power parity provide the basis for understanding how prices and rates of interest across different countries are related to one another.

Interest Rate Parity

Interest rate parity is a theory that relates the difference in the interest rates between two countries to the ratio of the spot and forward exchange rates of the two countries’ currencies. Specifically, the interest parity condition can be stated as follows:

$$\begin{array}{c}\text{Difference}\text{in}\\ \text{Interest}\text{Rates}\end{array}\text{=}\begin{array}{c}\begin{array}{l}\text{Ratio}\text{of}\text{the}\text{Forward}\end{array}\\ \begin{array}{l}\text{and}\text{Spot}\text{Rates}\end{array}\end{array}$$

$${\displaystyle \frac{\left(1+\begin{array}{c}\text{Domestic}\\ \text{Rate}\text{of}\text{Interest}\end{array}\right)}{\left(1+\begin{array}{c}\text{Foreign}\\ \text{Rate}\text{of}\text{Interest}\end{array}\right)}}=\left({\displaystyle \frac{\text{Forward}\text{Exchange}\text{Rate}}{\text{Spot}\text{Exchange}\text{Rate}}}\right)$$ (19–5)

This equation can be rearranged such that

$$(1+\begin{array}{c}\text{Domestic}\\ \text{Rate}\text{of}\text{Interest ...}\end{array}$$