Interest rate parity is like you having a good hair day. It’s a theory, and it doesn’t always exist (but sometimes does).
To be able to spot a parity, we’re looking at interest rates in two different countries that trade capital easily with each other. Interest rate parity is the theory that the difference between the interest rates of two countries is due to the expected appreciation or depreciation of the currency.
For instance, say there’s Little Pony Kingdom and Big Bird Kingdom, and they both allow their people to invest in each other’s banks and currencies. If Little Pony kingdom’s interest rate was 5% and Big Bird kingdom’s interest rate was 7%, then interest rate parity theorizes this is because investors expect Little Pony currency to appreciate by 2%, or Big Bird currency to depreciate by 2%.
The idea is that, if investors could make more money simply by putting their money into higher interest rate accounts, they would (and do). In countries that swap money like it ain’t no thang, you’d think everyone would be putting their money in the “smarter” place where it’d make more money. But, of course, some currencies are more stable than others. So the theory is that investors stay in lower interest investments if they think that currency will be worth more in the future.
The idea is that the returns from investing in either country should be the same, regardless of their interest rates. Forex traders that try to find the better place to park their cash use parity to make more money (well, they try, anyway).
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Finance: How does foreign exchange work?11 Views
Finance allah shmoop how does foreign exchange work All right
Well there's risk when you buy and sell goods and
services outside of the u s that isn't there when
you buy and sell goods inside the u s your
smoothies and absence a major chain of a thousand smoothie
shops you buy a million bananas a year the customers
believe that they have a peel you buy all of
them plantains actually these little guys from uganda and just
agreed to pay in ugandan shillings One u s dollar
buys about four thousand ugandan shillings and that's a lot
of bananas You take the risk on the foreign exchange
currency because well you don't like hedging your bets you're
just going to take the risk if the currency moves
up or down it's on you horse at another way
Yeah if you were nervous about relative currency valuation fluctuations
well you could be a kind of currency life insurance
in paying a ten or twenty percent premium above where
the relative currencies air trading today that for thousands of
one thing and you could sleep pretty well at night
knowing that your rates were fixed like you're basically paying
Someone else to take the risk of uganda suddenly getting
its financial act together in its currency skyrocketing so that
a u s dollars only buys you three thousand or
two thousand ugandan shillings or things go the other way
But you don't like buying insurance You know how nice
the jets are that insurance executives fly and you know
about warren buffett He didn't get there for free so
you didn't had you didn't do anything to worry about
currency but then all of a sudden china decides to
adopt uganda as its new financial partner agreeing toe underwrite
all of uganda's debts basically in return for well uganda
Yeah they liked owning uganda way better weather and they
also got the highly prized you r l uganda dot
com So then almost literally overnight the ugandan shilling becomes
highly more valued under the deeply respected and feared auspices
of the chinese banking system So instead of a dollar
buying you for thousand schillings while now a u s
dollar only buys you one thousand so your cost of
bananas just went from four hundred bucks a ton to
sixteen hundred bucks and the marginal cost of those banana
Plantain Things in your shakes went from thirty cents over
a dollar twenty and with profit margin per shake it
only two fifty to start with twelve new profit margins
suddenly dropped almost in half Eventually you'll have to find
another banana supplier or raise prices or figure out a
substitute But well for now it looks like this Foreign 00:02:29.253 --> [endTime] exchange deals Profits will get eating